Tag Archives: Negative Interest Rates

Why negative interest rates are justified.

The Free Exchange column in The Economist referred to negative interest rates as neither unfair of unnatural. Irving Fischer used the metaphor of the world’s oldest ship’s biscuits from a voyage back in 1852. Known as hardtack these biscuits were renowned for their longer storage life and therefore making them an important source of nutrition for sailors.

Fischer wrote in ‘The Theory of Interest’ in 1930 an imaginary scenario where a group of sailors are shipwrecked and the only food they have to sustain them is hardtack. Fischer proposed the question ‘under what circumstances would sailors borrow and lend biscuits? For most people interest is the reward for saving and delayed satisfaction so negative interest rates would seem to be unjust. In the case of shipwrecked sailors if one of them is prepared to lend another a biscuit the lender would want more than one biscuit in return and the more hungry they are the higher the interest rate. However Fischer pointed out that the interest rate should be zero as if it were positive it would mean that the sailor would have to take more than one hardtack biscuit to repay the loan. However no sailor would accept these terms as he could instead eat one more piece from his own supply, thereby reducing his future consumption by one hardtack biscuit. And a sailor who had already depleted his supply would be in no position to repay borrowed biscuits. If for instance the sailors were washed ashore with perishable items the interest rate would be negative – Fischer concludes that the rate of interest for any commodity should be negative not positive.

Recently banks in Japan, Switzerland, Denmark and Sweden started charging customers for saving money which asks the question why should people pay to keep their money in banks when they had already earned it? But charging customers interest is a natural occurrence when you consider that savers preserve their purchasing power without any care required to prevent any resources eroding. In 1916 economist Silvio Gesell gave his treatise in favour of negative interest rates on money. His said that storing wealth required considerable effort and ingenuity especially commodities like meat, wheat, fruit etc which are perishable. Gesell said that our goods rot, decay, break and rust. Only if money depreciated at a similar pace would people be as anxious to spend it as suppliers were to sell their perishable commodities. To keep the economy going he wanted money to rot like potatoes and rust like iron.

The negative interest rate introduced by Japan accompanied by an inflation target three years before is in effect pursuing Gesell’s dream of a currency that rots and rusts, albeit by only 2% a year.

Source: The Economist – Free Exchange – 3rd February 2018

Negative Interest Rates – What it means?

The aim in many developed countries is to stimulate economic growth and to raise inflation within the target bands as stipulated by many government’s central banks. For some countries the immediate objective has been to prevent their currency from rising making their exports more expensive and imports cheaper. Therefore the thought of negative interest rates discourages investors from buying your currency which would push up its value. The EU, Denmark, Sweden, Switzerland and Japan, central banks have decided to have a negative rate on commercial banks’ excess funds held on deposit at the central bank. In effect, private sector banks have to pay to park their money – see graph below.

New Zealand is currently in a bit of a predicament in that the OCR (central bank rate) is at 2.25% which is relatively high compared to other central banks and therefore does attract ‘hot money’ into the economy – money that ‘parks’ to earn interest. However if they drop interest rates to ease the pressure on the NZ$ they run the risk of further inflating the housing market by making borrowing cheaper.

For the consumer as soon as the rate banks offer fall below 0%, savers have an incentive to withdraw their money and put it under the mattress. By charging negative rates the central banks are hoping that the trading banks will keep more of their money and therefore lend it out to investors. However the desire to reduce a banks reserves is futile as if someone borrows money from a bank and buy a new car the money is paid to the car company who will then deposit the money in their account which increases the reserves of the bank.

Overall negative rate reflect the constant state of weak aggregate demand in many developed economies since the 2008 financial crisis. Central banks have kept their policy interest rates very low to stimulate economic growth and more recently to get higher inflation. However, how low can they go?

Negative Interest Rates

Below is a very good cartoon from the FT looking at negative interest rates.