Extreme times sometimes lead to extremely unusual sights. At the moment, nominal interest rates in Denmark are negative. The zero lower bound on interest rates has been smashed: the return to holding cash is higher than the return to depositing it in a bank or investing it in government debt (with anything less than a five year maturity). Wow. Before asking how we can even get negative rates, how did the economy get here?
Fearing some combination of the breakup of the Euro area, a European banking crisis, and a Europe-wide fiscal crisis, European investors are getting out of risky Euro-denominated assets, such as deposits in European banks or short-term European government debt, and into safer claims denominated in safer currencies, like claims on banks and governments that are denominated in Swiss Francs or Danish Krone. Thus, capital is flowing into Switzerland and Denmark and pushing interest rates down in these countries.
Following the increase in demand for these currencies, the Swiss Franc has appreciated significantly against the Euro, but the Danish Krone is pegged to the Euro. For Switzerland, the appreciation hurts exports and increases imports. For Denmark, there is little immediate effect on exports and imports, but the pressure for the currency to appreciate is the same. To stop the appreciation, the Danish central bank – Nationalbank — has to buy Euros and sell Krone. This is what the peg means and how the value of the Krone is maintained against the Euro. As it turns out, the central bank doesn’t actually sell Krone. Instead, the central bank buys Euros from banks and pays for them by crediting their Krone accounts with the central bank, account balances which are called “reserves.” Reserves are a lot like commercial bank’s bank accounts with the central bank. These reserves can be withdrawn from the central bank as Krone, and some are as the bank’s customers make withdraws to buy safe assets like Danish government debt and the bank withdraws from the central bank to meet the withdrawals. One upshot of all this is that the Danish central bank has roughly doubled its foreign reserve account balances and is becoming a long-short currency fund: long Euros and short Krone deposits (and Krone themselves – cash in circulation is a central bank liability). But that is almost an aside, the interesting point is that the demand for Krone-denominated Danish assets has driven interest rates on short term government debt negative. And Nationalbank has now reduced the interest rate it pays on reserves to negative 0.2 percent! Yes, it is more expensive to hold reserves with the central bank than to hold cash in the vault.
And this is how we actually get negative nominal rates: the convenience and safety of deposits or short-term government debt relative to cash. Holding a large amount of cash is inconvenient and risky. As an individual, it is much easier to buy a house with a check than with cash (imagine how you would feel walking with the suitcase of money from the bank to the closing agent). As a business, it is much easier to meet payroll with deposits than cash. And even as a bank, vaults are only so big and so safe. So short term nominal rates in Denmark are solidly in the negative range. The Zero Lower Bound is broken. Expect an increase in vault construction and possibly an increase in bank robberies. And a reconsideration of the Zero Lower Bound as an economic law.
