VoB Writing Contest 2020
November 25, 2020
VoB Bulletin 1st Issue
August 6, 2021
Interest Rates Are Changing around the world and Here's Why
Envision a world where you pay the bank for holding onto your money and the bank pays you for taking out loans. Even though this view might sound bizarre to us, it doesn't so much to Europeans and the Japanese; this is exactly what is happening in their homelands.
The whole idea of negative interest rates might seem counterintuitive and crazy to some but it is a potent economic tool. I know you are thinking "Why would a bank or lending agency pay someone to borrow their money?" Considering they are the ones taking the risk by lending. You're not wrong about that, but Central banks have to take drastic and unpredictable measures at times of desperate needs to keep the economy from reaching a state of deflation.
As growth rates have started to trickle down over the years, countries have been looking at various ways to revive the economy. One unorthodox device that policymakers have at their disposal is negative interest rates. It is reserved only for portentous economic times when economists are left with no other choice.
What are negative interest rates?
Interest rates are defined as the sum you pay to borrow money. What are negative interest rates? They're exactly what any logical human brain would perceive it to be. A negative interest rate means an interest rate below zero. Instead of the bank paying you, you pay the bank to hold onto your reserves, like a storage fee.
The mechanics behind negative interest rates is quite simple. When there is a period of low inflation or deflation consumer spending is low which stagnates the growth of the economy. One option which federal banks have in this case is to lower the interest rate to encourage borrowers to inject money into the economy. Negative interest rates help to increase spending by making it costlier to hoard money in the bank.
With time the threshold for lowering interest rates has gone down close to zero and approximately zero in some parts of the world, making negative interest rates almost a natural consequence. Though it is a fairly new concept, governments around the world are adopting negative interest rates policies, especially during COVID-19 when central banks are constrained to make economic decisions. The Bank of England has asked local banks to prepare for negative interest rates and The Federal Reserve in the US set interest rate to 0 which is the lowest in US history.
How does it work?
Negative interest rates work by shrinking interest margins and penalising consumers and businesses for keeping savings in the bank. But if this is true, what's stopping people from stuffing their mattresses with cash? For starters, it's not safe. Your house may burn down at any moment, depriving you of all your life savings. And for big institutions of the world with billions of dollars, it's just not an option. Think of the interest like a storage fee you pay the bank to keep your money safe. That fee depends on how much you are saving and on the bank's interest rate policy.
As of 2020, $18 Trillion of all government bonds around the world are negative. More countries want to lend money but there's no taker as economic growth is not substantial. Some areas of Europe have as low as -0.5% interest rate. It is still not enough considering the natural rate of interest in Germany is at around -2%. Governments will be forced to employ even extreme measures of negative interest rates in the future. Then the government has to be the one who borrows and spends money in different sectors of the economy like infrastructure and employing a green economy.
Negative Interest rates in action
In 2014, central banks of Denmark, Germany and some other European countries introduced negative interest rates for the first time to tackle the Eurozone crisis. The European Central Bank (ECB) introduced a -0.1% interest rate to increase borrowing and hold off deflation.
The Bank of Japan was the first central bank in the world to switch to zero interest rate in 1999. Japan has been in a long period of deflation over the years. Finding no other measures in 2016, the Bank of Japan introduced negative interest rate. Both ECB and BOJ haven't been able to come out of the negative territory.
In the EU, inflation rate still lingers the same which raises the question of whether negative interest rates are effective. Many experts think people simply responded to negative interest rate policies by moving their savings from one bank to another. Research indicates that there were no incentives for people, corporations, and non-government organizations to spend money instead of keeping it tucked away in banks. However, Other research done by the ECB suggests policies have worked and kept Europe out of falling into a deep cycle of deflation. The whole thing has been like an experiment by the ECB and other central banks and that's why you won't find many topics regarding negative interest rates in textbooks.
What does it mean for the future?
The subject of negative interest rates has been a hotly debated one, especially politically due to a lack of understanding of the matter. Going into it nobody was sure if this was going to work out. There was a lot of research that suggested positive outcomes but there also was the fear of people burying money underground and bringing down the whole banking system. So far, banks in Europe and Japan haven't reported any kind of fall in earnings. But there are still lots of challenges to overcome and questions to be answered. Let's take a look at how your personal finances will be influenced if negative interest rates policies are implemented in the future:
- Loans: Recently a Finnish bank called Nordea Bank offered a 20 year mortgage loan at 0% interest rate. You are thinking that's great! I can finally buy my dream house without paying any extra! But this in turn will encourage borrowers to take out loans and buy housing properties which in turn will create a housing shortage and drive up costs.
- Credit Cards: In the US, according to the federal reserve customers pay an average of 16.27% interest on credit card loans. Although it is unrealistic to expect that people will get paid every time they make a swipe, interest rates will certainly go down, giving consumers incentives to spend more.
- Savings account: Considering the whole concept of negative interest rates is to encourage spending instead of keeping money in the bank, savings accounts could become a thing of the past. Jyske Bank (A bank based in Denmark) in 2019 launched a negative interest rate based savings program where customers who hold more than 1.1 million USD are charged 0.6% of their savings annually.
Bottom Line
Negative interest rates are an eccentric monetary policy tool used by policymakers in challenging macroeconomic environments. Experts argue complementary policies such as complementary deposit facility, expanded assets purchase program, expanded quantitative easing program, currency intervention, etc., have to be implemented for negative interest rate policies to be successful. It is a new concept and we are learning more about it every day. But rest assured, more countries will soon follow suit as countries around the world face growth disappointments, a depressed inflation rate and a declining real interest rate. Will negative interest rates policies be successful or will they bring a tumultuous meltdown of the financial markets like that of 2008? The answer remains an obscure one and is up for debate.
Written by
Rahat Hossain Rahim
