Central Banks are under the mistaken belief that negative interest rates will be the magic kiss which turns their toad economies into prince charmings. Why exactly do they think this? What makes Draghi, Kuroda, and others think imposing negative interest rates will stimulate credit and lending in their respective economies?
It is important to understand the logic behind this historic moment in global monetary history. Negative interest rates are unprecedented and shows how far we have gone off course in the policy related to money and credit markets. They are already having a tremendous effect in several European countries and Japan. They hold significant future implications for gold as well.
Why Negative Interest Rates?
The reasons are quite simple. Having tried the carrot without much success, central banks are moving towards using the stick to get the behavior they want.
The carrot was zero interest rates. But that hasn’t worked out so well. Offering super low rates in order to entice lending hasn’t developed into the robust credit market they were hoping for. Now they are looking to use the stick of imposing negative interest rates. This effectively imposes a penalty on banks if they do not engage in the lending that the central bank desires.
Just like with ZIRP, central bankers are going to find out the hard way that negative interest rates are not the magic salve that will resuscitate an otherwise vegetated credit market. Lack of available credit is not the problem. We are swimming in an ocean of available credit. Rather, the issue is with adequate demand. From the bank’s perspective, there simply aren’t enough creditworthy borrowers. Solvency must precede lending. In our debt saturated economy, solvency is increasingly rare.
There is good reason for the commonly heard refrain, “Banks only loan you money when you don’t need it.”
What then will the banks do?
First, the banks could just absorb the loss on their capital and choose not to lend at all. This is what most banks in Europe are doing and will likely continue to do up to a point. Many banks opt to simply take the loss and buy the government bond, because there aren’t enough qualified borrowers in the private market. With falling operating margins, contrary to Draghi’s wishes, banks may be even less willing to lend.
Second, the banks could pass the losses to depositors. As a depositor, instead of receiving minuscule interest on your deposits, you will now have to pay to keep your funds in the bank. This action would cause a price differential between electronic dollars and paper dollars. Electronic dollars would be discounted and cash would have a premium. This would most likely lead to massive withdrawals of cash thus setting a floor under the negative rate and dramatically reducing a large source of funding for the banks. Not an ideal scenario to say the least.
Thirdly, the banks will start lending when they shouldn’t. This is the bank acting under a perverse incentive. It is perhaps the most damning of all the consequences resulting from negative interest rates. Negative rates will impose constant losses on their capital for as long as it’s held at the Central Bank, i.e. they are paying to hold reserves at the Central Bank. This is a new cost incurred to the bank that it did not have before. The deeper into negative territory the rate goes, the greater the cost. The longer capital is held there, the greater the cost.
So banks may end up doing what the central bank wants them to do. They start to engage in credit operations with businesses and families in the economy. Yet, if there are no good deals to be had then the penalty imposed by the Central Bank forces the banks to entertain more speculative and more risky loans. Since it becomes increasingly costly to play it safe with the Central bank, many banks will opt to play it risky. This quote from a Bloomberg piece captures it perfectly;
“It’s part of the ECB’s very clear message, …Take risks — whether that’s credit quality or maturity — and help us finance businesses for the longer term.” [italics and emphasis mine]
However, the potential losses of a risky bet gone badly could be much larger and with greater collateral damage. This is bubble blowing territory where everything looks good until, well, until it doesn’t.
In fact, if rates fall greater into negative territory a bank may even have to choose between which two losing alternatives will lose the least! If this is not a clear symptom of our corrupt and distorted money and credit system today, then what is? Why are banks operating under policy which forces them to decide between losing alternatives? This is not a policy designed for the creation of wealth and the accumulation of capital. It is the polar opposite. It is a system which encourages the destruction and consumption of capital on a large scale.
Sadly, this disease is well on its way to devouring Europe. But one stops and wonders. Surely, this isn’t how the great cities and economies of Europe were built. This is not how the modern food and industrial supply chain were created. It is one thing for a company to have to choose between a better and worse alternative. Such a decision companies must make all the time. But when all individuals and businesses, banks included, are continually operating in a system with significant distortions in important price signals and incentives which encourage increasingly risky behavior at lower and lower promised returns (or read higher costs) then something is very seriously wrong. Such a system represents the polar opposite of how the great human civilizations of history were built, developed and flourished. This is not how wealth and prosperity are created. This is how they are destroyed.
Conclusions: Welcome to the Money Matrix
Make no mistake, negative interest rates are not a good thing and they are not representative of a free market in money or credit. They are a perverse contradiction to what true credit relationships should look like. The risk of parting with one’s capital for a duration of time should be appropriately compensated via the rate of interest. Having to pay a counterparty to loan out your capital with no compensation is an upside-down deal that no one would participate in if there weren’t better choices available. And therein lies the problem, for banks today and for depositors too, there simply aren’t that many good choices available thanks to our central planners.
This gets to the heart of what causes negative interest rates to begin with. Negative interest rates are a long term effect of a closed loop credit system which forces more capital to flow towards government favored entities than it otherwise would in a free and open system. Either its government debt outright which is bought up in greater and greater quantities forcing yields to go lower and lower. Or its a category of assets that the government directs market players to purchase. Read the above quote one more time. Notice anything? The central bank wants your help to finance businesses for the longer term. Wait a second here, why? Why are we favoring businesses that need a longer timeframe to operate profitably in the market? What if we need businesses which come to market with goods and services on a shorter time frame? And shouldn’t it be us, you and me, the actual players in this game of economy who put up their own capital, time, energy, resources, efforts and labor that provide the appropriate incentives for each other for where capital should flow and where it is most needed? How does the central bank even know where capital should go, how much, and when? Meanwhile, total outstanding debt is increasing and productive enterprises get squeezed. This is not a pretty picture.
Unfortunately, it’s only going in one direction. The disappearance of available yield in the marketplace and the appearance of negative yields are here to stay. What’s important to understand is that unlike Neo in the Matrix, they are not systemic anomalies. Rather, to borrow a phrase from the Architect of the same film, they are features “inherent to the programming of the matrix.” Despite Yellen, Draghi’s or Kuroda’s attempts, they will persist until the very foundations of that matrix are adequately addressed.
Only a free market for money and credit will cause the floodgates to open. Only then, will money and credit flow freely and abundantly to where they are most needed and most beneficially allocated. Only then will the processes that lead to capital creation and wealth production begin again in earnest. Until then, well, in the words of Morpheus, “The Matrix is a system, Neo. That system is our enemy.”
A version of this article was originally published at SchiffGold.com