Then from about 2011, we saw central banks make active use of their balance sheets, buying financial assets outright under what has become known as quantitative easing and in the process growing their balance sheets to sizes far beyond the pre-crisis norm. And since 2012, we have seen some central banks reduce their deposit rates below zero, thus breaking what was long believed to be the “zero lower bound” – in other words, the “iron fact” that interests rates could not go below 0%.
It may look as though central banks have been casting around, looking for anything that works. But in fact their various measures – first low interest rates and abundant liquidity, then QE, now a negative interest rates policy, or NIRP – have had one consistent goal: they have all been designed to revive the banking system and thereby allow it to help revive the economy.
NIRP has been introduced in the eurozone, Japan, Sweden, Denmark and Switzerland. There are theoretically two ways in which NIRP should work. First, negative interest rates should encourage banks to deploy their reserves with central banks, for example by spurring bank lending and risk-taking, and (where banks choose not to lend) by buying assets. The theory here is that any of these uses of the reserves is better for the bank than paying the central bank to warehouse them, and all of them are, other things being equal, stimulative for the economy.
Unfortunately, the evidence that NIRP works in any of these directions is as yet inconclusive.
The second way in which NIRP is supposed to work is by depreciating the currency. Here, the evidence is more mixed. There is clearly some impact on the currency from NIRP, but unfortunately, the evidence also implies that the effect is fleeting, and moreover, the more countries employ NIRP, the more difficult it is for any one country to use it to weaken its currency against everyone else’s. We cannot all devalue at the same time.
Meanwhile, there is one major negative side effect of negative interest rates. For there to be economic benefit to the wider economy from the central bank’s actions, banks must pass on the lower interest rates to their customers. They have, by and large, done this for their borrowers, though not yet to the extent of giving them negative rates. But they have found it difficult to pass negative rates through to their depositors.
Households, in particular, have an aversion to paying banks for looking after their money, and any bank that chose to pass on negative interest rates to its retail depositors would quickly find its customers switching to banks that have not followed suit – or simply increasing their holdings of cash. But not passing on the negative rates means that the banks will suffer from reduced margins, which erodes their balance sheets and thus works counter to any hope of stimulating further growth of credit.
To put this another way, for monetary policy to be able to influence the real economy, the banks have to act as a conduit, passing the changes in interest rates through to their customers. An easing of monetary policy benefits the real economy only if the banks pass the lower rates through to ordinary people. If they do not, if the conduit is broken, then NIRP ceases to act positively on the real economy and starts acting negatively on the banking system.
This is arguably already happening. Hence the concern being expressed by various governments, most notably Germany’s, that current central bank policy is counterproductive and harmful for the banking system. And hence also the growing interest in a radical new proposal.
If the banking system conduit is not working, if even NIRP cannot help central banks add financial power to the economy, perhaps the authorities should ignore the banks altogether and make direct payments to consumers. This would be an important change of attack: the aim would be not “to revive the banking system and thereby allow the banking system to help revive the economy”, but to bypass the banking system almost completely.
This is the so-called “helicopter money” approach, in which money is directly credited to consumers’ bank accounts in a metaphorical “helicopter drop”. And arguably, we have already seen versions of helicopter money, in the “cash for clunkers” programme in the US and the compensation for mis-selling of payment protection insurance in the UK. Both of these were government-directed payments direct to consumers, in which reasonable amounts of money (a few thousand pounds or dollars) were given to a wide section of society, with, crucially, the majority of recipients likely to spend their windfall not save it.
The UK PPI repayment programme has so far credited consumers with over £22 billion – well over 1% of gross domestic product – and the majority of the money has been spent. It is not unreasonable to suggest that this extra consumption has proved very beneficial in reviving the UK economy since the crisis.
Change of attack
And so, with NIRP not working as hoped and causing collateral damage to the banking system, pressure on central banks to “move on” to the next policy is growing. Whether “helicopter money” is ever employed, let alone becomes mainstream central banking, remains to be seen. But one thing is clear. With economies still operating well under capacity and no sign yet of governments engaging seriously in fiscal stimulus, central banks do not have the luxury of doing nothing.
John Nugée was chief manager of reserves at the Bank of England