The Absurdity of Negative Interest Rates by Paul-Martin Foss

Note that it is only the Austrian school of economics that has a correct view of the natural rate of interest such that the concept of a negative natural rate of interest is an impossibility. This view is due to the realization that interest is not exclusively a monetary phenomenon. Even in a barter economy there would be interest rates. Such rates would be determined primarily by time preference, the fact that humans value present goods more than future goods, plus a risk premium due to the possibility of default. Thus it is only the Austrian school that realizes why manipulation of interest rates by central banks to negative levels can cause harm to the economy.

Indeed, this is one of the most important aspects of Austrian school economics: correct definitions. By correctly defining the natural rate of interest as an expression of time preference, it becomes readily apparent that a priori, this rate can never be negative.

The European Central Bank (ECB) made waves recently with its decision to lower interest rates on its deposit facility to -0.30%. That means that banks wanting to park their money at the ECB have to pay the ECB for that privilege. The supposed reason for introducing negative interest rates is to spur lending on the part of banks. Rather than being able to park their money at the ECB for free or for a small guaranteed return, the ECB wants banks to put that money to use by lending it. The idea of negative interest rates was once seen as impossible to achieve by many central bankers. But since the ECB’s decision last year to introduce negative interest rates, the concept has become increasingly accepted among central bankers, with even a few Federal Reserve officials supporting the idea of negative rates. But are negative interest rates really feasible?

What we can’t forget is that the real rate of interest can never be negative. The real, or natural, rate of interest is a function of the preference for present goods over future goods. A bird in the hand is worth two in the bush, in other words. A negative natural rate of interest would mean that someone prefers less in the future to more in the present. Given the choice between $20 today and $10 tomorrow, you would prefer the $10 tomorrow. That is a complete absurdity that would never happen in reality. But when you realize that most of the assumptions made by mainstream economists in creating their models are absurd, unrealistic, and nonsensical, you can understand at least a little why those practitioners of voodoo mathematics think that negative interest rates are a potential policy tool.

If central banks continue to lower interest rates, it could paradoxically result in rising market interest rates. Consider the case of the average bank, which takes deposits and loans out money. The bank’s income is dependent on the spread between the interest rate the bank charges to borrowers and the amount of interest it pays to depositors. As central banks begin to introduce negative interest rates to their deposit facilities, charging banks to hold reserves at the central bank, banks have to find a way to recoup that money lost. If they begin to start charging negative interest rates to depositors, as one Swiss bank already has, they risk having depositors withdraw their funds from the bank.

Since deposits are what allow banks to loan money in the first place, banks may have to start calling in loans in order to satisfy depositors. As the amount of loans outstanding shrinks, the bank’s income will decrease. It can make up for that by downsizing its operations, laying off staff and closing facilities. The combination of reduced income and laying off employees sends a negative signal to markets, indicating that the bank is unsound, which could lead to even further depositor withdrawals and, in the case of a publicly traded bank, a decline in its stock price. The bank’s preferred solution then might be to keep income up by widening the spread between deposit rates and borrowing rates by increasing the interest rate charged to borrowers. And thus dropping into negative interest rates on deposits can lead to a rise in interest rates for borrowers.

The rest of the article can be read here.

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