Negative interest rates – fantasy land? European Central Bank President Mario Draghi is contemplating taking interest rates into a twilight zone shunned by the Federal Reserve – negative interest rates. Huh? Yes, Draghi said the bank discussed the possibility of lower rates into negative territory, sparking a euro sell-off last Thursday at the recent ECB rate decision press conference.

Should Draghi elect to cut the deposit rate to zero or lower, he’ll be entering territory few policy makers have dared to venture. Sweden’s Riksbank in July 2009 became the world’s first central bank to charge financial institutions for the money they deposited with it overnight. The Fed rejected cutting its deposit rate from 0.25 percent last year. With Europe’s debt crisis damping inflation pressures and curbing growth, the ECB may feel the benefits outweigh the negatives, as the EU economy stays mired in recession, tittering on depression – just ask the Greeks and the Spanish. So what are the ups and downs of negative interest rates?

The upside is obvious. If low interest rates are stimulative, negative interest rates are even more. The $2 Trillion being held on corporate balance sheets would come flying out into huge business investments. People would bid up asset prices to get out of the negative interest bearing paper currency. It would change the psychology of money fundamentally. At last the central banks could create real inflation. And the downside? It obviously would make it difficult to save up for investments and eventual retirement – it penalizes the savers – which used to be a good thing. The big issue though is, why would banks loan any money – as they would be loaning at a loss. Credit would dry up even further.

Would it be even possible to implement? Negative interest rates have been proposed in the past, notably in the late 19th century by Silvio Gesell. Gesell suggested issuing money for a limited duration, after which it must be exchanged for new bills; attempts to hold money thus result in it expiring and becoming worthless. With new technology and electronic transfer patments this is today very doable. Other options include, levying this negative interest rate concept on existing paper currency via a serial number lotteries.

So how would banks make money at loaning money at a loss? The only way they could do this is if they held partial ownership in the asset being lent against. Hmmmm … this sounds a little like Islamic banking principles – huh? – now we really are going into economic fantasy land. Islamic banking does not allow charging of interest, in stead they must take a ownership risk stake in the loan itself and receive dividends. The basic principle of Islamic banking is based on risk-sharing which is a component of trade rather than risk-transfer which we see in conventional banking.

So how likely are we to see negative interest rates? Negative interest rates would in a sense be a highly progressive tax on money – a system that would automatically redistribute wealth downward – unlike today’s system that automatically redistributes wealth upward. An interesting thought, but elites will hardly allow this to happen. Besides I am sure they could find a way to game this system as well. However, watching the Euro drop like a stone on the mere mention of this topic by ECB’s Draghi, gives the idea credibility. How did we get from central bank policy to Shariah Law?

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Blue Point Trading Market View – December 10, 2012

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