The Dark Side of Negative Interest Rates

The Dark Side of Negative Interest Rates.

Ten Reasons Negative Interest Rates are Even Worse than Artificially Low Interest Rates.

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Fed Chair Janet Yellen Is A Supporter of Negative Interest Rates.

When Janet Yellen was first appointed to the Chair of the Federal Reserve we noted that Janet Yellen was a supporter of negative interest rates. In “Janet Yellen and Negative Interest Rates” we re-published her 2010 comment in support of negative interest rates:

“If it were positive to take interest rates into negative territory I would be voting for that”

In “It’s Yellen!” we predicted:

When Ms. Yellen becomes the Fed Chair a more than decade long progression of dysfunctional monetary policy will be complete.

We will have gone from the low interest rate policies of Alan Greenspan, to the no interest rate policies of Ben Bernanke to the negative interest rates of Janet Yellen.

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Since Ms. Yellen’s appointment she has presided over a Federal Reserve that tapered and ended the third quantitative easing (QE) program started by her predecessor, Ben Bernanke. Since the official end of QE3, Ms Yellen and her Fed cohorts have been threatening to raise/normalize interest rates. To date they have not done so.

Recently, however, some Fed officials have begun talking about negative interest rates.

While the Federal Reserve has been talking about raising rates (but not doing it), negative interest rates have been injected into the Federal Open Market Committee meeting discussions and speeches by Fed officials.

Why Negative Interest Rates?

Central planners love “tools” that allow them to officiously intervene in markets to obtain what they deem to be desirable results. If low interest rates are desirable, what can be better than no interest rates or negative interest rates?

Low, zero and negative interest rates faciliate spending of money by making it cheaper to obtain and costlier to hold. Indeed, Ms. Yellen recently admitted that cash was an inconvenient store of value. Cheap money encourages spending that thereby increases demand for finished goods and services. Increased demand is what Keynesian central planners believe drives an economy. Therefore central planners favor anything they can do to intervene and give incentives to spend or mandate spending.

Artificially low and negative interest rates, however, are like genetically modified ingredients; they seem to work at first but cause problems later on.

Take my money, please!

In the “Dark Side of Artifically Low Interest Rates” we noted that central banks setting rates at artificially low levels do not reflect a market price for money. Negative interest rates set by central banks are not only artificial, but surreal. Bank depositors pay for the bank to hold their deposits and borrowers get paid by the bank to take out loans!

For borrowers sounds great, right? Maybe not. Here is the dark side of negative interest rates:

The Dark Side of Negative Interest Rates

1. Are Theft

Negative interest rates are a form of theft. The longer a depositor holds money in a bank the less money there will be available for withdrawals.

Bank Deposits are Not Bailments

Charging to hold items of value, like gold, silver, jewelry or even cash in a bailment arrangement is not theft. A bank depositor arrangement, however, is not a bailment. Banks do not store depositors’ money.

Negative Rate of Interest Loans Are Not Theft

A bank deposit is nothing more than unsecured loan by the depositor to the bank. It would be quite an odd arrangement for someone to loan another party money and only ask for a portion of it back. Perhaps in a time of severe and persistent deflation such a loan might be made. Receiving less than your principal back on such a loan would not be considered theft either.

What makes negative interest rates theft is that banks to whom depositors lend money do not store the depositors’ physical cash or guard and insure it against theft. Instead, banks create legally sanctioned reserves from depositors loans in multiples of those loans that they then use to conduct their businesses. Click here for an explanation of how fractional reserve banking works.

Since banks are chartered and sanctioned by governments, this fractional reserve banking and central bank mandated negative interest rate scheme becomes a license to steal depositors’ money each month. Of course, one is free (still) not to loan money to banks and avoid the monthly sanctioned theft, but given a bank account is required to pay taxes and most bills, it is not a practical option. Thus, in order to function in the economic system one must keep some money in a bank account and allow the bank to raid it each month.

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2. Punish Individual Savers

Negative interest rates punish savers young and old.

Young Savers

Younger people looking to save their money in order to buy larger items like cars and homes will find it harder to do so with negative interest rates. This is viewed as a feature not a flaw of central planners. If young couples are saving money for a down payment to buy a house, that money is not being spent the entire time it is saved. If the money is not being spent, it can’t create inflation and jobs.

Further, central planners don’t view lack of savings as an impediment to buying a house. Rather they argue that negative interest rates make it attractive just to finance the entire home purchase with no down payment at all.

Savings are a 20th Century concept. Negative is the new positive! Embrace it.

Old Savers

The impact of negative interest rates means that retired people can no longer rely on fixed income to fund their expenses because under a negative interest rate regime there are no interest payments.

Artificially low interest rates have already decimated many retirees’ savings as they have had to pull principal out because the interest payments were not large enough to fund their expenses. Under negative interest rates, the bank will perform the task of depleting and accelerating the decline of retiree’s principal by taking their cut each month.

Unable to fund their own retirements, many retirees will remain in the labor force or re enter it, competing with younger workers for jobs, or risk their savings in the stock market or vote for increased retirement benefits from their governments.

Central planners are undeterrred by the predicament of the impact of negative interest rates on retirees – old people own stocks and homes too and they go up under our zero and negative interest rate policies, so they also benefit from our interest rate policies. Suck it up!

3. Rewards Debtors

Negative interest rates reward borrowers of all sizes. The more one borrows the more one gains.

Small Debtors

Debtors win with negative interest rates because their loans no longer have burdensome interest payments. For borrowers with the right credit profile, getting paid to borrow money to buy things is a boon, especially if the things you buy go up in value. Even if they don’t, it’s still nice to be paid a little something to buy things you want.

Large Debtors

Under negative interest rates, the more you borrow, the more you “save”. Negative interest rates encourage more borrowing, which increases demand, so large borrowers are expected to do their part and borrow more. The largest borrowers are sovereigns. Many central planners view sovereign entities (often their employers) as the drivers of the economy and job growth.

If governments can borrow more money and get paid to hold it, they can engage in more governent spending to build infrastructure, fight climate change, provide greater healthcare benefits and provide free college for all.

Lowering the cost of borrowing to less than zero removes any restraints that profligate governments might have on increasing their debt load.

After all if debt PAYs, why not do more of it?

Unrestrained by any worry of ever having to pay interest, just think of what governments can achieve!

4. Encourage Non Productive Savings.

Artifically low rates discourage savings in banks because they pay little interest. Under negative interest rates, however, depositors have to pay the bank. In such circumstances savvy depositors may decide to hoard cash in the banks’ safe deposit boxes and pay the annual fees (some banks have already banned holding cash in safe deposit boxes to prohibit this option) or hoard cash at home.

Saving cash at home doesn’t pay interest, but it allows the saver to retain his principal. Saving cash at home makes it subject to theft by a different set of crimminals, but also means that money is removed from the system. Money saved at home is not spent or available to the banks to lend to buy cars, to loan for mortages, or to lend for investment purposes. (under negative interest rates, banks also have little incentive to lend money if they have to pay their borrowers to take loans.)

Thus, the central planners’s goal of encouraging more spending via the implementation of negative interest rate would be thwarted if people started saving at home.

5. Push Up Housing Costs

If interest rates are negative, borrowing to purchase assets is encouraged. Increased demand for assets that rely on financing like real estate will drive up the prices of homes, making homes less affordable.

Those with the best credit scores, the richer portion of society, will benefit most from negative interest rates and buy the most homes. Those with fewer assets and lower credit scores will have limited or no access to negative interest rates, leading to fewer homes being sold to lower and middle income people and a further deterioration of the home ownership rate in the United States.

6. Create Asset Bubbles

Anyone with extra money, incuding those that already have stuffed their mattresses beyond capacity with cash, will eventually realize the need to spend it or invest in other assets.

Since the rich can only buy a limited amount of consumer goods, they will buy real estate, art, yachts, fine wine, collectibles, private jets and stocks and drive the prices of those assets higher and thereby increase their net worths.

7. Create Further Wealth Inequality

Rising real estate, stock and other assets prices creates wealth inequality as the richer segment of the population own most of these assets. Negative interest rates are only a benefit to those that can take advantage of them. The main beneficiaries of negative interest rates will be those who have access to credit-those who already have substantial assets and income.

Negative interest rates exacerbate the wealth inequality situation because if one loses money by saving and therefore only spends, one can’t save to accumulate capital to start a business or to invest in order to buy appreciating assets like stocks and real estate and in doing so get rich. Meanwhile, the already wealthy will benefit from negative interest rates as they can increase their borrowing in order to buy more assets.

As home prices rise, wealth disparity is created between homeowners and non homeowners. Homeowners get richer merely by occupying homes while renters don’t obtain the same passive benefits. Homeowners also gain access to cheap credit not available to renters in the form of negative interest home equity loans and benefit from the mortgage interest deduction. Those not owing stocks or real estate will miss out on the appreciation of stocks and lacking good credit will not participate in the housing market.

As stock and other asset prices rise and are held in increasingly fewer hands further wealth disparity will be created. Thus, a major issue that central planners have been trying to solve with increasing urgency since the publication of Thomas Pickety’s “The Economics of Inequality” will have been exaserbated by their negative interest rate policy.

8. Are Inflationary

The Fed and other central planners are enamored with price inflation. Like the person who sees a fast car speeding by and billowing smoke and determines the smoke is making the car go faster rather than the engine, central planners believe that rising price inflation itself drives growth. They believe rising prices are a factor in growth rather than an often unnecessary by product.

The goal of negative interest rates is to increase credit to encourage more spending. Rather, as we have seen with zero interest rates, the increase in spending is in the form of the wealthy buying stocks and real estate creating price inflation in those assets. In addition, because credit is cheap and readily available the prices of cars have risen to an all time high.

Rising prices merely make the things that consume the bulk of low and middle income budgets – transportation (car prices) and cost of shelter (house and rent prices) more expensive. Thus, inflation created by artificially low and negative interest rates benefits the rich who hold stocks and real estate and punishes the poor, who can not afford higher home prices and pay more for rent.

9. Discourage Investment in Capital Equipment, Labor and Research and Development

Corporations reacted to artificially low rates by buying back their own shares (either with existing cash or with dollars borrowed at the artificially low rates) to reduce the inventory of shares available on the market and thereby increase their earnings per share. As earnings per share increased their companies’ stock prices often rose (or declined less steeply than they would have without the share buybacks).

Capital Equipment

The management of corporations buying back their own shares realized that doing so instead of investing in new capital equipment that might improve their companies’ long term profits, provided a far better return on investment in the short term in the form of higher stock prices that rewarded shareholders and management that own the company shares.

Thus, artificially low rates encouraged companies to use their cash (or to borrow at the artificially low interest rates) to buy back their own shares to drive up their share prices, rather than to invest in their businesses. This explains partially why the economy showed limited growth but the stock market rose to record highs.

Jobs

To further reduce expenses and increase profits and their share prices, companies often also lay off workers and apply a portion of the savings to share buybacks.

Innovation

Companies can also lower their costly research and development budgets to boost profits and direct the savings towards increased share buybacks

Perhaps with higher market interest rates, companies would invest in capital equipment and labor to gain a competitive advantage over their competitors. If companies, however, make the determination that they get a better and more immediate return on investment in the form of higher share prices from buying back their own shares than hiring new employees or making investments in their business, workers are not hired and additional productive capacity is not built.

Negative interest rates will ensure the trend of preferring share buybacks to capital investment continues. Longer term, companies that don’t invest in capital equipment labor and research and development will be at a competitive disadvantage.

10. Encourage Malinvestment by Sending False Signals

When investments are made during a period of artificially low interest rates they are often malinvestments as the low rates may send false signals to entrepreneurs and home buyers that the economy is good and investments/purchases should be made.

In a non centrally planned economy savings and investment provide the capital needed to create productive capacity that is self-sustaining. Negative interest rates would further discourage savings as the return on savings is nil. Therefore, when rates are artificially low or negative, capital gets diverted from productive investments where there might be a long term return on investment, and flows instead towards either speculative ventures or assets (like real estate) with the potential of large returns, or towards the purchase of consumer goods.

The Fed and other central banks, however, have driven interest rates down precisely because the economy is not doing well and to encourage, rather, trick entrepreneurs and consumers to employ capital in places they otherwise might not spend or invest. Negative interest rates, the thinking goes, would further encourage or trick entrepreneurs and consumers to continue their malinvestment binges.

Austrian economists argue that artificially low interest rates fool entrepreneurs into making investments they otherwise would not make. We think, rather, many entrepreneurs understand the artificial nature of the low interest rates but nonetheless take advantage of them, hoping interest rates stay low long enough for their projects and profits to be realized.

Consumers and home buyers, on the other hand, we believe are fooled by artificially low interest rates as to the underlying health of the economy.

With the onset of negative interest rates, sagacious entrepreneuers (or more aptly, astute Fed watchers) will have projected correctly in anticipating that interest rates would stay long enough for their projects to be completed. Consumers and homeowners not paying much attention to interest rates or the economy will assume continued increases in home prices are a sign a strengthening economy.

Initial public offerings of non-profitable companies have soared under artificially low interest rates and would be expected to continue to be peddled by venture capitalists on Wall Street under negative interest rates. This video encapture the new thinking on how to position a start up company.

Lord Maynard Keynes was a proponent of stimulating the economy to bring forward demand when the economy was in recession. In reaction to criticism that stimulus spending would in the end create problems further down the road, Keynes remarked “in the end we are all dead”.

Negative interest rates are designed to create a longer road, a larger bubble and give artificially boosted economies a longer lifespan.

How Does it End?

Intervention begets interventon. Like Michael Jackson’s plastic surgeon, one incision is never enough, he needed to make more and progressively deeper cuts until Mr. Jackson’s visage was no longer attractive or recognizable. There are numerous possible unintended consequences of negative interest rates and possible reactions that central planners may try to make the scheme work that we can save for the comment section below.

All manipulation schemes eventually become overwhelmed by natural market forces. Artificially low and negative interest schemes will be no different. Eventually, the market will demand higher rates for the risk of extending credit to unstable banks and to sovereigns that meet their obligations by printing the difference.

Things may go well for a while as the negative rates spur rising stock and real estate prices. Without high yielding (or ANY yielding) alternative places to put their money and armed with the false understanding that rising stock and real estate prices mean the economy is doing well, people will continue to pour money into the real estate and stock markets chasing them higher until the bubbles bursts.

As rates eventually rise and turn positive, however, gains on unprofitable speculative ventures will evaporate, share prices of speculative companies with no earnings will crash, companies will go out of business and workers will be laid off. On the consumer side, spending will slow, the consumer goods will have been used up, the bills will need to be paid on the goods purchased and there will be little or no savings to pay for them. A slew of bankruptcies will ensue.

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Further Reading:

From the Smaulgld Dark Side Series

The Dark Side of Minimum Wage Laws

The Dark Side of Artificially Low Interest Rates

The Dark Side of Rising Home Prices

The Dark Side of a Cashless Society

Janet Yellen and Negative Interest Rates

European Central Bank’s Negative Interest Rates Help The Fed Exit QE

U.S. Plans To Bail-In the Banks

Negative Interest Rates In Europe Means European Banks Buy U.S. Treasuries

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