Here's how negative interest rates can change people's attitudes about money

Flickr/Weldon Kennedy

The idea of negative rates isn’t new. What’s new is the willingness to try them out, and the Federal Reserve just sent its clearest signal yet that it is headed that way, too.

The Fed has warned banks to get ready. We had all better do the same.

Earlier this month, my good friend David Kotok sent around links to several academic and central bank negative-rate studies.

One was a 2012 article by Kenneth Garbade and Jamie McAndrews of the Federal Reserve Bank of New York. Their title tells you what they thought at the time: “If Interest Rates Go Negative… Or, Be Careful What You Wish For.”

Their point was less about the theoretical wisdom of NIRP and more about the actual potential consequences. They believed we would see a variety of odd responses to a very odd policy situation. For starters, all kinds of incentives would reverse.

Empty Bank Accounts

Under negative deposit rates, buyers would want to pay their invoices as soon as possible, while sellers would want to delay receiving cash as long as possible.

Think about your credit card bill.

If you normally spend $10,000 a month, your best move would be to send the bank that much money before you spend it, then draw down the resulting credit balance. The bank would no doubt try to discourage this practice.

Could they? We don’t know.

Flickr/Weldon KennedyVaults with Physical Cash

Garbade and McAndrews throw out another interesting idea: special-purpose banks:

If rates go negative, we should expect to see financial innovations that emulate cash in more convenient forms. One obvious candidate is a special-purpose bank that offers conventional checking accounts (for a fee) and pledges to hold no asset other than cash (which it immobilizes in a very large vault). Checks written on accounts in a special-purpose bank would be tantamount to negotiable warehouse receipts on the bank’s cash. Special-purpose banks would probably not be viable for small accounts or if interest rates are only slightly below zero, say -25 or -50 basis points (because break-even account fees are likely to be larger), but might start to become attractive if rates go much lower than that.

Ludwig von Mises fans will recognize that this approach is not far from the Austrian economics goal of 100% reserve banking. It isn’t quite there because the vault contains fiat currency instead of gold, but I think Mises would recognize it as a step in the right direction. (The fact that Fed economists see it only as an exotic theoretical possibility wouldn’t surprise him, either.)

The consequences of such banking would be more than theoretical. If enough people wanted to use these special-purpose banks, demand for physical cash would go through the roof.

There simply wouldn’t be enough to go around if it just sat in vaults instead of circulating. Furthermore, if the vaulted cash in these banks reduced deposits in normal loan-making banks, the whole banking system might grind to a halt.

Flickr/Weldon KennedyCash Hoarding

That being the case, I suspect the Fed would prohibit banks from operating this way—but they can’t stop people from hoarding cash under their mattresses. The one thing they could do is eliminate physical cash. Denmark, Sweden, and Norway are already considering ways to do so.

Even more ominously, Bloomberg recently reported that the European Central Bank plans to get rid of 500-euro notes, the Eurozone’s largest-denomination bills. They portray this move mainly as a crime-fighting measure, but it would clearly make cash hoarding much more difficult.

And if Larry Summers and a few other well-known economists like Ken Rogoff have their way, we will see the demise of the $100 bill in the US. You thought you were just carrying those Ben Franklins around for convenience, not realizing that they make you a potential drug dealer in some people’s eyes.

And of course, hoarding cash would undermine the Fed’s goal of fighting deflation. Holding cash is by definition, deflationary.

How to Protect Your Wealth in a Negative Rates World

Gone are the days where you could earn a decent interest on traditional “safe haven” investments like CDs, money market, and savings accounts. Watch Mauldin Economics’ editors Tony Sagami and Jared Dillian discuss how you can protect and grow your wealth throughout the grand monetary experiment of negative rates.

The article was excerpted from Thoughts from the Frontline.

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