What to do with negative rates?

Negative interest rates have become a reality for institutional investors and banks in many European countries. Yet, private households so far have been shielded to a large extent from these negative rates since banks didn’t pass on negative rates to retail customers. Individual banks like the Alternative Bank in Switzerland or Danish Jyske Bank have charged their customers negative rates for some time now, but in general, investors enjoyed a 0% interest rate on their deposits. Last fall, however, in a concerted move, the majority of Swiss banks introduced negative interest rates to customers with deposits of one million Swiss Francs or more.

The idea behind negative interest rates is to punish savers for holding their savings in cash and incentivise them to pay down debt or invest in risky assets. Yet, particularly in countries like Switzerland and Germany, many investors are so risk-averse that they refuse to switch from cash to risky investments like stocks. These conservative investors are now caught between a sure negative return on their deposits and a potentially much larger loss when they invest their savings. UBS was clever enough to find a loophole that allows them to offer a 0% deposit even as they charged deposits in Switzerland with negative rates. However, the capacity of this loophole is likely limited and soon exhausted.

But I think central bankers and economists are misguided when they think that negative interest rates will push households to invest their savings. Instead, it could be that negative interest rates lead to lower investments and higher savings.

Put yourself in the shoes of the average Joe, or to put it in Swiss terms: Herr Müller. Herr Müller keeps money in his bank account for several purposes. First, the bank account is needed to pay for his bills. Second, it is a savings vehicle where he can be sure not to lose money. And if the bank goes bankrupt at least some of his money is insured.

Now, the bank charges negative interest rates on his bank account. The first thing Herr Müller will likely do is to look for other safe assets to invest in. Unfortunately, the yields on government bonds in Switzerland or Germany are even more negative than the interest he pays on his bank account. He also cannot withdraw his money from his bank and store it at home or in a safe deposit box because in a world of electronic payments that is mighty inconvenient.

Furthermore, he knows he wants to have a certain amount in his bank account as an iron reserve against unforeseen emergencies (Herr Müller is Swiss and as a result, he always prepares for worst-case scenarios).

Now, Herr Müller starts to see his account balance decline as the bank charges negative rates. Because Herr Müller, like so many people, suffers from money illusion, he starts saving more money in his bank account to ensure the balance does not decline. In fact, if Herr Müller uses his savings account as a vehicle to save for retirement, negative rates will incentivise him to save even more than before not only to make up for negative rates but to make up for foregone positive rates.

In the end, as interest rates become more and more negative, Herr Müller and other people like him start to save more, not less. And that, of course, means that they consume less and the economic impact of negative interest rates could be a slowdown in economic activity, not an acceleration.

Whether I am right with these assumptions is so far unknown because there is no research that I know of that looks at the reaction of households to negative interest rates. Instead, we are running this experiment in different countries in Europe as we speak. What we do know, however, is that about half the people in laboratory experiments will not spend or invest their savings when faced with negative rates of up to -1%.

And what we can observe in recent years is that despite a strong global economy and declining unemployment in Western Europe and the United States, households in countries that suffer negative interest rates have increased their savings rates between 2015 and 2019 while households in countries like the United States and the UK with positive interest rates have reduced their savings rates. Something is rotten in the state of Denmark, and Sweden, and Germany …

Change in household savings rate between 2015 and 2019

Source: European Commission.