Monday, October 20, 2008

Is It Time For A Negative Interest Rate?


In 1960 I was 24 and a fairly new full-time student at Ruskin College when I was set an essay by my economic theory tutor on the likely impact of a negative interest rate. Unfortunately I could find no reference to anything called a "negative interest rate" in the reading list which he had supplied, nor could any of my fellow novice students enlighten me on the meaning of the term.

So when it came to the tutorial, I read out what I had thought through for myself. My tutor kept correcting me until it dawned on him that I had persistently got hold of the wrong end of the stick. He then heard me out in silence.

I had ignored the notion that changes can occur in the value of money due to inflation or deflation. Instead I dreamt up a situation in which real values were static, but any savings which people deposited would receive a cut when retrieved. Save, say £100 and get £95 in return.

Even such an odd theory gives some limited scope for intellectual gymnastics and my tutors end-of-term comments obviously looked back on this incident. He reported that I "showed a distinct ability to think for myself, but at a superficial level" ! It is a position which is, no doubt, reflected regularly in this blog.


The likely impact of a negative interest rate is, however, a key contemporary issue. For it refers to a situation in which the rate of interest could feasibly be outmatched by the rate of inflation. The basic rate of interest fell to 4.5% on 8th October, yet in September the rate of inflation had already reached the higher figure of 5.2%. In practice many available rates of interest still exceed the 4.5% figure, but the inflation and interest rates are fast closing in upon one another.

Ken Livingstone is amongst those calling for a further cut in interest rates to boost investment. In real terms this would produce a negative interest rate for savers.

The case for doing this is made in today's Morning Star by Jerry Jones. He states that the government should "drastically reduce interest rates to around 2% and bring in regulations last seen in the 1950s and 1960s to ensure that the banks pass on the lower rate.....(to) ease the situation of those heavily in debt and (so) people would have more to spend. This would increase overall economic demand. These measures would make it cheaper for individuals and businesses to take on loans, which would help to boost economic demand, investment and employment. Fewer people would be in danger of losing their homes through getting in arrears.....(the) downside of slashing interest rates whilst inflation stands over 5% is that interest rates would be negative in real terms (my emphasis HB) so savers would lose out.However, cuts would act as an incentive to invest and spend, which would help to stimulate the economy".


Given that I first stumbled into negative interest rates 48 years ago, I will add two extra factors to Jerry Jone's powerful analysis.

First, savings are also used for investment purposes when banks and other financial institutions are obliged to act sensibly. Money withheld from savings needs to be invested or spent to create growth. However, money kept in purses and wallets does less than money properly saved.

Secondly, if the Government are to adjust interest rates in order to influence economic activity then (although they hold reserve powers), they need to reclaim the power to do this from the Bank of England. Those of us who came to learn about negative interest rates the hard way, knew that Gordon Brown made a great blunder in his first act as Chancellor of the Exchequer when he tied his hands behind his back.


Timitz said...

The idea of purposely creating a negative interest rate in order to stimulate spending strikes me as interesting. If you set all money to devalue that would certainly spur the economy. Have you heard about that idea advocated by Gesell? It was apparently attempted in Austria and parts of the US during the Great Depression with great success. What do you think the long term effects of such a policy would be?

Harry Barnes said...

Timitz : A negative interest rate should produce pressures for people to stop saving. But what will they do with their money instead? They might (a) purchase gold, silver and jewels, (b) put savings in foreign banks offering higher interest rates, (c) keep the money under the mattress (etc). What matters is will they place their money in other areas which leads to it then (again) being circulated - Keynes claimed that the "velocity of circulation" of money was also of significance.

Another consideration is what would have happened to their money if it had remained in the bank under uncut interest rates. A % of it could presumably be used for investment purposes or lent to others for investment purposes - or lent to purchase houses etc. Which would be better for demand than, at least, (b) and (c) above.

A negative interest rate could be a risky strategy. But the lastest interest cut brought it a bit nearer.

The problem is that when acting as economists we need to know a great deal about the economic data before deciding how we move - yet such data leads to financial, stock market and other interests reacting also and changing the data.

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