Negative Interest Rates: Another Misguided Attempt to Increase Bank Lending

by | Economy, Markets, & Interest Rates

There is much talk in the financial press about ‘negative interest’ rates—which adds yet another oxymoron to a list that includes ‘Great Depression,’ ‘jumbo shrimp,’ and ‘open secret.’

It is a head-scratcher that a person could deposit $1,000 at their bank and get $995 back. Were that true, they might as well have kept their money under the proverbial mattress.

The European Central Bank, Sweden, Denmark, Switzerland, and Japan have all implemented some form of ‘negative interest.’ None of these countries or regions, however, has seen commercial banks charging their customers for depositing money.

Increasing Bank Lending

Instead, what the financial press is referring to is another desperate, misguided attempt by the Central Banks of these countries to increase bank lending. What they are hoping for is, if they charge banks for depositing money, banks will decide to make more loans to earn more interest rather than leave their money at the Central Bank and watch it deplete from deposit fees.

However, we had seen this scenario before, when the Central Banks of the world instituted quantitative easing. Here in the United States, bank reserves jumped from $46 billion in 2008 to around $2.7 trillion today. During this time, respected economists, journalists, and politicians opined about possible inflation caused by commercial banks lending those recently acquired reserves.

For example, on January 3, 2013, former Senator, Phil Gramm and Stanford Economist, John Taylor wrote in the Wall Street Journal: “with banks holding excess reserves rather than lending them out–and with velocity at a 50-year low and falling–the inflation rate has stayed close to the Fed’s 2% target.”

Also, that same month, Journal reporters Jon Hilsenrath and Kristina Peterson wrote: “One reason the hawks have been wrong about inflation is that the money that the Fed has pumped into the financial system has tended to sit at banks without being lent to customers.”

The Money Multiplier

Inflation never happened, because the theory that reserves multiply into loans—the so-called ‘money multiplier’—is a myth. A vestige of a time when countries were on the gold standard and, theoretically, the amount of gold a Central Bank owned dictated commercial bank lending.

In today’s world, the number of reserves that banks deposit at their Central Bank has almost no bearing on credit creation. Nor can the banking system reduce the total amount reserves by making loans.

Say I borrow $100,000 from Bank A. Along with the loan, Bank A will credit me back with a deposit for $100,000. If, the next day, I move the $100,000 from Bank A to Bank B, I will still have my $100,000 loan with Bank A, but the money will now reside in Bank B.

Bank A will then transfer $100,000 from their reserve account at the Federal Reserve to Bank B’s reserve account. Bank A will have less money earning negative rates; however, Bank B will have an extra $100,000 exposed to negative rates. Thus, a loan will merely move reserves from one bank’s reserve account to another bank’s reserve account.

Central Banks

I am not one who believes that Central Banks are evil or that we need to audit our own Central Bank—the Federal Reserve. But a Central Bank penalizing banks for having too many reserves, when it was the Central Bank’s bond purchases (quantitative easing) that had credited the banks with the reserves in the first place, brings to mind a quote from a famous but misguided economist, Karl Marx, that history repeats itself “the first time as tragedy [financial crisis], the second time as farce [negative interest rates].”

But if the economy continues to slow, or  worse yet, goes into a recession, and our Central Bank, the Federal Reserve, joins other Central Banks and implements negative interest rates, the ineffectiveness of that policy might create the opening for what Thomas Kuhn, in his famous book The Structure of Scientific Revolutions, called a paradigm shift.

From an economy too reliant on finance and banking for economic growth to one built on the blocking and tackling of economic growth: entrepreneurship, education, manufacturing, investment, and infrastructure

Bloomberg Article on Central Banks Implementing Negative Interest Rates

Paul Sheard Article With the Quotes from Phill Gramm, John Taylor, John Hilsenrath, and Kristina Peterson (PDF, Page 11)

Thomas Kuhn’s Book at Amazon

These are the opinions of Financial Advisor Tim Hayes and not necessarily those of Cambridge Investment Research. They are for informational purposes only, and should not be construed or acted upon as individualized investment advice.

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Tim has been a professional financial advisor for 26 years. He specializes in building custom portfolios for people that are saving their money for retirement or are already retired.

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