The Negative-Interest Rate Experiment: Mixed Results

SMITH BRAIN TRUST — Central bankers in Japan and the Europe Union are at their wits' end in trying to figure how to generate demand and stave off deflation. Both banks have dropped interest rates into negative territory, encouraging spending by making saving literally costly. Yet the publics of the two economic regions have reacted differently. Each is unhappy for a different reason.

Japanese investors seem to view negative rates and the continuing downward trend for rates as a reason for extreme worry. Japan's main central bank rate dropped to -0.1 percent in January, and the central-bank governor, Haruhiko Kuroda, recently said that rates may go down even further. This has caused something of an uproar: Senior citizens are taking out money and putting it into safes, while parliament has called Kuroda in for repeated questioning.

In contrast, the president of the European Central Bank, Mario Draghi, ignited worries precisely by saying that rates were not likely to drop further. The ECB cut a key rate this month to -0.4 percent. But Draghi subsequently said: "Can we can go as negative as we want without any consequences on the banking system? The answer is no." European bank stocks rose when the rate cut was announced, then dropped after Draghi's remarks. Investors seem to have expected continuing monetary stimulus. (In addition to lowering interest rates, both the Japanese and European banks are buying bonds to increase the money supply.)

Haluk Ünal, a professor of finance at the Robert H. Smith School, at the University of Maryland, has argued that the "equilibrium" real rate of interest in both Europe and Japan is negative, the result of overcapacity in existing production facilities coupled with very high savings (that is, low demand). "So in this environment, interest rates are a blunt tool," he notes. "They can't stimulate demand entirely on their own."

These are some of the challenges lower rates can't fix: aging populations that are more inclined to save than to spend, or work. Stalled productivity in the major western economies, despite the spread of information technology.

Perhaps most significantly, the massive amounts of saving in China creates an imbalance in the world economy that remains untouched by regional reductions in interest rates. China, Ünal notes, has taken the correct step in relaxing the one-child policy. The hope is that China starts consuming goods and services from the rest of the world. But China, at present not a consumer based economy, has been unusually stubborn in resisting spurs to consumption.

There also may be behavioral-economics (that is, psychological) factors at work, Ünal suggests. Even if negative interest rates are the proper policy, their introduction seems to underscore a sense of crisis. "People know that central banks lower interest rates when the economy is struggling," Ünal says. "So when banks introduce negative rates, that must mean things are truly dire." Ironically or irrationally, the association of negative rates with fiscal emergency works against their stimulative effect.

In the United States, the Fed declined to raise rates in March. In the current environment, it would have been "insane" to raise rates, Ünal says. Looking ahead, the CME Group's FedWatch Tool puts the odds of an April Fed increase at only 12 percent.

If all else fails in Europe and Japan, some analysts are suggesting a resort to so-called "helicopter money," a direct infusion of cash into consumers' bank accounts. The term refers to an argument by the late U.S. economist Milton Friedman, who said that "dropping money out of a helicopter" could jump-start spending. It's considered a radical move, but discussion of it is on the rise in the European and Japanese contexts.