Deeply negative nominal rates are on their wayAug 8, 2019·Alasdair Macleod
Growing evidence of a severe global recession is sure to provoke more aggressive monetary policies from central banks. They had hoped to have the leeway to cut interest rates significantly after normalising them. That hasn’t happened. Consequently, as the recession intensifies central banks will see no alternative to deeper negative nominal rates to keep their governments and banks afloat through a combination of eliminating borrowing costs and inflating bond prices. It will be the last throw of the fiat-money dice and, if pursued, will ultimately end in the death of them. Gold and bitcoin prices are now beginning to detect deeper negative rates and the adverse consequences for fiat currencies.
Central banks face a dilemma: how can they cut interest rates enough to stop an economy sliding into recession. A central banker addressing it will note that the average cut required to put an economy back on its feet is of the order of 5%, judging by the experience of 2001/02 and 2008/09 and what their economic models tell them. Yet, in Euroland the starting point is minus 0.4% and in Japan minus 0.1%. In the US it was 2.5% before the recent reduction and in the UK 0.75%. The solution they will almost certainly favour is deeper negative nominal interest rates.
Given mounting evidence that the global economy is entering a significant recession and drifting towards a cyclical credit crisis, this topic is suddenly relevant. Regular readers of my articles will know that I have highlighted empirical evidence that a combination of trade protectionism and a turn in the credit cycle are the recipe for an economic slump. In combination these were the two factors that collapsed the US stockmarket in 1929 and led to the great depression of the 1930s. The economic theory behind it is clear. Today, American trade tariffs come at the end of the longest and most aggressive period of credit expansion ever seen. It is not an overestimation to expect that a credit crisis combining with American trade protectionism this time has the potential to be worse than that of nine decades ago.
Furthermore, we have arrived at this point through increasing injections of fiat money and credit over successive credit cycles, because central banks do not permit credit distortions to unwind. Instead, in their mission to protect commercial banks from defaults they encourage malinvestments to persist. It will not be just a case of unwinding the credit distortions following the Lehman crisis, there is a long legacy to deal with from previous credit cycles as well.
Following the collapse of the Bretton Woods Agreement in 1971, the freedom granted to central banks to print money is the framework for current monetary policies. As well as funding government deficits, monetary expansion has been used to protect the financial and commercial establishment at everyone else’s expense. We are told moderate price inflation is good for us when it obviously impoverishes society’s disadvantaged. The true purpose is to permit monetary and credit expansion. Furthermore, price inflation is always quantified by governments keen to suppress unfavourable evidence. The combination of monetary inflation and the suppression of evidence of the effect on prices is now the backbone of monetary policy.
It is a policy which has added viciousness to the credit cycle, leading to ever greater credit crises. You would think that progressively greater failures of monetary policy over succeeding credit cycles would cause rational humans to stop and think. But united in their groupthink, central bankers incline to the view that it is not the policy that’s wrong and it’s not their fault: it is the fault of businesses (they call it a business cycle) and more intervention is the solution.
Rational individuals know that there is another credit and economic crisis in the wings, and they already know how central bankers will respond. They will want to reduce interest rates to rescue their economies by cuts at least as aggressive as in the past, which means having the leeway to slash rates by a minimum of five per cent. What our rational individuals have yet to realise is it takes monetary policy into deeply negative rates everywhere. Entire AAA-rated bond yield curves are likely to be forced into negative territory, following the Swiss government bond market, which is already there. The denial of time-value will mean a government bond with no final redemption date priced at less than infinity will be technically a bargain. That is the measure of distortion.
There can be no doubt that central bankers feel increasingly trapped. Reading between the lines, it was hard to escape this conclusion following last week’s reduction in the Fed Funds Rate. Mario Draghi at the ECB will be glad to hand over the reins on 1st November. His replacement is a lawyer and socialist politician who reinvented herself as the head of the IMF. Christine Lagarde’s only qualification for the job is the same as Mark Carney’s at the Bank of England: she is regarded as a safe pair of hands and is expected to steer the ECB along familiar monetary tramlines.
She knows little about economics. Worse, she is hampered by having been a French finance minister, where knowledge of free market economics is a disadvantage. But conveniently, the IMF, which she is leaving to head up the ECB, recently published a working paper showing her and her fellow central bankers how to enable deep negative nominal interest rates.[i]
This working paper, to which we will return later, follows another written in 2015 by the same authors, again published by the IMF, entitled Breaking Through the Zero Lower Bound.[ii] The first paper comes up with fifteen “misconceptions” about eliminating the zero bound. None of these deal with the problem of time-preference, nor, more remarkably, the fact that deeply negative rates will put the whole commodity complex into backwardation and risk a wholesale run on bank deposits from large depositors. Nor are there more than just oblique references to the true objectives of negative rates: to facilitate government funding and to rescue the banks.
The most important economic issues are simply ducked.
The origin of the belief in negative rates
The two authors mention the history of the desire to reduce interest rates, commencing with the work of Silvio Gessel (1862-1930), who proposed the introduction of a stamp duty on physical paper currency: paper money would only retain its value if it was endorsed every month with stamps purchased at a post office. This would in effect impart a negative yield on paper cash set by the cost of the monthly stamps.
By giving paper cash a negative yield, Gessel believed interest rates on loans could be made to move towards zero. The obvious flaw was interest rates were interest rates on lending and borrowing gold, which backed most currencies at the time. It would require at the least coordinated action by all issuers of gold substitutes and was impractical even before one considers transgressions of price theory.[iii]
In fact, interest always had a bad name, termed usury by the Christian church and banned at various times through its long history. It is still banned by the Moslem faith. People cannot get their heads around the idea that money appears to be able to earn money without any effort expended by its owner. Keynes was tormented by this problem as well and gave over five pages in his General Theory to Gessel, after initially dismissing his work and then admitting to becoming profoundly impressed. Gessel appears to have provided Keynes with the bones for his argument that savers did not deserve the remuneration of interest and could be written out of the future as providers of monetary capital.
While Gessel only proposed negative interest rates on physical cash, Keynes pointed out that “a long list of substitutes would step into their shoes - bank-money, debts at call, foreign money, jewellery and the precious metals generally and so forth”. In their papers Messrs Argarwal & Kimball focus on the issue of bank money.
Given the genesis of thought from Gessel through Keynes, perhaps we should not be surprised that the IMF’s two working papers make no mention of time preference. Classical economists, who took Say’s law as a fundamental truth, understood that the role of money is to act as the intermediate facility for all economising individuals to transform their production (or labour) into consumption. This being the case and with current possession of goods being more valuable than future possession, money must reflect these characteristics. It follows that for a post-Keynesian economist to suggest otherwise is in defiance of simple price theory.
This is why Keynes had to dismiss Say’s law by deliberately defining it ambiguously and getting his version to stick. But that leaves us with what we know to be an unnatural condition of negative interest rates and negative bond yields. We are so far down this road that there can be no turning back, because to do so would unleash pent-up destructive forces.
How to manage deeply negative rates
The obvious problem with deeply negative rates is that they encourage the hoarding of paper cash. The more recent of the Argarwal & Kimball working papers offers two basic approaches, both of which involve making it costly to hold paper cash.
They call their preferred method the clean approach, whereby a central bank introduces a discount rate on cash withdrawals by commercial banks, applied on its return. To implement it, the central bank would have to define electronic money as the unit of account, not physical cash, which is the common default. If the clean approach raises legal difficulties, they recommend a second method, which they call the rental fee approach. In this method, a negative rate of return on paper currency would be expressed by a percentage fee on bank withdrawals from the cash window at the central bank.
Either method would have the effect of closing the arbitrage window between hoarding paper cash and negative rates on the public’s deposits at the banks. In theory, this would allow a central bank to impose negative rates as deep as they wish, removing any lower bound and gaining the flexibility to set negative nominal rates at the level their economic models suggest would be needed to stabilise an economy sliding into recession.
Deeply negative interest rates would be very unpopular with depositors at the banks, and the working papers suggest that central banks can protect their public image as guardians of the state’s money by handing over the entire problem of implementation to the commercial banks. They would have the discretion to not charge negative rates on small deposits, assuming they value their retail banking franchises. Commercial retailers, according to the authors, are already used to absorbing credit card fees and adding sales taxes, so should be able to absorb the added cost of accepting cash payments.
Overall, one cannot help but be struck by the casual attitude of the authors with respect to the monetary property of bank customers, while proposing solutions to the problems arising from negative interest rates that protect the public standing of central banks. There is no attempt to consider the wealth destruction faced by members of the public and their businesses from such damaging interest rate policies. Those harmed most are the elderly, the poor and unbanked. These are the people any civilised government should be helping.
The underlying reason to be concerned over the future course of monetary policy is there is no evidence that manipulation of interest rates by central banks actually works, let alone the more extreme policy of negative nominal interest rates. Realistically, interest rates can only be determined by economic actors on the basis of their subjective assessment of the value of time preference and the standing of their counterparty. This was not obvious to post-Keynesian economists who have accepted Keynes’s denial of Say’s law as well as the belief behind Gessel’s supposition that interest rates can be done away with. Our contemporary monetary and financial system assumes that interest is simply the cost of money and therefore a hinderance to economic progress.
Borrowers for the most part see interest as a cost, because they have to incorporate it in their calculations. People living on their savings, such as the elderly, are disinterested in time preference while focused solely on making ends meet. But it is the duty of economists to look deeper into the question, which they fail to do. The two working papers co-authored by the IMF’s experts are flawed in this respect, commencing with group-think assumptions. They contain no economic analysis and no attempt to discern the catallactic consequences.
Where nominally positive interest rates still exist, in many cases they are already negative when adjusted for the loss of purchasing power of the underlying currencies. But when one incorporates independent estimates of price inflation (where they exist) they are demonstrated to be even more negative in real terms.
Viewed at from this perspective, the proposal for deeply negative nominal rates is truly shocking. The sum of wealth transfer through price inflation and, say, a negative interest rate of five per cent can only be viewed as economically destructive. Assuming Shadowstats and the Chapwood index provide a reasonable approximation of the annual loss of purchasing power for the dollar, the imposition of negative interest rates of this quantum means the general public and their productive businesses could lose up to fifteen percent of their wealth and earnings annually. Nowhere, it seems, is this acknowledged, and one would have thought the sheer scale of economic destruction is worth noting. Instead, central bankers and economists turn a blind eye to the destructive nature of their monetary policies. Consequently, the whole financial system is built on a lie.
The question then arises as to how long deeply negative rates can be imposed on society. A moderate monetary intervention generally goes unquestioned, given a public belief that all actions emanating from the state and its institutions are in the national interest. This is why Argarwal & Kimball acknowledge that steps must be taken to deflect criticism from central banks to commercial banks when interest rates go deeply negative.
Being protective of their customer relationships, the authors assume that commercial banks will only pass negative deposit rates through to their larger depositors. Banks are already under stress from margin compression, which can only get considerably worse under these proposals. If a bank is to survive, it will need to pass on the full force of negative interest rates to its larger depositors. What the authors fail to take into account is that large depositors are not going to just sit there and take a three, four or five per cent annual deduction on their accounts. They do not understand that they will put the whole commodity complex into backwardation, all but guaranteeing an attempted flight out of bank deposits.
Large depositors tend to act the same way at the same time. By having other avenues cut off, such as the ability to demand physical cash without penalty, a depositor is forced to sell his currency entitlement for assets or goods to other similarly reluctant depositors. Very quickly, a scramble to get out of bank deposits ensues and a currency’s purchasing power collapses. For a central bank there will be a temptation to balance the level of negative rates with this tendency to exchange deposits for assets in order to keep asset prices gently rising.
The dangerous game of keeping the asset bubble inflated
If they are appraised of the dangers of deeply negative rates, central bankers might take a more cautious approach, seeking to lower them to moderately negative levels, just enough to support bond and stock prices. Residential property prices could also be stabilised by this means. There is no doubt that asset inflation, so long as it doesn’t unduly fuel consumer price inflation, is seen by central bankers to be a desirable objective. But it amounts to a tricky balancing act, a passage between the Scylla of economic depression and the Charybdis of monetary inflation.
We have seen the ineffectiveness of interest rate suppression in a normal credit cycle, and we now face a violent one, the consequence of American trade protectionism coinciding with the end of an unprecedented expansionary phase of the current credit cycle. Negative nominal rates of two or three per cent will fail to achieve a positive economic result, except perhaps for stoking asset inflation. As long as consumer price inflation appears to be under control (quite likely in an economic downturn) pressure will be maintained for still deeper negative rates to keep inflating the asset bubble.
Nothing could be more calculated to drive money out of the banking system than deepening negative nominal interest rates. If central banks persist with deeper negative interest rates, the flight of deposits into anything else undermines the purchasing power of the currencies involved. Asset inflation then rises out of control, and despite the depressed state of the economy, consumer prices will rise as well. All the evidence will then point to one thing: it is not prices that are rising, but the purchasing power of currencies are spiralling downwards.
The only way a currency might be subsequently stabilised is by following deeply negative nominal rates with rapid and substantial interest rate hikes. But that will simply lead to an alternative debt crisis, and as a deliberate policy can be ruled out. Markets will set higher interest rates instead.
When will deeply negative rates be introduced?
Despite the contentions in the IMF’s working papers, we can be reasonably sure that central bankers will be initially reluctant to introduce deeply negative rates. In the past they have understandably shown caution when venturing into the policy unknown, and they will wish to see only moderate asset inflation.
Instead, as the global economy shows more signs of a deepening recession, we can expect central banks to expand the quantities of their base money as a first resort. The priority is likely to centre on funding government budget deficits and getting cash into the banks’ balance sheets, both of which quantitative easing achieves. Where interest rates are already negative, pushing them much further into negative territory is likely to be viewed as a second choice. Therefore, in the absence of a credit crisis threatening the banking system it seems unlikely that nominal rates of much more than minus two or three per cent will be deployed, unless the global economy really slumps.
All this changes in the event of a credit and systemic crisis. So long as there is fractional reserve banking, regular credit crises are endemic to the system. No matter how well capitalised a bank appears to be, at the onset of a credit crisis it risks being rapidly overwhelmed by bad debts and falling collateral prices. In this event, for a central bank the immediate priority is to stabilise both the domestic and global banking system and to underwrite asset prices. This was successfully achieved following the Lehman crisis, and crucially, the unprecedented increase in the quantity of money and credit did not appear to lead to significant price inflation.
It is that experience, which silenced monetarists and other critics, that informs today’s policy-makers. We can expect central bankers to think they can expand their monetary bases significantly without ill effects. In a crisis, this permits them to cut interest rates deeper into negative territory. The deepest cuts are likely to be in the Eurozone, where they are already negative and banks are most undercapitalised, some of which are already facing solvency issues. Furthermore, Christine Lagarde’s officials at the IMF have already paved the way for her to implement deep negative rate policies in her new role by issuing the two papers referenced in this article.
Following a credit crisis, government finances always come under strain. Lagarde will have a primary objective to finance them through quantitative easing, likely to be far greater than seen heretofore. By taking an aggressive approach to negative interest rates, government funding will be better facilitated, at least in the short-term. At the same time, negative interest rates in the order of three or four per cent will raise the value of existing government bonds, giving the appearance of solvency to the banks. But negative interest rates on the required scale will cause depositors to seek alternatives for the reasons described above. In short, they are likely to lead to a crack-up boom, where with a gathering herd instinct, first large and then smaller depositors seek to buy anything just to get rid of deposit money.
Already, we have some advance warning of these potential developments in the rapidly rising prices of gold and bitcoin. Given the trap that Messrs Argarwal & Kimball appear to have unwittingly set for central banks and especially the ECB, it is unlikely the destruction of the value of deposit money will be a drawn-out process. A crack-up boom is not a boom at all, but a currency collapse. And given it will emerge from a systemic crisis, likely to commence in the Eurozone but certain to rapidly become global, deeply negative nominal interest rates will ensure a currency collapse happens very quickly once it starts.
Given the rapidity with which the global economy is now declining, we will be lucky if a credit crisis leading to deeply negative nominal rates doesn’t happen later this year. The pace at which depositors in the banks then become aware of what is happening to their fiat currency will determine the speed and extent of the currency collapse.
[i] Enabling Deep Negative Rates to Fight Recessions: A Guide, by Ruchir Argarwal and Miles S Kimball, April 2019. https://www.imf.org/en/Publications/WP/Issues/2019/04/29/Enabling-Deep-Negative-Rates-A-Guide-46598
[iii] The Natural Economic Order, Silvio Gessel, 1916.
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