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When Interest Rates Become Negative

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Denmark homeowners are now receiving checks each month because their mortgages have negative interest rates. A negative interest rate means the lender is paying the borrower to borrow money from them -- borrowers get paid and savers are penalized.

For those of you unfamiliar with the idea of a negative interest rate, it is a monetary policy tool where the central bank's interest rates are set below zero. It is intended to spur economic growth and increase inflation (yes, increase inflation) by incentivizing banks to give more loans so businesses will invest and consumers will spend. During times of low growth and falling prices, people and businesses hoard money instead of spending and investing. Left unchecked, this would result in a collapse of aggregate demand, further falling prices, a slowdown in real output and an increase in unemployment.

To break this downward spiral and stimulate borrowing and lending, a more expansionary monetary policy is often called for. However, if stagnation is too deep, simply lowering the central bank's interest rate may not be sufficient to stimulate borrowing and lending.

As early as the 1970s, the Swiss government adopted a negative interest rate regime. More recently, others have followed suit: Sweden (2009 and 2010), Denmark (2012), and the European Central Bank (2014). Now Bank of Japan and Bank of Israel have announced similar negative interest rate moves in 2016. Currently, negative interest rates are the official policy of the European Central Bank with a deposit rate of -0.40 percent; Switzerland, -0.75 percent; Sweden, -0.35 percent; and Bank of Japan, -0.10 percent. That is why all United States banks paid serious attention to Federal Reserve Chairwoman Janet Yellen's comment in February that she would not take negative interest rates off the table should the economy see a downward turn.

While getting a check back from your mortgage lender may seem like an answer to a prayer, there are some unintended consequences of negative interest rates that are almost mathematically predictable. So, what kind of upside-down world are we in when interest rates become negative?

Imagine that banks have to pay a fee to keep their deposits with the central bank. A natural inference is that banks may choose to hoard the money in their own vaults, instead of lending it out. There is some evidence to suggest that negative interest rates in Europe actually decrease the number of interbank loans.

Imagine that retail banks may choose to absorb the costs associated with negative interest rates by paying them, rather than passing the costs to depositors for fear of bank runs. So, the expectation that bank customers and banks would move all their money holdings out for productive uses will not materialize.

Imagine that banks impose negative interest rates on top of the fees you already pay on checking and savings account balances. It is just one more "tax" on your money. Will you still keep your money in the bank? If not, will you take it out and put it in a safety deposit box or under the mattress? Will you spend it, loan it to others, or invest in the financial markets?

Imagine a negative interest rate is also another tax on banks, so the idea that low or negative interest rates will encourage or force banks to lend is ludicrous. Punishing banks for not making loans by charging interests on banks' cash will lower bank profits and share prices -- hardly a way to get them to lend. Remember, liquidity was never the problem for bank lending.

In 2008, fearing that the $700 billion bank bailout deal would be blown if Democratic support was withdrawn, Treasury Secretary Hank Paulson dropped to one knee and implored Nancy Peolosi, Speaker of the House to consider the ramifications.

"It was really a moment of levity in a rough day, rather than a display of humility," said Paulson.

However, after having forced the 10 "too big to fail" banks to accept the money, Paulson did not answer Federal Reserve Chairman Ben Bernanke's rhetorical question, "They would loan out the money. Would they?" As both Paulson and Bernanke feared, the banks never did loan out the bailout funds.

Stop imagining! The U.S. has been in a de facto negative interest rate environment for years. Whenever the T-Bill rate dropped below 1.5 percent, which has been the case for the last eight years, the real interest rate has been negative, given an average 1.5 to 2.0 percent inflation rate. After various fees that banks already charge on your checking and money market accounts, do you really believe you are receiving that positive 0.25 percent interest rate?

Today, more than $26 trillion of government bonds now trade at yields of below 1 percent, with around $7 trillion currently yielding less than 0 percent. The move comes as an increasing number of governments around the world show negative yields. The Japanese 10-year government bond was at -0.13 percent, while the German two-year yield was at -0.54 percent, and Switzerland's 11-year yielded at -0.43 percent. The real question, then, is "Where is the growth?"

The real issue is that banks will not give out more loans simply because the cost of funds is lower. Instead, they look at the likelihood of future growth so they can get their money back. Businesses will not borrow money just because the interest rate is lowered to negative, but look at future growth to be able to pay the loans back. Consumers will not take out loans to buy new cars or homes just because the financing term is attractive. Thus, the notion that "negative interest rates will produce loans and generate economic growth," is just wishful thinking.

In fact, even the consideration of a negative interest rate policy, a "Hail Mary" move, may implicitly admit that the previous monetary tools -- such as the three rounds of quantitative easing -- have failed.

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