Negative Interest Rates: Even Worse Than They Seem?

Are you frustrated thatsavings account ratesare still barely above zero at most banks? It could be worse. The European Central Bank has imposed a negative interest rate on certain deposits, and central banks in Denmark, Switzerland and Sweden have also resorted to negative interest rates recently.

A negative interest rate means that banks effectively charge depositors for holding their money, rather than paying them interest. That's not a very appealing prospect, but the harmful impacts of negative interest rates can go well beyond just the erosion of deposit values.

Extreme stimulus measuresWhat's the logic behind this? Think about it as an extreme form of monetary stimulus.

After all, it has become customary for central banks to lower interest rates to boost the economy, so why not lower them all the way into negative territory? The idea is that this will encourage economic activity by creating an incentive for people to spend their money before it loses value. Also, negative interest rates discourage people from investing in the country that offers them, causing the currency to lose value. That may sound like a bad thing, but a cheaper currency makes a country's prices more competitive against foreign competition.

Though well-intentioned, negative interest rates could have some harmful side effects. Here are some of the problems that negative interest rates could create for investors and consumers.

1. Disruption of income generationIt is not just the idea of earning a negative return that makes sub-zero interest rates unappealing. Many investors have a need for the regular liquidity generated by interest payments, but if interest rates are negative, liquidity can only be obtained by dipping into principal.

2. Downward pressure on currencyAs noted above, negative interest rates can help a country's trade competitiveness by making its goods relatively cheap. However, there is a downside to a declining currency: It discourages investment from foreign countries. From the perspective of an investor outside of a given country, negative interest rates not only carry a negative return to begin with, but a declining currency could make losses even steeper.

3. Encouragement of riskier savings optionsPeople have long joked about stuffing money in the mattress, but if the bank is going to charge you to hold your money, that kind of alternative might start to look attractive. The problem, of course, is that this carries a heightened risk of theft or loss due to fire or other calamities.

4. Artificial inflation of stock and bond pricesFalling interest rates tend to drive stock and bond prices higher. This might be especially true with negative interest rates, because people will be particularly hungry for investment alternatives. This can create a bubble in asset prices that will burst as soon as interest rates are no longer held at artificially low levels.

5. Excess debtOne premise behind low interest rates is to encourage people to borrow and spend money. That makes sense if people are sitting on stockpiles of savings, but for a country like the U.S., it can exacerbate an already troublesome debt burden. While the U.S. has not yet resorted to negative nominal interest rates, there have been times over the past few years when inflation has been higher than interest rates, making those rates negative on a real basis. This only feeds a dangerous borrowing habit.

6. Discouraged lendersThe attempt to encourage borrowing may backfire if low interest rates create a disincentive to lend. Why should a bank take the risk of lending money just to get a low or possibly even negative return? The impact of low interest rates in the U.S. in recent years has been blunted by the fact that lenders have tightened underwriting standards because low rates leave little room for default risk.

7. Future shocks for borrowersFrom credit card customers to corporations, many borrowers routinely renew debt. The problem is that if low interest rates encourage them to take on higher debt burdens, those rollovers could become unaffordable once rates return to more normal levels.

Perhaps the worst aspect of negative interest rates is that are indicative of a troubled economy. In effect, negative interest rates mean people are being coerced into spending money, lest they see their savings lose value. That weakness should make U.S. investors wary of European markets these days, and perhaps even thankful for the low -- but still positive -- interest rates in this country today.

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