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The Truth About Those Negative Interest Rates

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It’s interesting to see someone in the journalistic tribe actually getting the impact of negative interest rates right. That being that it could be entirely counterproductive to drop them below zero. Go far enough below zero and it would, absolutely, be counterproductive. We don’t know exactly where the dividing line between that could and would is even as we know that it’s there.

An unfortunate good guess is that it’s probably somewhere before negative interest rates would do much good anyway.

What surprises even more is that this good sense is in that sinkhole of economic understanding, The Guardian:

Of course, there was more substance to Bailey’s argument than that. Like his predecessors, he argued that negative rates would put a huge strain on high street banks, which would see their profit margins on lending squeezed. Tighter margins would lead them to accept households and businesses with only the safest credit histories, meaning fewer loans would be granted. Rather than being expansionary, negative rates would lead to a contraction in borrowing – the opposite of what the central bank wanted to achieve.

Hmm, well, yes, it would be contractionary at some rate but not so much because of bank profit margins:

The problem lies with savers who are offered negative interest on their savings. What happens if they refuse to accept this new reality? They will take their deposits out of the banks and find another home for them.

Gold is the usual safe haven from negative interest rates, but middle-income families are unlikely to start buying bars of the stuff or even derivatives of gold that allow punters to buy and sell more easily. Cryptocurrencies on the other hand – long seen as an esoteric and volatile form of money – could take off even more than they have already with mainstream savers.

And, deprived of deposits, the high street lenders will then lack the reserves they need to lend, defeating the object of the exercise

Well, yes. Although even that’s not the basic worry. And soon enough we’ll have the MMT crowd along to insist that banks don’t lend out deposits anyway. Sigh. The MMTers always, but always, missing that the bank does have to fund a loan with a deposit by 4.30 pm on the day of the loan.

The way to cut through all that misunderstanding is to take a step back to the money supply. A falling money supply is contractionary – both MMT and Milton Friedman are with us there. And much of the money supply – less in these troubled times, some 97% in normal – is produced by that banking system in the form of credit.

Cool beanz.

So, we lower interest rates, more credit is issued because the price looks right to more people, we gain that expansion in the wide money supply. But do still grasp that the banks need to get that credit back into their books, they’ve still got to attract the deposits in order to fund the loans they’ve just made.

So, what happens if interest rates go significantly negative? Just to show the argument, say 50%? Well, consider how you’d make money with a negative 50% interest rate. You borrow as much as you could, stick it under the mattress then bring half of it back in a year to give to the bank and you’d have made 50% of the sum borrowed, right? OK, you’ve got the risk of the mattress getting riffled but at some negative rate you’d happily take that.

But that’s ludicrous – and it is. But at some interest rate between minus 0.1% – which is a who the hell cares rate – and minus 10% we’ll trigger that sort of behaviour. People with money won’t put it in the bank. They’ll switch to cash which goes into a vault. And what’s our dividing line here? Around and about the cost of gaining cash to put into the vault then guarding it while it’s there. 1% per annum say? 2%? Summat in that region.

And note what happens, cash in the vault can’t be used by the banking system as a deposit to fund loans. Well, cash that belongs to the bank can be but not cash owned by not the bank.

The end result of this being that significantly negative interest rates reduce the wide money supply, exactly the thing we’re trying to avoid – or the opposite of what we’re trying to create – by playing with interest rates in the first place.

What the actual number is? Wouldn’t surprise to find it is of the order of 1%. Which is about as low as we can make interest rates then, minus 1%.

That is, while negative rates are possible they’re not hugely useful because using them to any great extent causes the very problem we’re trying to avoid.

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