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What Causes Negative Interest Rates?

12 May

[courtesy Google Images]

[courtesy Google Images]

Natural News reported in “The cash crisis begins as Chase to start charging 1% fee on bank deposits starting May 1” that:

 

“Beginning May 1, JPMorgan Chase [JPM] will begin charging certain (wealthy) depositors for the ‘right’ to keep their money in JPMorgan Chase banks.

“As noted by GovtSlaves.info, the bank sent some of its larger depositors a letter that said it would charge them a “balance sheet utilization fee” of 1 percent annually on deposits in excess of the money they require for operations. In other words, that amounts to a negative interest rate on many of those deposits.”

 

Let’s start by assuming that the Natural News report’s conclusion that a 1% “balance sheet utilization fee” can be properly described as a “negative interest rate”.

The concept of “negative interest rates” is increasingly in the news.  However, the concept remains mysterious to most people.

An Interest Rate Whose Time Has Come?

Natural News:

 

“The Swiss National Bank, meanwhile, has a much lower deposit interest rate of minus 0.75 percent amid worries that the Swiss franc will disrupt trade. . . . [T]he cost for banks to borrow from each other in euros went negative for the first time.

“As of April 17, bonds making up 31 percent of the value of the Bloomberg Eurozone Sovereign Bond Index—€1.8 trillion ($1.93 trillion) worth—were trading with negative yields.”

 

European banks aren’t just subjecting ordinary borrowers to negative interest rates.  European banks are even subjecting banks to negative interest rates.  In combination with JPM’s recent application of negative interest rates in the US, it appears that negative interest rates may be an idea whose time has come.

Nevertheless, while negative interest rates become increasingly common, their cause remains mysterious.  What causes negative interest rates?

Some suppose that negative interest rates are caused by deflation.  Deflation is usually associated with economic depression.  Insofar as JPM and other banks impose negative interest rates on depositors, it might follow that those bankers believe that the US and EU economies are headed for more deflation and an overt economic depression.

I’m not convinced.  I suspect that there may be a far simpler and more obvious explanation for negative interest rates: the need (or greed) to raise bank profits.

 

Conspiracy Theory

The Natural News article continues:

 

“What’s the bottom line? Coy and others [who authored the Bloomberg article] believe that there is at least some effort to completely devalue paper currency and make all money ‘virtual’, which can then be controlled by the government through its control over the financial sector. . . .”

 

That’s a conspiracy theory.  It may well be that governments of the world are preparing to eliminate paper currencies and make all “currency” digital.  But I don’t believe that negative interest rates and “complete devaluation” are meaningful parts of that conspiracy.

So long as paper dollars and digital dollars are deemed equal in value, “complete devaluation” of paper dollars would mean that the purchasing power of the all dollars—even digital dollars—was reduced to zero.  That reduction could only be achieved through hyperinflation. I don’t see how the system can “completely devalue” (and therefore destroys “dollars”) paper dollars without doing the same to digital dollars.

You can kill the dollar by hyperinflation (which reduces the dollar’s value to zero), but I don’t see how you can kill the dollar by deflation that increases the dollar’s value.   That’s like arguing that government can get rid of all the gold by suddenly increasing the price of gold from $1,200 to $10,000 an ounce.  Increasing the price of gold will only increase the demand for gold.  Deflation (increasing the purchasing power of fiat dollars) will, likewise, only increase the demand for dollars.  Can gov-co kill the dollar by making it more valuable?

Of course not.

Hyperinflation might stimulate the economy.  But, left unchecked, it will cause complete devaluation (destruction) of the paper dollar.

Deflation, on the other hand, might depress the economy, but will increase the value and longevity of the dollar.

You can’t destroy the dollar by making it more valuable.

Any attempt to link negative interest rates to some conspiracy to “completely devalue” (and destroy) the dollar strikes me as irrational.

 

Government Regulations

 

“Although dollar interest rates are higher, JPMorgan Chase’s balance sheet utilization fee fits the pattern:  In today’s low-interest-rate world, the only way [JPM] can shed deposits in response to new regulations is to go all the way to less than zero,” said Coy.

 

OK—now, negative interest rates are starting to make some sense.

When government regulations depressed interest rates on bank loans towards near-zero, the bank’s profits must’ve also declined towards “near-zero”.

To compensate for artificially-low positive interest rates imposed on borrowers, banks might impose negative interest rates on depositors to guarantee they make some profit.

I.e., government imposed near-zero interest rates to entice consumers into borrowing at cheap rates and spending their borrowed currency into the economy.  Increased consumer borrowing/spending was expected to “stimulate” the economy.

Gov-co (the government + the Federal Reserve) enacted laws, regulations and/or policies to effectively restrict the amount of positive interest banks could charge on loans to borrowers.  That may have seemed like a good idea, but there was an adverse consequence:  In order to entice consumers into borrowing at cheap rates and spending, government cut bank profits.

Whether those interest rate cuts were merely annoying or potentially threatening to the banks’ financial survival is unclear.  In either case, however, it’s certain that the banks weren’t pleased to see their profits cut.

It seems only logical to suppose that banks reacted to government-imposed, near-zero interest rates on bank loans by implementing negative interest rates on bank depositors.

After all, banks must make enough profit to stay in business.  Somebody’s got to pay the banks for the services they provide.  If the law prevents the bank’s borrowers from paying a fair positive rate of interest on loans, then the bank-depositors must be made to pay a negative interest rate on deposits.  There is no third possibility.

Remember, banks make their profits off the spread between the amount of interest they pay to depositors and the amount of interest they charge to borrowers.  There has to be a sufficient spread between interest paid on deposits and interest charged on loans to for banks to stay in business.

If government effectively restricts the amount of interest charged on loans to borrowers, the banks have two choices:

 

1) accept diminished profit margins that might put them out of business; or,

2) restore the spread by reducing the interest paid to depositor to negative rates.

 

These choices aren’t evidence of some secretive financial alchemy—they’re just evidence of logic.  Like any other business whose profit margins have been reduced, to stay in business, banks must cut their costs. The primary cost in issuing loans is paying interest to depositors.  By imposing near-zero interest rates on loans, gov-co cut bank profits.  Banks have apparently reacted by imposing negative interest rates on deposits in order to restore their profit margins.

Negative interest rates seem surprising because, so far as I know, they are only a recent “invention”.  But, in the end it’s just mathematics.  It’s just using negative numbers where previously, the banks might’ve reduced the interest paid on deposits from 3% to 2% to 1% or even down to 0.1%.  Those are all positive numbers and seem unremarkable.  But there’s no mathematical reason why the interest rate on deposits might not be further reduced to negative numbers like -1% or -2% or even -10%.

Yes, the idea that depositors would pay negative interest rates to banks seems incredible.  But, we live in incredible times.  If government is protecting borrowers with near-zero interest rates, it follows that if the banks are going to profit (and perhaps even survive), negative interest rates will have to imposed on depositors.

 

When Thieve Fall Out?

The imposition of negative interest rates may be evidence of the banks’ collective refusal to be impoverished by government-imposed “near-zero” interest rates on loans.  Negative interest rates might even be evidence of the banks falling out with the gov-co.  Government should be (secretly) furious with JPM because negative interest rates on deposits could be every bit as harmful to the economy as raising positive interest rates charged on loans.

For the past several years, the Federal Reserve has talked about possibly raising interest rates but, so far, has failed to follow through.

Why?  Because higher interest rates would slow borrowing, slow spending and slow an already fragile economy.  Banks, wanting or needing more profits, may be tired of waiting for the Fed to actually raise interest rates, might achieve the same result (as raising positive interest rates on borrowers) by imposing negative interest rates on depositors.

Either way (by raising the positive interest rates on loans or imposing negative interest rates on deposits), the economy should tend to slow, stall, and slide deeper into recession or depression.

If JPM truly imposed negative interest rates on May 1st, government might see that imposition as an assault.  If so, we could expect to see some sort of retaliation directed at JPM.

 

How Banks Profit

People who earn and save wealth and then deposit currency into banks are “depositors”.  People who borrow currency from banks are “borrowers”.  Banks are institutions that make a profit by facilitating the transfer of currency from savers/depositors to consumers/borrowers.

Historically, banks paid some positive but low rate of interest (say, 3%) to the “depositors” who deposited their wealth into bank accounts.  Banks then loaned some of the depositors’ deposits to worthy borrowers.  Banks normally imposed a higher, positive rate of interest (say, 7%) on the loans made to borrowers.

Traditionally, the bank’s profits were found in the difference between the low interest rates (say, 3%) paid to depositors, and the higher interest rate (say, 7%) charged to borrowers.  In this example, the bank would net 4% (the difference between the 3% it paid for deposits and the 7% that it charged for loans).

In this hypothetical example, a simplified mathematical formula for bank profits would be:

 

Interest charged on loans (7%)

minus interest paid on deposits (3%)

= bank profits (4%)

 

But, in order to “stimulate” the recessive economy back into “recovery,” the gov-co has imposed near-zero interest rates that diminished the amount of interest most borrowers are required to pay from, say, 7% to 3%.

As government regulations (intended to “stimulate” borrowing, spending and economic recovery) reduced interest paid on loans from, say, 7% to3%, the banks found themselves caught in a mathematical squeeze something like this:

 

Interest charged on loans (3%)

minus interest paid on deposits (1%)

= bank profits (2%).

 

Where, formerly, banks might’ve earned 4% on their gross deposits, under near-zero interest rate regulations, banks might now earn only 2%.  In this hypothetical example, near-zero interest rates might cut bank profits by half.

Banks (and depositors) can’t be happy with their reduced profits.  Some banks might not even be able to survive if their profit margin were cut to just 2%.  Some depositors, faced with only a 1% earnings on their deposits, might move their capital into other domestic investments like stocks, bonds or gold or into foreign markets that paid higher rates of interest on deposits.

Prevented by government regulations from raising positive interest rates on loans made to borrowers, the banks instead imposed negative interest rates (minus 1%) on depositors.  Now, the mathematical formula reads,

 

Positive Interest charged on loans (3%)

minus the negative interest rate (-1%) charged (not paid) to depositors

= bank profit (4%).

 

Thanks to a negative interest rate imposed on depositors (and despite the gov-co-imposed “near-zero” interest rates on loans), banks could once again achieve a 4% profit margin.

The implication of this hypothetical example is that, while there may be several possible causes for negative interest rates, the primary cause for negative interest rates may be the banks’ attempt to evade the low-profit consequences of government-imposed, near-zero interest rates.

Negative interest rates are not the inevitable consequence of deflation or economic depression.  Yes, negative interest rates might be exacerbated by the effects of deflation and economic depression.  But the primary cause for banks imposing negative interest rates on deposits is the gov-co’s central planners attempt to artificially and arbitrarily regulate the economy by manipulating interest rates.

 

Bottom Line?

JPM’s imposition of negative interest on deposits might not signal that they expect more deflation and a deeper depression.

Instead, JPM may be merely trying to make a buck in the artificial economic climate created by gov-co’s central planners.  This artificial climate is at least irrational, perhaps insane, and potentially suicidal.

In the final analysis, the free market—despite its propensities for panics—is more rational than central planning.  Why?  Because a true free market is ultimately fair and subsidizes no one.  It’s the perception of “fairness” that may be the free market’s greatest strength.  Conversely, it may be the inherent perception of unfairness (unearned subsidies for some; unearned costs for others) that ultimately defeats central planning.

Negative interest rates imposed on depositors indicate that something strange is happening to the US dollar and financial system.  But can the primary source of that “strangeness” to be found in the banks’ greed, the deflated economy, or in the irrational imposition of near-zero interest rates by central planners?

In the end, there must be a reasonable (“fair”) balance between the interest paid by borrowers, interest earned by depositors and the profits earned by banks.  If that balance is destroyed, one entity (depositors, borrowers or banks) will be unfairly subsidized and the other two entities might be destroyed.  Because the relationship between the three entities is symbiotic, if any entity is destroyed, the whole system disintegrates.

That balance should be determined by the free market.  When gov-co’s central planners impose near-zero interest rates on bank loans in order to subsidize consumers/borrowers and artificially stimulate (manipulate) the economy, they destroy that balance, destroy the perception of fairness, and tend to impoverish depositors and banks.

Prevented by law from raising positive interest rates on borrowers to fair levels, banks react by reducing interest rates on depositors to negative levels.  By imposing negative interest rates on depositors, banks are fighting to “rebalance” the system and restore their profits.

Of course, in doing so, the banks may behave just as badly as government.  I.e., by imposing near-zero interest rates on loans, government unfairly subsidizes borrowers and unfairly impoverishes bankers and depositors.  Banks react by imposing negative interest rates on depositors.  Depositors will react by moving their currency to foreign markets that pay positive interest rates on capital or into gold which is not directly affected to interest rates.

The only entity that has not yet been clearly attacked by government, banks or depositors is our beloved class of borrowers/consumers.  But we can just about bet that the borrowers’ time is coming.  Sooner or later, the borrowers/consumers are going to find it almost impossible to get a loan.  What happens then to the “consumer-based economy”?

While we wait to see, here’s a question and answer for you to consider:

 

Q:  What’s the ultimate cause for negative interest rates on bank deposits?

A:  Government regulations that artificially suppress the interest rates banks can charge on loans.

 

If negative interest rates seem irrational, they are a logical reaction to the more fundamental irrationality of government-imposed near-zero interest rates.  Mental illness is contagious.  When gov-co’s central planners do something crazy (like impose near-zero interest rates on loans), the banks (in their attempt to survive) will also do something crazy (like impose negative interest rates on deposits).

Gov-co’s central planners caused negative interest rates.

 

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2 responses to “What Causes Negative Interest Rates?

  1. Roger

    May 12, 2015 at 4:14 PM

    > What causes negative interest rates?

    This is of course a complex question which no honest and competent economist will reduce to a simplistic answer.

    Given that limitation, we can still identify the main reason for negative interest rates: the basic economic principle of supply and demand.

    Interest rates are often referred to as the “price of money”. When loan demand is down, as happens during a recession, banks must correspondingly lower the price of the money they wish to lend in order to attract borrowers.

    Otherwise, if banks kept interest rates high during a recession, many potential customers would be unable to afford a loan and the banks’ business – not to mention economic activity in general – would soon dry up.

    Thus, the principle of supply and demand under conditions of economic recession is why we’d expect the current low (even negative) interest rates interest we now see in Europe, Japan and the United States.

     
  2. Allshewrote

    November 15, 2015 at 10:49 AM

    You are confused. The Federal Reserve is an independent agency, not subject to government regulation, therefore, what they do, the rates they set, are not government imposed, they do this to themselves. They offered cheap interest rates? Guess what? They compensate for low interest rates by making money on the volume of dollars loaned. $10 @ 10%, yields the same as $100 @ 1%; notice that prices rise as interest rates decline? The Fed has painted itself into a corner and is looking for a way out, enough of this nonsense of banks needing to do this or that in order to comply with new regulation, they wrote the regulation themselves.

     

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