Why negative interest rates don’t work

Austrian economics has a bad rap, and we will opine that misgivings about a lot of its conclusions are not without cause. However, even bad economics can sometimes provoke insightful thinking. Here is a question posed by Eugen von Böhm-Bawerk in 1889:

A tree is growing in the forest… when do you cut it down to harvest its wood? Böhm-Bawerk suggested that the decision is driven by the rate of interest. As long as the rate of growth of the tree is higher than the rate of interest, the value of the wood in the tree grows faster than money. When the growth rate of the tree falls below the interest rate, you cut it down.

When the rate of interest is negative, when do you cut down the tree? Never! Well, at least not until it dies and threatens to fall on your house. So… why are negative interest rates and bond yields a good idea?

The blogosphere is full of predictions that the ECB will cut interest rates rather than undertake new QE. The logic is that bond yields in Germany, France, the Netherlands and other countries have gotten so negative that they are below the deposit rate at banks. So banks hold onto deposits as liquid reserves rather than pay borrowers, including the government, to take cash off their hands. Cut rates, the argument goes, and it becomes more expensive for banks to hold cash, unleashing vast amounts of liquidity.

This idea is silly: There are three key challenges to bank lending in Euroland, all of which would be made worse by another rate cut.

1) Deposit rates are negative. Banks make money taking in deposits at negative rates, and they reduce those earnings by lending out cash. Making short-term rates more negative does not change this reality.

2) Yield curves are inverted. Take a deposit at minus 40 basis points and lend it out for five years to a triple-A rated corporate at minus 60 basis points—spreads have been compressed to zero by ECB corporate bond purchases—and the bank actually loses 20 basis points on the deal. Lowering the deposit rate will not uninvert the yield curve: It will only lower the whole thing. Yield curves are negatively sloped for a reason, and the slope of the curve is independent of the level of the base of it. If you cut short-term rates to uninvert the yield curve, and if expectations are that you will do it again if the curve inverts, then you risk triggering a cycle of interest rate cuts, bond yield declines, and still more rate cuts because the curve has not uninverted at all. This is a spiral that no central banker wants to initiate!

3) The key reason banks are not making more loans is that they lack enough capital to meet regulatory requirements. This has been the problem since the global financial crisis, and it has been made worse by the ramping up of capital adequacy requirements. Nothing about cutting already negative interest rates makes bank capital rise relative to the value of assets at risk.

Negative interest rates have not worked for a while. There is no reason to think that making interest rates even more negative will be any more successful in revitalizing the Euroland economy.

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