Monday, August 22, 2011

Negative Interest Rates

by Richard Crews
A couple of weeks ago an astonishing thing happened: the largest bank interest rates fell below zero. This is equivalent to depositors saying, "Please, please take my money--no interest payments needed. Oh, that's not good enough? OK, I'll pay you to take my money."

On August 4, 2011 the Bank of New York Mellon, the world's largest custodial bank, announced that they would charge 13 bps on deposits more than 110% of a client's monthly average (bps stands for "basis points"; each one bps equals 0.01% interest). That day the rate on short-term U.S. Treasury bills fell below zero percent.

As N. Gregory Mankiw, a professor of economics at Harvard, pointed out, "The problem with negative interest rates, however, is quickly apparent: nobody would lend on those terms. Rather than giving your money to a borrower who promises a negative return, it would be better to stick the cash in your mattress. Because holding money promises a return of exactly zero, lenders cannot offer less."

"Nobody would lend on those terms" unless one (or both) of two considerations prevail: First, no other investment looks safe. Even mattresses can burn up in a fire, and there is a financial "fire" burning in the Eurozone these days with Greece, Spain, Ireland, and now even Italy looking like they may not be able to pay their bills, that is, the governments may not make good on their bond debts. And a lot of big banks are holding those bonds. Some of the world's safest investments look shaky.

Second, inflation can eat away at your winnings. If you are pretty sure that $100 stuck away in a mattress today will only have $97 buying power a year from now, you might be willing to store that money someplace else where it would be sure to have $99 in buying power in a year.

Lending of money for (positive) interest has long been frowned on by major religions. Christians called it "usury." "Riba" is the word in Arabic, and "ribbit" in Hebrew. Philosophers dating back to Plato and Buddha opined against it.

But bankers and wealthy investors are a clever lot. They have always found ways to get around restrictions imposed by religious or legal authorities. In the Middle Ages Hebrew scholars decided that although, by Talmudic Law, Jews could not charge interest payments to other Jews, they could morally lend money to non-Jews for interest. And in the wake of the Great Recession, the Dodd-Frank Act of July, 2010 set up a panorama of consumer protection, banking, and Wall Street reforms, but it did not establish any federally mandated interest rate maximum--though many people thought it should.

We live in strange times--not just technologically, ecologically, and politically, which are obvious, but in terms of macroeconomics as well.