Occam's Razor

Donald Trump wants the Federal Reserve to drop interest rates to zero or to even allow them to go negative. It’s pretty obvious why: so he can avoid being at the wheel if a recession inconveniently hits before Election Day. He’s clearly freaking out about the election still more than a year away, as also evidenced by his decision to suspend some tariffs on Chinese goods.

Why should negative interest rates matter to you? It’s not like you can set up a Federal Reserve bank account. The Fed Funds Rate is currently 2.25%. This is the interest rate the Fed requires that one bank charges another bank to park its funds in their bank. It usually parked there only overnight. Any excess reserve a bank has on hand is money they cannot earn interest on. So parking it overnight at another bank allows them to make some money on it.

So what does this mean if the reserve rate is set to 0%? It effectively means there is no reason for a bank to park its excess reserves because it will not earn the bank any money. They might as well lend it. What happens if it’s a negative number, say -1%? Then effectively a bank takes a hit to park its money elsewhere. It would be stupid not to lend it.

A bank could pass its lower profitability from these lower rates onto its depositors. This happens routinely when the Fed Funds Rate changes. We bank at Ally Bank. When the Fed cut its rate by .25%, my savings and money market interest rates were cut by this amount too. Anticipating a rate cut, we at least did one thing smart: we took out a certificate of deposit for one year, which locked in our rate. We’ll earn 2.47% on it after one year, but not before. In general though most people don’t like to tie up their cash like this, so when the Fed Funds Rate drops, they will lose interest income. Better to take that money and risk it on investments is the hope.

Banks could in theory charge depositors’ negative interest rates, i.e. charge them for holding their money. (Considering all the bank fees we pay, some of us in effect already are!) They probably won’t, but accounts that effectively draw little to no interest at least one advantage: safety. Or do they?

Most accounts are fully insured because they don’t pass the threshold of $250,000 per depositor per bank. So yes, if a bank goes under you are likely to get your money back. But since the Glass-Steagall law (passed as a result of the Great Depression) was repealed in 1999, things have loosened. Banks can now invest in speculative investment with depositors’ money. This resulted in the Great Recession when banks loaded up on toxic assets to chase their bottom line. For them, the worst thing that can happen is they declare bankruptcy, which is what happened to so many banks in the Great Recession. The government got to clean up the mess and shoulder any financial losses, i.e. you and me assumed the risk.

Now, as the economy improved and Republicans controlled government again, these financial rules were loosened even further. In 2018, Trump signed into law new regulations that eased oversight on the largest banks, by raising the criteria for what comprises a very large bank. This results in less regulator oversight.

Add in low or negative interest rates though and we add a lot more risk to our financial system. Trump of course is hoping these low rates will incentivize banks to loan money, pumping up the economy. (It might also save him boatloads of money, if he can renegotiate interest rates on his loans.) But by incentivizing banks, we are in effect incentivizing risky loans. In short, we risk another Great Recession, or possibly another Great Depression by doing this.

Some countries are trying negative interest rates to stem deflation or deflation fears. Deflation occurs when money you have today is worth more tomorrow. In that case, there is no incentive to invest the money. Rather, you want to hold onto it, which means it’s not available for others to use. By making savers pay negative interest, it encourages them to loan out the money to stimulate the economy instead.

As a tactic for stopping deflation, maybe it has some merit. It’s working marginally in Japan, which has experienced years of deflation. But the United States is not in a deflationary environment. Hopefully though the Fed is instead trying to prevent deflation from happening in the first place.

Negative interest rates don’t have to lead to financial calamity, at least if they are properly overseen and regulated. But in this country it would be a very nervy thing to do at present. The Fed’s toolset though is very limited and well tried. The Fed’s policy of quantitative easing (imitated by lots of central banks) was one tactic of desperation after the Great Recession when the economy was still a mess even after virtually zero interest rates. Quantitative easing is essentially the Fed buying up investments others don’t want to buy with money the Fed creates out of thin air. They control the money supply, and can create money willy-nilly. That and low interest rates are about all the tools they have left.

A negative interest rate policy looks like the next and more desperate step to keep an economy from sinking into depression. It is basically a tool to use for deflation, which is what happened in the Great Depression. It’s like a fire extinguisher alarm: break glass only in case of emergency.

If investors though figure deflation is going to happen, they have an option: take the money out of the banking system and figuratively put it in the mattress. That way no one can use it but at least it’s safe, unless someone looks in the mattress. It’s more likely though they will move it to currencies and economies that are not deflating.

So hopefully the Fed will take a pass on Trump’s idea. In reality, the problems of our economy are structural and these tactics of the last ten years are basically stopgap measures. The Fed should have been doing more modest increasing of interest rates instead, as our economy, at least if it’s not in a recession, should be able to handle it. Mostly our economy is showing every sign of being over-leveraged and fragile again. If your economy is truly strong, you don’t need to even think about using these tools.

If this house of cards collapses again, it will be felt the way it was last time: soaring unemployment, wiped out savings. A lot of it will be due to risky investments, just like the Great Recession. If you are looking for a true revolution, another Great Recession or Great Depression is a good way to start one.