Understanding Negative Interest Rates and Their Impact on the Economy: Insights from Financial Advisor Tim Hayes

Globe on desk signifying global impact of negative interest rates.

There is much talk in the financial press about ‘negative interest’ rates—which adds yet another oxymoron to a list that includes ‘Great Depression,’ ‘jumbo shrimp,’ and ‘open secret.’

It is a head-scratcher that a person could deposit $1,000 at their bank and get $995 back. Were that true, they might as well have kept their money under the proverbial mattress.

The European Central Bank, Sweden, Denmark, Switzerland, and Japan have all implemented some form of ‘negative interest.’ None of these countries, however, has seen commercial banks charging their customers for depositing money.[1]

Instead, what the financial press is referring to is another desperate, misguided attempt by the Central Banks of these countries to increase bank lending. What they are hoping for is, if they charge banks for depositing money, banks will decide to make more loans to earn more interest rather than leave their money at the Central Bank and watch it deplete from deposit fees.

However, we had seen this scenario before, when the Central Banks of the world instituted quantitative easing. Here in the United States, bank reserves jumped from $46 billion in 2008 to around $2.7 trillion today. During this time, respected economists, journalists and politicians lamented that if we could just get commercial banks to lend those recently acquired reserves, happy days would be here again.[2]

But it never happened, because the theory that reserves multiply into loans—the so-called ‘money multiplier’—is a myth. This is a vestige of a time when countries were on the gold standard and, theoretically, the amount of gold a Central Bank owned dictated commercial bank lending.

In today’s world, the number of reserves that banks deposit at their Central Bank has almost no bearing on credit creation. Nor can the banking system reduce the total amount reserves by making loans.

Say I borrow $100,000 from Bank A. Along with the loan, Bank A will credit me back with a deposit for $100,000. If, the next day, I move the $100,000 from Bank A to Bank B, I will still have my $100,000 loan with Bank A, but my money will now reside in Bank B.

Bank A will then transfer $100,000 from their reserve account at the Federal Reserve to Bank B’s reserve account. Bank A will have less money earning negative rates; however, Bank B will have an extra $100,000 exposed to negative rates. Thus, making a loan will merely move reserves from one bank’s reserve account to another bank’s reserve account.

Moreover, banks are more concerned about being paid back the loan. So they are not going just to start lending money simply because a Central Bank is charging them for leaving excess reserves.

Penalizing banks for having too many reserves, when it was the Central Bank’s bond purchases that had credited the banks with the reserves in the first place, brings to mind a famous quote from another misguided economist, Karl Marx, that history repeats itself “the first time as tragedy [housing debacle/financial crisis], the second time as farce [quantitative easing/negative interest rates].”[3]

I am not one who believes that Central Banks are evil or that we need to audit our own Central Bank—the Federal Reserve. However, I think we need what Thomas Kuhn, in his famous book The Structure of Scientific Revolutions, called a paradigm shift.[4]

For the past twenty-five years, Central Banks have dominated the economic landscape. In his book Maestro: Greenspan’s Fed and the American Boom, Bob Woodward referred to one Central Banker, Alan Greenspan, as “the Maestro” for his supposed ability to orchestrate economic growth.[5]

But if the economy continues to slow, or goes into another recession, and our Central Bank, the Federal Reserve, joins other Central Banks and implements negative interest rates, the ineffectiveness of that policy will mark the last straw for those who think that the policies of a Central Bank can be the driving force of economic growth.

[1] Random, Jana, and Simon Kennedy. “Negative Interest Rate Less Than Zero.” BloombergBusiness, January 29, 2015. http://www.bloombergview.com/quicktake/negative-interest-rates

[2] Sheard, Paul. “Repeat After Me: Banks Cannot And Do Not “Lend Out” Reserves.” Standard & Poor’s Rating Services, August 13, 2013. https://www.kreditopferhilfe.net/docs/S_and_P__Repeat_After_Me_8_14_13.pdf

[3] Marx, Karl. “The Eighteenth Brumaire of Louis Napoleon.” Die Revolution, 1852.

[4] Kuhn, Thomas S. The Structure of Scientific Revolutions. Chicago: University of Chicago Pess, 1962.

[5] Woodward, Bob. Maestro: Greenspan’s Fed and the American Boom. New York: Simon & Schuster, 2000.

These are the opinions of Financial Advisor Tim Hayes and not necessarily those of Cambridge Investment Research. They are for informational purposes only and should not be construed or acted upon as individualized investment advice. Content provided via links to third-party sites should not be considered an endorsement of content that we cannot verify completeness or accuracy of.

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