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
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
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
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
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
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
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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guide to the subject matter. Specialist advice should be sought
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