The failure of Negative Interest Rates

In past decades, central banks in developed countries, such as the Bank of England, the European Central Bank and the Federal Reserve, have often dropped rates to spur post-recession economic growth. However, in the decade following the Great Recession of 2008, several central banks experimented with negative interest rates, with Denmark being the first to do so in 2012. In times of sluggish economic growth, proponents claim that negative interest rates have proved beneficial by boosting aggregate demand. With this said, statistics have suggested otherwise, with its long term effects on both spending and the profitability of the financial sector being largely negative. In this way, setting interest rates to below zero has limited effectiveness and therefore, it should be avoided by central banks in all circumstances.

Proponents of negative interest rates argue that negative interest rates boost aggregate demand in an economy. This is because, in times of economic difficulty, banks view lending as too great of a risk, given the higher rates of unemployment and a greater chance of default, and thus opt to put their excess reserves with the central bank. However, with negative interest rates, banks are discouraged from doing this, as they lose some of their funds when depositing them with the central bank. Thus, the only alternative is to lend out money, thereby increasing aggregate demand and investment in the economy. Therefore, the purpose of negative interest rates is to stimulate economic growth by encouraging banks to increase their lending capabilities. Contrarily, evidence has been shown this not to be the case. In Switzerland, year-on-year GDP growth stood at 2.9% in late 2014. However, following the introduction of negative interest rates at the start of 2015, year-on-year GDP growth fell drastically to just 0.7%. This can be attributed to many factors – most notably, the effect of negative interest rates on the financial sector.

Setting interest rates below zero, negatively impacts the financial sector, as has been the case in Switzerland. Banks, in general, are aware that if they charge customers for depositing money, customers would withdraw their funds immediately. Such a move would reduce the amount of working capital, thereby causing severe funding issues. Therefore when negative interest rates are introduced, banks are forced to absorb the costs of depositing money with the central bank, as they are unable to charge customers for depositing money. This has been the case in Switzerland, with negative interest rates of -0.75%, yet a deposit rate of 0.25%. Whilst ordinary banks in nations with positive interest rates earn interest from depositing these funds with the central bank, Swiss banks have been placed at a loss. To rectify this and minimise losses to profits, lending rates have been forced higher. Thus, it is no surprise that in Switzerland, a country with negative interest rates, lending rates averaged 2.6% in 2020 – over twice that of the UK, with the latter at 1.1%. These higher rates stifle investment, as it is more expensive to borrow money, thus reducing economic growth.

In addition, having interest rates below zero leads to exorbitant property prices, due to riskier investments by both pension funds and banks. Negative interest rates have caused bond yields to become negative, with Swiss 10 year government bonds having a -0.3% yield as of July 2021. As bond yields determine how much pensioners receive in benefits, these negative bond yields have forced pension funds to seek riskier investments – particularly in real estate. Banks too are in the same predicament, due to the aforementioned depository crisis, leading them to invest further into the real estate market. Thus unsurprisingly, Swiss property prices have grown faster than those of the United States since 2010. The same phenomenon has been witnessed in Sweden, another European nation that experimented with negative interest rates, with the real estate index increasing 50% (from 160 points to 240 points), whilst interest rates were below zero. Such house price inflation has forced millennials and the low-paid into a lifetime of renting, rendering it impossible for them to get onto the property ladder, with renters comprising a majority of the Swiss population – unlike in the UK and US where they are a minority.

Lastly, negative interest rates discourage spending. The purpose of negative interest rates in these European nations was to encourage spending, lifting the threat of recession in the process. However, what followed in countries such as Sweden was an increase in savings, as a posed to more spending. Following the introduction of negative interest rates in 2015, Sweden’s savings rate as a percentage of household income increased, from 12% to 15% by 2019. During this same period, the household saving ratio in the UK, a country without negative interest rates, fell from 10% to just over 5%, between 2015 and 2019. The phenomenon of higher saving rates in countries that have adopted negative interest rates can be explained through the permanent income hypothesis. This theory by Milton Friedman is based on the notion that individuals will spend money at a level that corresponds with their long-term average income. Thus, if inflation is expected to be higher, as is the case when interest rates are reduced, individuals set aside more of their income to ensure that they have enough retirement money to survive. This explains the higher rates of saving in Sweden, following the introduction of negative interest rates. Thus, whilst negative interest rates are designed to boost spending, people save more instead, to keep up with the final income that they desire, due to the expectation of higher inflation.

To conclude, whilst the intentions of negative interest rates are positive, the results are far from so. Failed experiments in both Switzerland and Sweden demonstrate this, with rising property prices, reduced spending and limited economic growth experienced in these nations after the introduction of negative interest rates. It is never a good idea for central banks to set interest rates below zero, due to its harmful effects on the economy as a whole.