August 2017

Policy, Economic and Investment Management Implications of Low or Negative Interest Rates

By Yin Kon

At no time in the past have recorded interest rates been negative. Not through European wars, World Wars, the Great Depression, or the Great Recession. Theories on negative interest rates are not new, but their validity remains open to debate.

Silvio Gesell, for some the father of modern negative interest rate theory, illustrated inflation with the following analogy: a weekly loss of one thousandth of a note’s face value results in an annual depreciation rate of approximately 5 percent. He postulated that holding money does not involve carrying charges1. Goods and services, on the other hand, are perishable immediately by delivery, by decay, or by obsolescence. This creates an incentive to save.

Production, which is constant in the short run, determines aggregate supply; on the other hand, the amount of money divided by the price level times velocity of circulation constitutes aggregate demand. Because deflation raises the real interest earned on money but reduces it on real capital assets, disinvestment takes place, thus depressing general output. In Gesell’s framework, when the amount of money is increased with the intention of strengthening demand and offsetting deflation, the outcome instead is the hoarding of money. This conclusion seems to be anecdotally true as evidenced by the widening gap in wealth and income across the world. Gesell’s cure for an economic crisis is to subject the money supply to natural decay via taxation by way of negative interest rates.

We argue that some premises of Gesell’s theory are incorrect:

  1. The premise that holding money does not involve carrying charges is false because the value of money declines over time due to inflation (unless, of course, deflation is present). Furthermore, by holding cash the investor misses the opportunity of owning appreciating assets;
  2. Gesell implicitly assumes some linearity between the marginal propensity to save and interest rates, and therefore that a negative interest rate must propel consumers to save less and spend more. This may not be the case and indeed the relationship between interest rates and consumption can bend backward. Furthermore, Gesell ignores the fact that different age cohorts may have different marginal propensities to consume or save. Therefore, it cannot be concluded that low or negative interest rates reduce the propensity to save.
  3. Gesell assumes that supply and production volumes are fixed in the short run. But with supply chain and technological improvements such as just-in-time management, production can be ramped up or down quickly.

Keynes2 believed that negative interest rates, as proposed by Gesell, are infeasible due to liquidity preferences. Zero or negative interest rates indicate a preference for future consumption over current consumption. Since base money is the most liquid assets, a rational economic agent will not hold any other type of asset unless it earns a sufficiently high return.

We argue that negative interest rates are not infeasible today because the predominant form of money supply is not what it used to be in the early 1900s. Keynes assumed that different forms of money supply were perfect substitutes and that any attempt to levy negative interest on registered accounts above the carry and storage costs of currency would cause substitution of the former by the latter. Today it is possible to eliminate the carry and the storage costs of cash with the use of non-cash currency (and certain regulatory requirements such as anti-money laundering). These new qualities of money are responsible in part for the existence of negative nominal interest rates.

The purpose of negative interest rate policies is to avoid liquidity traps and deflationary spirals. Using a Keynesian framework, where demand determines output and inflation adjusts the gap between actual and potential output through the Phillips curve, Buiter and Panigirtzoglou (Overcoming the Zero Bound on Nominal Interest Rates with Negative Interest on Currency: Gesell's Solution, 2003) showed that the liquidity trap region can be eliminated, when money is not essential, by setting the Gesell tax so that the interest rate on currency keeps a constant distance from the short-term interest rate on non-monetary assets.

Menner’s (2010) short-run analysis shows that the introduction of a Gesell tax reduces the period of recovery and brings back output and employment to its steady state level relatively quickly. Adding monetary expansion to the Gesell tax mitigates the severity and duration of the recession, but it must be noted that in the medium- and long-run, the economy follows quite closely the pure Gesell tax scenario.

Low or negative interest rates may not be a cure for slow economic growth. In developed markets, households and firms have reduced their debts after the Great Recession of 2008 instead of saving or investing. Furthermore, negative interest rates diminish the profitability of the banking system, erode its financial strength, and reduce incentives to make loans to businesses. In the Gesell framework short-term, low or negative, interest rates may not lead to Pareto efficiency in the IS-LM model.3 As the LM curve shifts rightwards with monetary expansion, equilibrium interest rates can decline below zero while income expands. Any decline in consumption (for instance due to uncertain expectations regarding regulation, employment, inflation, taxation) could shift the IS curve downwards, which would result in contracted income even as interest rates continue to decline.

Monetary policy has political and social effects. For example, low interest rates create massive pension under-funding problems. In certain municipalities and towns, the ratio of investments to liabilities is about 1:3, indicating that there is a high probability that these plans will become insolvent unless effective action is taken. This situation generates uncertainty on how to save for retirement and how to invest during retirement. As interest rates approach zero, retirees and others who should focus on fixed income securities look instead at risky assets in an attempt to maximize return.

Even in an environment of negative short-term interest rates, long-term valuations are based on positive interest rates. This is so because long-term interest rates include a risk premium element that far exceeds the negative rate. However, if the stable growth assumption is linked to the long-term interest rates then assumed growth must decline with lower interest rates. Low growth assumptions affect investment decisions and explain the investors preference for growth investing over value investing in recent years.

In an environment of very low or negative interest rates, fixed income securities can be riskier than equities. Specifically, duration risk is magnified. Thus, if in a security portfolio fixed income securities are used to hedge the risk of equity securities, the high cost of the hedge should result in a smaller allocation of fixed income securities. The change in risk characteristics could render traditional asset allocation frameworks unreliable. If markets do not expect interest rates to rise then the duration risk will be less pronounced but economic growth will be expected to remain low.

Note: This article incorporates excerpts from Cordelius Ilgmann’s and Martin Menner’s book Negative Nominal Interest Rates: History and Current Proposals and Includes our Thoughts on the Subject, January 2011.

Yin Kon, CFA, is chief investment officer at InterGeneration Capital Management (ICM). He can be contacted at


1 Cost associated with storing a physical commodity or holding a financial instrument over a defined period of time. Carrying charges include insurance, storage costs, interest charges on borrowed funds, and other related costs. As carrying costs can erode the overall return on an investment, due consideration should be given to them in considering the suitability of the investment, and also while evaluating investment alternatives.

2 John Maynard Keynes, 1st Baron Keynes CB FBA, was a British economist whose ideas fundamentally changed the theory and practice of economics and the economic policies of governments.

3 The IS–LM model, or Hicks–Hansen model, is a macroeconomic tool that shows the relationship between interest rates and real output, in the goods and services market and the money market (also known as the assets market).