Blame politicians for those negative interest rates – not central bankers

Economic View

Simon Wren-Lewis
Thursday 10 March 2016 08:00
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George Osborne cut investment in flood defences before Storm Desmond hit in December
George Osborne cut investment in flood defences before Storm Desmond hit in December

At the end of last year the United States’ central bank, the Fed, increased short-term interest rates. It was a big moment. US rates had stayed at almost zero for seven years, and were last increased a decade ago. Did the Fed’s move mark the point where monetary policy around the world would finally become normal again?

Unfortunately, the global economic news since then has been mostly bad. Data released a few weeks ago showed US GDP growth at the end of last year of only 1 per cent at an annual rate. UK growth over the same period was higher, but the increase in the more relevant GDP per head was little more than 1 per cent, which is well below historic trends.

The eurozone was equally bad. With China and other emerging economies slowing, commodity prices and world trade appear very weak. The financial markets, which until recently appeared to believe things could only get better, are becoming distinctly nervous that another recession could be a possibility.

Academic economists do not normally get involved in forecasting, because they know it is little better than guesswork. What academics do worry about is devising policy that can effectively respond to an unpredictable economy. They worry that if another recession comes, central banks will have little or no ammunition to offset its impact. The ECB is trying quantitative easing, but experience from other countries suggests that its effect is very difficult to judge, so it hardly represents a reliable and effective alternative to interest rates.

This has led to talk about the possibility of negative interest rates. Some central banks, such as Sweden’s, have set interest rates slightly below zero. The immediate hope is that this encourages banks to lend more. However if a recession comes, firms and individuals are likely to want to cut back on borrowing, so the impact of slightly negative rates is unlikely to be enough.

The situation might be very different if central banks set interest rates well below zero, at -3 per cent, for example. That would force commercial banks to start charging customers for the privilege of having a bank account. Instead of receiving interest on your money in the bank, you would lose some percentage of your money each month or quarter. The hope would be that lots of people would decide that it just wasn’t worth saving, and the extra spending would stimulate demand enough to get us out of any new recession.

There is an obvious problem with this strategy. Rather than lose money by having a bank account, you could hold it as cash instead. The interest rate on cash is by definition zero. So all this policy might do is increase the amount of money stashed under mattresses. It is for precisely this reason that we talk about a lower bound for nominal interest rates.

But now some economists are thinking about getting rid of cash as we know it. If the only money that mattered was electronic in form, we would have no choice but to pay to save if interest rates went negative, and the lower bound on interest rates would disappear.

How have we come to this, where central banks and economists are seriously thinking about setting negative interest rates? If you are fed up with receiving so little on your savings, who should you blame?

The answer is not the Bank of England, but the Government. The Bank’s governor, Mark Carney, may be too polite to say this too loudly, but his problem is that the Government refuses to borrow to invest.

Economists around the world, including those at the OECD and IMF, understand this. Both organisations urged governments at the recent G20 summit to increase their investment in infrastructure and research. This would help demand, which would allow interest rates to rise, giving banks ammunition if a recession did come. It would also help improve the supply side of the economy. Their pleas fell on deaf UK and German ears.

Why did Osborne change his rule? A cynical answer is that he thought it would win him votes

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When George Osborne became Chancellor in 2010, he adopted a fiscal rule that targeted the difference between current government spending and taxes. That made a lot of sense, because it gave him the freedom to borrow to invest in roads, houses, schools or hospitals when the conditions were right.

Unfortunately he chose instead to cut back investment sharply, even when that investment involved vital needs such as improving flood defences, but at least his rule then gave him the freedom to do otherwise.

His new fiscal charter, in contrast, aims to achieve a surplus on the difference between total government spending, including investment, and taxes. That means he has no freedom to borrow to invest, so he will ignore the IMF and OECD.

Why did he change his rule? A cynical answer might be that he thought it would win him votes. Labour were committed to continuing to target the current balance, so he could claim they were still not being prudent enough. A less cynical answer would be that he wanted to reduce government debt as quickly as possible.

But cutting back on investment to reduce debt quickly makes no economic sense when interest rates are almost zero and there are plenty of useful things for the government to invest in.

Imagine a firm whose bank offered it an interest-free loan. Other banks were queueing up to do the same, so there was no prospect of the firm facing a credit crunch. The firm’s chief executive had plenty of money-making projects on the drawing board, but instead turned down the loan because it would increase the firm’s debt. As a result, the firm did not grow and without new projects its profits fell. The shareholders of that firm would have every justification for sacking their chief executive.

But that is exactly what George Osborne is doing to the UK economy. Governments of the eurozone economies are following a similar strategy. Sluggish growth and talk of negative interest rates are two of the consequences.

Simon Wren-Lewis is professor of economic policy at the Blavatnik School of Government, Oxford University​

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