Something fascinating is going on with negative interest rate policy: It’s having the opposite of its intended effect.

A negative interest rate is a simple concept — it means that money in a bank account shrinks over time, rather than grows. It takes the time value of money and heightens it by penalizing saving.

The concept started in 2014 in Europe and since, Japan has also followed suit. Negative interest rates are applied to reserves held by commercial banks, meaning that no small time individual is going to lose the nominal value of the money in his bank account. The policy trickles out to create negative yields on government bonds — meaning that if you put 100 units of currency into a bond, you won’t get all 100 back at maturity — and onto large institutional savers — meaning that entities with large sums of money sometimes have to pay the bank to store their money.

The US does not have negative interest rates, but because other countries do, the US has to hold interest rates low to keep the dollar competitive. (A strong local currency is not always a good thing because it makes your exports more expensive.) See the chart below? If you know what you’re looking at, that interest rate chart tells you nearly everything you need to know about access to wealth, success, income inequality, and the post-Great Recession economic recovery.

How does this affect you? Well, it means that you aren’t going to get a lot of return on your savings account any time soon. It means that home values are going to continue to rise quickly in economic hot beds, as access to capital remains cheap. And, in theory, it should make you want to invest your money in stocks, in new business ventures, or in consumption of goods.

But, does it?

Low interest rates seem to have worked. But negative interest rates are still untested.

The purpose of negative interest rates is to encourage financial activity, lending, and inflation. A negative interest rate is a “use it or lose it” policy — it encourages commercial banks to lend money rather than to save it. It is supposed to create a mentality similar to your “use it or lose it” vacation leave or flex account — when you know that your asset is going to be lost over time, you’re encouraged to use it now. And this mentality is meant to trickle out to consumers.

But here’s the problem: Negative interest rates are bad psychology. It communicates uncertainty and thus, encourages individuals to act cautiously and to save more money. Instead of creating a free-for-all of money flow, people are hunkering down, spending less, and saving more.

The Wall Street Journal today quotes several people who are hunkering down and cites statistics on reduced consumption after negative interest rate policies were implemented. People are feeling that they need to save more today to build up wealth. (Not mentioned: I guess these folks don’t want to take their chances with the stock market.)

The interest rate on three-month US treasuries. (Source: barchart.com)

And this makes perfect psychological sense. We know that when people feel richer, they are more likely to spend on consumption, more likely to take risks. Negative interest rates are meant to communicate that it is riskier to leave your money in savings than to spend or invest it now — that’s the rational outcome.  

But that’s not how people think. People are not perfectly rational with their money. Individuals are certainly not trained to consider inflation risk.

I wonder if the problem is not so much with negative interest rate policy as it is with how it’s communicated. Because here’s what it means to the financially enlightened: It is still probably a good time to take risks or to start a business. The US is not likely to grow interest rates while trading partners are stuck at negative.

Here is also what it says to me: The ‘experts’ are acting on theory, trying their best, but never really fully sure of what they’re doing and not good at measuring unintended consequences. Economic policy is experimental.

What do you think?

More light reading:

Are Negative Rates Backfiring? Here’s Some Early Evidence (WSJ)
Everything you need to know about negative rates (WSJ)
Bloomberg quick take: Negative interest rates (BBG)
Julius Baer Charges Institutional Clients for SNB Negative Rate (BBG)
Even Warren Buffett is confused by negative interest rates (MarketWatch)
Bill Gates: Low rates pose leverage, bubble risks (CNBC)