Swinging an economic power tool with the negative interest rate
In December, Switzerland took the radical move of introducing a 0.25% negative interest rate. While it is an unusual method, this is not the first time it has been utilized; though admittedly the use of a negative interest rate is one of the larger and more radical options for a central bank to wield. What is it, why would you want it, and does it work?
In most normal circumstances, interest rates are positive, and the lender will receive money for doing so in the form of interest. However, a negative interest rate heralds a reversal of the situation, where it no longer pays to lend money. When an amount is deposited, it depreciates as interest is levied on the deposited sum. This sounds like a bad thing, but sometimes it can be an incredibly useful tool for central banks.
In Switzerland’s case, due to the simultaneous collapse of the ruble, oil prices, and general world economic “tremors,” investors have begun looking at the country as a safe haven for their money. Switzerland has long filled such a role and as such money began to pour in. To stop this from happening, a negative interest rate was introduced by the central bank, and since it no longer paid investors to deposit money into the country, the influx of cash was stemmed.
Why would the inflow of money need to be stemmed in such a manner? A major effect of such an in-pouring of money was the inevitable rise in value of the Swiss franc against the euro. This in turn makes the purchase of Swiss goods and services more expensive and hurts the wider economy. In fact, due to this problem, the Swiss had set a cap so that the Franc was never stronger than CHF 1.2 to €1. This artificially imposed limit on the rise in value of the CHF keeps export costs down and maintains a trade surplus, which is beneficial to the wider economy. Early this year the cap was lifted abruptly sending the Euro on a roller coaster ride.
The idea is not a new one, however. Back as far as the nineteenth century, the German activist and economist Silvio Gesell was proposing negative interest rates as a “tax on money” or, more specifically, on holding or carrying money. Even respected economists such as John Maynard Keynes have held the torch for some form of negative interest rates for a time, though Keynes settled on a mildly inflationary economy as a means of achieving the same end. However, the idea of a negative interest rate has support for a variety of functions and from across the political spectrum.
Indeed, the UK’s central bank, the Bank of England, briefly considered cutting their interest rates from the record low of 0.5% to a negative figure. This was ostensibly to promote lending to small businesses and to stir money around the economy rather than banks holding onto it. However, in the end this “radical” move was abandoned, partly due to the fear that it might bankrupt smaller banks whose focus was providing savings and current accounts rather than dealing in high finance. The proposal for a negative interest rate has not been ruled out as a future option though.
There is a way around this problematic facet of negative interest rates that other countries have practiced in the past. When Denmark introduced negative interest rates for a short time in 2012, it distinguished between the base rate and a deposit rate. This meant that only money deposited in the central bank was subject to the negative interest. The European Central Bank (ECB) has this option as well, being another institution that holds two interest rates.
The idea of negative interest rates garners support from across the political spectrum, from capitalists to anarchists. However, in the long term it tends to have a detrimental effect on savings if and when investors decide to try and recoup their costs from customers. In any case, a range of other measures are available to banks and governments. Quantitative easing, for example, has been used by both the UK and the US to achieve this end.
It very much matters what the banks want to achieve. The idea of a negative interest rate is clearly the sledgehammer of the toolbox. The thing to consider, though, is the problem one that needs such a hefty tool? With Switzerland, it is early days still and the answer remains to be seen. With increasing jitters in the world economy and things still looking decidedly fragile, it is almost certain that the idea of negative interest rates will remain close to the surface.
With Switzerland outside of the Eurozone, and indeed the EU, negative interest rates are unlikely to have a large knock-on effect in the short term and will certainly help to achieve the Swiss franc’s relative parity with the euro—thus achieving Switzerland’s aim of keeping exports down. However, in the longer term this type of protectionism may soon outlive its usefulness. Unless curtailed either by raising rates again or some other means, the Swiss will need to deal with the inevitable inflationary pressures awarded by lowering the rates in the first place.
By: Adam Faust, Founder/Principal Deep Blue Financial