The world is upside down, interest rates are negative

We take many things in life for granted just because we have never seen them be any other way. You will surely agree that among those things is the expectation, that when we deposit our money in a bank, the bank will pay us interest as a compensation for having our money available for its profit making operations. The bank gains and we gain. We deposit a 100 and at the end of the year, we can withdraw 103 (in the past even 120 or 130). Can you imagine it being the other way around? How, you ask? Simply by turning the situation upside down. The bank would not pay you for your money, but it would charge you a certain amount. In other words, you would pay your bank for having money in your account. You would deposit a 100 and at the end of the year you would only be able to withdraw 95. Does it seem absurd to you? Don’t worry, you are not alone. Many economists consider negative interest rates impossible. Despite of that, their existence is a reality.

We can find examples of negative interest rates in countries throughout history. But these are geographically or time-isolated cases. However, today we live in a world where more and more things are becoming upside down. And one of them is the fact, that negative interest rates are shifting from a deviation to a norm (for the time being only within the financial system). In June 2014, the European Central Bank made a significant decision and lowered its base interest rate on deposits to -0.1%. In September 2014, it “raised” this rate to -0.2%. And rates lower than zero are a reality not only in the eurozone, but also in other European countries. In Switzerland, the rate is actually -0.25%. Central banks in Sweden and Denmark also have negative interest rates. The British central bank also considered the option of introducing negative interest rates, but it decided not to use it. For now. Introducing negative interest rates is not only unusual, but also highly controversial. Why then would central banks do it? And most importantly, why, for god’s sake, would commercial banks still keep their reserves with them when it means they will gradually diminish?

There is a couple of reasons for that. The ECB, in its statement from June 2014, in which they tried to justify this unorthodox measure, stated that the main motivation is their effort to maintain price stability. Specifically, their “fight” against falling price levels, or deflation. In the case of Switzerland and other European countries, the main motivation could be an intervention against a too strong of an exchange rate of their currency. The negative rates should “expel” foreign depositors, which should weaken the exchange rate. This measure is also considered pro-growth, because it should discourage commercial banks from holding their money and instead make them invest it in the real economy. Whether these goals will be really achieved remains questionable. The only thing that is certain is that these unorthodox measures contributed to the deformation of the financial market. Even government bonds (now including Slovakia as well) are being sold with negative interest rates. But why would investors buy these bonds? The answer has two parts. One part is that they have to – especially institutional investors – because of regulation. The other part is that they want to because it still gives them relative security compared to other alternatives that could result in even higher losses. However, if the interest rates remain negative for too long, not only will businesses start preferring briefcases and households will start using mattresses, even banks could start preferring cash at a large scale.

Everyone must see that this situation is not normal. Negative interest can cause much more damage than good. They are an expression of utter desperation and a proof that the traditional monetary policy is out of tricks. Get used to them. They might be here for a long time.

Author: Ján Oravec

Translated by: Jakub Jablonický

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