Do Negative Interest Rates Work?

by Andrea Lan

Countries such as Japan, Switzerland, and Denmark are dabbling in the world of negative interest rates in an effort to encourage spending. Negative interest rates are exactly what they sound like: instead of earning interest on savings, the central bank will shrink the account balance on bank  reserves. Theoretically, central banks will target a negative overnight lending rate in an effort to encourage people to spend and banks to loan in order to increase demand for borrowing, while lowering the cost of borrowing.  
​
This however does not mean that all interest rates are negative, it is just a rate that the central bank targets.Fundamentally, people need incentive to save. Thus, the longer people lock down their money, the higher the interest rate will be on those savings. Shown in the chart on the left, the short term lending rate starts negative, while long term bonds still yield a positive return. Consequently, banks are struggling to make a profit and keep excess reserves for overnight interbank lending.

Nevertheless, the theory behind negative interest rates remains to be just that: a theory. Reality shows that negative interest rates do more harm than good. In response to near negligible inflation and falling prices, Japan introduced a .1 of one percent fee on banks’ reserves in 2014. Two years later, “core consumer prices [still] fell .5 percent”. Additionally, only two months post negative interest rates, demand for Japanese bonds increased. Suggesting that despite negative interest rates, people were still willing to secure their money in bonds rather than spend it. Four years later and Japan has yet to hit its 2% target inflation. Though Japan has recently seen a small boost in their economy, it would be a reach to credit it to negative interest rates given the recent increase in prosperity within the global economy. Undoubtedly, the recent inflationary pressures could very well explain the boost in price levels that many of these countries have been looking for. While this unorthodox form of monetary policy has put more money in circulation, it does not mean that the money is being well spent or, for that matter, even spent at all.

The long term effectiveness of negative interest rates is questionable. Although low interest rates make borrowing cheaper, it does not mean the investments being made are in the interest of increasing capital stock, labor force, and furthering education.  Looking into a country who is no stranger to negative interest rates, Denmark has been below zero for five years this July while their prosperity remains dubious.  Despite Denmark’s flourishing housing market, the high-risk borrowing that comes with low interest rates leads to unreliable loans. Leaving the country with an influx of potentially-questionable loans if the interest rates were to ever rise again. If the interest rate were to resume positive rates, many will no longer be able to afford their loans, posing the threat of defaulting on loans… sound familiar? In 2008, the millions of people who defaulted on loans which they could not afford largely contributed to the catastrophic collapse of the housing market. 

All in all, this new phenomenon has not been proven to be effective in the short run and poses many potential problems for long term growth of an economy. Putting more money in people’s pockets does not guarantee that they will spend it.

​Intrigued? This will not be the last that you hear of the fascinating world of negative interest rates, Although interest rates are negative our interest in them certainly is not!

​

---