07/03/2016 5:55 AM AEDT | Updated 15/07/2016 12:51 PM AEST

Why Negative Interest Rates Could Be Positive

Faced with a failing economy, the costs of not cutting rates enough, or of prematurely raising them, far outweigh the risks of having too-low interest rates.

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Unfortunately, the New Year holiday spirit appears not to have been enough to disperse the risks faced by the global economy. 2016 has so far been plagued by the turbulence that characterised 2015. Many of these symptoms are familiar: anxiety has intensified about the slowing Chinese economy, declining commodity prices continue to wreak havoc in related industries, and financial markets suffer significant ongoing volatility. Some, however, sprung up while we were busy working off those holiday kilos. For instance, deepening negative interest rates in Europe and Japan.

Last month, Reserve Bank of Australia (RBA) board member John Edwards warned that negative interest rates in Europe and Japan could push up the Australian dollar, hindering any successful transition away from the mining boom. At its meeting last Tuesday, however, the RBA decided to leave the cash rate unchanged at 2 percent. Its commentary on the dollar: "The exchange rate has been adjusting to the evolving economic outlook." In other words, they're pretty chilled about it at the present.

Negative interest rates are an unconventional monetary policy response to a deteriorating economy. Low interest rates stimulate weak economic activity by leading to more borrowing and spending. This is achieved through a number of channels including, but not limited to, asset markets (they tend to increase asset prices such as houses and shares), the banking sector (they increase loan supply), and households (they ease borrowing constraints). Hence, faced with increasingly stagnant economies, the central bankers of Europe and Japan have pushed their interest rates lower than economists once thought possible -- below zero -- in an attempt to stimulate demand.

Such extraordinary monetary policy, however, is not risk free. The problem is that monetary policy is a little bit like conducting CPR with a sledgehammer -- it can get the job done, but it tends to have unintended side effects. Furthermore, the risks involved tend to get larger as rates approach zero. Unsurprisingly then, critics have been quick to point out the potential detrimental side effects of negative rates.

Critics assert that ultra-low interest rates, and negative rates by extension, engender financial instability. There is truth in this. Ultra-low rates can cause financial vulnerabilities, as they tend to contribute to higher leverage, debt burdens and risk taking. A build up of these vulnerabilities could foreseeably set the stage for a future financial crisis and recession.

In addition, negative rates are not good for commercial banks because they compress their net interest margins. This squeezes their profits, and erodes their strength over time. While it is tempting to derive pleasure from banks eating their 'just desserts' for their role in the Global Financial Crisis, we'd only end up shooting ourselves in the foot. As Nobel Prize-winning economist Paul Krugman reiterates, economics is not a morality play and treating it as such only ends up with everybody worse off. Put it this way, another round of bank insolvency is unlikely to improve your retirement fund.

On the other hand, low interest rates also improve financial conditions. They make servicing debt easier and they increase asset prices, which tends to make people and businesses wealthier (unless, of course, you are attempting to get into the Sydney housing market). Thus, the overall effect of negative rates on financial stability depends upon the tradeoff between financial conditions and financial vulnerabilities.

While research in this area is ongoing, the evidence so far suggests that, overall, ultra-low interest rates do cause a slight increase in financial instability. It must be remembered, however, that an underperforming economy, extracts large economic, human and social costs, not only for the current generation but future ones as well. Furthermore, a sick economy is itself a source of financial instability.

Ultimately, the decision comes down to weighing up the pros and cons. On one hand, the financial vulnerabilities resulting from ultra-low interest rates, while certainly not negligible, are not guaranteed to manifest into an actual crisis. On the other, the costs from a stagnant economy are already being realised. Hence, faced with a failing economy, the costs of not cutting rates enough, or of prematurely raising them, far outweigh the risks of having too-low interest rates.

After all, economists generally agree that threats resulting from ultra-low interest rates are better addressed by targeted financial regulation -- known in the jargon as macroprudential policy.

What does all this mean for Australia?

Well, the RBA seems pretty content to sit back and watch for the time being.

In a statement released on Tuesday, it said: "Over the period ahead, new information should allow the Board to judge whether... the recent financial turbulence portends weaker global and domestic demand."

So the RBA is holding its fire. Low inflation gives it the scope for cuts should the need arise, however, it doesn't judge the recent global developments as large enough threats. Yet. Should China suffer a hard landing, or America reverses its interest rate course, then the RBA will need all of its ammunition. After all, while we now know that the zero lower bound isn't literal, it's still not that much less than zero, and 2 percent doesn't give it many shots.