Zeroing in

Negative rates are just an incremental positive

Negative interest rates are not quite as strange as they sound. That's good, as they are spreading. But they are unlikely to work as well in practice as they do in theory.

After adjusting for inflation, lenders have often received a negative return. Still, there is something disconcerting about the European Central Bank charging banks for making deposits. On Thursday it doubled the negative interest rate to -0.2 per cent. And even old-timers who remember the punitively negative real rates of the 1970s must feel queasy at the German government's -0.03 per cent rate for three-year debt, with France at the same rate for two-year paper.

The cognitive dissonance is easy to explain. The ECB wants to stimulate lending and spending by making safe assets unattractive. With euro zone inflation at just about zero and nervousness everywhere, only negative rates stand a chance of success. Crossing the zero bound, as economists call it, creates problems for IT systems, but in theory negative rates work just as well as positive ones.

Banknotes, which have a relatively attractive zero yield, suddenly look like a good investment. But almost all the funds that banks and investors hold are electronic, and have to be invested in an electronic asset. An annual return of -0.03 per cent is not better than nothing, but it is better than the ECB's -0.2 per cent.

The newest ECB stimulus is likely to increase the sub-zero realm, since much of the money created to buy securities from banks will ultimately end up being used to buy government debt. That will increase the number of sovereigns which are paid to borrow, and lengthen the maturities with negative yields. Unless persistent deflation sets in, investors will get a bad deal. But disgruntled savers are arguably a lesser evil than an endless recession. However, the sub-zero theory might not work in practice.

In the euro zone, unhealthy sovereign and private balance sheets look like much bigger drags than the cost of money. The debt overhang could be addressed directly, but only by testing a much stronger investor taboo than negative rates: the horror at massive debt writedowns.