Negative Interest Rates

What is it? 

A monetary policy tool that sets the nominal target interest rate below the lower bound of zero percent. It effectively means that you pay the bank for storing your money.

Why is it done? 

During deflationary periods, consumption and investments fall. This reduces the aggregate demand and creates a negative pressure on the economy. This happens because people prefer to save and hoard money instead to spending and investing it.

Theoretically, a negative interest rate reduces the lending and borrowing rates and this increases the credit demand. Consumption and investment go up and aggregate demand increases.

Problem solved? Not quite.

What it really is? 

It is a tax. The oxford definition of tax goes as follows:

A compulsory contribution to state revenue, levied by the government on workers' income and business profits, or added to the cost of some goods, services, and transactions  

Negative interest rates are set by the central banks (government), contribute to the state revenue and are added to the cost of banking services.

Only difference is that it is not compulsory to store money in central banks. You can put it in a safe or shove it under your mattress. But for commercial banks with surplus reserves, there is no mattress big enough to hold their cash. Ultimately, it becomes a necessity to store money in central banks and pay the ‘tax’ on reserves.

Who bears the burden of the tax?

Tax incidence could fall on three entities:

• Banks 
• Depositors 
• Borrowers 

Banks: 

If the banks choose to not pass on the tax and have low after tax profits, it would negatively impact their share prices and lower the equity. The incidence falls on the investors and share prices plummet.

The Bloomberg graph below shows decline in share prices of European banks. Faltering investor confidence is a major cause of this trend.

Image source

Depositors: 

If the banks choose to pass the incidence on the depositors, chances are high that the depositors would choose to not store money in banks and actually shove it under their mattresses. Not to forget, money hoarding is the very thing that the central banks were trying to avoid in the first place.

In case, depositors pay up the incidence, they would have less money to spend on goods and services, i.e. consumption will fall further.

Borrowers: 

Passing the incidence on to the borrowers would mean charging them a higher interest rate on loans or a higher loan processing fee. This would lead to a fall in credit demand and reduce investments, beating the primary purpose once again.

Conclusion

Data shows that negative interest rates aren’t delivering what was expected of them and it is not difficult to see why. Trying to solve a deflationary crisis from the supply side by a tool that contracts demand is as contradictory as it gets. The further central banks, ECB especially, tread into the negative interest rates territory, the more difficult it will get for the European banking sector. Forget economic growth, the interest rate differential could lead to a major capital flight when US increases its interest rates in the coming months.