IT PAYS TO KNOW: What’s a Negative Interest Rate???

By JUDD MATSUNAGA, Esq.

At the beginning of the year, Japan’s central bank announced negative interest rates in a move to boost a stumbling recovery in the world’s third-largest economy. It hopes that negative interest rates will encourage commercial banks to lend more and stimulate investment and growth. (Source: Associated Press, Jan. 28, 2016)

You ask, “Say Judd, what’s a negative interest rate?” We all know that interest rates are the reward we get from a bank by putting our money in the bank. It doesn’t matter that the bank uses that money to make more money. Even as children, we are taught to save money and watch it grow, e.g., compound interest.

A negative interest rate is when you pay the bank to put your money in the bank. That’s right, if you keep money in the bank you are actually losing money instead of saving it. So it’s less of a reward and more of a penalty. If you have a bank account that pays no interest, yet you are charged monthly banking fees, ATM fees, etc., you are experiencing negative interest rates and don’t even know it.

Here’s the simplest explanation I found: Let’s say you have a kid who is all grown up. He’s still living at home and in no hurry to get a job. You’d like him to get a job and become a responsible, tax-paying member of society. So you ask your friends, “What’s the best way to get my kid out of the house?” Someone’s going to tell you, “Make him pay rent.”

That’s kind of the thinking behind negative interest rates. You are the Central Bank. Your kid is like the bank reserves, i.e., the money. The food and shelter you provide is like the interest. If the economy needs to be “stimulated,” you need to get him out into the workforce. So the rent you charge is like the negative interest rates.

Banks are just like us — they want somewhere to put their money where it’s safe. And, of course, where it’s going to earn them interest, even if its just a little bit of interest. So they put their reserves into the Central Bank. But the Central Bank isn’t interested in making money like a regular bank.

The Central Bank’s job is to control the money supply. Which means making sure that the correct amount of money is going around the economy at any one time. And to do that they might try to get banks to keep more of their reserves at the Central Bank, or they might try to get banks to spend those reserves by lending them to investors, consumers and businesses.

In other words, think of those reserves like the grown up kid living in your house. One day, you might decide to get the kid out of the house and into the workforce. So you decide to charge him rent. In the same way, the Central Bank charges (not pays) banks an interest rate, i.e., negative interest rate, so the bank’s reserves may be used to stimulate the economy.

But the fact is that no one really knows if negative interest rates will actually work. Out of desperation, negative interest rates are no more than a high-risk experiment used by several of the world’s central banks, i.e., the European Central Bank (June of 2014), the Bank of Japan (January 2016), Central banks of Switzerland (2014), Denmark (2014), and Sweden (2015).

According to Warren Buffet, third-richest man in the world (Forbes) and arguably the greatest investor of all time, “What’s happened to interest rates is really extraordinary. You can go back at all the writings of the great economists, and you won’t see a word about sustained negative interest rates. We are doing something that the world hasn’t seen ….We do not know how this movie plays out.”

Since a banking system with negative interest rates means that banks would effectively charge customers to hold their money, Buffett said he would likely withdraw cash if the trend spreads. “If currency in a bank is worth less than currency in your hands, that could produce something in the way of behavior.” He joked that he would be better off stashing cash in a giant mattress instead of banks if only he could find a trustworthy person to sleep on top of a billion euros. (Source: U.S. News, Feb. 29, 2016)

However, many other experts don’t find the situation quite so humorous. Last week it was reported that Swiss banking giant UBS Group AG “blasted” the negative interest rate environment brought on by the easy money policies of central banks:

“The introduction of negative interest rates — now not only in Switzerland, but also in large parts of Europe and in Japan — is an extraordinary measure and should only be used in extraordinary times,” said. “We can all only hope that the times of such drastic measures by the central bank pass as quickly as possible … Unfortunately, I have to say unfortunately, there is little indication that negative interest rates will soon be a thing of the past.” (UBS Chairman Axel Weber, Wall Street Journal, May 10, 2016)

“Because of low and even negative interest rates, we and the whole industry are now presented with a frankly absurd question: do we still really want to take on client assets when doing so costs the bank money — and when we have to back up liquid assets with an unreasonably large amount of capital?” said UBS Chief Executive Sergio Ermotti. “I have my doubts as to whether this is good for the financial system and the economy.”

Mr. Ermotti noted that UBS has already been forced to pass along negative rates to businesses and increase the rates it charges on some loans. “If the conditions remain as they are or grow worse, we will have to consider extending these measures to very wealthy clients and increasing interest rates on loans yet higher,” he said.

The lack of impact on the real economy reflects the failure of these policies to materially increase consumption and investment. Heavily indebted or increasingly cautious households are reluctant to borrow to fund spending. Low business investment reflects lack of demand, over-capacity, and a reluctance to increase debt in a potentially deflationary environment.

The intent of the central banks is clear: reduce debt by confiscation and transfer wealth from savers to borrowers. However, even in the best of circumstances, monetary policy’s ability to restore a slumping economy to full employment through negative interest rates may be limited.

The monetary policy used by the central banks around the world has not worked. This is the central bank’s ultimate admission of defeat, e.g., its “hail Mary,” as traditional means of bringing excessive debt under control have failed. Negative interest rates are actually a sign that the Central Bank may have run out of other ways to get the economy going.

In conclusion, let me make it perfectly clear that I am not saying that you should take all your money out of the bank and stuff it in your mattress. DO NOT PANIC! “OK, but should I be worried?” you might ask. Yes, be very worried. Negative rates so far have not boosted growth or inflation. Instead, the policy is creating serious economic and financial distortions that can make a bad situation even worse. To be continued…

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Judd Matsunaga, Esq., is the founding partner of the Law Offices of Matsunaga & Associates, specializing in estate/Medi-Cal planning, probate, personal injury and real estate law. With offices in Torrance, Hollywood, Sherman Oaks, Pasadena and Fountain Valley, he can be reached at (800) 411-0546. Opinions expressed in this column are not necessarily those of The Rafu Shimpo.