Debt can only be reduced by strong growth, inflation, currency devaluation (where the borrowing is from foreigners) or default. All the strategies other than growth involve some level of transfer of value from savers either by reduction in the nominal value returned or decreased purchasing power.
Growth and inflation are low. Devaluation is difficult if every nation pursues a similar set of policies attempting to reduce the value of their currency. Debt default on the scale required would destroy a large portion of the world’s savings as well as affect the solvency of the financial system, triggering a collapse of economic activity. As a result, policy makers refuse to allow write-downs of trillions of dollars worth of debt that cannot be paid back.
In the absence of any politically acceptable and economically manageable solution, policymakers now must rely on extend and pretend strategies combined with financial repression. Low rates and QE allow borrowings to be maintained to avoid a solvency crisis..
Central banks are covertly using negative rates to reduce excessive debt levels by transferring wealth from savers to borrower through the slow confiscation of capital. In the US, zero interest rates have reduced the interest cost of the US$15 trillion US banking system. The reduction in annual interest income for savers is around $450 billion, from roughly $500 billion to only $50 billion annually. Negative interest rates reduce the principal of the debt directly.
These actions retard growth, promote deflation and create fertile condition for financial crises. Such policies are also difficult to reverse as high debt levels and the asset values that support them are only sustainable with very low interest rate.
Investing and Nothingness
The greatest puzzle relates to why investor’s would accept negative interest rates. There are several possible explanations.
First, the need for security and safety may dictate investment in government bonds or insured bank deposits backed by the full faith and credit of the sovereign that has the ability to issue currency to make repayments.
Second, returns are relative. In Europe, purchasing bonds yielding more that the official rate at the central bank, even if it is negative, is the least worse alternative.
Third, investors may be attracted by the opportunity for capital gains from price appreciation if they expect yields to become more negative.
Fourth, foreign investors may be attracted by possible currency appreciation. In recent years, investors have purchased Swiss and Danish government bonds speculating on the appreciation of the Swiss France of Danish Krone.
Fourth, investors may be driven by real rather than nominal returns. Bonds with nominal low or negative returns may preserve or increase purchasing power where expected deflation is greater than the negative yield, providing positive real yields. In Japan, deflationary pressure supports investment in zero or low yielding cash and government bonds.
Fifth, investment mandates force fund managers to purchase negative yielding bonds, irrespective of the fact that its locks in a loss.
Where investment powers are limited to cash or bonds in a currency with negative rates, the investment manager must allocate funds to such securities. Passive bond funds are designed to track a specific index. The funds must purchase the bonds included in the index. These funds indexed to government bonds, estimated at around US$900 billion, are required to buy negative yielding securities. Pension funds and insurance companies have investment guidelines which require allocation of a portion of funds to cash or governments, also forces purchases of negative yielding securities.
Sixth, banks and insurance companies are forced to purchase negative yielding securities. Liquidity regulations require these entities to hold high quality securities.
Banks have cash flow timing mismatches or gaps between deposits and loans which must be invested, usually in short dated government bonds.
Seventh, central banks with restricted investment choices are also buyers of negative yielding securities. For example, the ECB’s QE allows it to purchases bonds with negative yields provided it can fund the bond purchases at a lower official deposit giving it a positive carry trade.
However, large and persistent negative interest rates would meet significant resistance, triggering a wide variety of behaviours designed to avoid losses.
Motivated by the desire to avoid an effective tax on savings in the form of negative interest rates, investors can resort to strategies to preserve wealth.
First, investors can physically withdraw cash and hold it. In the 1990s, in Japan low interest rates and concern about bank failures drove significant withdrawals of cash driving rapid growth in home safes.
Amusingly, the Association of Bavarian Savings Banks, encouraged the savings banks it represents to hoard cash in its vaults to avoid negative rates on its deposits with the ECB (known as Strafzinsen or punishment interest). With clinical Teutonic logic, the Association made its case. Insurance cost of 0.1785% would be below the ECB rate of negative 0.30% at the time. The analysis showed that member banks (with €245 billion deposited at the ECB) would reduce its loss from €735 million per year (0.30% of €245 billion) to only €437 million per year.
But while theoretically feasible, it is unlikely to be a realistic option for businesses, governments and wealthy individuals. The modest size of the largest denominations of notes (US$100 or Euro 500) is one constraint. Security, transport and insurance are additional constraints.
Second, investors may avoid negative rates by resorting to a variety of near cash instruments. One option would be bank cheques which are transferable.
Investors would withdraw savings or creditors obtain payment by banks cheques which would not be banked until needed or could be negotiated to pay for goods and services.
Third, investors could hold savings in foreign currencies only converting into a negative yielding currency when needed. This strategy avoids negative yields but entails foreign exchange risk, unless this can be effectively hedged.
Fourth, real assets such as land, property, commodities especially precious metals and collectibles would be favoured as a store of value. Businesses may over-invest in inventories of production inputs which can later be used.
Fifth, alternative payment behaviours offer a means of avoiding negative yields. There would be an inherent incentive to make payments quickly and defer receipt of funds due. This could be extended to prepayments, where parties could pay for future obligations in advance.
Prepayment of taxes, suppliers or employees would be encouraged. Recently, one Swiss canton was forced to stop discounts for early tax payment and is actively discouraging overpayment of taxes. In a reversal of traditional practice, it wants to receive money due as late as possible.
Reversing normal practice, holders of credit cards could prepay running down the credit balance as required over time. Pre-paid instruments such as gift vouchers, transport passes or mobile phone cards can act as stores of value and negotiable instruments. These strategies avoid the effect of negative yields but entail increased credit or performance risk.
These innovations are socially and economically destructive.
Funds become tied up in unproductive assets. Savings do not circulate to provide essential financing of social and industrial investment, perversely reducing growth. Capital allocation is distorted by the sole desire to avoid negative rates.
New behaviours create new systemic risks. Payment systems and products, designed for positive interest rates, will alter the flow of funds and exposures within the economy when used in an unintended manner.
The shift out of banking deposits affects the funding of banks. Ironically, this is inconsistent with bank regulations which favour retail deposit financing of financial institutions. The reduction and instability of funding as liabilities shift to certified cheques or prepayments may reduce the ability of the financial system to extend credit, further hampering economic activity.
In effect, the disruption from negative interest rates may damage the arrangements it is designed to preserve.
Positive Action/ Negative Reaction
Effective negative rates would require abolition of cash itself.
To date, the case for banning cash itself has been couched in terms of deterring criminality or terrorism, eliminating tax avoidance, enhancing efficiency by faster funds flows, reducing costs or even improving hygiene by preventing contact with bacteria and virus harbouring notes. In September 2018, Andrew Haldane, Chief Economist at the Bank of England, explicitly set out the real reason.
He argued that presence of cash constrained central banks from setting negative rates to stimulate a depressed economy. In a future economic or financial crisis, current low rates would restrict the effectiveness of monetary policy. Enhancing the ability to use negative rates would provide central banks with additional flexibility and tools to deal with a slowdown. It would be an imaginative, rapid and durable mechanism for levying negative rates to confiscate savings.
Abolishing cash requires radical change. Despite increasing reliance on electronic payment, cash is still extensively used. In the US, cash is used for around 40-45% of consumer transactions by volume, around 20-25% by value. For small value transaction and in emerging markets generally, currency is used more extensively. In effect, currency remains an important medium of exchange and means of payment for legitimate, legal transactions.
Cash use globally remains high among the poor and older people. Elimination of currency has implications for social and financial exclusion. The individual cost of converting these users to digital payments is non-trivial.
Central banks would lose financially. There would be a fall in seigniorage revenue, the difference between the minimal cost of creating currency and the investment return on government bonds. The amounts lost are significant. It would reduce the loss-absorption capacity of central banks and reduce a source of revenue affecting public finances.
An exclusively digital or electronic payment system increases security and operational risks significantly. Risk of counterfeiting, cyber hacking as well as disruptions to operations due to technology failures are considerable.
In his speech advocating abolition of cash, Dr. Haldane accepted that public support for banishing cash was uncertain. Any such action is social and political. Citizens are likely to resist the loss on anonymity and privacy. Where the elimination of cash is linked to negative rates, it would be seen as a tax on savers and state confiscation of savings. The intrusion of the state and authorities on this scale would become an explosive political issue.
Negative All Around
Negative rates point to the fact that global economic system cannot generate sufficient income to service, let alone repay, current debt levels. It is an attempt to maintain artificial current asset values and the debt that it supports. Artificially depressed rates only allow this excessive debt to be managed. It does not improve the real economy or enhance its productive capacity. In fact, the toxic side effects of the policies are damaging to economic activity. Such financial manipulation will ultimately reach its limit, with catastrophic consequence.
© 2017 Satyajit Das All Rights Reserved
Satyajit Das is a former banker. His latest book is ‘A Banquet of Consequences’ (published in North America as The Age of Stagnation to avoid confusion as a cookbook). He is also the author of Extreme Money and Traders, Guns & Money.