Negative interest rates are weird, but that’s not what’s wrong with the global economy

There’s a big difference between above and below.
There’s a big difference between above and below.
Image: Reuters/Alexandre Meneghini
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Negative interest rates used to be a thought experiment for economists.

Now they’re a fact of life.

Central banks in the euro zone, Japan, Sweden, Denmark and Switzerland have pushed their short term interest rate targets below zero, in an effort to weaken their currencies and fight disinflationary pressures.

It’s not working.

How do we know? For one thing, people are still buying government bonds issued by these countries even though negative interest rates guarantee a loss of capital if they’re held to maturity. Thus people must be betting on some form of deflation, either through outright price declines or a surge in currency values.

Moreover, there’s very little in the way of conclusive evidence that negative rates in and of themselves are the solution to deflation. True, Sweden, which has had negative rates in place since early 2015, has seen inflation recently pick up a bit.

On the other hand, Switzerland, where negative policy rates have been in place since early 2015, remains deep in deflation, with prices falling nearly 1.3% in December 2015 compared to the same month in 2014.

For larger economies such as Japan and the euro zone, inflation remains stunningly weak, despite negative interest rates. There’s little indication a burst of inflation will break out any time soon.

Negative interest rates might work if pushed into even deeper into negative territory, but that depends on the tricky assumption that the banking system will transmit lower rates to the real economy through a surge in lending. So far, banks have instead retrenched as lower rates on bank loans have crimped profits.

Besides, as Keynes wrote in the 1930s, when interest rates are close to zero, monetary policy becomes much less useful as a tool re-invigorate the economy.

No, when you’re a liquidity trap such as we are now, fiscal policy, a.k.a. government spending, is a far better way to juice economic growth.

And this is exactly what the financial cognoscenti are saying now.

Former US Treasury Secretary Larry Summers is recently wrote that “preparations should be starting with respect to the rapid application of fiscal policy.”  Former head of the UK Financial Services Authority Adair Turner has been prescribing central bank financed spending by governments. Hedge fund giant Ray Dalio thinks the US economy needs fiscal and monetary authorities to team up for a big money drop. The central thrust of bond market maven Mohamed el-Erian’s new bookThe Only Game in Town, is that politicians need to do more to boost economic growth.

This seems to be the emerging consensus. Let’s hope it’s not too late to put it into practice.