Will interest rates go negative? - The Share Centre Blog

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Michael Baxter

Will interest rates go negative?

Written by: Michael Baxter on January 16th 2013

Category: Thought for the day

They call it a liquidity trap. Rates fall to zero, so they can’t fall any further, and still the economy limps along bottom. But this may change. Maybe mobile phone companies will provide the means by which central bankers can cut rates below zero.

You may recall, back in those heady days when interest rates were around 5 per cent, economists used to look at Japan, scratch their heads and say “it won’t happen here, but what will we do if it does?”

The problem Japan had back then was that rates were near zero, but still the feeling was that savings were too high, borrowing too low. Rates needed to fall further still, or so they said.

In theory you can’t have negative interest rates. This is because if you have to pay an interest rate to lend someone money, you would be more likely to just keep it. If banks start charging you to lend out your money, you will simply stick your cash under the mattress, or bury it in a hole in the garden.

As an aside, I note that in Japan the savings ratio fell from around 15 per cent in the 1990s to around one per cent today.  There are many factors at play here, but one may simply be because Japan has move to stage two in its demographic process.  At stage one, its aging population fretted about their future retirement and saved more. Stage Two is when a high percentage of its population has retired, and starts to draw down on savings.

All sorts of strange things happen when we are in liquidly trap conditions.  Take two theories I have referred to here before: the paradox of toil and the paradox of flexibility. Both theories assume zero interest, and an economy operating below full capacity. The paradox of toil concludes that if we are at such a point, and everyone responds by working harder, unemployment rises and economic hardship worsens. The paradox of flexibility draws similar conclusions, but in this case from the assumption the labour market becomes more flexible.

If these theories are right, then the so called supply side reforms will be ineffective. This is quite different from the Thatcher era, when interest rates were much higher, and the UK did indeed require a more dynamic and flexible labour force.

But returning to the problem of what to do when rates are zero, the current thinking seems to be for central banks to go out and buy bonds via QE. But this policy has the flaw that banks remain undercapitalised, and households and businesses don’t want to borrow.  It appears that no matter how much money is spent on buying bonds, the underlying problem of lack of demand remains.

I recall, back before the 2008 crisis one idea floated in Japan was to ban cash, to make all transactions electronic. If you could achieve that it would be possible to cut interest rates as low as you like.

I say this, because I note that Vodafone’s boss Vittorio Colao reckons 2013 will be the year that the British public embrace the idea of using their mobile phones to make transactions.

Okay, this does not mean the end of cash, not yet.

But it does seem to me that notwithstanding the Fed minting a one trillion dollar coin that we are steadily moving towards an era when cash becomes obsolete.  I am sure that within a few years our mobile phones will become the means by which we conduct most of our smaller transactions. Indeed mobile phones may not only replace cash, they may replace credit and debit cards. However, the issue of batteries may need to be addressed. It won’t really do to find you can’t put petrol in your car because your phone’s battery has gone dead.

But here is my prediction. If the economy is still in the doldrums as technology helps create a cashless society, negative nominal interest rates will follow.

These views and comments are those of the author alone and do not necessarily reflect the view of The Share Centre, its officers and employees

Tags: cashless society mobile phones, Japan savings ratio, liquidly trap, negative interest rates, paradox of flexibility, paradox of toil

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