We are on the precipice of change. The way our institutions approach macroeconomics could see the biggest change since the 1990s. This revolution has been precipitated by the economic fallout from the Covid-19 crisis. But it’s been a long time coming- the breakdown of monetary policy is the underlying cause that has prompted a more serious consideration of using negative interest rates to bolster the economy.
There have been two, arguably three, major shake-ups in how policymakers have done their jobs. The first gave birth to macroeconomics itself- John Maynard Keynes’ commentary regarding the Great Depression showed how the market doesn’t always readjust itself, and that government intervention is necessary in recessions. As Keynes put it, “in the long run, we are all dead”. Government stimulus was to be paid for by debt if needed, which was in turn be serviced during the good times.
But this couldn’t fix the stagflation of the 1970s, where low economic growth was coupled with high inflation. Milton Friedman, the father of monetarism, argued that controlling the money supply was the best way to maintain living standards in the long term. Economic efficiency and low and stable inflation were to be prioritised at the immediate expense of employment. His brand of neoliberalism influenced Thatcher and Reagan, as well Paul Volcker, the US Federal Reserve’s Chairman in the 80s. Finally, there was a mini shake-up in the 90s, where policymakers combined these two philosophies.
Today’s possible economic upheaval has been evoked by monetary policy having lost most of its effectiveness. Central bank interest rates have been at near zero for a decade, so there’s little room left to increase aggregate demand (i.e. GDP) using interest rate cuts. I mean, you can’t go lower than zero. Or can you?
Once considered unthinkable, negative interest rates may soon become commonplace in economic policy. The basic idea is that you get paid to borrow and charged to save. This inverted dynamic is a desperate attempt to get consumers and businesses to spend and borrow.
Negative rates are by no means a new policy instrument: the European Central Bank and the Bank of Japan dipped their toes into the world of negative rates years ago (2014 and 2016 respectively) amidst weak growth and fears of a deflationary spiral.
The two other major central banks, the Fed and the Bank of England, have not yet implemented this still radical idea. But the coronavirus-induced recession has warranted a deeper consideration of such a policy. And while those who have tried negative interest rates tend to stay close to zero, some economists are pushing for at least a negative three percent figure to combat the economic crisis.
Proponents of negative interest rates claim their ideology is more appropriate than public borrowing, which makes it harder to repay debt if inflation compels central banks to raise interest rates.
However, a potential criticism would be that they could squeeze bank profits to dangerously low levels. This would make the financial system very fragile and unable to absorb external shocks, which is a much larger threat to the economy. Any interest rate rises will surely be incremental in the foreseeable environment, so there will continue to be a very small chance that the government will default on its debt. As such, investors will still see public bonds as a safe asset, meaning the abundance of supply should keep the cost of borrowing down.
Moreover, negative rates don’t travel well through the wider economy. Although central banks can take their interest rates below zero, commercial banks are unsurprisingly loth to the idea of passing that on to their customers’ savings accounts. Think about it- why would anyone put their money in a bank account if the amount would deteriorate? Banks would lose virtually all of their business, since their clients would be better off simply storing physical cash in a safe or under their mattresses.
If banks were to try implementing negative rates regardless, there will likely be a run on the banks, whereby depositors rush to withdraw their money. To protect their cash reserves from depletion, banks would be forced to raise their interest rates, which negates the whole point of below zero rates.
The efficacy of this radical policy as a whole may be overstated anyway. For instance, some countries are actually saving more despite negative interest rates. And it should be acknowledged that giving people a hard shove back to using paper money would make transactions more cumbersome and collecting tax more difficult, possibly dampening the growth potential of the economy.
Of course, the obsolescence of hard currency as we transition to a digital world will increase the feasibility of negative consumer interest rates. Indeed, countries that have opted for having some of the lowest interest rates have a lower propensity to use cash, increasing the impact negative rates can have. If there was no physical money at all, people would be left with little alternative but to accept negative rates on their savings, although they will surely be disgruntled.
This cashless society is still a long way from being a reality. In the meantime, there are some clever ways to nudge consumers to go more digital, which will amplify the efficacy of negative interest rates. These include getting rid of high denomination banknotes or making paper money more fragile or awkward to store. More stringent regulations can be placed on ATM withdrawals. These ideas may be an outlet for economists’ creativity, though I doubt they will have any noteworthy effect.
Central banks themselves are considering a better (but still unlikely) idea: letting the public open accounts with them directly, without mediation from private banks. This would allow them to pass on interest rate changes, whichever direction they may be, straight to the broader economy. Shortening the monetary policy transmission mechanism this way could give a central bank greater leverage in influencing economic behaviour and outcomes.
Joe Biden, the favourite to win the US presidential election this year, is contemplating variations of this idea. The big drawback in this case though, is that no consumer will choose to interact with the Fed if private banks have better interest rates, or if keeping cash is a better alternative. Granted, this could be a good idea to implement in more normal times, as it will help fix unavailing monetary policy.
However, it would be incorrect to say that a private bank has never passed on the central bank’s negative base rate to its customers. Last year saw a Danish bank unveil a negative interest rate mortgage, meaning you pay less than the actual value of the home- essentially a discount on the property courtesy of your mortgage lender. Before you start considering purchasing holiday homes in Denmark, I should warn you that such mortgages tend to just inflate house prices. Besides, although negative, the rate is still very close to zero.
Some of you may have by now gleaned that I am not a fan of negative interest rates. Although uncharted and risky territory, I accept that they need to be considered during desperate times. Accordingly, it is almost certain that they will become more prevalent in the current circumstances, possibly even required, given the dearth of other options.
Certain economists prefer to allow debts to skyrocket- as long as inflation is higher than interest rates, debt can be controlled. Others propose using a mix of redistributive policies like Universal Basic Income (UBI) and more rigourous antitrust regulation to reduce inequality as well as increase innovation and competition. As ever, economists will struggle to reach a consensus on the best recession-fighting approach. What is clear, however, is that we are about to turn the page to the next chapter in economic history.