A few weeks ago, I shared an IG post that discussed an IMF paper which was produced in 2018 that outlined a system to start having negative interest rates go as low as policy makers want them to. After looking back at the post, I don’t feel that it conveyed this revolutionary idea strongly enough so I am going to present it in more detail and why I think it could be potentially destabilizing socially.
The Current Floor
Much of the rich world post crisis has endured stubbornly low interest rates. This causes problems for traditional monetary policy for when the next downturn arrives. When that happens, many rich countries will not be able to cut rates much further to stimulate the economy as they are already low. As you can see below, only a few countries have room to cut rates even lower out of those in the OECD, a club of mostly rich countries.
Source: IMF
Why can’t they go lower than 0%? It’s mostly because of cash. If the central bank were to set a negative interest rate of say -3%, and this was passed on to your bank account, you could just close your account and take out the cash and let it sit under the mattress where it can at least get 0% interest.
Even though some central banks like Switzerland have implemented negative rates, they only charge these to the banks for overnight money. The banks are terrified of passing these negative rates on to customers for fear of what I described: customers would likely just drain the bank of much of its deposits and hence funding, which could blow up the bank. Because of this, those banks in countries with negative rates would rather just keep deposits to a minimum at the central bank and eat the cost.
So the option of holding cash essentially acts like a floor on interest rates. It keeps policy makers from having the ability to push negative rates much lower.
Why Would They Want To?
It may be worth stepping back to remind ourselves why the central bank cuts rates in the first place during or just prior to a recession.
During a recession, economic activity slows down. This means demand for many products falls and when this happens, companies may be required to cut back due to the slower sales. This puts people out of work that then buy less as they are unemployed and reduces demand for other products, whose companies lay more people off and the cycle continues. To break this cycle, the central bank or the Fed as it is known in the US, cuts interest rates to make borrowing more cheap. Now projects that can be funded by debt for a company can be funded more cheaply and may be come viable based on cost. It also encourages investors to take more risk, if the bank doesn’t pay much interest a company may say why not start a new project that will earn a return? Households may say let’s buy stocks instead of earning little in bonds and bank accounts. This takes time to filter through but eventually starts to push economic activity back up until it pulls the economy out of recession.
Historically, rates have been high enough that the Fed can cut them 1% or 2% to stimulate the economy, which makes a huge difference in the borrowing costs of firms and the risk that investors want to take for returns. Currently however, if rates are close to 0%, how can they be cut even more to stimulate the economy? Especially if there is a floor of 0% due to the option of holding cash as I described above?
The Proposed Solution
The authors at the IMF notes that creating deeply negative rates would be easy if all money was electronic. The fact of the matter is that many countries still use a lot of cash (see below). So how to deal with this issue of people having the option to hold cash?
Source: IMF
The authors came up with an ingenious approach. Most advanced economies have some portion of payments and savings in electronic cash. To make rates deeply negative, the central bank would announce 2 types of currencies: cash and electronic money or e-money. People would be allowed to transact in either currency.
The central bank would then charge a negative interest rate on the e-money, and depreciate the exchange rate of cash to electronic money by the same rate as the negative rates offered for electronic money. This idea is probably best illustrate with an example.
Let’s say you have $100 that you put into a bank account and the Fed announces a negative 3% interest rate. After a year, you would have 97 e-dollars in your account. If you chose to take out the cash you could do so, however the exchange rate for cash to e-dollars would slowly depreciate throughout the year. If you wanted to exchange the cash for e-dollars after a year, $100 cash would only get you 97 e-dollars.
Goods would start to have 2 prices: cash and e-dollars. This would function similar to some countries that have dual currencies or small countries that use two different currencies for historical reasons like past high inflation. Think of Argentina or Peru. Argentina still prices their real estate market in US dollars.
This system would essentially remove the lower bound for interest rates and clear the path for central banks to set them as low as they want. Negative 4%, 5%, 10%? No problem, just keep going lower.
The Consequences
Is this really what we need though? How could this be potentially destabilizing to overall debt, saving and the social order? Would this be a back door bailout to indebted consumers?
Let’s assume this is implemented in the US since this is the market I know best. The immediate consequence is that an already indebted consumer in the US would be incentivized to spend even more and do it faster. If your money is losing value day by day, even if it is slowly, there becomes little incentive to hold any money at all. Rather the incentive is to spend as soon as you get paid and buy material things that won’t lose their value like cash.
Think about if consumer loans, mortgages and car loans went negative as well. Instead of paying interest for a home loan, the bank pays you a little every month in the form of paying a little principal off for you. Debt to purchase appreciating assets like homes could explode, driving prices up. The same may be true for commodities like gold or crypto currencies which maintain their value compared to e-money.
Anyone with decent credit could refinance their positive rate loan to a loan that automatically is reduced every month by negative interest. This could produce a potential backlash by savers who feel they are paying to bail out the spendthrifts, simile to how the Tea Party arose out of the housing crisis.
In a way, deeply negative rates would induce behavior that is similar to how people act during hyper inflation. There would be a rush for real stable assets, there would be no incentive to save and the rich who would be sophisticated enough to take advantage of this could funnel money out of the country or load up on free debt at will. The wealthy could then bid up and buy up massive amounts of real assets then rent them to the less fortunate. This could further widen the already yawning gap between rich and poor which is already causing social instability.
There is also the question of how much would international and institutional investors be willing to take? The world keeps its money in the US for the moment because of the great growth opportunities here but what if the growth prospect becomes less appealing and rates are deeply negative? Who would want to hold debt then? At some tipping point, rates may go so negative that investors start to push back and demand a less negative or at least zero rate to invest. This would make the negative rate idea backfire, actually increasing rates in the long run as money flows away to places where rates are positive.
The blog post on this posits that the government would have to do a lot of communication with the public about negative rates before implementing but I don’t think there is much communication that could prevent the destabilizing behavior that would ensue. Deeply negative rates and dual currencies could erode the trust in institutions by the public as they could see it as the government stealing from them when they already pay taxes. It could start a spiral of bad behavior and a widening wealth gap which could start to fray the social fabric we take for granted.
I am not one for sensationalism but an ingenious idea to implement negative rates may not be the right one given the potential consequences.
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