Why Negative Interest Rates Even Work At All

Reading Lorraine’s post last week on negative interest rates, I did a bit of a double take. “Negative interest rates!?,” I wondered, “Why would any right-minded entity enter into such a disadvantageous arrangement?” Well, it turns out that having money–as in actually possessing currency–can be costly, especially if you have very large amounts of it. NPR’s All Things Considered put out a nice little exposition on this concept. One of my favorite parts of the story is a quote excerpted from a speech by Fed Vice Chair Stanley Fischer that lays out why holding currency can be costly:

“It turns out that holding currency is not so easy. If you’re going to keep your billion dollars in currency, you’re going to have to find a place to store it. You’re going to have to pay for that. You’re going to have to insure it. And you’re going to have to have it guarded.”

Even though the costs of currency-holding become most apparent at the institutional level, they also exist at the individual level. I am reminded of an interview that Planet Money did with a Greek mechanical engineer who had withdrawn a huge amount of cash from the financial system to put in his own house. His intricate setup shows how currency-holding costs can affect individuals:

SMITH: And so our mechanical engineer withdrew his money from the bank, 50,000 euros – 50,000 euros in 500-euro notes, which are the ones that drug dealers famously use. So he bundled it all together. He brought it home. And he started planning where to put the money in his apartment….  It’s in the refrigerator, but not in with the milk and the frozen peas. He’s a mechanical engineer, after all. So what he did was he pulled his refrigerator out from the wall. He opened up the back of the refrigerator. And he put 50,000 euros underneath the compressor, screwed it all together, and he pushed it back. It was like his own private bank vault. And he thought of everything. I asked him, well, won’t the thieves see the scrapes on the floor where you pulled out the fridge? And he’s like, no, no, no, I put little pads on the refrigerator. And so I asked him, well, what if a thief comes with a screwdriver and takes the whole refrigerator apart? And he says, that is why he replaced the screws in the back with special screws.

On a fundamental level, this is why negative interest rates can work at all: holding currency isn’t free. It can be much more advantageous to hold onto a bond, even if it’s a net money-losing proposition. Whether negative interest rates are prudent economic policy, however, is another question all together.

Leave a Reply

Your email address will not be published. Required fields are marked *