No Bunnies & Elephants with Negative Interest Rates

BunnyThe idea of negative interest rates has been given renewed attention with the Bank of Japan being the latest central bank to actually implement negative rates on some deposits. Recently, Bloomberg Business published a cute cartoon featuring Janet Yellen and bunnies to explain the theory of how negative interest rates are supposed to work. Unfortunately, this theory is fatally flawed and a more apt cartoon illustration would be Dr. Seuss’s The Cat in the Hat Comes Back.

The Theory
We covered negative interest rates a year ago when European bonds started trading at yields below 0%; so for a crash course or refresher on what negative interest rates are and how they work, check out our previous article first.

Bloomberg’s cartoon starts with the fact central bankers want negative interest rates to incentivize spending and borrowing and to deter people from hoarding money. People are not dumb, and if they are charged money on their savings in a bank, they will take it out and stick it under a mattress rather than pay for it to sit in a bank.

Central banks, the theory goes, should instead focus on the big players: the banks. Since they have so much money and need to keep some of it in electronic form with the Federal Reserve, they won’t be able to ‘stick it under a mattress’. If central banks charge them on the margin (in other words, a portion of deposits, but not necessarily all of their deposits), then it should incentivize the big banks to hand out more loans.

More loans will spur businesses to invest, grow and hire more people. In addition, negative rates will drive down the value of the dollar, making exports cheaper, which will also fuel growth. Sounds like cute bunnies and sunshine right? Not quite.

The Reality: The Cat in the Hat Comes Back
The foundational flaw to this entire approach is the Keynesian idea of jump-starting the economy by trying to increase aggregate demand: borrowing and spending is the ultimate goal for central bankers. But sustainable spending can only come after savings, production and wealth creation.

If businesses don’t see opportunities to grow, and if banks don’t see credit-worthy customers to whom to lend, and if consumers are tapped out and don’t want to take on more debt, then making interest rates lower is not going to help. These are signs of structural problems that can only be fixed by the liquidation of bad investments and reallocation into more productive ones.

In other words, this theory is pushing on a string, and a better illustration of the problem would be the childhood book The Cat in the Hat Comes Back by Dr. Seuss. The Federal Reserve and other central banks have created the initial pink ring around the bathtub with too much debt and easy credit. Like Dr. Seuss’ Cat, central banks continue to try to rid the world of their initial problem, only to make it worse, spreading it to other areas and creating new problems in the process.

One part of the Bloomberg cartoon that is correct is the recognition that people are not dumb and will withdraw their money from a bank that demands payment for storing it there. We may be witnessing this already. Even though retail banks in Japan have not yet enacted negative rates, they did lower their deposit rate, and citizens are obviously worried it will get worse because sales of safes have recently soared as the Wall Street Journal reports.

Truth Can Be Stranger Than Fiction
It gets worse. Realizing that cash imposes a hurdle to employing negative rates, central bankers and economists have started to talk seriously about an outright ban on cash! Harvard economist Kenneth Rogoff has made calls to ban cash to implement negative rates; while most recently, former Treasury Secretary Larry Summers advocated getting rid of the $100 bill and 500 euro note, albeit under the pretense of curbing crime and illicit activities.

If people are not dumb and will seek alternatives to negative rates, what makes central bankers think that other bankers are dumb and will keep their money at negative rates? Banks will find other ways to compensate, by either passing on these negative rates to consumers, or more likely, try to disguise them and compensate with other fees. Consumers will follow suit, finding ways to get rid of excess money balances, perhaps by prepaying utility bills and taxes.

Creating more credit or attempting to induce people to take out more loans will not create wealth. Contrary to Seuss’ story, there is no magical “Voom” tool to set everything right before anyone gets hurt. What ultimately needs to happen is for central banks to get out of the business of trying to control or stimulate the economy with their monetary tools and let people’s savings and time preferences set the appropriate rate of interest.

Chris Kuiper, CFA is currently a student and researcher at George Mason University, pursuing a Master’s of Economics. His previous experience includes asset management, investing and banking.