Negative Interest Rates Aren't a Solution to the Crisis

Includes: DIA, SPY
by: Nikhil Raheja

All deposits at commercial banks are stored at the respective central banks. This is a service provided by the Central Bank to the bank, for which it charges no commission or fee. Some central banks do however offer a little interest on the deposits they store for the banks. This policy measure allows the central banks to manipulate interest rates in the economy since a commercial bank would be disinclined to lend the money to another bank or a customer at 5% if the central bank offers it 6% on the deposits it is already holding. Conversely, the central bank may lower the interest it offers to the commercial bank and give an incentive to lend at lower rates to customers. To create negative rates, the central bank can decide to “charge” the commercial bank an interest for storing the funds with the central bank. So for every day the commercial bank sits on deposits, it would be charged for the privilege of doing so. To prevent getting penalized for depositing funds at the Central Bank, the commercial bank must dispose of the money. It would naturally do so through the existing lending mechanisms, i.e. by lending it to another bank or to an individual.

This is a unique way to force the banks to lend money during a crisis, during which banks are generally hoarding their cash. If the central bank, say the Federal Reserve, charges the banks a rate of 10% annually for storage of funds, the commercial banks would try their best to lend the money at rates higher than -10%. So, a commercial bank would be happier lending it to a family at -7% than getting charged 10% interest for storing it at the Federal Reserve. This will have created negative interest rates in the economy. In July this year, the Swedish central bank did impose a charge on banks that store their deposits with it. However, the negative interest rates charged are less than perfect since a bank is charged an interest only if it fails to deposit the money with the central bank before 2pm every day, hence the banks in Sweden do have a way of getting around the problem of the negative rates.

Another technique of creating negative interest rates, as proposed by Gregory Mankiw of Harvard is if the

Fed were to announce that, a year from today, it would pick a digit from zero to 9 out of a hat. All currency with a serial number ending in that digit would no longer be legal tender. Suddenly, the expected return to holding currency would become negative 10 percent.

That move would free the Fed to cut interest rates below zero. People would be delighted to lend money at negative 3 percent, since losing 3 percent is better than losing 10.

What the above strategy overlooks is that not all money is currency. Only a certain portion of the total money in the economy is in the form of currency, the rest is notional money. Hence, only those holding currency notes would be under pressure to get rid of them, not those holding deposits at the Fed. When a bank receives cash deposits from a customer, it turns in the cash to the Fed, in exchange for the promise of withdrawals, when required. Hence, even though an individual got rid of his currency notes by depositing them at the bank, the bank simply turned them into the Fed, so no one was stuck holding the notes. Hence this strategy would simply encourage people and the banks not to hold currency notes, but not discourage bank deposits.

The futility of negative interest rates

Let’s suppose the Federal Reserve (Fed) does manage to use the first technique of charging the banks for storing their deposits with the Fed. It will encourage the banks to get rid of their deposits by lending them as soon as possible. This will create maximum loans in the economy since the banks would no longer be hoarding any money, hence eliminating the problem of lesser availability of loans. This would also eliminate the prospects of deflation temporarily.

However, it would do little to prevent the long term imbalances in the US total credit market debt composition. The US consumers and corporates are already leveraged up to the hilt, and are unlikely to borrow anymore. Negative interest rates will prompt people to borrow and hold on to the money, only to return a lesser amount to the bank later, but they are unlikely to use the money for either consumption or production. Hence, the whole task of providing loans at negative rates to people would prove futile.

The US consumers are neck deep in debt and are only likely to begin to borrow more once the debt levels fall to manageable levels. As can be noted in the graph below, the consumer and corporate debt levels usually peak around 100-150% of GDP each and fall for years. Until the debt levels have fallen significantly, borrowing for consumption and for businesses will stay low, even though negative interest rates may encourage borrowers to borrow to simply milk the opportunity to make free money. Professor Mankiw would do better by understanding the problem of too much credit market debt in the economy than by continuously harping about the merits of increased bank lending.

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