What is a negative interest rate??
Filed Under Economics, Economy, Jeremy
The article posted in The Times argues that a negative interest rate may be the only thing that can save Japan from its current deflationary spiral. While we are all aware of how positive interest rates work (i.e. the lender gets the interest whereas the borrow pays the interest), how do negative rate work? Who gets the interest and what keeps borrowers from taking out a $1 billion loan and never repaying it since the negative rate would eat the principle down to nothing?
The short answer to the first question is that the lender is “technically” paying the borrower interest by forgiving debt owed. This never really happens, however, because what keeps me from borrowing the $1 billion is simply the fact that no one would lend it to me because they could do better by either holding on to the money or spending it themselves! So why even talk about a negative interest rate? It is best to think of the negative interest rate from the lenders perspective and see that it is really the case of money, or more easily, purchasing power, disappearing. It is explained very well in this NY Times piece from April.
If you want a short answer about what negative rates are, consider saving for retirement by using all your money to buy a car and then plan on reselling that car in forty years and using the proceeds for your retirement. That is an investment with a negative interest rate!
Now for the long answer:
To understand what negative interest rates are and how they work, you must first recall that money in most developed counties is Fiat Money meaning that is has no intrinsic value itself, but can be exchanged for things of value. This is contrary to using gold coins as currency which can be melted down and used as gold in jewelry. The only thing that gives the ten dollar bill in your pocket “value” is that vendors must accept it for ten dollars worth of stuff (it says so right on the bill – its legal tender) and because the vendors knows that they can do the same once your exchange is completed. The value of the stuff we can exchange our valueless money for is called its purchasing power. Consider that just a couple of years ago ten dollars could purchase ten gallons of gasoline (i.e. gasoline cost one dollar per gallon). With the increase in the price for gasoline (i.e. inflation), that same piece of paper now only buys five gallons of the same gasoline; the paper’s purchasing power has fallen.
The real interest rate is nothing more than a measure of how that purchasing power changes over time. A positive real interest rate means purchasing power is increasing over time so you can buy more later than you can today. A negative real rate means your purchasing power is falling over time so you can buy more today than you can tomorrow. For those more mathematically inclined, consider the follow formula for the REAL interest rate:
Real Interest Rate = Nominal Interest Rate – Inflation Rate
The nominal interest rate, part of what determines your real rate, is what your banks pays you on your savings or you pay on your loan and the inflation rate is the rate at which prices are changing. If the nominal rate is higher than the inflation rate, people will save or spend money tomorrow because they will have more purchasing power later than they do today.
The problem facing the Japanese government in the article linked above is that inflation is negative (deflation) meaning that even with a zero interest rate (meaning you pay nothing to borrow or, more importantly, you get nothing for lending) people would still rather hold on to their cash because they are getting positive real interest because prices are falling (recall a negative times a negative is a positive). If they are saving, then they are not purchasing today meaning that the economy can not recover easily because there is no need to produce stuff because no one is buying stuff. If there is no reason to produce stuff, there is no reason to hire workers and thus there are no pay checks. To get people to spend their money today you must change their incentives from saving for tomorrow to spending today.
We generally assume that the government can not “create” inflation by raising prices because prices are determined by the market place, not government. So the only way to get purchasing power, or the real interest rate, to decline in the face of deflation is to make nominal interest rates negative. Recall our lender above who lends out $1 billion only to be repaid nothing in the end because rates are negative. Essentially what is happening is that in each period (year) some of that money that he lent out is evaporating into nothingness. That is what a negative nominal interest rate really is, the evaporation of money. As a result he has an incentive NOT to lend it out (or put it in a savings account) but to spend it himself.
So how might a government pull this off? Consider the example given in the NY Time piece: Once a year the government pulls a number from zero to nine from a hat and every piece of currency whose serial number ends in that number is no longer legal tender. If the number pulled was ’8′ and your ten dollar bill from above ends in ’8′ it is no longer accepted by vendors and it reverts back to a green piece of paper with a picture of a dead president on it (no gasoline for you). In this case ten percent of all cash just evaporated creating a negative ten percent nominal interest rate. The obvious incentive in this case is to not hold cash.
The above lottery system is a very crude and imprecise way to creating negative rates which is why The Times piece discusses a cashless society. Another way the government could create a negative rate with more finesse would be to order banks to “delete” a given percentage of everyone’s bank account balances. If this were the case in an economy with hard currency, people would not hold money in banks or any other electronic form, but would hold cash because without a lottery system outlined above, cash is safe, it can not just be ‘deleted’. Once all the money is in cash form, the delete option is no longer viable and this “tool” is lost to the government. Therefore cash must not be an option as would be the case in a cashless society.
While this may seem controversial or impossible, recall that in the U.S. the total amount of “money” in the system was last reported by the Federal Reserve to be about $9.5 Trillion whereas the amount of currency or paper money in the economy was only about $849 Billion of that $9.5 Trillion, or about nine percent of our “money” is actually in hard form. Additionally it is the government which determines what is legal tender giving them the ability to determine what money is “good” and what is just green paper.
So in summary, a negative real interest rate is the reduction of purchasing power in general and is something that can happen anytime nominal interest is less than inflation. A negative nominal interest rate is the case where money actually disappears from one’s bank account with the hope of getting people to spend it today and not save it until tomorrow. Can it actually work? Likely not given the openness of the world’s economy today; there are just too many ways other than spending for a person to “save” their money.
Hopefully that has answered the question of what a negative interest rate really is. As my grade school algebra teach would say…”clear as mud, right?”
JG
Comments
2 Responses to “What is a negative interest rate??”
yikes. Thanks for answering this but now for a few clarifications. 1) Isn’t deleting funds from someone’s bank account just theft? (or we do we interpret it as some sort of x% flat tax?) and 2) as you implied at the end of the post, what would prevent Japanese citizens from _right now_ transferring all their money to…euros…on the chance that Japan will go cashless but before the financial markets have adjusted conversion rates (which they would do, I presume, after Japan makes the official statement that this is something they _will_ try)?
For clarification one: In one sense, it would be theft, however, like I said, the government gets to pick what is legal tender and what is not so one ‘could’ argue that deleting some of your money holdings is perfectly legal. I think it would definitely be a major legal battle not to mention political suicide! (Of course I am sure many thought the same about warrant-less wire taps) I would not want to call it a “tax” because that is a transfer of funds from you to the government and that is really not what is happening, unless the government had one big bonfire!
Clarification Two:Nothing keeps the citizens from doing this which is why I don’t think it will never work given the openness of the economy today. All this policy would do would kill the Yen as a currency and I am not sure that would help a deflationary cycle (it is a remedy for a hyper-inflationary cycle, though).
So in the end I think this is a theoretical construct created in a “lab” and can never actually exist outside a mathematical model.