Negative interest rates, helicopter cash to pep demand?

Currently, all the major economies of the world are slowing down and a global recession in the near future is considered a real possibility. The ‘inversion of the yield curve’ (meaning long-term interest rates going below short-term rates) — considered by many as an indicator of the financial market expecting a recession—has recently taken place in the US.

Among the policy instruments being talked about, the most puzzling (for the layperson) and controversial (for policymakers) is monetary policy in the form of negative interest rates. Though one would find no reference to negative interest rates in macroeconomics textbooks, at least in their earlier editions, this is an important part of current global reality.

It started in 2014 with the European Central Bank (ECB) adopting a negative interest rate policy, to be followed by Sweden, Denmark and Switzerland. Then, in January 2015, Bank of Japan (BOJ) went down the same path. Currently, though short-term interest rates are still in the positive territory, long-term 30-year interest rates are negative in Germany. According to one estimate, about half of government debt today, if one leaves out US debt, bears negative interest rates. Recently, US policymakers have also begun to give it a serious thought, in case another recession hits the country.

How does it work and what are its likely costs and benefits?

The basic logic behind negative interest rates is that this would induce people to spend, rather than save and earn negative interest rate on bank deposits. Banks, too, would find it profitable to lend money to businesses and consumers, instead of parking surplus funds with the central bank at negative interest. All these would stimulate aggregate demand and production of goods and services, which is the need of the hour.

In addition, negative interest rates would discourage capital inflow from abroad and encourage capital outflow, thereby depreciating domestic currency and boosting net exports through cheaper exports and dearer imports. The negative interest rate may also be a signalling device to the market that the central bank is willing to do anything to stimulate demand and prices, thereby creating positive expectations. Expectations about the future play an important role in influencing the current economic decisions of people.

Note, however, that even with negative nominal rate, real interest rate (equal to nominal interest rate minus the rate of inflation) can be positive with falling prices (or ‘negative inflation’ which often accompanies recession, as in Japan for a long period). Also, if the currency is expected to appreciate at a sufficiently high rate, capital inflow may take place even with negative interest rates.

The downside risk is that negative interest rates may further squeeze the spread between borrowing and lending rates (as it is very difficult to attract depositors with negative rates) and hence profits of already stressed banks. Banks may also be required under law to hold certain percentage of assets in government bonds even if the interest rate is negative. All these may force the banks to lend less to the private sector than before, in which case it would be counterproductive. In fact, instead of depreciating, the yen has actually appreciated, relative to many other currencies, in the post-negative interest rate period.

The truth is that the prolonged slowdown in Japan and many European countries has not reversed despite negative interest rates and no one knows how the consequences would unfold in future. A lot may also depend on how negative the rate is. There is virtually no difference between zero (which has been the case for many countries for a long time) and minus 0.1% interest rate (that Bank of Japan has). But the impact, both positive and negative, would be more pronounced if the value of the negative interest rate becomes bigger. In fact, ECB has very recently reduced interest rates to as low as minus 0.5%.

Another new idea being floated around is the injection of ‘helicopter money.’ Milton Friedman first introduced this term to refer to a hypothetical exercise where additional notes are dropped from a helicopter, picked up by people and spent on goods and services. Basically, it suggests that the central bank should put new money directly in the hands of the public or the government to spend. It may take the form of sending a bonus tax refund cheque to taxpayers or a windfall credit in everyone’s bank account, or the freshly printed money may be used by the government to finance additional expenditure.

This is believed to be a surer way of increasing aggregate expenditure than injecting liquidity by the central bank buying bonds from the public. In the latter case, one kind of financial asset (money) is being substituted for another kind (bonds) in peoples’ asset portfolios and it may fail to increase expenditure on goods. In the case of ‘helicopter money’, it would directly stimulate private or public expenditure.

But, again, there are question marks. It is possible that in a recessionary situation people may save, rather than spend the windfall, especially when they know it is not going to be repeated in future and there is always the possibility of loss of jobs and regular income in the coming days.

One can also argue that if ‘helicopter money’ is used to finance additional government expenditure, then it is a combination of monetary and fiscal expansion. In that case, even if it becomes successful in stimulating expenditure, the credit should go to expansionary fiscal policy, rather than monetary policy. Further, additional fiscal deficit would create problems of debt servicing later, which is the major reason why most countries have withdrawn their fiscal stimulus, despite the prolonged slowdown.

(The writer is a former professor of economics at IIM-Calcutta)