September 18, 2021

First published September 17, 2020

Why interest rates don't go below zero — and why digital currencies can change it

Central banks set the interest rate to influence investment decisions, raising the interest rate to moderate investment when the economy is booming and lowering the interest rate to boost investment when the economy is slowing down (see the previous post). But how low can the central bank set the interest rate?

Physical cash creates a lower zero bound on the interest rate

Central banks cannot lower the interest rate below 0% or at least not much below 0%. Why not?

Suppose the central bank sets the interest rate at minus 10% and you have 100 euros to invest. If you invest at an interest rate of minus 10%, you will have only 90 euros left after one year. You might as well keep this money in coins and banknotes and it will still be 100 euros after one year. Therefore, no one would ever invest at an interest rate of minus 10%.

More generally, too negative an interest rate cannot be sustained. Central bankers say that there is a zero lower bound on the interest rate.

A slightly negative interest rate can be sustained, however. The short term interest rate in the Euro Area is currently minus 0.7%. It means investors are losing money on their savings. In principle, they would rather hold their money in coins and banknotes. In practice, this can only be done for small amounts of money, but holding large amounts in cash is costly: you need to get the banknotes, store them, hire security, etc., which is costly and not worth the effort to save 0.7%.

Preliminary conclusion: An interest rate slightly below zero can be sustained, but not too much below zero as long as people have the possibility to hold physical cash.

Digital money could break the zero lower bound

Central banks are talking about creating digital currencies while China already launched a pilot program. A sign that these ideas are gaining traction is that a Wikipedia entry for central bank digital currency exists since 2017.

An under-appreciated consequence of substituting physical money with digital money is that it would make it possible for the central bank to set a negative interest rate. People would no longer be able to escape the negative interest rate by holding physical cash. In a world with a digital money and a negative interest rate, the balance on your digital money account would shrink over time as the central bank charges you the negative interest rate.

Conclusion: The zero lower bound on interest rates exist as long as physical money exists. But in a world in which digital money has replaced physical money, nothing prevents the interest rate to go in deep negative territory.



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I would have thought that the impact of lowering the interest rate below 0 in these digital currencies would be quite limited as people would have the chance to hold their money in for example cryptocurrencies that are completely decentralised.


I don't have a definite answer to this question based on facts, because a situation where people can choose between holding a digital currency issued by the central bank with negative interest rate, and holding a cryptocurrency such as bitcoin with zero interest rate, had never existed.

But we have a way to think about this situation based on the experience of traditional currencies. Take for example the year 2006. The short-term interest rate on the US dollar was 5% and the short-term interest rate in euro was only 2%. A European could have decided to hold dollars instead of euros to take advantage of the interest rate differential. In practice, very few people did so. Why not? Because when you live in Europe, your expenses are in euros, so holding dollars is not only impractical, it is also risky because the exchange rate between the dollar and the euro can fluctuate widely. It turns out the dollar depreciated 8% relative to the euro in 2006, so holding cash in dollars instead of euros in 2006 would have lost 5% instead of earning 3%.

The same insight applies to cryptocurrencies. Their exchange rates vis-a-vis traditional currencies are very volatile, even more so than the exchange rates between traditional currencies. Therefore, holding a cryptocurrency to escape a negative interest rate on the central bank digital currency would be very risky.

As a final word, one way to think practically about this issue is to ask yourself: How much of my savings would I convert in bitcoins if the interest rate on my checking account was minus 2%? and what about minus 10%? This might give us a hint on how low interest rates could be in a world of digital currencies.

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