The Feasibility of Negative Interest Rates

TND Guest Contributor: Paul-Martin Foss | Carl Menger Center for the Study of Money and Banking | 

Alex Pollock of the American Enterprise Institute seems to have missed the point of the European Central Bank’s (ECB) introduction of negative interest rates at its deposit facility.

Negative interest rates are like a 100% tax rate in many respects. If you set a 100% tax rate, people are just going to stop working. Not everyone, mind you, because there will be black markets and people trying to do what they can to keep from starving to death. But the economy for all intents and purposes will cease to function, hence the reason it is “impossible” to impose a 100% tax rate.

If you enact negative interest rates (i.e. charge people to deposit money), people will stop depositing money. It won’t be instantaneous, and there may still be some people who don’t mind paying to deposit money because they judge the cost of holding it themselves to be higher. But the reason the ECB enacted the negative deposit rate in the first place was to discourage banks holding money at the ECB. That’s why, on the first day negative interest rates went into effect, deposits at the ECB’s deposit facility declined by 65%. They’ve since rebounded, as evidently some banks must prefer paying the ECB than holding money in their own accounts, which is the likely reason why the deposit rate has been further lowered. Economists always argued that negative interest rates were “impossible” because it would lead to a decline in and eventual disappearance of deposits, which is exactly what will happen at the ECB. Just watch what happens to the ECB’s deposit facility on Wednesday when the new, lower negative interest rate takes effect. The size of the deposit facility will eventually shrink to zero, just as the ECB intends.

Pollock also mistakes the introduction of negative interest rates by the ECB with negative interest rates at commercial banks. As far as I am aware, no commercial bank has introduced negative savings rates. Sure, there are account fees, fees for not maintaining a minimum daily balance, overdraft fees, etc., all of which taken together have much the same financial effect as negative interest rates. But if a bank were to introduce a negative interest rate on its checking and savings accounts, it would quickly lose business to other banks, credit unions, wire services businesses, payday lenders, or Bitcoin. You can charge a negative interest rate, just like I can charge $5,000 an hour for my services, but if you think that you’ll be in business for long by doing that, you’re in for a hard reality check.

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This article was published at the Carl Menger Center for the Study of Money and Banking website and is reprinted with permission.