On Project Syndicate
– and in other places in recent months – orthodox US economist Kenneth Rogoff has presented the case for deeply negative interest rates
. Another financial sacred cow falls; yes, interest rates can be negative, even substantially negative. It can take a
while, though, for shot sacred cows to die. Keynes, in the 1930s, mortally wounded the 'balanced budget' bovine. And the
experiences of Japan in the 1990s, and the United States in the Second Gulf War (when taxes were cut), dealt to the
hallowed cow of 'fiscal responsibility'. Yet those ghostly cattle-beasts still stalk the minds of politicians,
bureaucrats, and journalists.Interest as a Yield
Interest is a mystery to most of us. It's actually two conceptually distinct – though related – things. Interest in nature is better referred to as 'yield'. We may think of a herd of beef cattle. The gross yield is essentially the calves,
with the net yield being the beef and leather produced, subject to the constraint that the herd is maintained over time
at its usual size.
Thus, the concept of 'yield' is similar to the concept of 'profit'. In a bad year for the farm, there may be a loss, for
example because a natural disaster led to the death of all the calves. In that sense, the yield – or interest on capital
– can be negative. Further, with this concept of interest, negative interest is unequivocally a bad thing, and the
higher the interest (ie yield) the better.
When I was a boy, we had school 'banking', a basic saving account using the symbol of a squirrel, supposedly a creature
that saves (nuts) due to an instinct of thrift. We received interest on our school savings, something those squirrels
never did on their savings. The squirrels' yields on their hoards of nuts are always negative; some of those nuts go
missing or deteriorate. (For squirrels to gain a positive yield, they would have to plant most of their nuts, then wait until the new crop of nuts could be harvested.)
I also remember my mother explaining to me the difference between a 'savings bank' (such as the Post Office Savings
Bank) and a 'bank' (such as the Bank of New Zealand). She said that interest was a 'reward' for saving money. And she
said that money held in a bank account did not earn interest; actually, customers paid fees to hold their money there.
But, she said, they could draw on their 'money in the bank' by writing cheques to other people. So I understood the
'principle of convenience'. I cannot say that I really understood the reason for the 'reward', though. It was in
another, later, conversation with my mother that I learned about lending; and it bothered me then – as it bothers many –
to think that, if I had money in the bank, then somebody else might be spending it; hence a reward was justified. I
eventually understood banking; indeed, in the days before banks became financial supermarkets. I had to study economics
academically, however, before I had any real inkling about where money comes from.
My generation – and other generations – grew up to learn that interest is natural, and always positive. And we leaned
that the secret to wealth was restraint and compound interest. Thus, we came to see indefinite economic growth in the
same way, as a process of accumulation rather than circulation. The idea that squirrels saving nuts indefinitely would
become wealthy was always an illusion; likewise, economic growth as a process akin to compound interest was always an
I learned – when an adult, through financial economics – that interest can be a 'price', as well as a 'yield'. (In fact,
interest is two prices. One of these is the price of 'risk'. Different borrowers have different risk profiles. Higher
risk borrowers pay a higher price to borrow money. I am not particularly concerned here, however, about that price which
is commonly called 'risk premium'.) Interest is a price, that if set correctly, regulates economic life; it can
facilitate growth when growth is needed, and facilitate slowth when slowth is needed. Very low interest rates penalise
the pointless accumulation of money, and facilitate the circulation of money.Interest as a Market Price
If we can imagine interest rates being three percent (as they usually were when I was a boy), and, the amount of money
lenders wanted to lend being the same as the amount of money that borrowers wanted to borrow, then the 'price of
loanable funds' would be three percent, and that market would be balanced.
If there was a shift in this 'loanable funds' market, with say more people wanting to borrow, then excess demand for
loanable funds would require the interest rate to increase. Following that price increase, this market would establish a
What if there was a change in circumstances (other than a rise in interest rates) that caused fewer people to want to
borrow money. Or caused people to repay loans more quickly? Or more people to want to lend money? Or people wanting to
be repaid more slowly? Or more people wanting to relend money that has been repaid?
These situations would induce a fall in interest rates. And there is no necessary reason why that price fall should stop
However, if banks could lend money to the Reserve Bank and get one percent interest, they are unlikely to lend to anyone
else unless the banks charge an interest rate above one percent. So, for the market to balance properly, the interest
rate set by the Reserve Bank should reflect underlying conditions in the loanable funds market.
If underlying conditions require that the Reserve Bank set a negative 'Official Cash Rate', then so it should. It would
mean that the Reserve Bank's large wholesale customers – the banks and the central government – would be paid to borrow
from the Reserve Bank.
Obviously, if borrowing from the Reserve Bank increased too quickly in response, the Reserve Bank would have to reset
the rate back to positive or zero. But what if these customers were not sufficiently induced to borrow more by negative
interest rates, then the Reserve Bank would have to 'go more negative'; interest rates would keep dropping until balance
is established in the loanable funds market.
If the interest rate (price) is set too high, there will be too little borrowing and spending, and many frustrated
lenders. The result may be an economic recession. If the interest rate (price) is set too low, there will be too much
borrowing and spending, and not enough people wanting to lend. The result may be some inflation.
It is worth noting that some economists in New Zealand – Eric Crampton (of the New Zealand Initiative) for one – favour
negative interest rates (pure expansionary monetary policy) over an expansionary fiscal policy where governments borrow
(and spend) enough to allow the interest rate to stay positive. This is the view generally favoured by economic
liberals; economists and others who are sceptical of governments having too large a presence in the market economy. This
scepticism is based partly on a general distrust of large government, and partly on a disbelief in the competence to
bureaucrats to make the best spending decisions. Economic liberals generally see private spending as more efficient, at
the margin, than government spending. ('At the margin' means considering 'extra spending' rather than 'total spending'.)
Certainly, if governments fail to take on enough new debt this year, the case for negative interest rates will
strengthen. And the case for deeply negative interest rates in countries more affected by Covid19 than New Zealand will
be strong if governments in those countries run insufficiently large budget deficits.Negative interest rates in the past
Except for the recent cases of Sweden
, Denmark, Switzerland and Japan, I know of no historical cases of negative nominal interest rates. But negative real interest rates have been quite common. The last time we had substantial negative real interest rates in New Zealand was
from the late 1960s to the early 1980s. Then, inflation rates were higher than interest rates, so saved money would buy
less in the future than in the present. And repaid money could buy fewer goods and services than the money could have
bought if it had been spent instead of lent.
While the capitalist world did not fall apart in the 1970s, many people felt that they were entitled to positive interest rates, without ever being able to say why. And those people instigated a revolution, called neoliberalism.
In today's world, without inflation, negative real interest rates also mean negative nominal rates. (An interesting
case, however, is Switzerland, which for a while had negative inflation and less negative interest rates, meaning that
real interest rates were not negative.) Thus (unlike in the 1970s), the quoted (or 'headline') interest rates – at least
in wholesale financial markets – would have to be negative. This is what makes some people very uneasy.
In my chart analysis of Sweden and Australia
, I noted that there was a particular reason why Sweden, Denmark and Switzerland had to have negative interest rates. In
order for these countries to have similar trade surpluses as their comparable countries inside the Eurozone (Germany,
Netherlands and Austria), they had to avoid appreciations of their currencies. That meant they needed interest rates
lower than in the Eurozone; and the Eurozone had a core wholesale rate of zero.
The Swiss Franc has been stable against the also-strong United States dollar since 2014. Many people prefer to hold
money in Swiss Banks despite the negative interest they 'receive'; to these people, it's like paying a fee to keep their
money in the best place for them; not unlike the situation my mother told me about in relation to banks in the 1960s.Deeply Negative Interest Rates
It may well be necessary for interest rates in some countries to go deeply negative. That will mean negative retail interest rates (term deposits), and negative mortgage rates.
Imagine deposit rates and mortgage rates set at, say, minus two percent.
The situation would not be fundamentally different from that of the 1970s, when the incentive was to borrow and spend
rather than to save and lend. But, the obvious new problem is that people will want to drain their interest-bearing bank
accounts, as stashes of cash, and then bury this cash under the bed, or some such place.
Fortunately, the world now has an infrastructure for cashless transactions. It would not be necessary to ban cash –
notes and coins – entirely, though fear of infection from paper money is probably precipitating the end of cash. While
notes and coins are convenient for small day-to-day payments – especially when there are power cuts or other
infrastructure failures (such as software virus pandemic) – we could still make promises (the oldest form of money
ever). One benefit would be to abolish all banknotes worth more than $20, forcing the criminals with large stashes of
cash to come to the bank, and explain how they acquired so many high-denomination banknotes.
Another advantage would be that, with no real alternative to electronic money, then fees charged to vendors using EFTPOS
(and the like) would have to be abandoned.
The most important thing would be that we would understand that – at certain times – it is irresponsible to not spend
our incomes, and that such anti-economic behaviour as money hoarding would incur a cost. It would mean that high-income
frugal people would be incentivised to earn less in the market economy. There would no longer be an incentive for people
to earn very high incomes, and there would be more space for today's disadvantaged people to earn adequate incomes.
In other words, interest rates that at first sight should lead to more spending could in fact lead to sustainable
living. In turn, as some people choose to earn less and lend less, then conditions would gradually come to favour a
return to higher (zero or positive) interest rates.Thinking outside the box
Even orthodox and conservative economists can think out of the box. They can apply their economics' training to new
situations, so long as they can free themselves from non-economic constraints on their thinking.
Too much of our policy chatter is conducted either by people unable to think like economists – most politicians,
bureaucrats, journalists, businesspeople – or economists and financial analysts who have studied economics but whose
cultural backgrounds have inhibited them from grasping the creative power that economic thinking can give them.
Substantially negative interest rates represent one very important thought experiment that well-taught students of
economics can lead public discussion on.
Kenneth Rogoff: The case for deeply negative interest rates
. Think Outside, 11 May 2020