How Negative Interest Rates Ruin Our Economies

There is a chance we will see them in the US soon

Mario Draghi, president of the European Central Bank (ECB), addresses the media following a meeting with the ECB’s council in Frankfurt, on Sept. 6. The European Central Bank has applied the concept of negative interest rates to money banks hold at the Central Bank. (Johannes Eisele/AFP/Getty Images)

As the U.S.-China trade war deepens, it creates ripple effects throughout the world. Growth rates are falling in China and other economies from Asia to Europe. In response, central banks are cutting interest rates to stimulate economic activity and growth.

It’s More Than the Trade War

Though the trade war isn’t the only cause of slowing growth in China, it is a major factor. Costly business regulations and social programs in places such as in Japan and the European Union are also a drag on economic activity and investment. What’s more, even though modern economies run on debt, too much debt in the system hinders growth and demand. But central banks are betting cheaper borrowing costs will stimulate investment in the economy.

However, lowering interest rates to counter sluggish demand isn’t always effective. Falling interest rates can have their own psychological impact on the business cycle and undermine business confidence instead of improving it. Adding more debt-fueled liquidity to stimulate demand in the economy then leads to diminishing returns on said debt and eventually default.

A Race to the Bottom

Of course, dramatically cutting interest rates also tend to devalue a currency. That’s a real temptation because it makes a country’s goods and services cheaper on the world market relative to other currencies. When one country does this, however, others often do as well to gain the same advantage. It becomes a race to see who can devalue their currency the fastest. At the same time, those nations with devalued currencies import fewer goods, since those goods have become relatively more expensive. A vicious circle of devaluation and economic contraction can occur.

But some countries are doing more than just lowering interest rates to near zero percent. Some have introduced negative interest rates into their economies. Although negative interest rates aren’t new, the scale with which they’re being used around the world is cause for concern, if not alarm.

Through the Financial Looking Glass

If the use of negative interest rates sounds backward or upside down, that’s because it is. Negative rates turn all the conventional rules and assumptions of finance and economics on their head.

For example, under normal economic conditions, a trade occurs in a relatively continuous and steady manner. The business cycle expands and contracts and interest rates react accordingly.  But generally, as economies grow and mature, long term demand grows as well. Banks, companies and individuals invest in an expanding economy and borrow or lend money to do so.

In this typical scenario, all the classic economic rules and assumptions of the time value of money, return on investment and so forth, apply. Positive yields in the form of interest received on money come with lending, just as interest paid by the borrower to the lender comes with borrowing.

But in a distorted economic environment—say, in a trade war for example—trade declines and growth is stymied. Economies stall or even contract. The uncertainty and risks of investing in such a climate rise. In this situation, investors in Europe, Japan and other places prefer to hold their money in the bank rather than risk investing in a shrinking economy. That’s what happening now.

A Downward Spiral

The risk-averse dynamic that accompanies or cause negative interest rates is a downward spiral for the global economy. As demand continues to fall, a new set of assumptions take effect.

When countries resort to negative interest rates, depositors actually lose money on the principal they put in the bank. It’s counter-intuitive, but negative interest rates require depositors to pay the banks interest (or fees greater than the interest) to hold their money. At a net annual interest rate of negative one percent, for example, a one-million-dollar deposit would decrease by one percent or $10,000 after one year. People are punished rather than rewarded for saving money.

This isn’t fantasy. Banks in Switzerland and Denmark have already adopted negative interest rates. The Bank of Japan is also using them and the Reserve Bank of New Zealand is seriously considering doing so as well.

What’s more incredible is that Denmark is now offering mortgages with negative interest rates. That means the bank pays you to borrow money to buy your house.

But wait, it gets worse.

Negative interest rates aren’t just impacting deposit accounts and mortgages. They’re now a part of the government and corporate bond markets in several countries that are paying negative interest rates on long term bonds.

For instance, all of Germany’s government bonds are now only offering negative interest. Currently, there are $15 trillion worth of negative interest bonds in the world, if not more. In 2014, there were none. This is a worrying trend.

Negative Interest Rates for the US?

So far, negative interest rates are not on the horizon for the United States. Although interest rates in the United States are low, they’re not near zero. The federal funds rate is between 2-2.25 percent. Still, more interest rate cuts are already expected due to the trade war with China and President Trump’s demand for lower interest rates from the Federal Reserve. Mainstream economic circles have been calling for negative interest rates for the past decade and there is a fair chance we will see them this time around, depending on if a recession hits and how bad it may be.

But there are also other conflicting influences at work as well. The relatively strong U.S. economy means a strong dollar, regardless of interest rate cuts by the Fed. This makes American goods more expensive, which could cause the American economy to slow, potentially inducing further rate cuts.

A Sobering Reality

We’ve entered into an era of systemic malfunction and high economic uncertainty. Whether negative rates come to the United States or not, the U.S. economy will still be affected. In fact, it already has been. Foreign capital exposed to negative interest rates will continue to chase positive returns on their savings in the foreign-driven inverted yield curve in the U.S. bond market.

The expanding use of negative interest rate bonds and deposits in economies around the world pose a sobering reality. Distorted interest rates no longer provide the market the information it needs to function properly. Without this price mechanism for money functioning correctly, how will capital flows remain efficient?

James Gorrie is a writer based in Texas. He is the author of “The China Crisis.”

Views expressed in this article are opinions of the author and do not necessarily reflect the views of The Epoch Times.