This has been a mistake for several reasons. It discourages the holding of liquid deposits (which logically yield zero or negative), but it does not make people anticipate consumption, if prices stagnate or fall. Presumably, there is point of theoretical indifference between the % paid by the depositor, and the % who expect the price of the product to fall. If these numbers are equal, it will be indifferent to you to keep the money in the bank and wait for your expectations of a fall in the price to be fulfilled. That said, a marginal increase in the accrued interest rate will lead to you preferring to keep the money in house and save the deposit, depending on the costs of managing these bank notes.
What about banking? Banks always have the problem of the yield curve, namely the higher it is, the more profit margin it provides: simply put, banks borrow short on deposits, and lend long on loans. And the greater the positive difference between the two types, the more margin they have to cover risks and obtain profits.
But if in Europe interest rates are negative, the slope of the curve is positive, as can be seen in the graph.
Now, let’s think about how the bank’s margin works in this case of negative rates. In the short term, the bank “charges” the depositor 0.8% and “pays” the 30-year borrower a rate of 0.1%, which means a differential for the bank -apart from being very narrow- in which the margin depends on the liabilities, not on the assets. Something which is really strange. And it explains why it matters to the banks if interest rates are positive or negative: because the short term interest rate -from which they receive the benefit- has a floor, as we have pointed out, if they want to avoid a deposits flight. Ergo, the slope of the curve in negative rates may be positive, but it is always very narrow.
In the end, the banking sector finds itself in a situation as if the curve were flat, with a brutal narrowing of its margins and results. It decapitalises because it needs provisions, and becomes a zombie, a candidate for a crash, as can be seen in the very low level of Spanish bank shares. And it not only ruins the banks, but a variety of financial institutions like the pensions savings banks, which are forced to put up money to save their contract with customers.
The only thing the negative rates favours is the drift towards risk speculation (stock market, real estate), which distorts the entire financial system and generates bubbles.
The theoretical attraction
In the US, where the Fed has refused to follow the path of negative rates, the spread between the official rate (0%) and the 30-year rate (1.67%) offers a wider margin, as can be seen in the graph. The only beneficiary is the government, which takes on cheaper debt.
However, this is not the end of the story. Negative or ultra-low interest rates can be economically damaging. There are several reasons for this.
Firstly, the policy sends a clear warning that the central bank believes there are problems ahead. This results in people not spending but saving their money in preparation for the coming storm. Therefore, the policy discourages not only retail spending but also business investment. The latter depends on individual consumption, albeit indirectly in some cases. An industrial manager will not invest in a plant to double production unless he or she believes there is a reasonable possibility of increasing sales in the future.
Secondly, as interest rates drop, companies with defined benefit pension plans– and there are still thousands of them – need to put more money into their pension funds to pay the promised level of retirement income. This leaves less money to invest in the business and pay dividends to shareholders.
Thirdly, the lower the return on interest deposits, the more an individual needs to save to maintain a certain income. In a low interest rate environment, everyone pulls out all the stops. Negative rates are likely to be even worse. All of these factors tend to slow down economic activity.
Little or no inflation also acts as a brake on economic recovery. People tend to postpone spending if they are not worried about prices going up. In fact, increased online shopping has led to strong competition that has caused prices to fall for some products.
A vicious circle
Low interest rates increase the value of capital assets, such as property or stocks. In fact, stock markets have produced good returns since interest rates were slashed more than a decade ago. Unfortunately, this has widened the gap between the “haves” and the “have nots.
The only group benefiting from low interest rates are borrowers. Since our government is borrowing on a larger scale than ever before, they are lucky that at the interest they have to pay is lower than it otherwise would have been.
It is time for the central banks in the US, Canada, Japan and the EU, as well as the Bank of England, which are supposed to be independent from their respective governments, to send a signal that the next move in interest rates will be towards a gradual increase. (Coordination is needed to avoid the risk of disruptive competitive devaluation.)
This signal would reverse the trends described above and could also, contrary to conventional theory, encourage a modest revival in inflation. This in itself would be welcome since inflation is the best way to reduce national debt.
Another benefit of modest interest rate increases would be to make banking more profitable. This is necessary. Profitable banks are more secure and increasingly likely to lend money to businesses that need it.
“A vicious circle could become a virtuous one. (Martin Jacomb in the Telegraph). We are now aware of the cause of the poor health of our banks, and those throughout Europe.