the plan for the future

Cash for negative interest rates

15 June 2021 (latest revision: 11 August 2021)

The Invisible Hand
Ara Economicus

The problem with cash

Negative interest rates may be here to stay. Interest rates are the result of supply and demand for money and capital in financial markets. The factors that drove interest rates down are still in place and may not go away. And so, it may be better to allow interest rates to go down further and into negative territory. For that reason, we may need a holding fee on central bank money.

Most money is in bank accounts, lent to banks by depositors. Central bank money is not a loan. The central bank money we all know is cash. But banks have accounts at the central bank. The balances in those accounts are central bank money too. So, if the central bank sets the interest rate, it is the interest rate of these accounts.

Cash comes with an interest rate of zero. Cash can be an attractive investment when interest rates on bank accounts are negative. Depositors may take their money from the bank and put their savings in cash. In Switzerland, where interest rates are the most negative, banknotes of 1,000 francs and safe deposit boxes are in short supply. Hence, interest rates can’t go further down as long as cash remains the way it is.

When people stop lending money and take their money from the bank, the economy runs into trouble. With a holding fee on central bank money of 10% per year, it can be attractive to lend out money at negative interest rates like -2% because you don’t pay the holding fee on money lent. That includes bank accounts. And so, you may keep your money in the bank even when interest rates are negative.

Cash as a loan to the government

A holding fee of 10% per year would make cash unattractive. And in Wörgl, people had to buy stamps and glue them to the banknotes to keep them valid. That is cumbersome. If the interest rate on cash would be a bit lower than interest rates on bank accounts, that might be enough to stop people from hoarding banknotes. And if we do not have to glue stamps on banknotes, cash would be more practical to use.

So if cash is a loan to the government rather than central bank money, the interest rate on short term loans to the government could be applied. That rate would be much better than the holding fee, for example, -3%. There would be an exchange rate between cash and central bank money. The value of cash could gradually decrease at a rate of 3% per year, so you don’t have to glue stamps on banknotes to keep them valid.

Human psychology

Negative interest rates reduce the balance in your account while inflation is stealthy. Wage changes are more visible than price changes as some prices go down while others go up. Even when negative interest rates and deflation are a better deal, people might not opt for it. Psychologists have discovered that the pain of a loss usually outstrips the pleasure of a similar gain, which makes people risk-averse.

When interest rates are negative, money disappears, so inflation will probably be lower. There might even be deflation, which means that prices go down. That could be a better deal than printing money to produce inflation, as this money usually ends up in the hands of the rich while everyone else pays for the inflation. But most people do not like to see their account balance go down because of a negative interest rate.

They may prefer the illusion of a small gain that amounts to a loss in reality to the illusion of a similar loss that is, in fact, a win. And there is a risk that the expected benefits from negative interest rates do not materialise. It is not rational, but human psychology is the way it is. There may be a fix for that by hiding negative interest rates and make them look like inflation. To explain how we have to look at the characteristics of Natural Money:
  • Central bank money carries a holding fee of approximately 12% per year. If you own this money, then € 1,00 turns into € 0,88 after a year. It can make lending at negative interest rates attractive.
  • Interest rates on bank accounts might be around -2% per year. Depositors don’t pay the holding fee but the interest rate the bank offers.
  • Cash is a short-term loan to the government and carries the interest rate of short-term government loans, which might be -3%.
  • Central bank money and cash are separate currencies. They have an exchange rate. Cash gradually loses value relative to the money issued by the central bank.

  • Making cash the money in people’s minds

    If balances of bank accounts are expressed in cash rather than central bank money, negative interest becomes hidden from the public. The interest rate on short-term government loans is one of the lowest. Banks must be able to offer at least this interest rate so people won’t see their money disappear because of negative interest. And if prices in shops are expressed in cash, cash will become the currency in people’s minds.

    If the interest rate on cash is -3%, the value of cash goes down by 3% per year in terms of central bank money. So if a bank offers an interest rate of -2%, and the account is settled in cash, it appears as if the interest on the bank account is +1%. And if the deflation rate is 1%, prices go down by 1%. Meanwhile cash goes down 3% in value so that it appears there is an inflation rate of 2% as cash prices go up by 2%.

    It can be seen as a trick to make people act in their best interest. Nowadays, the interest rate on bank accounts is 0%, and inflation is 2%, so you would lose 2% in purchasing power per year by holding money in a bank account. In the example above, the loss is 1%, which is a better deal. Natural Money can be a better deal for account holders. The economy will probably do better, so real interest rates can be higher.

    Critics might argue that we could be fooled by this scheme, just like we were fooled before by inflation. We won’t notice the negative interest rate, just like the inflation previously. But separating cash from central bank money and expressing prices and the value of bank accounts in cash currency can clear the psychological barrier that stands in the way of adopting negative interest by the public.

    Central bank money should remain the accounting unit in the financial system for bank accounts, debt and interest, and the prices of financial assets like stocks and bonds. A similar situation existed in Europe between 1999 and 2002. After the introduction of the digital euro, cash was still the old national currency.