Bank of Japan brings negative rate experiment to a close.
It was bad for society and only helped the central planners to consolidate. But what does it mean for the economy?
On Tuesday, 19 Mach 2024, the Bank of Japan raised interest rates for the first time since 2007, the first hike in 17 years. The Japanese central bank had maintained negative interest rates for banks since 2016. This means the historic era of negative interest rates has now come to an end, since all the other central banks that had introduced negative interest rates in the decade after the 2008 financial crisis, such as the ECB and the Swiss National Bank, had already raised them in the aftermath of the inflation of late 2021 and 2022. Until now, the Bank of Japan had been the only central bank that thought it unnecessary to raise rates.
For those who believe that interest rates are a key driving force in the economy and markets the higher rates provided however few reasons to fret: while higher rates are often said to slow economic growth, the Bank of Japan only raised rates from –0.1% to the range of zero to 0.1%. Not earth-shattering.
But there are those – like myself – who have said many years ago that negative or zero interest rates are not a good idea: instead of stimulating the economy, they do the opposite: They impose a penalty on the banks and this usually has negative consequences for the customers of banks, especially those key players in the economy that employ the majority of the workforce in the country, namely small and medium-sized enterprises: it is well-established in the economic research literature that the small firms are largely dependent on borrowing from banks for external funding.
Interest rates have gravitated towards zero already from the late 1990s in Japan. There is no evidence that this has stimulated the economy. To the contrary, my empirical work has shown that interest rates follow economic growth and are positively correlated with it, with statistical causation running from economic growth to interest rates. As Japanese growth slumped in the 1990s (as I had warned since 1991), interest rates were going to come down. Since interest rates are not the cause of economic growth, what, then, drives the economy? The answer is the quantity of bank credit creation – but more on that in future articles.
For now, we should remind ourselves that the central bank policy of negative interest rates has been a failure. This is not surprising. Why were negative rates ever thought to be a good idea? Here are some of the most important alleged reasons why lower rates are erroneously thought to stimulate economic growth:
1. “Lower rates stimulate business investment and hence economic growth.” Those who think that negative or zero rates may be a stimulus to the economy must believe that during times of negative (or zero) interest rates, companies are somehow able to borrow at negative (or zero) interest rates, i.e. when you apply for a bank loan, the loan agreement states that the bank will pay you a monthly or quarterly fee for the privilege of receiving this new purchasing power. Nice idea, but there is no evidence that this has ever happened.
2. “Lower rates stimulate the economy by forcing ‘savers’ to withdraw their money from banks and thus putting the money to more productive use in the economy” This idea is so flawed from so many angles that it is hard to know where to start. Firstly, the facts: deposit balances in “surplus saving” countries like Germany and Japan, remained positive and very large even under the central bank policy of negative interest rates. That is of course because deposit interest rates only rarely were lowered into negative territory, even at the height of the central banks’ “negative interest rate policy”.
Why did banks not pass on the negative rates to depositors? Just look at Silicon Valley Bank to observe a bank management that does not wish to attract depositors (keep the old depositors or attract new ones) with appealing interest rates. When bank management does not wish to keep deposits from depositors, a run on the bank can ensue, which results in the rapid closure of the bank (since central banks in practice choose not to fulfil their function of lender of last resort in the case of a run on smaller banks). Since able bank management knows this, banks have mostly refused to lower deposit interest rates into negative territory.
Of course, the above argument is also flawed for other reasons, namely when savers withdraw money from banks, the bank balance sheets shrink, which is equivalent to a monetary contraction, and any suggestion that this is stimulating to the economy can only be dreamed up by someone who assumes that banks are merely financial intermediaries and hence can be left out of any macroeconomic analysis (and hence someone who should not even be confronted with this question, since it is clearly out of scope of analysis). Since banks are not financial intermediaries, but creators of the money supply, through their function of creating deposits when they extend loans, it makes no sense to argue that the economy will benefit from deposits being withdrawn from banks. To the contrary, it is bank loans that need to be expanded and put to productive use in the economy, since this is fresh money. And we need freshly created money for economic growth (see my Quantity Theory of Disaggregated Credit). Shifting deposits from A to B is growth-neutral, just like pure fiscal policy. (Yes, you saw that right. Fiscal policy, when not backed by monetary policy, does not stimulate economic growth).
3. “Low interest rates stimulate investment and hence higher growth”. This is the fundamental idea proposed by academic economists, based on their models that make a lot of unrealistic assumptions, including that banks do not exist and money is not needed for economic growth. This argument suffers from the pars pro toto fallacy or fallacy of composition: While for one investor, ceteris paribus, lower rates may well increase investment, this is not true for the whole economy. For one, for the whole economy interest rates are the result, not the cause – as indeed empirical evidence on the relationship between interest rates and growth indicates. Furthermore, in the ‘real world’, as opposed to the economists’ fictional world, the money supply is created by banks. And small firms need to borrow money from banks, as capital markets are mostly closed to them due to small size, and when there is a downturn banks tend to restrict lending to small firms at any interest rate. Indeed, the market for bank credit is rationed at all times, since the demand for bank loans always exceeds the supply: Due to money being so jolly useful, demand is always high and the theoretical “equilibrium” interest rate would be so high that banks would refuse to lend at such high rates, because this drives away the sensible, conservative and reliable borrowers and would leave the bank with the reckless speculators, who they in fact do not want to lend to. So when central banks lower interest rates in downturns, this almost never means that more small firms are able to borrow, and more cheaply, since they are always credit rationed and in a downturn are the ones cut off from bank credit, at any interest rate. For them, it has always been a bad joke to talk about “negative interest rates”, as central bankers have done for almost two decades, since firms always have to borrow at positive interest rates, and many small firms, the main employer in any economy, in those times could not borrow money at all.
Since borrowers could not borrow at negative rates, and since depositors largely did not have to pay negative rates on their bank deposits (with some exceptions in Germany, Switzerland, etc.), for whom have negative rates actually been relevant?
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