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    Negative interest rates are becoming the new normal

    Saturday, 01 August 2020
    This is an opinion article by an external contributor. The views belong to the writer.

    The International Monetary Fund predicts that global public debt will reach its highest level in history with 101% of GDP in 2020. Economists expect it to be higher even than the debt mountain after WW2.

    IMF chief economist Gita Gopinath however, says that despite record public debt, governments should not give up giving the public aid available in many countries.

    “While the trajectory of public debt could drift up further in an adverse scenario, an earlier-than-warranted fiscal retrenchment presents an even greater risk of derailing the recovery, with larger future fiscal costs,” wrote Gopinath in a note released a couple weeks ago.

    The IMF also recently announced that it is forecasting a greater than expected global recession. The eurozone’s GDP will shrink by 10.2%, Latin America and the Caribbean by 9.4%, and the US by 8%.

    Going back to WW2 in terms of debt also means using more tools from the “war economics” playbook. The “pandenomics”, of 2020 as a description of the fiscal and monetary response of governments to the economic fallout of COVID-19, is very much similar.

    In order to increase debt we keep the interest rates low. This is what the US Treasury and Fed agreed to in April 1942. They controlled nominal interest rates on short-term and long-term government securities.

    After the completion of the transition from war to peace in 1945, the continuation of low interest rates allowed the Allies to pay off the debt they had incurred during the war effort. Low rates allowed for the Les Trente Glorieuses (‘The Glorious Thirty years from 1945 to 1975’) to happen in France and in many other European countries.

    Pandemic of lowering interest rates

    Pandenomics may mean the era of negative interest rate as a normal policy option.

    According to Andrew Lilley and Kenneth Rogoff, evidence from the US shows that markets not only expect the interest rates to remain low in the future, but also expect negative interest rates to be down.

    Moreover, markets are no longer convinced that even quantitative easing can lead to inflation reaching the target, which leaves very few alternatives to monetary policy apart from negative interest rates.

    In response to the recession, which after the financial crisis of 2008 covered almost all economies of the world, several central banks in developed countries reduced interest rates to close to zero. Some went further, lowering deposit rates from commercial banks below zero.

    Today, apart from the European Central Bank and the Bank of Japan, negative interest rates are also in use in Switzerland, Denmark and in Sweden.

    Sweden, Norway, Bulgaria and the Eurozone have interest rates of 0% which make them basically negative and some other countries have almost negative rates or negative real interest rates (including the inflation), as in the case of Poland (0.1%), Canada (0.25%) or the US (0.25%).

    Since only the beginning of March 2020 the world’s central banks have cut interest rates. The only exception to this rule was the National Bank of Kazakhstan, which raised its key rate by 2.75% to support its currency in light of current oil prices.

    The American Fed, has however after several rate increases began to lower them, but has not reached zero, let alone gone negative, which is publicly criticized by president Donald Trump.

    The justification for negative rates is simple. Positive interest rates are a reward for investors who earn, risk and give loans.

    Negative interest rates punish banks that operate too safely by accumulating cash on reserves at central banks.

    Therefore, they are to encourage banks to increase lending. Since central bank rates are the benchmark for the cost of loans throughout the economy, government and corporate bond yields have fallen.

    New normal?

    Just months before the pandemic, analysts from the Bank for International Settlements (BIS) warned that it is worrying when something that was unthinkable until recently (negative interest rates) is becoming the new normal.

    There are also economic analysts who argue that negative rates have helped economies and that – at least so far – they can be managed. They point to the lack of other available options, because public debt in many countries is already so high that increasing the fiscal deficit would be risky, so you have to use other tools to stimulate the economy.

    Opponents believe that, like inflation, it would constitute a punishment for the economy, but economists agree that negative rates would only be a strategy to enable them to overcome recessions and deflation faster, and that in the long run average rates would give an added, real return on savings.

    Paul Schmelzing argues that during the last 700 years of economic development we are going in one direction and that is to lower interest rates. He sees a couple sub-periods of changing interest rates. The first was in the 16th century, when the Turks were pushed away in the Balkans and gold mining resumed in the region. The second was related to the widespread use of the credit system in 18th century England, when reasonable interest-bearing loans ceased to be available to only wealthy individuals. The third turning point came after the Napoleonic wars as a result of the formation of modern nation-states and with them sovereign monetary systems. All this made money cheaper.

    Schmelzing draws the fundamental conclusion that the time of low (sometimes even negative) interest rates that characterizes the modern economy is not a transitional trend on the sine wave of history. This is a natural direction in which our civilization has been marching for a good few centuries.

    This trend is important. It shows a constant and clear decrease in interest rates. In the 15th century, the average interest rate on loans was 9%, in the 16th century already 6%, in the 17th century 4.6%, in the 18th century 3.5%. And so on, up to 1.3% (so far) in the 21st century.

    Negative or near negative interest rates are becoming the new normal and are going to help pay our pandemic debt.

    Piotr Arak