Through the Looking Glass on Rates

On January 29th, Japan's central bank governor, Haruhiko Kuroda, announced that the Bank of Japan would introduce a Negative Interest Rate Policy, or NIRP, on bank reserve deposits held in excess of the minimum requisite. The European Central Bank, and central banks in Switzerland, Denmark and Sweden have already partially blazed this mysterious trail. The banks have done so in order to weaken their respective currencies and to light a fire under inflation. Swiss national bonds now carry negative rates out to maturities of eleven years, meaning investors must lock up funds for eleven years to receive even a small positive nominal return!

There are economists and investors to whom these policies seem logical. After all, if low interest rates are good, wouldn't negative rates be better? Many have argued that the "zero bound', or the point past which rates can go no lower, is simply the same type of archaic thinking that brought us the gold standard and moral hazard. 

These contemporary economists like to suggest that markets should become comfortable with negative rates and accept that they have an important role to play in the "science" of modern finance. But this analysis ignores the fundamental absurdity of the concept.

Money has a time value. Funds available today are worth more to the owner than money available tomorrow. I would imagine that, if asked, 100% of people would choose to receive $10,000 today rather than the same sum a year from now. Many might even pay for the quicker delivery. Even if we allow for the unlikely possibility that real deflation exists, and that consumers are therefore making sensible decisions in deferring purchases, life is uncertain and consumers are impatient. That's why banks have always had to offer interest to savers to lock up their funds on account. Paying for the privilege of not spending one's money is a completely new development in human history, and one that I believe is at odds with fundamental concepts of economics and psychology.

The ECB, as did the Bank of Japan (BoJ), cited economic stimulation as its main reason for negative rates. These sentiments were recently cited in a blog post by former Fed President Narayana Kocherlakota where he urged his former Fed colleagues to bring rates into negative territory. The logic is that people and businesses would refuse to pay to keep their money on deposit, and would instead withdraw those funds to spend and invest. However, zero percent interest rates do not appear to have had this affect. The money may, in fact, have been spent, but the growth never materialized. So will the dead horse we are beating suddenly get up if we beat it harder? Apparently so.

Only eight days before taking the dramatic and highly debatable step to trigger negative rates, Bank of Japan President Haruhiko Kuroda had assured his Parliament in Tokyo that such a policy was not even being considered (Reuters, 1/21/16). But less than six days later, after attending the World Economic Forum in Davos, his position had changed. Did private discussions with world leaders in Davos convince him that a serious international recession and credit crisis would unfold unless all central bankers could fire all available weaponry?

After the financial crisis of 2008, the U.S. Fed and the Bank of England (BoE) followed the lead of Japan to experiment with QE and ZIRP, even though those policies never delivered a recovery to the Japanese. The Fed and BoE unleashed stimulation with unprecedented vigor at home and then urged acceptance by other central banks. In essence, a huge global debt crisis was to be cured, or at least postponed, by even more international liquidity based on massive debt creation and the socialization of bank losses.

Much of the massive synthetic liquidity created by the QE experiment was funneled into financial assets. This diverted business investment away from job-creating investment in plants, equipment and employment. Wages remained stagnant and consumer demand and GDP growth were disappointingly flat. According to data from the Bureau of Economic Analysis, expansion of real U.S. GDP growth between 2009 and 2015 averaged 1.4 percent per year or less than half the average rate of 3.5 percent experienced between 1930 and 2008.

Meanwhile, ZIRP has caused mal-investment along with an unhealthy reach by banks and investors for high yield, but riskier investments. This became most obvious in the high yield debt market, which now is being hit hard by the fall in oil prices.

Negative interest rates mean that borrowers are paid to borrow. This serves as a powerful inducement for companies to borrow up to the hilt to buy other companies, to pay dividends that are unjustified by earnings levels and to invest in financial assets. Often this includes buying back their own corporate shares thereby increasing earnings per share, the share price and linked executive bonuses.

For savers, negative rates discourage savings, stifling future business investment and consumer demand. However, central banks hope that discouraged savers will instead be lured into spending on consumer products and create short-term economic growth albeit at the price of future growth.

Negative interest rates mean that lenders have to pay borrowers and that depositors have to pay banks to keep and use their money. One does not require a PhD in economics to recognize this as an unnatural distortion that will create more problems than it solves.

If individual and business depositors draw down their balances, the deposit base of banks will fall as will the velocity of money circulation. This will not only discourage lending, but, through reverse leverage, cause bank liquidity problems. Should banks with loans to high-yield companies and emerging market nations, especially those hit by falling oil prices, see their loans become non-performing at the same time as deposits are falling, a potentially catastrophic banking crisis could threaten. Since the Financial Crisis of 2008, over $50 trillion dollars of new debt have been added globally to the levels that precipitated the banking crisis in the first place.

Negative interest rates act effectively as a hidden tax funneled directly to banks. They are inherently unhealthy. Currently, they could indicate also a measure of unease among two of the four most powerful central banks. If so, that could well escalate. Depositors should be aware acutely of the hidden risks to their deposits. Already, nations with looming bank liquidity problems, such as Russia and many in Africa, are increasing their levels of bank deposit insurance to reduce potential political unrest.

Readers know that we have felt for many months that the U.S. is far from ready for interest rate increases. We are of the opinion, now echoed by others, that the U.S. will see zero and possibly even negative interest rates before it experiences a one percent Fed rate. This does not bode well for our future.

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John Browne is a Senior Economic Consultant to Euro Pacific Capital. Opinions expressed are those of the writer, and may or may not reflect those held by Euro Pacific Capital, or its CEO, Peter Schiff.

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