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The ever-falling lower bound

We were told for a long time that negative interest rates were impossible, that central banks had to stop lowering interest rates when they hit a "zero lower bound" early in the crisis. Reality has again proved its awkward tendency to rebel against economists' assumptions about how it should behave.

In most of Europe (the eurozone, Switzerland, Denmark and Sweden) official interest rates are sub zero. A large part of the outstanding European bond universe now charges negative yields - it looks like even Italy, Spain and Portugal will soon be paid to borrow. New bond issues are going in the same direction. Already, investors have agreed to pay the German government for taking their money for five years. But the weirder, and arguably more important, aspect of the negative interest world is how it is beginning to affect the private sector.

The New York Times has an interview with two Danish women that shows the new reality hitting the "real economy". One, an entrepreneur who was just granted a business loan from her bank, can celebrate not only funds for an expansion, but also that after fees, she will be paid about $1 per month net for taking the loan (her interest rate is -0.0172 per cent). The other, a student, is now being charged interest on her deposit balance. Her bank is encouraging her, sotto voce, to take her money elsewhere. (The WSJ, meanwhile, reports on technical challenges: talk is of a Y2K-style problem of unprepared computers.)

Through the looking-glass as these phenomena may seem, the important thing to notice is that they show private banks doing just what they always do. That is to say, they price their products to protect their spreads. Having to pay negative interest on their reserves with the central bank requires them to protect their bottom line somehow. They can do this by passing some of the cost on to their own depositors. Or they can do it by making their balance sheets work harder - ie lend more. Even if they have to pay borrowers to take the loans, this still generates a profit if the lending rate is higher than the deposit rate. Ultimately the effect must surely be to discourage people from saving and entice them to borrow, spend, and invest. Nouriel Roubini offers a very level-headed reminder that the point of negative interest rates is just the same reason we want low interest rates in normal cases of weak demand. Their job is to reduce excess savings and stimulate aggregate spending.

We should be happy, therefore, that people were wrong about the "zero lower bound" (ZLB). We should be less happy about the influence that the ZLB concept has had on what policy makers think they can possibly do. It's a case, to paraphrase Keynes, of practical men (lamentably, most central bankers still are) being the slaves of not-even-defunct economists. Paul Krugman and like-minded economists have built much of their case against fiscal austerity on the powerlessness of monetary policy (and as a result a greater effect of fiscal stimulus on aggregate demand) once interest rates hit zero. There are obviously other arguments against fiscal consolidation, but it serves no one that a principal premise of the case that has actually been made, is wrong.

Now ZLB defenders are revising their positions. Even Krugman admits to having been "too casual". So the focus is moving to a somewhat-less-than-zero lower bound, and quite a bit of thinking is going into establishing how much that "somewhat less" is. Since the alternative to keeping money in a negative-rates banking system is to hold zero-yielding cash, these efforts concentrate on estimating the costs and inconvenience of storing cash. Krugman, however, in the same post linked above, argues that convenience is irrelevant. With negative interest rates, he claims, there is no opportunity cost of liquidity, so people hold all the liquidity they want. At the margin, any dollars held in cash are only for the purpose of storing wealth - so only storage costs matter, and the actual lower bound is not that far below the zero Krugman has long insisted on.

But it's more complicated than that. Krugman's logic implies, correctly, that with negative interest rates, cash is becoming a (relatively) high-yielding asset rather than a medium of exchange. But then the opportunity cost of cash is, like with other assets, not just the missed return on better-yielding safe investments (which may have disappeared), but the relative illiquidity of the asset. And cash is not the most liquid asset around (unless you're in the illegal drugs or weapons trade). Current accounts are. So current account balances are really what should be seen as the "liquid asset" in the standard argument about liquidity preference, with cash one of the relatively illiquid ways of storing wealth instead of maintaining liquidity (try paying your household bills with cash stuck in your safe deposit box). The easier it is to transact electronically, relative to cash, the greater is the relative illiquidity premium foregone by holding cash - and the lower interest rates can go before people choose to hold cash instead.

How much more liquid deposits are than cash varies from place to place, but the technology is obviously working in favour of electronic means of transaction. A fascinating blog post by JP Koning reports that Sweden has passed "peak cash": the amount of physical cash in the economy has been declining since about 2007. (Homeless magazine vendors apparently accept card payments.) Even in the US, which lags far behind Scandinavia in putting state-of-the-art electronic payments technology to work, 80 per cent of transactions are cashless.

Not only does technology mean the rest of the world will eventually go in the same direction in Sweden. Governments themselves can affect the liquidity premium on deposits over cash by making cash less liquid (eg by not printing more cash or withdrawing large denominations - and there are much more radical options) or improving electronic money. Wherever the lower bound on interest rates is, it is both lower than most people think and set to keep falling.

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Numbers news

  • US Fed Funds futures for September dropped on Friday after another good US jobs report. That implies the market odds for an interest rate rise in September are now better than even.
  • Japan's Q4 growth figure was revised down today, but its composition meant improved news: consumption was better than previously thought, and the main drag on growth was an inventory drawdown.

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