Monday, June 9, 2014

How Not to Think about Negative Rates

Last week’s big monetary-policy news was the ECB’s decision to target a negative interest rate, in the form of an 0.25 percent tax on bank reserves. This is the first time a major central bank has announced a negative policy rate, though some smaller ones (like the Bank of Sweden) have done so in the past few years.

Whether a tax on reserves is really equivalent to a negative interest rate, and whether this change should be expected to pass through to interest rates or credit availability for private borrowers, are not easy questions. I’m not going to try to answer them now. I just want to call attention to this rather extraordinary Neil Irwin column, as an example of how unsuited mainstream discussion is to addressing these questions.  

Here’s Irwin’s explanation of what a negative interest rate means:
When a bank pays a 1 percent interest rate, it’s clear what happens: If you deposit your money at the bank, it will pay you a penny each year for every dollar you deposited. When the interest rate is negative, the money goes the other direction. … Put bluntly: Normally the banks pay you to keep your money there. Under negative rates, you pay them for the privilege.
Not mentioned here, or anywhere else in the article, is that people pay interest to banks, as well as receiving interest from them. In Irwin’s world, “you” are always a creditor, never a borrower. 

Irwin continues:
The theory is that when it becomes more costly for European banks to keep money in the E.C.B., they will have incentive to do something else with it: Lend it out to consumers or businesses, for example.
Here’s the loanable funds theory in all its stupid glory. People put their “money” into a bank, which then either holds it or lends it out. Evidently it is not a requirement to be a finance columnist for the New York Times to know anything about how bank loans actually work. 

Banks will most likely pass these negative interest rates on to consumers, or at least try to. They may try to do so not by explicitly charging a negative interest rate, but by paying no interest and charging a fee for account maintenance.
Note that “consumers” here means depositors. The fact that banks also make loans has escaped Irwin’s attention entirely. 

Of course, most of us are already in this situation: We don’t receive any interest rate on our transaction balances, and pay are willing to pay various charges and fees for the liquidity benefits of holding them. 

The danger of negative rates, per Irwin, is that 
It is possible that, assuming banks pass along the negative rates through either fees or explicitly charging negative interest, people will withdraw their money as cash rather than keeping it on deposit at banks. … That is one big reason that the E.C.B. and other central banks are going to be reluctant to make rates highly negative; it could result in people pulling cash out of the banking system.
Again the quantity theory in its most naive and stupid form: there is a fixed quantity of “money” out there, which is either being kept in banks — which function, in Irwin’s world, as glorified safe deposit boxes — or under mattresses. Evidently he’s never thought about why the majority of us who already face negative rates on our checking accounts continue to hold them. More fundamentally, there’s no explanation of what makes negative rates special. Bank deposits don’t, in general, finance holdings of reserves, they finance bank loans. Any kind of expansionary policy must reduce the yield on bank loans and also — if margins are constant — on deposits and other bank liabilities. Making returns to creditors the acid test of policy, as Irwin does, would seem to be an argument against expansionary monetary policy in general — which of course it is.

What’s amazing to me in this piece is that here we have an article about monetary policy that literally makes no mention of loans or borrowers. In Irwin’s world, “you” are, by definition, an owner of financial assets; no other entities exist. It’s the 180-proof distillation of the bondholder’s view of the world.

Heterodox criticism of the loanable-funds theory of interest and insistence that loans create deposits, can sometimes come across as theological, almost ritual.  Articles like this are a reminder of why we can’t let these issues slide, if we want to make any sense of the financial universe in which we live.


  1. The ECB reduced the deposit rate by a whopping 0.1% (previously the smallest change was 0.25%) from 0% to -0.1% (which doesn't automatically make "interest rates" negative - that depends on the abundance of reserves). The excitement is out of proportion to the move, and the negative rate (let's not call it a tax) doesn't affect the public at all, since only banks can hold ECB deposits.

    1. Of course you are right, 0.25 points won't matter for anything. But it's still interesting to ask whether a tax on reserves is in general equivalent to a negative rate, and if so, how this will effect credit flows and the larger economy.

      It is true that only banks can hold reserves at the ECB. The idea that banks would "lend their reserves to the public" is part of the general quantity-theory-for-third-graders quality of the column. But it doesn't necessarily follow that taxes on reserves will have no effect on interest rates for nonfinancial borrowers. It's possible that a tax on reserves could shift the whole complex of rates downward. I'm not sure this is right, but it isn't obviously wrong.

  2. On that note - how about some recommended reading!

  3. Is it not contradictory to say on the one hand "Bank deposits bank loans" and on ther other "Loans create deposits"? What am I missing?

  4. To say liability X finances asset Y just means that X and Y are added to the balance sheet by the same transaction or series of transactions. Assets are always financed by liabilities, this doesn't imply that liabilities are causally prior. To say that liability X creates asset Y, on the other hand, implies some kind of priority for the liability. I think this is standard language? -- tho I can see now it could be confusing.

    The idea that banks receive deposits first, and then lend them out, is just wrong -- one of the biggest mistakes people make in thinking about finance. But I do think some Post Keynesians bend the stick a little too far in the other direction, and talk as if banks are never constrained in their ability to emit new liabilities, and that the size of bank balance sheets is limited only by capital-asset ratios.

    1. Thanks for responding, that makes sense.

      I really enjoy your blogging, keep fighting the good fight!

    2. that the size of bank balance sheets is limited only by capital-asset ratios.

      ... or that there is no limit on bank balance sheets at all, and that the nonfinancial sector always faces an infinitely elastic supply of credit at the policy-determined interest rate. This was "horizontalist" position of Basil Moore etc., tho I don't know how many people still hold it.

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