The Absurdity of Negative Interest Rates

The European Central Bank (ECB) made waves recently with its decision to lower interest rates on its deposit facility to -0.30%. That means that banks wanting to park their money at the ECB have to pay the ECB for that privilege. The supposed reason for introducing negative interest rates is to spur lending on the part of banks. Rather than being able to park their money at the ECB for free or for a small guaranteed return, the ECB wants banks to put that money to use by lending it. The idea of negative interest rates was once seen as impossible to achieve by many central bankers. But since the ECB’s decision last year to introduce negative interest rates, the concept has become increasingly accepted among central bankers, with even a few Federal Reserve officials supporting the idea of negative rates. But are negative interest rates really feasible?

What we can’t forget is that the real rate of interest can never be negative. The real, or natural, rate of interest is a function of the preference for present goods over future goods. A bird in the hand is worth two in the bush, in other words. A negative natural rate of interest would mean that someone prefers less in the future to more in the present. Given the choice between $20 today and $10 tomorrow, you would prefer the $10 tomorrow. That is a complete absurdity that would never happen in reality. But when you realize that most of the assumptions made by mainstream economists in creating their models are absurd, unrealistic, and nonsensical, you can understand at least a little why those practitioners of voodoo mathematics think that negative interest rates are a potential policy tool.

If central banks continue to lower interest rates, it could paradoxically result in rising market interest rates. Consider the case of the average bank, which takes deposits and loans out money. The bank’s income is dependent on the spread between the interest rate the bank charges to borrowers and the amount of interest it pays to depositors. As central banks begin to introduce negative interest rates to their deposit facilities, charging banks to hold reserves at the central bank, banks have to find a way to recoup that money lost. If they begin to start charging negative interest rates to depositors, as one Swiss bank already has, they risk having depositors withdraw their funds from the bank.

Since deposits are what allow banks to loan money in the first place, banks may have to start calling in loans in order to satisfy depositors. As the amount of loans outstanding shrinks, the bank’s income will decrease. It can make up for that by downsizing its operations, laying off staff and closing facilities. The combination of reduced income and laying off employees sends a negative signal to markets, indicating that the bank is unsound, which could lead to even further depositor withdrawals and, in the case of a publicly traded bank, a decline in its stock price. The bank’s preferred solution then might be to keep income up by widening the spread between deposit rates and borrowing rates by increasing the interest rate charged to borrowers. And thus dropping into negative interest rates on deposits can lead to a rise in interest rates for borrowers.

That’s the problem when central banks decide to fool around with something so vital as interest rates. Expecting market interest rates to move in linear fashion along with the rates set or targeted by central banks is futile. Human beings are not computers that react in predictable fashion, with a change in input A resulting in a predictable change in output B. Central bankers, despite both theory and practice condemning their failures, still have not learned that lesson. Central banks continue to play with fire, as their monetary manipulation constantly results in economic booms and busts. By pushing rates into negative territory, they are pouring gasoline on that fire. Negative rates that are low enough to encourage deposit withdrawals risk collapsing the entire banking system, built as it is on an inverted pyramid of fractional reserves. While this wouldn’t be the first time central bankers have collapsed an economy through their own ignorance, arrogance, or stupidity, the ramifications in a world far more developed, far more interconnected, and far less familiar with hardship could be catastrophic. It’s time to pull out the canes and get these jokers off the stage before they do even more damage than they already have.

Image: Bloomberg