If you’d suggested just a few years ago that we’d soon be living in a global economic landscape in which an increasing number of central banks would have their interest rates set to zero, or even negative, most people would have thought you where outright mad. What seemed crazy and absurd then is reality now in an increasing number of nations. Since Februari 2012, Sweden, from which I myself originate, are amongst these nations.
When a central bank set its interest rates to negative, it means that the commercial banks will have to pay for holding overnight deposits at the central banks. Most banks are still offering positive interest rates on their customers’ deposits. All else would seem insane. I mean, imagine having to pay to keep your money in the bank. Well, remember how alien negative interest rates seemed just a few years ago? Well, now they’re a reality, and most likely we’ll soon see negative interest rates in an increasing number of commercial bank accounts in countries where central bank interest rates are negative.
Why pay for storage if nothing is stored?
While negative interest rates might seem absurd, one could also turn the issue on its head – why should it be free to store ones cash at the bank? I mean, the bank has storage costs for safekeeping all your cash right? Well, yes and no. While banks do spend a fair amount of money on security systems, this money is for the most part not spent on safekeeping physical cash but on ‘safe keeping’ ones and zeros in cyberspace. Most of the money supply in any modern economy exists as digital numbers stored in the banks’ servers. In most developed countries, much less than 5% of the total money supply is cash. This holds true even for a society like Singapore where relatively large amounts of cash still circulates.
This stands in stark contrast to a system where gold is used as money or as a means of saving ones wealth. Precious metals used to act as the monetary unit for thousands of years and banks used to hold gold coins on deposit and issue deposit receipts that was a claim on a certain amount of these gold coins. These claim checks then circulated as money with full gold backing. Naturally, the gold banks had storage costs handling a physical product, namely gold and silver bullion. The gold and silver was not only bulky but also susceptible to theft, hence, ‘interest rates’ on physical gold on deposit was negative. At least on gold that was held on a current gold account – available for immediate redemption.
Sometimes the gold bankers fell for the temptation of issuing more claims than there where gold on deposit. A lucrative practice if the gold banker could charge interest rate on lending out these claims, but also a dangerous practice should the customers suspect something. Any suspicion that all of the customers’ receipts weren’t backed by gold could trigger a bank run in which a majority would redeem their claim cheques for gold. If the bank had issued more claim cheques on gold than what actually existed in the vault, the bank would fall. A healthy mechanism that deterred bankers from succumbing to the temptation of only holding fractional reserves.
The fact is that your cash deposited in a modern bank are not yours at all and you are in fact an unsecured creditor to the bank. The balance in your account is just a ‘promise to pay’ should you decide to ask your bank to do so. As long as not everyone asks for payment all at ones, everything is fine.
Negative interest rates and physical cash
Singapore is still an economy where physical cash is widely used and, in many cases, cash payment is the most viable alternative as the merchant fees banks charge for credit card services can sometimes be hideous. This leaves retailers with no other choice than to pass the fees on to their customers, or offer their customers to pay in cash. Singapore lends itself well for cash use as the rock-bottom low crime rate makes the risk of getting robbed very low. Cash is also safe as it eliminates any counter party risk – you get the product, the merchant gets the cash. There are no payment systems that can fail or banks that can collapse – It’s just cold hard physical cash.
As a customer with the bank, you of course have the ability to close your account and redeem your cash should you be unsatisfied with any eventual new negative interest rate scheme. But there’s a risk that you wouldn’t be the only one doing this. Would the banks have enough cash to cover all of its claims should a larger majority of customers deiced to take redemption?
While Singaporean banks are usually quite well capitalized, most banks in the western world in general, and Europe in particular, are not. In Sweden, research confirmed by the very chairman of the central bank himself shows that a bank operating in Sweden only need about SEK 2800 in cash to create a housing loan of SEK 1,000,000.00. The rest of the ‘money’ backing the loan can consist of various hybrid capital instruments in several different tiers.
The Swedish banking system is extremely highly leveraged, in large part due to an overheated housing sector were housing prices have soared beyond what any regular income can afford. In contrast to the Singaporean government, the Swedish government has showed little or no interest to mitigate the situation and cool down the market. Politicians are scared that any such measure might upset voters that would see the price of their property fall. Only when the politicians parliamentary term has ended are they calling for something to be done, which happened a while ago when the former Swedish minister of finance said that the negative interest rates are a dangerous experiment that may create new bubbles and abet existing ones.
Preventing bank runs thru the abolition of cash
Banking is a scheme of mutual indebtedness. The public owes the banks a lot of money, and the banks owes the public a lot of money. Again, all deposits are debts to the account holders that are to be paid in cash upon request. But all the money on deposit was also created by people going into debt when they took a loan. These loans can be housing loans, car loans or credit card payments that created credit card debt. When debts are repaid, the bank deposit money disappears out of circulation and the money supply (M1) shrinks.
Bank runs occur when there’s a distrust in a certain bank or in the banking system at large. If depositors feel that their deposits are in danger – perhaps due to their bank being on the brink of financial insolvency or collapse, or due to a more widespread impending collapse of the entire financial system – they will naturally try to withdraw their money. If it’s only a matter of one single insolvent bank, with rest of the financial system in good health, one might get away with simply transferring ones cash balance from the insolvent bank to a solvent one. But if the banks in an entire country are on the brink of financial insolvency, you might have to stand in line in front of your bank to ask for your physical cash. Hopefully you’ll get some, because remember – banks only keep fractional reserves and as a depositor, you’re an unsecured creditor.
We’ve seen bank runs happening recently in countries like Cyprus where an insolvent banking system on the verge of financial meltdown has forced the banks to shut their doors, declaring one or several ‘bank holidays’, effectively banning depositors from withdrawing their funds. It ain’t pretty when pensioners living on a fixed income can’t get cash to buy food and other necessities.
In the end, some of the largest depositors had to take a ‘hair cut’ in Greece, forgoing more than 47% of any savings exceeding EUR 100,000, in total loosing some EUR 4 billion. Most of these depositors where pension funds followed by private savers.
There’s one way to prevent a bank run that is particularly effective, namely the abolitionist solution, i.e abolishing cash.
We’ll discuss this in further detail in part 2 of Cashless society, negative interest rates and hyperinflation.
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