Reader Questions on Negative Interest Rates

Our reader L from Mumbai has mailed us a number of questions about the negative interest rate regime and its possible consequences. Since these questions are probably of general interest, we have decided to reply to them in this post.

The NIRP club – negative central bank deposit rates – click to enlarge.

Before we get to the questions, a few general remarks: negative interest rates could not exist in an unhampered free market. They are an entirely artificial result of central bank intervention. The so-called natural interest rate is actually a non-monetary phenomenon – it simply reflects time preferences. Time preferences are an inviolable category of human action and are always positive.

Market interest rates consist of the natural interest rate plus two additional components: a price (or inflation) premium that reflects the expected decline in money's purchasing power, and a risk premium or entrepreneurial profit premium that reflects the perceptions of lenders of a borrower's creditworthiness and generates an entrepreneurial profit for those engaged in lending.

One often reads that interest is the “price” of money, but that is actually not quite correct. It is really a price ratio, the difference between the valuation of present against that of future goods. An apple one can obtain today will always be worth more than a similar apple one can obtain at some point in the future. If time preferences were to decline to zero, people would stop consuming altogether. All efforts would be directed toward providing for the future, but they would never see that future, because they would starve to death before it arrives.

In theory, time preferences can rise almost to infinity: for instance, if an asteroid were to hit Earth in two week's time and we knew for sure that it would destroy the planet, it would no longer make sense to provide for the future. Saving, investment and production would stop, and everybody would confine himself to consumption. But the opposite can never happen, since we cannot just stop consuming. As long as time passes and there is a “sooner” and a “later”, there simply cannot be zero or negative interest.

A far more detailed explanation of the topics summarized in the introductory remarks above can be read in Human Action by Ludwig von Mises.

Fiduciary Media vs. Covered Money Substitutes

Now let us look at L's questions. He writes:

I am interested in knowing more about negative interest rates. I feel at some stage it might lead to people pulling out their cash out of the bank. I am trying to figure out what happens when they do it en masse (Let us forget how they are going to store it for the moment).

Can it bring a bank down? Since banks seem to have a lot of deposits, no loans to make, it ends up as excess reserves, on which they have to pay negative interest rate to the CB (in Europe now) and thus they do not want it. In fact RBS I read somewhere refused a big deposit from an Institutional Investor. In such a case I am not able to understand how pulling deposits out of a bank can bring a bank down. Does it mean even if the bank has excess reserves a bank run can bring it down?

In a fractionally reserved system, any withdrawals from bank deposits will in theory create a “reverse multiplier effect”. Hypothetically speaking, if a banking system were to operate under a 10% minimum reserve requirement and was “fully loaned up”, having created $90 in additional money for every $10 on deposit, it would be forced to call in loans if people started withdrawing money from their deposits.

The banks in our example can only be “fully loaned up” under the assumption that all newly created deposit money was kept within the banking system, that all banks extended loans to the full capacity allowed by the reserve requirement, and that any imbalances between banks were canceled out via interbank lending of reserves. In that case the credit multiplier is simply given by the formula d/r (d=deposits, r=reserve ratio).

In reality, reserve requirements haven't played a role in the banking systems of developed economies for a long time, in the sense that have not represented an obstacle to credit expansion. As a result, the vast majority of deposit money extant prior to the 2008 financial crisis consisted of fiduciary media, i.e., uncovered money substitutes.