Negative Interest Rates and Deflationary Banking


May 2016
Ivan Obolensky

Many readers have heard of negative interest rates, but few are familiar with them, understand what they mean, and know their ramifications going forward. How is it possible to have negative interest rates on a mortgage, or even a credit card? The bank would pay me money? How is that even possible? The short answer is yes, it’s quite possible. Here’s how and why.

But before we go there, it is necessary to explain some things about money, and why negative interest rates have become a policy option.

Money is a portable storehouse of value. By putting an intermediate step in the barter system, early merchants had a means to store buying power for the future. How did the merchants know that the future buying power they stored would retain its value? The money itself, coinage, was made of precious metals and had an intrinsic value in and of itself. Banks originally were depositories. A merchant received a receipt for his deposited gold, and this receipt could be exchanged for goods and services. The bearer could cash it in at any time.

Some banking houses were financially stronger than others. They had more gold and a better reputation. The latter was important because once a house was trusted, it could create more receipts than the amount of gold on hand and issue them as loans. This is called Fractional Reserve Banking.1 The practice had the potential for abuse. A depositor might demand his deposit back only to find it was not available. This is an old, if not ancient, story.2

The Orazione Trapezitica, written in 393 BCE, records a legal speech by Isocrates (436-338 BCE), one of the foremost Greek orators of his time. In it, he argues for redress on behalf of his client who is seeking the return of deposits from Passio, an Athenian Banker, who refused, for whatever reason, to return them.3

In spite of the risk of abuse, Fractional Reserve Banking has its pluses. It allows loans to be made to those who need funds to start businesses, which create additional economic value in the form of employment and future production of goods and services. Without the initial funding, the potential positive economic benefit would never be realized.

Money, therefore, represents many things: physical goods, labor, as well as the amount of work necessary to make something. It is also a storehouse of future value in that it has the potential to create and purchase goods in the future. It has buying power.

Beyond what it represents, money is also a commodity that can be bought and sold like any other. When one gets a loan, one is buying money. When one is a lender one is selling money. If you are buying flour, it is so much per pound. When you buy money, the price you pay is so much interest per thousand expressed as an annual percentage rate.

Money is cheap when interest rates are low and expensive when interest rates are high. Cheap money in the past has usually led to economic growth and inflation.

Inflation is defined as too much money representing too few goods, and deflation as too little money representing too many goods. In an inflation, prices of things go up. In a deflation, the prices of goods fall.

Whether prices go up or down depends on the economic forces that are dominant.

If money is plentiful and inflation is widespread, market participants, including consumers and corporations, go on buying binges. It becomes economically wise to move money into physical things such as cars, gold, and real estate as fast as possible. The longer you hold onto money, the less it can buy. The more physical things you own, the more valuable they become. In such a system, money moves rapidly from consumer to merchant to wholesaler, and around and round. Debt is of benefit because not only does one buy things that are rising in price and retaining their value, but the money purchased in the form of loans is paid back with funds that are less valuable based on their buying power. This is a powerful incentive to spend.

Controlling this tendency is the province of central banks such as the US Federal Reserve.

Central banks have a mandate to maintain economic stability. One of the tools for that purpose is setting the level of short-term interest rates. By raising rates, money becomes expensive, economic activity is slowed, and inflation is halted. If the economy slows too much, interest rates are lowered to make money easily available, and the economy speeds up.

The last several decades can be characterized as a long period of inflation. Inflation promotes spending and thus consumerism.

Consumerism has been one of the most prevalent paradigms in Western and developing economies for well over thirty years. The attitude flourished during the long-term inflationary environment that started in the 1960s. During inflationary times, thrift, savings, and fiscal responsibility actually work against the individual, while conspicuous consumption and excessive debt are rewarded.

Economies, contrary to much academic teaching, are cyclical. Growth is neither constant nor is it guaranteed. It occurs in cycles. Deflations have followed periods of inflation over and over until the last century. The 1930s marked the last time the world has seen a prolonged deflation. Much of the praise for this long inflationary stretch has been given to central bank policies and actions that steered a middle course between economies that are too hot or too subdued, until now.

Today, deflation is much more pervasive, and deflations are very different economic environments from inflationary ones.

Operating in a deflation requires that you put off a purchase for as long as possible since whatever it is will be cheaper in the future. Immediate gratification becomes not only unwise but a distinct liability. Cash money earns interest sitting in the wallet because it will buy more and more over time.

Notice this is the opposite mindset to consumerism.

Deflation is not new. It has happened many times throughout history. Why is this time different?

In the past, economies routinely moved into inflationary credit bubbles that led to excessive spending, unwise investment, and overextended borrowers. (The US during the 1860s and 1930s.) As these economies reached their apex and started to contract, debtors could no longer support their debt and defaults became prevalent. Loans are potential assets to a bank since they generate income in the form of interest payments. When there is a default, the asset value of the loan is reduced, often to zero. Banks close (they become bankrupt) just like the depositories and banking houses of long ago. Bankers stop lending. Money becomes scarce, prices drop (deflation), and the economy grinds to a crawl until the bad loans are written off and a new cash infusion is provided. After a time, with the start once again of easy credit, the cycle repeats.4

In the past, deflationary cycles were a fact of life. There were no central banks. Since their inception at the start of the 20th century, there has been only one deflationary period of significance: The Great Depression, and central banks did not handle it well. Nothing worked over the long term. WWII is said to have pulled the US out of the depression more than any particular policy or action taken alone or altogether.

Being aware of this, current central bank policy is to prevent a deflationary economic slowdown by any means possible with the intention of recreating an inflationary environment while avoiding the defaults of past cycles.

Pushing money into the financial system to provide liquidity, providing as much easy money as possible by lowering interest rates to minimal levels, and preventing significant defaults are actions that were not taken in the 1930s. Banks closed in record numbers during that time and defaults were common, including sovereign debt issued by governments throughout the world.

Today the world’s financial and banking structure is very different from over a century ago. There are safeguards in place such as deposit insurance, but global financial institutions are significantly more interconnected. In the 30s, banks were isolated businesses, but not so today. A large loan default in one bank could lead to a cascade of counterparty defaults in others, precipitating a worldwide banking crisis. Although the effects of such a collapse are impossible to know with certainty, the Global Financial Crisis (GFC) of 2008 was an indication of how easily it could happen. The US was days away, in the autumn of 2008, from no available cash for payrolls. What would have happened had a large segment of the US population not been paid is a nightmare scenario that nobody holding economic responsibility dares risk finding out. Thus, providing liquidity by any means and avoiding major defaults have become the two overarching central bank policies because, in essence, there are no alternatives.

To add to central banks’ difficulties, much of their ammunition in the form of room to lower rates (rates are already close to zero), swapping bad debt for good debt, and cash infusions, has already been used up with limited success. The crisis, although eight years past, is to some extent, still with us.

After several rounds of the above, widespread inflation has failed to appear. Rather, the results have been a disparity of wealth and an asymmetric US economy that shows inflationary pressures occurring in only certain segments such as housing, healthcare, education, and stock market valuations, while deflationary pressure remains persistent in others such as commodities and wages.

There are reasons for this. Besides the cyclical deflation that happens during a typical credit cycle, there are several long-term deflationary forces at work today that the central banks must contend with that are making their job much more difficult.

Technology: Technology will always create deflation since by its very nature, it makes devices, manufacturing, and distribution more efficient and less expensive.

Demographic aging in developed economies: Populations of the developed economies are on average getting older and tend to spend more on health care and services than goods, driving down their demand.5

Globalization: Interconnectivity and free trade has created deflationary pressures in the form of lower costs of manufacturing as well as compensation competition across all segments of society. Free trade agreements have taken down barriers that previously allowed developed countries to insulate themselves from competition. Japan is a notable example. Once the walls came down, prices of labor services and goods dropped and are still doing so after more than twenty-five years.

The Internet: The greatest disruptions to tariff and economic barriers have come from the Internet. By putting millions of potential workers, corporations, products, and services on an equal footing, costs have fallen while providers’ and manufacturers’ ability to increase prices has been curtailed by competition.

Productivity: Productivity has been dropping in developed countries, particularly in the United States. On an individual basis, one of the reasons cited has been the increasing amounts of production time wasted on social media as the need for labor intensiveness decreases.6 At the same time, AI, computer controlled operations, algorithms, and robotics require less need for direct human action and supervision. Money is able to buy more product for the same amount of expensive human labor which is being replaced by automation as quickly as possible. This is deflationary and is a trend likely to continue.

Given these global deflationary themes, policy makers must create inflation in spite of them.

Japan was the first developed country to have to deal with a long-term deflation. It is still ongoing with no end in sight. They tried what is known as Helicopter Money, simply dumping cash into the pockets of citizens in the billions of dollars. It disappeared. Where did it go? Most of it went into freezers. In the 1990s, trading desks referred to Japan as the Freezer Economy. Recall that the mindset for a deflation is significantly different from that of inflation. The Japanese had already experienced years of deflation and simply took the cash and literally stored it in their freezers often in blocks of ice. Sitting there it earned phantom interest because with every month, the cash could buy more things.

Japan was also the first to implement negative interest rates and have for some time. Short-term government bonds were sold with a built-in premium that guaranteed that the holder would lose money; but doing this was far smarter than one might think. Japanese banks were not trusted and because the deflation rate of say 3% was greater than the guaranteed loss sustained holding the government bond to maturity (1.5%), the holder actually made money in terms of buying power.

Since then, the Japanese government has gone heavily into debt (237% of Gross Domestic Production7). It also purchased most of the extant Japanese corporate bonds, and is one of the largest holders of Japanese equities in an effort to support their markets. It is likely other central banks have observed the path the Japanese have taken and will reluctantly follow their example.

With most of the world’s interest rates near zero, negative interest rates are the next logical step in the search for economic stimulus by policy makers.

Negative interest rates will mean that holders of reserves rather than earning interest will be charged interest. The logic behind this policy is that savers, including corporations, will spend in the real economy rather than save. But policy makers have also learned from the Japanese foray into Helicopter money. Money pumped directly into the pockets of citizens will disappear into freezers and under mattresses.

Is it any wonder that the war on cash has begun under the pretext of denying criminals and terrorists access to funding?

Taking cash out of the bank and hiding it has been the recourse of citizens when confronted with a financial crisis as long ago as 400 BCE, if not before. Federal Deposit Insurance was created to alleviate depositors’ tendency to do just that after the banking panics of the Great Depression. Recently, the ECB announced that the 500-Euro note would no longer be printed as of 20188. Also, several noteworthy economists have announced that cash should be gotten rid of as it is unnecessary in a digital age.9 This is not coincidence.

But how can such a policy be implemented?

Negative interest rates mean that wherever interest is paid, the flow is reversed. In a savings account, the holder would be charged a monthly fee, or negative interest. Wherever interest must be paid (credit card debt, mortgage debt) by the debtor, the lender pays it to the debtor instead.

Think about that. If this seems confusing think about the Japanese and their freezers. It’s not about the money. It’s about what the money can buy.

Example: Suppose you are an apple merchant; you want to sell your apples for a higher amount than what you paid for them.

If there are few apples, you purchase apples at high prices and then add a mark-up. Your customers have to simply pay more.

What happens if you bought apples when they were really cheap, preserved them in some way, and then sold them at a later time when the price of apples was high? You would make a lot more money.

If you bought the apples when they were high, preserved them, and then had to sell them in a market place where apples were cheap, you would lose a lot of money.

Simple so far. Recall that money is a commodity just like the apples.

Let’s suppose you decide to lend out your apples rather than sell them. The market is cheap. You lend ten apples to a customer for a year, but you are a kind soul and say, “Look it’s possible that the price of apples could go up, so I tell you what, since you are a good person, pay me only six apples next year. How about that?”

The customer agrees. Such a deal! A year later the price of apples has tripled, and the customer comes back and gives you six apples. You paid a dollar an apple, but apples are now three dollars each. The customer pays you six apples now worth 18 dollars.

The apples you received were much more expensive than the ones the customer borrowed the year before.

In this you have the concept of how banks could make money with negative interest rates.

Suppose I borrow 1,000 dollars and a bank says, “Thank you for borrowing that money and as a special reward, we will pay you 120 dollars, or ten dollars a month, credited to your checking account.”

I agree. Such a deal! A year later I pay back the 1,000 dollars, only I notice the thousand dollars I paid can now buy twice as much as it did before. I just paid the bank $1,000 now worth $2,000 in terms of buying power. All told, I borrowed 880 dollars if I deduct the interest the bank paid me. The bank on the other hand paid out $1,120 and received back $1,000, which because of deflation is now worth $2,000 in terms of buying power. In real terms, the bank profited by $880.

This works with any mortgage just as easily, only the numbers are larger.

Such seemingly bizarre policies are not so bizarre after all, but are still a holding action. The real question before central banks is: how to ultimately avoid the default consequences that normally occur during a credit cycle while still preserving the banking system from vaporizing?

There are solutions. Some have already been tried.

The bailout (government stepping in with tax payer money) was one method and was given full rein in the months and years following 2008 with limited success.

The other is the bail-in.10 This was done in Cyprus and Greece relatively recently. Depositors over a certain amount simply forfeited a portion (30%) of their savings.11 This also worked to some degree; however, many depositors had the foresight to cash in their deposits via ATMs before the bail-in occurred. Others transferred their funds to accounts in other countries.

For a bail-in to work, it is necessary for depositors to keep their money within the system, which means a fully digital economy. The more funds on hand the less the forfeiture the depositors have to endure.

Whether this will actually occur is unknown, but with no alternative readily available, it might.

At some point, whether in the far distant future or closer still, the question of how to keep the financial system going must be answered and actions taken.

Welcome to the world of deflationary banking. It might not happen, but then again it might.



  1. Tamny, J. (2012) Ron Paul, Fractional Reserve Banking, and the Money Multiplier Myth, Forbes. Retrieved May 5, 2016 from
  2. Gascoigne, B. (2001) History of Banking, History of the World. Retrieved May 5, 2016 from
  3. Huerta de Soto, J. (2006) Money, Bank Credit, and Economic Cycles. Retrieved May 5, 2016 from
  4. Garrison, R. (2002) Business Cycles: Austrian Approach. Retrieved May 5, 2016 from
  5. Mauldin, J. (2016) 6 Charts that show the Global Demographic Crisis is Unfolding, Forbes. Retrieved May 5, 2016 from
  6. A. (2016) America’s Plunging Worker Productivity Explained (in 1 Depressing Chart) Zero Hedge. Retrieved May 5, 2016 from
  7. Ewing, J. (2016) Europe to remove the 500-Euro Bill, the ‘Bin Laden’ Bank Note Criminals Love, The New York Times. Retrieved May 5, 2016 from
  8. Elmore, Kirkwood, Chehabi, Evans (2013) The spiraling Cost of Debt, A Study on the Impact of Debt on GDP Growth and Long Term Interest Rates. Retrieved May 5, 2016 from
  9. A. (2016) Larry Summers Launches the War on Paper Money: “It’s Time To Kill the $100 Bill”, Zero Hedge. Retrieved May 5, 2016 from
  10. Zhou, Rutledge, Bossu, Dobler, Jassuad, Moore (2012) From Bail-out to Bail-in: Mandatory Debt Restructuring of Systemic Financial Institutions, International Monetary Fund. Retrieved May 5, 2016 from
  11. Osbourne, H., Moulds, J. (2013) Cyprus Bailout deal: at a glance, The Guardian. Retrieved May 5, 2016 from


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© 2016 Ivan Obolensky. All rights reserved. No part of this publication can be reproduced without the written permission from the author.

  1. Lucia

    In reading the article, it says about Japan “Short-term government bonds were sold with a built-in premium that guaranteed that the holder would lose money”. I realize it later says “guaranteed loss”, and this is so astonishing that I wonder if you can explain further. I think I would be put off from buying these bonds, how did they get people to buy them?

    • Ivan

      Thanks Lucia for the question. Let me know if this makes it clearer:

      Short-term bonds are sold at a discount determined by the market (say $900) and always mature at a set amount ($1,000). The interest earned is expressed in the difference between the issued price ($900) and the maturity price ($1,000). There is no interest payment.

      If you have a large amount of money, you cannot put it in a bank because if the bank fails, you lose it. There is only cash and short term government bonds as alternatives. If you purchase the bond at $1,010 and it pays $1,000, you lose 1%. If the $1,000 you receive can now buy goods worth $1,020 when it matures, you have made $10 in terms of what the money can buy. It is a good deal.

      Even if the buying power is not $1,020 and stays the same ($1,000), you have essentially spent $10 or 1% to ensure you get 99% of your money back. It is like buying insurance which is the way it is thought of in Japan. Banks are not trusted.

  2. Craig Houchin
    Craig Houchin05-22-2016

    Hey Ivan,

    Great explanation of a complex subject. As you are more of a market and economy watcher and historian than I, do you have any sense of what the market makers and shakers are doing with their money and investments to prepare or to hedge their bets in this current environment?

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