Little is known about the effect that negative interest rates have on human behavior. The current monetary policy, therefore, remains a risky experiment, Teodoro Cocca writes in his exclusive essay for finews.first.

This article is published on finews.first, a forum for authors specialized in economic and financial topics.

On November 1, Christine Lagarde takes over as the new head of the European Central Bank (ECB). While this change of personnel is taking place, the question about when the boundary is reached between benefit and damage of the unconventional central bank policy is the subject of controversial discussions.

With the onset of a global economic slowdown, rates may yet slip further into negative territory. The question is what we actually have in terms of consolidated knowledge about the medium- to long-term effects of negative rates on the way human beings make their decisions?

«One tends to forget that negative rates in Switzerland can't be compared to those in the Eurozone»

The economic research on this topic is based on theoretical modeling, some not particularly robust empirical data or inductive reasoning at best, whereby generalized conclusions are made based on more or less comparable historical observations. Typically, the example being used is Japan, which has had ultra-low interest rates for more than 20 years.

But negative nominal rates are a new phenomenon even in Japan. Switzerland too is being used as a positive example, leading the way as it did by introducing negative interest rates. One tends to forget that the negative rates in Switzerland in no way can be compared to those in the Eurozone.

Switzerland tries to counteract the appreciation of its own currency with the help of negative interest rates, while the aim in the Eurozone in a way is the exact opposite: there is no excess flow of capital into the Eurozone for sure, because first growth would need to be kindled. Switzerland therefore is hardly the best example to detect the true effect of negative rates on the substantially bigger Euro-region.

«Interest isn't the price charged for money, but the price paid for time»

Fundamental questions arise when a key price such as interest changes its direction. In economic literature, taking a closer look, interest isn’t seen as the price charged for money but the price paid for time. In this context, the issue becomes one of an individual’s preference for time that is psychologically very strongly affected.

To be able to invest, somebody has to forego the otherwise available consumption for a certain period of time. The incentive and reward for this is the interest paid. That somebody is the saver. The explanation provided by the temporal theory of capital for interest is valid to this day – but receives scant attention from central banks. If interest is negative it means in essence that people prefer to consume later rather than today.

Ludwig von Mises (the Austrian-American economist, 1881–1973) thought this to be unthinkable, because it contradicted all axioms of human behavior. The damage to be expected through negative interest is articulated in connection with the following issues: savings are discouraged, consumption boosted, the future in many ways consumed today; doing business on credit is being fostered, companies beguiled into misguided investments, political reform discouraged; assets are devalued and the pension provisions destroyed.

«A negative interest rate is counterintuitive even if not everyone is able to say so yet»

So what do all these factors have in common? The value of time is being diminished – the future loses in value in relation to the present. The realization of this seems surprisingly symptomatic for other burning issues (the buzzword being climate change). Inevitably, you are reminded of Momo in Michael Ende’s novel. Bald agents – the Men in Grey – of the Timesavings Bank pursue Momo. Their aim is to steal the time of humans – their future. A negative rate is upsetting the basis of the free market economy.

Once the sub-zero rates cease to kindle demand for credit, but instead increasingly are seen as a warning sign of a world that has become unhinged, they suddenly assume a contrarian effect. A negative interest rate is counterintuitive even if not everyone is able to say so yet.

Given that monetary policy is not a mathematical science, but influences the behavior of human beings in a real-world, it is the perceived message of the policy that is key. The reactions to the most recent ECB decision – for the first time mainly critical – indicate that not much is expected any more of the central bank.

«Historically, central banks have acted as institutions that create stability»

Hence, the ECB is entering new territory, where the economic sense of negative interest – to employ the language of central banks – isn’t sufficiently entrenched anymore. Thus it would act in a pro-cyclical fashion and deepen the slump in demand through a cycle of insecurity and distruction instead of counteracting it.

Historically, central banks have acted as institutions that create stability from a position in the background and which legitimized their actions with reference to their expertise, overview, and knowledge of complex relationships in monetary policy.

Should the perception increase of it being a destabilizing part of the problem and not a solution to it, there would be more at stake for central banks than the question about the next interest rate step.

Teodoro D. Cocca is a professor for asset and wealth management at Johannes Kepler University in Linz. Before joining the university in 2006, he worked in investment and private banking at Citibank for a number of years. He was a researcher at Stern School of Business in New York and a lecturer at Swiss Banking Institute in Zurich. The Swiss, who has Italian roots, is an adjunct professor for private banking at Swiss Finance Institute (SFI) in Zurich. He advises financial firms and government bodies in Switzerland and abroad. Since April 2011, Cocca has been a member of the board at VP Bank in Vaduz and heads the bank’s strategy and digitization committee. A new book, «Digitization in Private Banking» (in German) is out now at Frankfurt School publishers.

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