Negative Interest Rates

Macro · Aug 23, 2019

Recently some traditional economists were confused when they saw that more countries joined “the negative interest rates club”, so here is my opinion on this bizarre macroeconomic trend.

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We’ll try to explain why such a policy has occurred and why it can be a dangerous sign for the global economy. This article is a personal view and opinion of its author.

Deflation Problem

In our previous article we explained the general idea behind interest rates, so now we’re ready to jump to the next step and break down the deflation problem. For ages, all of the countries in the world have been haunted by a nasty thing called inflation, which means that prices of goods and services tend to grow so the purchasing power of national currencies decreases.

During the periods of high inflation people may lose their savings unless they can find a way to invest their money in capital goods or some speculative assets that can offer returns comparable to the rate of inflation (although exceeding it wont hurt).

One of the main goals of any central bank is to fight inflation and to keep it at a reasonable level (2-6%), but, in recent years, many developed countries found themselves in a weird situation: inflation has disappeared and now they’re facing the opposite phenomenon - deflation.

Switzerland, Sweden, Denmark and Japan, top tier countries in the developed world, have started to experience very low levels of inflation and, sometimes, plain deflation.

Deflation seems to be a positive thing at a first glance but after a deeper look, it may appear to be a danger for an economy. If prices for the majority of goods and services would go down, people would be able to buy more every year with the same amount of money, isn’t it a good thing?

It’s really a good thing for some people, but small business is concerned about that because deflation means that they will have lower earnings. It would be fine if the total market (GDP) would grow along with deflation, but countries that experience deflation are usually not in this position.

Another issue with deflation is that people don’t want to invest under deflationary conditions: if money can grow in value just sitting under your mattress, why would you take risks of investing it? Plus, there are few opportunities in a country to relocate money under a well-growing fund, a bond or a stock, because in a case of deflation, general business activity tends to fall and the total GDP does not grow at all. What people do is that they relocate their savings overseas to countries with a growing economy and “park” their money there, while their own economy is stagnating.

These are just a few known problems of deflation, and there are more. Deflation itself is often not a problem, but more of a symptom of something else: a population decrease, slow GDP growth, huge government debt, low business activity, etc.

The Effects of Low and Negative Interest Rates

Low or even negative interest rates lead to a massive growth of debt because central banks give out a lot of money to commercial banks at a low rate, thus they can (and supposed to) propagate cheap money further to people and business which is supposed to stimulate the demand. People tend to borrow a lot in this case: they take cheap mortgages to purchase a property as an investment.

This causes the rise of real estate prices and can even lead to a bubble. As a result, regular people from the middle class can’t afford to buy property if real estate prices go too far so they have to move out further away from big cities. Foreign investors bidding up real estate prices don’t help also, which makes the problem worse and can even lead to the rise of nationalism.

Three Main Central Bank Strategies

Historically speaking Central Banks have 3 different operating strategies (approaches):

  1. Friedman’s approach (Inflation targeting)
  2. Keynesian theory (Aggregate demand management/stimulation)
  3. Austrian School

First strategy tells us to increase or decrease the prime rate (interest rate) of a central bank to achieve a targeted inflation level, say 5%. This is a common European approach which is followed by many central banks not only in Europe. The Keynesian theory is all about cheap money and demand stimulation. The Austrian School is somewhat hard to explain and their approach is not even about numbers.

The interesting thing is that the negative interest rates are not even mentioned in any of the “textbooks” listed above, so this is something really new.

A Dangerous Precedent

Is having the interest rates of -0.25, -0.5, -1% or even lower a dangerous precedent for the economy? It’s hard to say now because CB (Central Banks) have been enacting this policy for quite a short period of time. The European Central Bank (ECB) explains it in very simple terms: inflation is low right now, economic growth is slow, therefore we lower the interest rates to motivate people to borrow and spend.

This logic appears to be quite straight forward and, perhaps, it’s wise that this new model is tested only on relatively small European economies (plus Japan), so the rest of the world can safely observe the results of it before copying such an approach.

Japan, however, is a totally different story and it has a complicated economy at the moment. Heavy debt (230%+), slow GDP growth of 1.7% and the aging population forces them to try out a new approach. Japan, still being a major world economy, faces a troubling future if it wouldn’t be able to come up with something almost revolutionary to counteract those trends.

Should We Blame Central Banks?

From the point of view of a central bank, in such a complex situation, lowering interest rates might be seen as the only solution. What would be an alternative action, to increase interest rates? The interest rate has been the only tool available to central banks up until the Great Recession.

Well, raising interest rates would obviously cause money to be more scarce and expensive, which many believe would cause stagnation and would complicate things even more.

Perhaps, the best solution leans outside of the central banks, maybe certain fiscal actions such as lowering tax rate would work well and it would get the economy back on track? Trump seems to believe that a lower tax rate would bring business back to the country and have a positive effect on the economy. He could be right, but it’s unfair to compare the US with small European countries or even Japan, those countries are very different.

Conclusion

It seems that the world would be facing a completely new issue of slowing growth to a point where we can even see a long worldwide economic decline.

One of the signals that prove that is the world’s population numbers, which, according to almost all projection models, will start to decline just after 30-50 years. Maybe it’s a good thing, who knows? After all, with the lower population, GDP per capita would be higher and everyone would be a bit richer, but this is true only if we can do something with the wealth distribution problem, which doesn’t seem to go away.

It’s very hard to say that the negative interest rates policy is the proper answer to the deflation problem, but it might be for some courtiers under certain conditions. We have to wait to see how will this policy show itself after 20-40 years in countries where those rates are already in place.

economics   finance   indicators   interest rates   macroeconomics   money   trends   government   europe   japan   banks

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