Deflation is negative inflation: a general decrease in the average price level and an increase in the purchasing power of money. Every school of economics considers deflation negative for economies. However the standard explanation of why deflation is terrible for economies is incorrect. The correct explanation is understanding the impact of deflation on the real rate of interest, and thus the ability for private firms and individuals to manage debt repayments.
It’s the simplest of all policies. If a central banker wishes to stimulate an economy – they cut the central bank base interest rate. If they wish to moderate it – they raise the rate. The classical theory being that manipulating the rate alters the cost of credit and thus encourages/hampers individuals and firms spending incentives accordingly.
As we can see from the charts above, developed economies have maintained persistently low interest rates ever since 2008 and the Global Financial Crisis (and in Japan’s case, a lot longer…). The central banks have been attempting to gee up economies with cheap credit, exactly as the theory advises. However, as has been seen in the years subsequent – economic growth in each of the same economies has been relatively anaemic in spite of the historically low interest rates.
Thus this post will investigate the channels that interest rates are supposed to affect the economy – looking how it is supposed to affect both individuals and firms. Although it is an elementary discussion, its apparent ineffectiveness in recent years highlights that an assessment is a worthy exercise.
Negative interest are yet another paradox in economics. Mainstream theory suggests that a rate of interest below zero should be impossible. Rational actors would never accept negative rates, choosing to hold on to cash instead and withdraw it from the financial system. However exercises in Denmark in 2012 and the ECB and Switzerland in 2014 have shown not only that negative interest rates are practically possible, but that they are gaining some acceptance in the central banking community as a legitimate tool. Furthermore, with developed economies trapped near the zero nominal lower bound and therefore needing additional stimulative tactics, their wider use seems increasingly more attractive. However the fact that negative rates have not been widely implemented in a world where extraordinary policies like Quantitative Easing has become common place, in spite of their obviousness, suggests that there are crucial reasons why policy makers have been so reluctant to use the tool. Reasons that will prevent mainstream implementation in the future.
This piece will discuss the premise of negative interest rates, their potential as a stimulative tool and their systemic impact to economies.