The Negative Rate Disaster

I’ll make you a deal: You can give me your money, and then I’ll give you back most of it next month. Or you can give it to me for 10 years, and I will give all of it back to you in a decade as long as you make small, periodic payments to me.

Who in their right mind would take this deal? Apparently there are some people in Europe and Japan who are doing this. This is the world of negative interest rates.

It was just over a month ago that the Bank of Japan (BOJ) announced its new policy of negative interest rates. Specifically, the central bank is imposing a negative rate of 0.1% on excess reserves held by banks. This is supposed to get the banks to lend money in order to jumpstart the economy.

This idea of negative rates goes against everything we have learned about money. An interest rate is supposed to be a reflection on the price of money in relation to time preference.

If you ask someone if he would prefer a dollar today or a dollar a year from now, most people are going to take the dollar today. Even if you may not spend it until a year from now, at least you have the option.

If you were offered one hundred apples to eat, you might prefer to have one a day for the next 100 days instead of getting them all at once, assuming that they would be fresh each day. That is because apples will go rotten. If you get 100 of them in one day, you better quickly sell them or find people to give them away to.

But money is not the same as apples. Money does not go rotten (setting aside what central bank inflation may do). You can save money. You can buy goods and services with it today, or you can wait for another time in the future to buy. This is the luxury of an advanced civilization with the use of money and a high division of labor.

Imagine a world a long time ago where people bartered goods and services. Imagine a baker with many loaves of bread having to find various people to trade with. It would be a nightmare without a common medium of exchange. It is much easier to sell the bread for some form of money that is widely acceptable. Then the baker can buy whatever he wants at the time of his choosing.

Interest Rates are a Price

The interest rate is really the price of money. You can borrow money for a certain length of time and pay a borrowing fee, which is the interest rate. You can also act as the lender, giving up your money in order to collect a fee.

The market interest rate helps coordinate savings and lending. It reflects the demand for money and people’s time preference.

If interest rates go up high, it is a signal of a lack of savings. It encourages people to save more, as they are rewarded with a higher interest rate payment. It also discourages borrowing, as borrowers will have to pay more for the money they borrow.

If interest rates are low, it is a signal that savings are high. It encourages people to borrow money, either for investment or consumption.

The problem arises when central banks push interest rates artificially below the rate that the marketplace would have determined. It sends false signals that there are more savings than what really exists.

Think about the housing bubble about a decade ago. The Fed had pushed interest rates artificially low. Homebuilders were falsely led to believe that people could really afford the higher prices. Banks were fooled, too, as they handed out loans with little money down (also encouraged by the government). And consumers were also falsely led to believe they could afford more than they really could.

At some point, the truth is revealed when it becomes evident that the savings really don’t exist. The low interest rates were not a reflection of high savings but of easy money from the Fed. Many families simply could not afford the high mortgage payments.

In our economy, money makes up at least half of all transactions, with the exception of the little bit of bartering that occurs. When the price of money is distorted, the entire economy gets distorted in various ways. Savings and investment are often discouraged, which are ultimately the basis for increased production. Resources are misallocated, making us poorer as well.

Japan’s 10-Year Yield

Just recently, the yield on 10-year Japanese government bonds went into negative territory. It has only been a small fraction of a percent negative, but it is incredible that anyone would pay the government to hold their money. And they are handing over their money for 10 years in this case.

To be sure, the Bank of Japan is buying some of this debt, which accounts for some of the madness. And it is likely the banks and other big players are buying most of the rest. It is hard to imagine a regular Joe buying a 10-year bond with a few thousand dollars’ worth of yen from his checking account in order to pay a fee.

If banks have to pay to hold excess reserves, and if they have few good lending options, then they will try to pass this cost down to their customers. So if the BOJ imposes a bigger fee, banks will charge their customers more to hold their money.

It is rumored that sales of safes are on the rise in Japan. People would rather store their own money than pay any kind of significant fee to have it held for them. Ironically, having cash withdrawn from the banking system would be deflationary, which is exactly the opposite of what the BOJ is trying to achieve.

There has also been increased talk about a ban on cash. Many governments are discussing (or implementing) getting rid of larger denominations. Some fear they are trying to ban all cash so as to prevent bank withdrawals in order to be successful with negative interest rates. This may or may not be a goal of various governments, but it isn’t likely to happen anytime soon.

In any case, the BOJ’s policy has worked in the sense of driving down rates that it does not directly control. This just tells you the lack of good options in some places. Some of the big players in Japan are willingly paying the government a small fee to hold their money for 10 years because they can’t find anywhere else to put it that is considered safe.

Finding Safety

There is talk in the United States about the Fed following the BOJ. But the Fed’s policy right now is going in the other direction. The Fed is paying the banks 0.5% on their reserves. The Fed would first have to drop this to zero before even considering negative rates. The Fed is paying the American banks not to lend.

U.S. Treasuries are considered just about the safest investment on earth (though I’m not saying that they are). It is highly unlikely that the U.S. government is going to directly default on its debt. It only defaults in the sense of paying back the debt in money that has depreciated in value.

With 2016 bringing a rocky start for the investment markets, longer-term yields have gone down as some investors seek safety. The 10-year yield on U.S. government debt is below 2% now.

If the rough patches in the economy turn into anything worse, then yields will likely go lower still. When you have a recession that is not coupled with high price inflation, you will tend to get lower yields as investors seek safety in long-term bonds.

Gold has also done surprisingly well over the last couple of months, despite increased fears of a global economic downturn. You have to wonder how much the idea of negative interest rates factors into this.

If I were living in Japan, I would rather put a good portion of my wealth into gold rather than give it to the government or a bank so that I can pay them to hold my money.

Gold may be a bright spot right now for no other reason than simply a lack of other good choices for investors who are seeking some safety.

Until next time,

Geoffrey Pike for Wealth Daily