The global financial crisis has brought in an era of low interest rates. Eight years on from the onset of the crisis growth remains subpar and interest rates have drifted lower still, sometimes into negative territory.
In their search for new ways of boosting growth some central banks have set interest rates below zero. The European Central Bank (ECB) became the world's first central bank to do so in 2014. Denmark, Sweden, Switzerland and Japan have followed the ECB and introduced negative rates. In a development that seems to turn the rules of finance upside down, private sector banks in these countries have to pay the central bank to keep their money. The same logic is at work in the government bond market where investors are now paying the Japanese, German and Swiss governments for the privilege of lending them money.
Negative interest rates penalise the holding of cash and are designed to encourage banks to lend to companies and households. Central Banks want to force cash out of bank vaults and put it to work in the economy.
Our sense is that negative rates in the euro area have reduced the cost of borrowing and helped weaken the euro. In these respects the policy is working. But, like an experimental drug, the effects of negative interest rates are unpredictable and unlikely to be wholly benign. The risk of unintended consequences are high.
Negative interest rates make it difficult for savers to generate income. The most prudent and cautious households and firms are penalised, while incentives are created to borrowing and risk taking. This "search for yield" creates a danger of a boom/bust cycle in risky assets like real estate and emerging market assets. It is just such behaviour which helped cause the financial crisis.
Negative rates put yet more pressure on banks. They have to pay – rather than receive – interest on their deposits with the central bank and face lower, or negative returns, on their holdings of government debt. When banks try to pass on negative rates, savers may respond by holding on to their cash rather than paying a penalty to keep it the bank. Negative interest rates squeeze bank profits and challenge traditional models of banking.
In time banks may feel they have no choice but to try to pass negative rates on to customers. Last week a German bank last week became the second to say it would begin charging for holding retail customers' deposits. The Royal Bank of Scotland investment banking division recently announced it plans to charge some financial institutions for holding their cash. So far such examples of consumers and businesses facing negative interest rates on bank deposits is the exception rather than the rule, but this could change.
A world of negative interest rates means that cash is king since its worth, unlike that of bank deposits, remains constant. Japan has seen a surge in sales of safes since interest rates turned negative. The FT has reported that banks across Europe have been exploring "keeping piles of cash in high security vaults" to avoid having to pay Central Banks to lodge money with them. If this practice became widespread it could destroy the ability of central banks to affect lending behaviour by moving interest rates.
If keeping cash in a bank account costs money, the incentives for anyone with cash in a bank is to pay bills early. In an inversion of the usual rules the Swiss canton of Zug has urged its citizens to cease pre-payment of taxes and wait as long as possible to file their returns.
Far from encouraging more spending negative rates may be seen by the private sector as a sign that something is wrong. This, in turn, could make consumers and businesses more cautious. Other factors are at work, but in the face of negative interest rates savings rates in Germany, Japan and Switzerland have been heading up, not down, as theory would suggest.
And this is the nub of the problem. It is easier to describe how negative interest rates should work in theory than it is to demonstrate that they are working in practice. As with any economic policy, there is no counterfactual. We have little idea what would have happened in the absence of the policy.
The theory is simple and attractive. Penalising cash holdings incentivises lending, spending and risk taking. The reality is much more complex.
The pragmatic argument for negative interest rates recognises the risks – but accepts them as the price to be paid for a chance to bolster growth. In the world of medicine patients routinely accept similar trade-offs. In medicine, as in economics, time will tell whether the gamble has paid off.
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