In August of this year, Germany issued 30-year bonds with interest rates below 0%. Yes, if you bought a $1,000 German bond with a rate of -0.11%, you would actually only receive back $998.90 on your investment. Now Germany was only able to sell less than half or the €2 billion of bonds they offered.
When you consider a negative interest rate, it stands for a value discount of the asset. It is saying that the money today is more valuable than taking the duration risk of investing and receiving money tomorrow. This is quite unnatural , as anyone would expect to be paid something for their foregoing the use of their money today in order to lend it to another to use. Saying that the new natural interest rate has turned negative is wrong, as it defies the natural order.
Thorsten Polleit identifies this strategy has found its way into monetary policy around the world with now over $17 billion of sovereign debt in the negative territory. These rates are “highly attractive to the state and those groups closely associated with it because if the central bank forces interest rates into negative territory, running debt becomes a profitable business, and financially ailing states and banks can reduce their debt burden at the expense of creditors.”
Wonderful, let’s continue to encourage irresponsible behavior!
Central banks manipulate market interest rates on all ends of the spectrum. They control the short term and impact longer term rates with the purchase and sales of debt securities. In Europe, the trend to negative rates has not been natural, it has been orchestrated by the European Central Bank (ECB).
It is conceivable that consumers and businesses could eventually see negative interest rate loans. If a bank in Sweden borrows from the ECB at a -2% rate per year, it pays back 98 Euros for the 100 Euros it has borrowed. If anyone could suddenly get a loan with a negative interest rate, it would be expected credit demand will skyrocket. To prevent this, the ECB would have to resort to credit rationing. The credit market will not determine who gets which loan and at what rates, the ECB would set guidelines for which loans and types of individuals and businesses would receive credit. This becomes an ultimately planned economy. Polleit paints an Orwellian picture where “the monetary policy of zero and negative interest rates—if it is consistently thought through—leads to the demise of (what little is left of) the free society as we know it in the Western world.”
If credit is not rationed while it is negative, it could reach levels of a speculative bubble which would eventually pop in a destructive debt deflation. This may be possible, but some will point to Japan where rates have been below zero for decades and yet no bubble has appeared. Maybe what is more plausible is the Larry Summers idea of a “Black Hole” monetary policy, when rates fall below zero, that the energy required to sustain the private sector economy cannot get out.
This trend does not bode well for banking profits. A study from the University of Bath, England over 7,359 banks from 33 countries between 2012-2016, found that bank margins and profits fell in those countries pursuing a negative interest rate policy compared to those who did not adopt the policy. Loan growth was damaged by the squeeze on bank margins that negative rates produce. The decline in profits for financial institutions, also erodes capital bases, which in turn, limits an institution’s ability to lend.
Recent statements from the head of Financial Supervisory Authority in Denmark warns that negative rates are pushing the European banks to a tipping point. Banks must change their basic business model or accept they will have to contract in size. The evidence is showing that negative rates are deflationary.
Currently, these phenomenons are happening to countries across the oceans from us. But if negative rates appear on our shore, while it will help those in a lot of debt, it will likely stagnate and imprison the private economy.