NEGATIVE INTEREST: THE DARK SIDE OF THE MOON-EY?
The ECB recently announced that it may consider an interest rate reduction on bank deposits to the point where the interest rate becomes negative. Currently, this rate, applicable to deposits from private banks to the ECB, is at 0%. A negative interest rate would imply making private banks pay to invest their funds with the ECB. It is as if the ECB gives such protection to deposits that it is necessary to pay for this guarantee over and above interest accrued by cash. The ECB is therefore indirectly pushing banks into loaning their surplus funds to states or private borrowers. This stance sends the message to the markets that the cohesion of the euro and the intervention of the Central Bank will not be impeded by symbolical thresholds.
Negative interest rates are not financial witchcraft. Obviously, it is worrying to think that the ECB will penalise deposits from private banks whilst at the same time it issues bank notes that are also recorded as its liabilities and which retain their face value. This is the flip-side, or rather the hidden side, of money. In addition, negative interest rates are only a temporary situation because interest is the “price of time” applied to money; such being the case, negative time does not exist.
However, some European countries (Denmark, Switzerland and Sweden) have already used this technique. Some states in the Eurozone have even made short-term borrowings under negative conditions during the sovereign problems of the very recent years. Moreover, we have already entered into the realm of negative interest rates, because the effective interest rates, i.e. after deduction of forecasted inflation, are negative. There is, however, a difference: negative effective interest rates do not tap into capital (€ 1,000 remains € 1,000, even if the interest rate is insufficient to cover inflation) whereas negative nominal interest rates alter capital (a deposit of € 1,000 becomes € 990, including interest).
Why is the ECB contemplating negative interest rates?
This situation stems from financial repression, a recession and the fight to reduce indebtedness. Financial repression is a context characterised by rates that are maintained at an artificially low level in order to lighten the load of public debt. The recession also exercises pressure on interest rates: since the needs for investment are exceptionally low, the amount of borrowed money decreases and its price devaluates, i.e. the interest rate decreases. If they were transposed to the economy as a whole, negative interest rates would be aimed at stimulating borrowing and consumption, as well as at discouraging saving since a deposit of funds would be penalised. The ECB probably also wants to ensure that the credit lines granted to private banks do not show up, in the form of deposits, on its own balance sheet.
The economy is therefore stagnant and the monetary circuits are jammed. It is entangled in a "liquidity trap" that characterises the periods during which consumption and investment are indifferent to the supply of money and miniscule interest rates.
This situation can also be disadvantageous: states’ indebtedness is reinforced by low or even negative rates. Such rates do not require discipline from states which can consolidate their debt at reduced cost. They also incite investors to take additional risks whilst contributing to the creation of asset price bubbles.
As for the financial institutions that draw their substance from the transformation of maturity dates (banks, life insurance companies), they are confronted with an inversion of the value creation chain. Banks, for example, possess placements that traditionally have a longer maturity date than their liabilities, i.e. the deposits which they receive. Initially, a decrease in interest rates has a beneficial effect on the balance sheet via unrealised capital gains, but this advantage dissipates over time. Interest rates that are too low hence lead to an ebbing away of profitability . In fact, financial institutions are torn between yields that are too low on their assets and incompressible demands for remunerations from their own customers. Furthermore, instead of enjoying a maturity date transformation margin between deposits and banks’ investments, the latter have to absorb the operational costs that exceed this very margin. This pressure is all the more severe when the decrease in interest rates is considerable.
In conclusion, with negative interest rates, we would enter into a strange new world. In its least severe form, it would resemble an inflationary situation. Since the banking channels are currently too slippery to translate creation of money into inflation, it is statutory decreases of currency rates that would be used as a temporary replacement. In other words, the decrease in the price of money replaces the weakness of its circulation in the economy.
On intuition, negative interest rates would not represent a distortion of the market, but rather a confrontation of public debt with reality. Public debt has its exact counterparty in the form of currency, of which it is a mirror image: public debt normally has the same value as the bank notes issued by the Central Banks. It is commonly acknowledged that public debt must be progressively reduced by 30%. This means that in an economy without growth, the monetary standard must be depreciated at the same proportion. Inflation, combined with low interest rates, makes it indeed possible to depreciate currency and public debt. However, in the absence of inflation, negative interest rates produce more or less the same result.
Finally, the difficulty is not entering into the realm of negative nominal interest rates, but emerging from it. If there is a brisk rise in interest rates, there is the risk of the economy contracting severely. This is why I sense that the path of negative nominal interest rates will only be a transitory one. They would place the economy in a situation of currency value loss before inflation replaces, at a certain moment, the negativity of interest rates.
