And another unintended consequence of negative interest rates

In the UK, the Bank of England is pondering whether it should introduce negative interest rates. The experience in countries like Germany, Switzerland, and Sweden shows that this is unlikely to help the economy or boost inflation. With negative interest rates, banks have an even lower incentive to lend than before because their interest margins become even smaller and many loans may simply become unprofitable. 

However, one thing that negative interest rates do is lift house prices. When savings no longer create any income in bank deposits or government bills and bonds, more and more households shift their savings from the safest assets to the next safest alternatives. And this is typically property. Every country that has seen central bank policy rates turn negative subsequently experienced an increase in house price gains. 

On the one hand, this is good, since consumers who see the value of their homes rise, feel richer and tend to increase their spending. And that, of course, helps the economy. This wealth effect is well documented in many countries and is one of the reasons why interest rate cuts stimulate the economy.

But unfortunately, there seem to be unintended consequences that may become important at zero or negative interest rates. Indraneel Chakraborty from the University of Miami and his colleagues have investigated the lending practices of banks during the house price boom of the late 1990s and early 2000s. What they found is that as house prices rose, banks increasingly focused their lending activities on the mortgage market and reduced their lending to businesses. From a bank’s perspective, this makes sense. First, mortgages are inherently safer loans than corporate and business loans because they are secured by the underlying property (let’s ignore for a moment that at the height of the property bubble these properties were worthless…). And if the prices of these properties tend to rise, then the safety of the mortgage increases. If capital is limited, banks should use their capital first for the loans that are most likely to be paid back in full and create a minimum required profit. Only if no more of these profitable loans can be underwritten should a bank lend money to riskier borrowers.

The problem is that these riskier borrowers are businesses and they increasingly got cut off from access to bank loans. The result was that they had to pay higher interest on new loans, had to delever their balance sheets because they couldn’t get loans at acceptable conditions and had to reduce investments because they didn’t have the capital to fund these investments. The chart below shows that with higher house prices, lending to businesses declined. 

Relationship between house prices and corporate lending

Source: Chakraborty et al. (2020).

On average an increase in house prices by one standard deviation (roughly 30% of the house price) reduces investments by businesses by 10.3% and balance sheet leverage by 4.2%. The effects seem to be bigger for smaller firms (which are riskier borrowers on average). Their investments decline by 15.7% and their balance sheet leverage by 7.1%.

My guess is that if interest rates are zero or negative, this effect may be even more pronounced. Banks that see their margins squeezed are going to shift their lending even more aggressively away from corporate loans to mortgages, creating an even bigger constraint on investments. And that means that economic growth is hampered even more on the investment side and may finally overpower the boost in consumption from higher house prices. The lower interest rates are the less growth is created by reducing rates. This is more than just Keynes’ famous pushing on a string where the central bank loses the ability to incentivise banks to lend. This is a situation where pushing on a string leads to the string recoiling and getting shorter and harder to reach for the people on the other side of the table.