I posted something on the Corner yesterday on the (unwelcome) trend towards negative interest rates in Europe and Japan. Much of my focus was on the effect that ultra-low (and indeed negative) interest rates were having on Germany. Last week, however, Morgan Stanley’s Huw van Steenis wrote a more general critique of negative rates in the Financial Times (and there are plenty more to choose from).
Conventional thinking is that negative rates are just a natural continuation of quantitative easing, like dialling down the air conditioning. This, though, underestimates how financial intermediaries may actually respond. They erode banks’ margins. They give lenders an incentive to shrink, not grow. They encourage banks to seek out opportunities overseas rather than in their home markets. They also risk disruptions to bank funding. All go against the grain of the central banks’ desire to ease credit conditions and support financial stability.
Driving rates through the “zero bound” is (in essence) an effort to force banks to lend and savers to spend. But there’s good reason (whatever else one thinks of the idea) to think that negative interest rates will be self-defeating, not least because of their damaging effect on banks’ profitability and thus their ability to lend:
One counter argument is that negative rates have so far proved fairly benign in Sweden, Denmark and Switzerland. The details are more troubling. Banks have tried hard to offset negative rates by charging more for lending — particularly for mortgages — and charging higher fees. As a result, borrowing costs have gone up not down.
The crux of the matter is this: the market is no longer sure how low rates might go in a range of countries. Peter Praet, chief economist of the European Central Bank, said last week: “As other central banks have demonstrated, we have not reached the physical lower boundary.” As long as this uncertainty remains, it is hard for banks to know whether the loans they are making are economically sensible or for investors to price banks’ securities with confidence. Beyond a further 10–20 basis point cut in the deposit rate of the ECB, the effect on banks’ earnings could start to be exponentially negative.
For banks, the indirect consequences of negative rates may matter more than the direct effect. There is a risk that market liquidity will be reduced, as negative rates mean financial intermediaries hoard high-yielding assets. There is also a question over how money market funds, which help many corporates to manage their finances, will navigate negative rates. In Japan all 11 companies running money-market funds have stopped accepting new investments.
Negative rates, if passed on by banks, could also start to erode consumer trust in banks as the right place for their cash. Sales of safes have risen in Germany and Japan since they were implemented.
A run on safes is not, to me, a sign of a healthy monetary policy.
In the course of a piece in the latest NRODT, I noted how the current “war on cash” offers a potential solution to some of those frustrated by the fact that (in essence) human nature puts a limit (those safes, for example) on how deep into negative territory interest rates can go:
In a speech last September, Andrew Haldane, the Bank of England’s chief economist, grumbled about the “constraint physical currency imposes” on setting negative interest rates. After considering various ways of dealing with this nuisance, he concluded that an “interesting solution” would be to “maintain the principle of a government-backed currency, but have it issued in an electronic rather than paper form.” This “would allow negative interest rates to be levied on currency easily and speedily.” Translation: Make people hold their cash in electronic form (and thus in banks); they will then have no means of escaping the levy on savings that negative interest rates effectively represent.
Before dismissing this as a form of madness that only Europeans could embrace, check out what Harvard’s Kenneth Rogoff has been saying. Writing in the Financial Times in May 2014, he argued that replacing paper money with an electronic alternative “would kill two birds with one stone.” It would strike a blow against crime, and it would free central banks from a bind that has “handcuffed” them since the financial crisis. “At present, if central banks try setting rates too far below zero, people will start bailing out into cash.” Indeed, they will: To its credit, the central bank of Switzerland, one of the countries now burdened with negative interest rates, has made it clear that it has no plans to junk its thousand-franc bills. It accepts that these are used as a store of value, something that Rogoff, no friend of the saver, might regard as reprehensible but the sensible Swiss do not. There has been a 17 percent increase in the number of these bills in circulation in the last year.
“Hoarding cash may be inconvenient and risky,” wrote Rogoff in a related paper, “but if rates become too negative, it becomes worth it.” He would clearly prefer to see that emergency exit locked and the key thrown away, leaving savers helpless in the face of whatever central bankers (and not only central bankers) might dream up.
And, no, that’s not a good idea.