Coping With Negative Interest Rates

October 12, 2019

Many people don't like negative interest rates. For that reason some politicians called for a ban on negative interest rates. This is a price control and that doesn't bode well for financial stability. Psychologists might be able to explain why people seen to prefer 2% interest with 4% inflation to -1% interest with 0% inflation. This doesn't seem rational, even more so because there are reasons to be happy with lower interest rates.

Lower interest rates affect mortgage payments. Taxes can be lower when governments don't pay interest. Interest costs are hidden in every product and service as corporations make investments that must at least make expected returns equal to the interest rate in the market. Hence, lower interest rates have a lowering effect on prices.

Negative interest rates and deflationary conditions may be here to stay. Interest rates are the result of supply and demand for money and capital. It may not be advisable for governments to create demand for funds by stimulating the economy and adding more debt. It might be better to let negative interest rates stimulate the economy without more debt and to help the public deal with the new situation.

If people see the number of monetary units in their account decrease, they may become dismayed, but when the monetary unit loses value, they seem less troubled. Perhaps people feel better with inflation and wage increases than with deflation and wage cuts, even when deflation and wage cuts are a better deal. A possible explanation is that inflation is less visible than negative interest rates and wage cuts.

People see negative interest rates reduce the balance in their account while inflation is stealthy. Wage changes are more visible than price changes as some prices go down while others go up. Negative interest rates and inflation could be a better deal because lower interest rates allow for more capital and wealth. Hence, there might be a cause to prevent people from fooling themselves in this way.

That can be done by hiding the negative interest rate in the same way inflation has been hidden. To explain how, we have to look at the characteristics of Natural Money. These are:

  • Central bank currency carries a holding fee of approximately 12% per year, so if you hold central bank currency then € 1,00 turns into € 0,88 after a year, which can make it attractive to lend out money at negative interest rates.

  • The holding fee is the new lower bound, not the interest rate. Interest rates on bank accounts might be around -2% per year in terms of central bank currency, so people don't pay the holding fee but the interest rate in the market.

  • Cash is a short-term loan to the government and carries an interest rate equal to short-term government loans in the market, which might be -3%. Henceforth, cash and central bank currency have different rates to prevent cash from being hoarded when interest rates are negative.

  • It is expected that interest rates go negative and remain in negative territory, so once most interest rates are negative, positive interest rates can be phased out to forestall a quest for yield leading to irresponsible risk taking.

  • Inflation is likely to end and deflation might set in, so the inflation rate might be -1%, which means that the price level goes down with 1% per year.

To see how this issue can be dealt with, it is important to realise that central bank currency and cash are to be separate currencies, and that a negative interest rate can be applied to cash, so that cash gradually loses value relative to the central bank currency.

With Natural Money cash loses value relative to central bank currency at a rate equal to the interest rate on short-term government debt. So, if the balances of bank accounts are to be expressed in cash rather than in central bank currency, the negative interest becomes hidden from the public.

The interest rate on short-term government loans is one of the lowest, so banks must be able to offer at least this interest rate so that people won't see the number of monetary units in their account go down. Prices may be expressed in cash only so that cash will be the currency in people's minds.

Inflation is expected to be low while there might even be deflation in terms of central bank currency so that cash could have a low inflation rate. If the assumptions above apply, then it may appear to the public that inflation is 2%, the interest rate on bank accounts is 1%, and that the maximum interest rate paid on loans is 3%.

It might be a good idea to call the central bank currency something like 'new currency for bank accounting' so that it may look like business as usual.

Critics might argue that people could be fooled by this scheme, just like they were fooled before by inflation. They won't notice the negative interest rate, just like they didn't notice the inflation previously. But separating cash and central bank currency and expressing prices and the value of bank accounts in cash can clear the psychological barrier that stands in the way of adopting negative interest rates by the public.

The account balances and interest rates expressed in central bank currency should be easily accessible at all times so that people can always access these data and inform themselves.

In order to avoid misunderstanding it must be stressed that central bank currency remains the accounting unit in the financial system. Bank accounts should be accounted in central bank currency, just like debts and interest rates as well as prices of financial assets. A similar situation existed in Europe between 1999 and 2002. In those years the digital euro was already introduced but cash was still the national currency.

A comprehensive explanation as to why interest rates may go negative and remain negative, and what the future financial system may look like, can be found on the Natural Money website via the following link:

https://www.naturalmoney.org

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