Central Banks are under the mistaken belief that negative interest rates could be the magic kiss which turns their toad economics into Prince Charmings.Why exactly do they think this? What makes Draghi, Kuroda, and others think imposing negative interest rates will stimulate credit and lending in their respective economies?

It is important to understand the logic behind this historic moment in global monetary history. Negative interest rates are unprecedented and show how far we have gone off course in terms of policy related to money and credit markets. They are already having a tremendous effect in several European countries and Japan, and they may eventually be coming to the US. Negative rates hold significant future implications for gold as well.

Why Negative Interest Rates?

The reasons are quite simple. Having tried the carrot without much success, central banks are moving toward using sticks to get the behavior they want.

Zero to low interest rates were the carrot. Offering super low rates in order to entice lending hasn’t developed into the robust credit market they were hoping for. So, now they are looking to use a stick – imposing negative interest rates. This effectively places a penalty, a tax even, on banks if they do not engage in sufficient lending the central banks’ desire.

Just like with ZIRP, central bankers are going to find out the hard way that negative interest rates are not the magic salve that will resuscitate an otherwise vegetated credit market. Lack of available credit is not the problem. We are swimming in an ocean of available credit. Rather, the issue is with adequate demand. From the banks’ perspective, there simply aren’t enough creditworthy borrowers. Solvency precedes lending. In our debt saturated economy, solvency is increasingly rare.

What will the banks do?

Banks could just absorb the loss on their capital and choose not to lend at all. This is what most banks in Europe are doing. Many banks opt to simply take the loss and buy the government bond, because there aren’t enough qualified borrowers in the private market. With these lower profit margins, contrary to Draghi’s wishes, banks may be even less willing to lend.