Negative Interest Rates: Time for Japan to Experiment (again)?

As deflation has been feared in the last two years since the financial crisis, central banks have pulled out the stops to try to prevent and counter it. "Quantitative Easing" (QE) has been the name of the game. It basically involves buying up loads of debt, including direct purchases of government debt, by throwing on the printing presses to flood the market with cash. Normally when more and more currency chases the same amount of goods, prices should rise. Under the extraordinary conditions of the past two years, however, this has not been the case. Deflation has thus far been mostly avoided in the rich world outside of Japan, which has suffered deflation on and off for the past 20 years since its financial crisis in the early 1990s.

Japan has coupled QE with fiscal stimulus on and off for two decades and yet still suffers deflation. There are also worries that Japan's capacity to stimulate with government spending may soon approach limits, though bond yields as of yet show no sign of this (Japan's debt is the highest in the rich world by far, but it is almost exclusively domestically held). Must Japan simply surrender itself to deflation, its economy a soufflé in a prematurely opened oven? Perhaps not. Japan has a few options. One would be more dedicated and aggressive QE. But there is also something else, something never tried before: negative interest rates.

Strictly speaking, there is no reason a central bank (or any bank, for that matter) could not offer negative interest rates. The problem is that many normal instruments of monetary policy would cease to function properly if this were done.

The problem with deflation is that people know that prices will be lower the longer they wait to purchase things. It also means that even small returns on investments are good ones because even stuffing money under the mattress makes you richer if prices constantly fall. This means riskier investments are unnecessary. All this means that people save and stay on the safe side, rather than borrow, spend, and engage in entrepreneurial activities. This devastates an economy, which requires some risk-taking and spending to keep it alive.

If a bank offers you a loan at an interest rate below inflation, that is an extremely strong incentive. It means it is cheaper for you to borrow the money, buy something today, and pay later than it would be to wait. That is why negative "real" (i.e. below inflation) interest rates give such a boost to an economy (and can normally spark strong inflation if overused).

If inflation is negative, however, this becomes problematic. A bank could, in theory, offer you a loan at -3% interest with an inflation rate of -2%. You could still buy a car at a lower price with the loan than without, and the car dealer would get to sell the car at a higher price now than it would later. The problem is: the bank would pay the difference. Why should it do that? True, it might receive loans from the central bank at -4% interest, earning a spread of just 1%, but that's a profit, right? The problem is: the bank would earn a 4% profit if it just left the money in the vault, didn't lend to anyone, and gave it back to the central bank (or rolled over the loan, taking on more). In short, the bank still has every incentive NOT to loan out the money at a negative rate, never mind a negative real rate.

Negative interest rates could help reduce government debt and allow a government to spend more. It is therefore possible that they might work. They would also help banks to re-capitalize and absorb debts, allowing them to then offer very low interest-rate loans, at perhaps even 1%, something not achievable in normal times. These measures might be enough. If negative interest rates needed to reach consumers, however, because deflation had become so entrenched and the currency continued to appreciate instead of inflation rising, the central bank would have to get even bolder. It would have to start lending to businesses and maybe even consumers directly. Absolute insanity? Perhaps, but if all else fails, this is something that would surely work to drive up inflation. If not done carefully, it could also spark huge investor panic. Desperate times?


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