I have recently read 2 interesting posts on negative rates by Stiglitz and Bernanke . Basically, they are trying to assess the impact and effectiveness of central banks pushing down rates to negative territories.

Stiglitz seems to think that it’s not going to be that impactful considering the fact that real interest rates are already negative  ( Nominal interest rate – Expected inflation = Real interest rate ) in many economies ( Europe and United States ). Even though real interest rates have decreased, business investment or rather investment in general is stagnating. Bernanke on the other hand, considered the negative rate policy as being a middle ground between no action and the expansion of quantitative easing ( Buying up of assets to raise prices and decrease interest rates ) and regard it as having a modest effect.

Let’s take a step back to consider the negative rates policy and the basic economic ideas behind it. Generally, interest rate is the percentage that ordinary people see in their bank accounts. If the stated interest rate in our deposits is 2%, then we can expect that our deposits will return 2% return in a years time. It might be a good idea then to put our money in the form of deposit as we are gathering a 2% return on it assuming all else the same. Now what if the banks suddenly inform us now that the stated interest rate would be -2%, in the sense that they will “charge” us for keeping our money. We as depositors would have the incentive to withdraw our money to prevent being charged.

Basing our basic understanding on the relationship between interest rates, consumption and inflation, we would expect to use the money that was withdrawn to spend on goods and services resulting in an overall increase in consumption. Interest rates decrease, consumption increase, inflation increase is the basic premise behind our basic economic ideas. By pushing the interest rates to negative territory, central banks are in essence telling consumers to take their money out from deposits and aggressively spend and consume. This is the same idea behind the zero bound interest rate ( Interest rate is positive but very near the zero level ) but just taken further past the zero bound.

The same question will be asked, how much bang can a further reduction of interest rate past the zero bound generate? It seems that much of the advanced economies are exhibiting Liquidity trap symptoms where GDP components such as consumption, investment and net exports are not responding proportionately to changes in monetary policy (interest rate changes). From a consumption point of view, Richard Koo is a fierce proponent of the notion that much of the advanced economies are in a balance sheet recession. Consumers are not responding to interest rate cuts because they are in a debt reduction objective. The first priority is to pay down debt and not spend, and that in effect weakens the intended inflationary effect that central bankers were banking on.

A negative rates policy might be no different from a zero bound policy if consumers are still in debt reduction modes and not increasing consumption. It seems there really is a limit to how much monetary policy can play in this context. Stiglitz is advocating for more measures to increase liquidity to small to medium enterprises who traditionally only have access to banks for funds. Bernanke on the other hand calls for fiscal policy to play a part too, in that government spending can produce a multiplier effect on the economy and generate much-needed jobs and income for ordinary people.

But I think the crux of the problem is how to develop a sustainable relationship between debt and consumption. It is obvious that if we are too indebted, we would want to decrease consumption to pay down debt, or increase existing debt to fuel current consumption which results in higher debt levels. If we go by the first choice, there will be a slowdown in consumption and the economy, which would trigger deflation and recession like conditions. If we go by the 2nd choice, we are just foregoing the problem to a later time period, where we pile on more and more debts until our lenders or investors decide that we no longer have the ability to repay. Inevitably, we will not be able to support our current consumption without more debt and our standard of living will have to fall.

All in all, monetary and fiscal policies are in the end neutral in the long-term. They are used as tools to buy time for much-needed reform in both government and market. Economic development ( this concept is very different from economic growth ) ultimately depends on government and market policies that are meant to maximise social welfare ( notice how I am using social welfare and not private returns like how most free market principles advocate for ). It seems that most of us are caught up in monetary policy mania and forgetting that much of our economic development are driven by developmental policies like affordable education, universal healthcare coverage, robust support structure for small to medium enterprises, technological improvements, and protection of democratic principles.