- In order to stimulate real growth and prevent deflation following the global financial crisis and economic downturn in 2007–2009, European central banks introduced “Quantitative Easing” (QE), an arsenal of unconventional monetary policy measures that included negative interest rates.
- In theory, negative interest rates can boost economic activity by encouraging banks and other entities to lend or invest excess funds rather than pay penalties on funds in bank accounts. The impacts of the negative interest rate policies introduced in Europe between 2012 and 2015 are difficult to quantify and assess: further downturns have been avoided but growth has been lethargic and declining profits have forced banks toward riskier practices.
- While negative interest rates can potentially provide short-term gains, persistent use can threaten severe systemic disruption, from the creation of market bubbles to a range of dysfunctional incentives.
Introduction: The Road to Wonderland
In his classic novel, Alice’s Adventures in Wonderland, Lewis Carroll takes readers to a fictitious land into which young Alice unintentionally stumbles. It’s a place where mad is normal, up is down, left is right, running as fast as you can is never fast enough, and at least six impossible things are believed before breakfast. Welcome to Wonderland; welcome to Europe (2012–2017); welcome to where I live. Let me explain.
For most of my lifetime, people (including me) believed that interest rates needed to be positive—in part, because they also believed that these rates could never be negative. Positive interest rates reward those who save or invest and penalize those who want to buy something now but don’t have the funds. For most of us, positive interest rates are logical and normal. Negative interest rates flip all of this upside down by rewarding those who borrow and fining those who save, which seems insane, crazy, and, yes, impossible. Nevertheless, in the words of legendary baseball coach, Casey Stengel, “They said it couldn’t be done, but sometimes it doesn’t work out that way.” This short article explains the road to Wonderland and how we got there.
To unravel the mysteries of negative interest rates, it’s helpful to start by looking at the historical background. During the global financial crisis and resulting economic downturn (2007–2009), central banks decided to use expansionary monetary policies to lower interest rates as close to zero percent as possible. The economies started to grow but at only at a slow pace so they chose to keep rates low, in the hope that individuals and businesses would be encouraged to borrow more, increase spending, stimulate economic activity, and create jobs. At zero percent, most of us thought that interest rates were at their effective lowest bounds, but here was the problem: Borrowing and spending remained sluggish, and nations were threatened by deflation. Further measures were necessary, but what could be done? That’s when central banks got the idea of introducing an arsenal of unconventional monetary policy measures in order to stimulate real growth and prevent deflation. All of these unconventional tools can be classified under the banner “Quantitative Easing” (QE). They included central bank purchases of increasingly risky assets, forward guidance, and negative interest rates.
Negative Interest Rate Policies of Central Banks in Europe
Negative interest rates impose penalties on those who deposit funds in particular accounts. For most of the nations that began using negative interest rate policies, the affected accounts were those held by commercial banks at central banks. Just as you and I deposit funds in banks, commercial banks deposit funds in central banks. They are there mainly for check-clearing purposes and also to satisfy central bank reserve requirements. By setting negative interest rates on these deposits, commercial banks are discouraged from keeping excess funds in these accounts and are, therefore, encouraged to lend.
Among the first central banks to explicitly pursue negative interest rate policies were Denmark’s Nationalbank, which started in July 2012, and the European Central Bank (ECB), which started in June 2014. The Swiss National Bank (SNB) and Swedish Riksbank followed shortly thereafter, in January and February 2015, respectively. In some cases (e.g., SNB’s policy actions), the moves were defensive, intended to prevent their currencies from appreciating in response to the ECB’s negative interest rate policy. The same holds true for the National Bank of Hungary, when it decided in March 2016 to introduce negative interest rates on commercial bank deposits.
Let’s have a look at the euro zone and the ECB to understand how negative interest rates work on commercial bank deposits. Assume a commercial bank customer deposited EUR 1,000 in an ordinary checking account at an Austrian bank. Central banks regulate what a commercial bank can do with these funds, and one of its tools is the reserve requirement, which basically compels banks to hold a certain percent of their deposits in highly liquid, low-yield forms, such as in cash in the bank vault and deposits at the central bank. Only the remainder can be lent out. For example, assuming the reserve requirement is 10%, our commercial bank would need to hold EUR 100 of the EUR 1,000 deposit in cash and/or central bank deposits, which means it could lend the rest (i.e., EUR 900). In times of economic uncertainty, the commercial bank may choose to hold more than the minimum, reducing the amount it lends to less than EUR 900, for example only EUR 700. To encourage lending, the central bank imposes a negative interest (penalty charge in the Eurozone -0.4%) on these voluntarily held excess reserves—in our example: EUR 200. To avoid this penalty of EUR - 0.80 [= 200 × (-0.4%)] the commercial bank has to keep excess reserves at a minimum. It can lend the excess reserves (the goal of the central bank), but it also can use the funds to purchase securities, such as notes and bonds.
The use of unconventional monetary tools and policies is a reflection of central banks’ ineffectiveness during highly stressful economic conditions when conventional tools, designed for “normal times” do not work. Consider, for example, open market operations, which involve the buying and selling of securities by central banks. In normal times, central banks purchase safe government securities, and, by doing so, they inject new funds into the financial system. The excess funds put downward pressure on interest rates and encourage borrowing. But, what happens when interest rates are already at zero percent? In response to this problem, central banks in Europe and around the world (e.g., England, Sweden, the United States, and Japan) began purchasing increasingly riskier assets, such as foreign currencies and mortgage-backed securities, to widen the distribution of entities receiving their newly created funds.
The ECB’s asset-purchasing program started in March 2015, when the bank committed itself to purchasing EUR 80 billion worth of public and private sector securities per month! The hope was to end this massive monetary inflow by March 2017 or earlier if medium-term inflationary expectations rose close to 2%. To prevent commercial banks from hoarding the newly created funds, central banks began charging a penalty—a negative interest rate on deposits.
Spillover Effects from Negative Central Bank Deposit Rates
The negative interest rate policies of central banks led to negative interest rates across the financial system: on interbank deposits, the deposits of ordinary individuals (like yours and mine!), government bonds (e.g., Austrian, Danish, Finish, German, Netherlands, and Swiss bonds), and also the bonds of highly credit-worthy corporate borrowers (e.g., Deutsche Bahn-the German state-owned rail company, Henkel-the German consumer goods group, Cooperative Rabobank-the Dutch Bank, and Sanofi-the French multinational pharmaceutical company). In Switzerland and Germany, commercial banks tried to pass the burden of negative interest rates onto their customers, hoping to start with their institutional clients and work down to businesses and individuals. The problem was that their depositors had options, one of which was withdrawing their funds in cash. By doing so, they would earn nothing, but incur no penalties. Other arrows in depositors’ quivers were (1) splitting their accounts into smaller amounts when bank penalties were imposed on large deposits, (2) transferring their funds to saving accounts and certificates of deposit when bank penalties were imposed on checking accounts, and (3) buying safe government securities. Caught between a rock and a hard place, banks balked, thereby slowing the spread of interest penalties to their customer bases. Interestingly, the flow of funds from customer deposits to cash took on an ironic twist in May 2016, when the ECB decided is should stop issuing the EUR 500 bill (the highest note possible in the Eurozone), starting at the end of 2018. The reason for demonetizing the EUR 500 note was to reduce financial crimes, such as money laundering, bribes, and tax evasion. The irony was that phasing out the EUR 500 note will increase the cost of holding cash, because you need five times more space to store cash in vaults if the EUR 500 note is not available anymore and EUR 100 is the highest bill. The elimination of high denominations of notes should discourage cash holdings as a reaction to low or even negative interest rates on deposit accounts.
Have Negative Interest Rate Policies Been Successful?
It is probably too early to say anything definitive about whether central banks’ negative interest rate policies have been successful. Economic growth for most developed countries has been positive but lethargic. Therefore, on those grounds, there is not much evidence to support a “Highly Successful” rating. Perhaps, we should be more lenient and give these central banks brownie points for preventing severe downturns. Despite the equivocal results to date, there are some interesting signs on the horizon that might give us good indications for what is to come.
One positive sign relates to what has been happening in the United States, with the Federal Reserve increasing its target interbank interest rate and expressing its intention to raise these rates higher during 2017. Such a policy by a country as large and economically important as the United States will help to pull up interest rates around the world. The election of Donald Trump and his promises of expansionary fiscal policies (e.g., for infrastructure) also could increase interest rates, and expected inflation.
On the negative side, since 2008, bank profits have been squeezed by the low and falling interests they earned on their loans and security purchases. On top of this, their costs have increased, due to the penalty charges imposed by their respective central banks. Some commercial banks have responded by cross-subsidizing both losses and low lending margins by using increased fees on payment transactions and account management services. Others have lent and invested in assets with increasingly higher risks, which was never the intention of central banks. In the end, one of the main reasons for the tepid success of negative interest rate policies has been the reluctance of many banks to lend to customers who might default. They also have been frightened by the added capital costs that come with such risky loans. Remember that the Basel Agreements (all three Basel I, Basel II, and Basel III) have required banks to hold capital in proportion to the risk-weighted assets.
Put in this perspective, I hope the world in which we live seems a bit less Alice-in-Wonderland-ish. Negative interest rates on bank deposits provide incentives for banks to lend, but there are also disincentives in the form of higher default rates and increased capital costs. On the bank customer side, negative interest rates subsidize borrowing, but why should businesses and individuals borrow if the economic outlook is gloomy enough to put principal repayments in jeopardy? Similarly, negative interest rates subsidize government borrowing, but if the nation already faces high debt-to-GDP levels, such liabilities could lower these nations’ credit ratings. For developing or debt-threatened countries, such as Argentina, Greece, and Italy, low interest rates would seem like a blessing, which they probably have been, but at the same time, is the answer to their problems really more debt? Moreover, might the ability to borrow at historically low rates reduce their incentives to implement necessary and fundamental reforms and to restructure their national budgets?
Persistently low interest rates also threaten to create stock market, real estate, and or other asset bubbles—all of which could wreak havoc on world economies, as the sub-prime crisis did from 2007 to 2009. Low returns increase the incentive to search for investment assets with higher yields, which means higher risks. The havoc that low interest rates wreak on banks will spill over to other financial institutions, such as insurance companies and pensions funds, which means our retirement nest eggs and the ability of insurance companies to meet claims from existing premium income could be severely challenged in the future. Funding gaps will be financed by higher premiums and reduced benefits. Is it any wonder there is such concern on the part of financial institutions, the Baby-Boom generation, insurance companies, pension funds, investors, and whoever else has given serious thought to what is going on?