The Potentially Devastating Consequences of Negative Rates

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Unless increased taxes are paid for the cost of present government spending and interest on the accumulating debts - which is now impossible - parts of the burden must be met by other means. It can be done either through borrowing, wiping out debts with devaluation (think inflation), explicitly targeting negative interest rate, a combination of all the aforementioned, or by drastic changes in fiscal and regulatory policies so as to build equity at a faster pace. If the latter is not done, taxing savers through inflation and negative interest are the limited options to erode the value of government debts. But they bring unpredictable consequences.

One reason the ECB opted for the negative interest rate solution rather than the more traditional ones is that the Eurozone now has one currency. With Germany adamantly opposed to inflation, and devaluation among the Eurozone countries not an option, negative interest rates are the way to solve the debt hangover domestically and the devaluation of the Euro by some twenty five percent relative to the dollar over the last year, internationally.

The aforementioned choices that the ECB and the U.S. have been facing in recent years are not markedly different from the ones the U.S. faced after WWII, though they are described with a different political vocabulary. Back then the Federal Reserve executed variations of today's QE techniques to insure negative interest rates; the goal being - as Marriner Eccles, the head of the Federal Reserve put it in 1951 - " maintenance of government credit." Mario Draghi, head of the ECB, has been echoing this view by stating his goal to do "whatever it takes to maintain the Eurozone."

Mr. Eccles was explicit that the goal of Fed policy was fiscal, adding to the above 1951 text the following:

"For the first five years (war years) of the last ten years, the problem was mainly fiscal, rather than monetary. Had we financed the war in greater part from tax receipts both our war and post-war problem would have been substantially reduced. But once the decision was made by the government to finance the war in large part by deficit financing, the Central Bank could not deny ... the Government money with which to wage a war for survival ... With respect to freezing of rates it must be remembered that you cannot engage in large scale deficit financing with a fluctuating interest rate pattern."

In 2014 fiscal policy allowed for total debt payments to be the same as in 2007, $430 billion, though total U.S. federal debt rose from $10 to $18 trillion during those years. Whether or not this qualifies as success when it comes to achieving "financial stability" remains an open question.

Replace the term "wars" with "mistaken policies" and the Eccles quote becomes similar to what we're seeing from the Fed and ECB today. The only difference is that instead of appealing to people's patriotism to buy Victory Bonds, the Fed and the ECB are allowing or "regulating" domestic banks, insurance companies and pension funds to hold "riskless" government bonds in the name of undefined and yet to be proven "financial stability." In fact, Central Banks now stand behind these "systemically important financial institutions" as their "lender of last resort," while Basel and other domestic regulations force banks, insurance companies, pension funds to stand behind governments as their "lender of first resort."

These policies may not amount to bank "nationalization" de jure, but nationalization is getting close to it de facto, since their combined effect is to shore up on government bonds. The term "lender of last resort" appears in quotation marks since the Central Banks did not practice what this term implied in the past; namely, lending to banks at high rates of interest in return for good collateral during liquidity crises. In this crisis, central banks lent at low interest for collateral of unknown quality, an event that could be repeated in future crises. None of these policies have much to do with "markets," and everything to do with unfortunate government and central bank policies. They constitute "nationalization of risks," the risks are of fiscal nature, yet they're carried out with under monetary veils.

The fact that the U.S. stock market has been - at least nominally - at an all-time high is not particularly surprising in such an environment. The problem is that stock-market signals no longer convey the information they did during normal times of positive interest rates. According to Bloomberg, companies have been buying back their shares at $5 billion per day, or roughly 2 percent of the value of shares traded on U.S. exchanges. Since 2009, they have bought back more than $2 trillion of their shares, spending about 95% of their earnings on buybacks and dividends, while issuing bonds at the low interest rates. Central banks' zero interest rate experiment brought about the profitable financial engineering and increased nominal stock prices. The latter do not signal improved real prospects, but only that the buying of one's own shares is a good investment with zero or negative interest rates.

Besides its aforementioned negative impact on risk finance, the Eurozone's negative rate will further drive investment to the U.S. (which still has marginally higher rates than the Eurozone), to Switzerland simply because its financial house is in order, and even to German bonds as an insurance policy if the Eurozone breaks up in total. The capital outflow will bring further Euro devaluation that will impoverish Europeans, all the while inducing its more mobile brains to move to greener pastures. Naturally it will contribute nothing to financial stability.

What could? Only drastic changes in fiscal and regulatory policies to bring about speedier rebuilding of equity, from bottom up. True, the present experiments with negative rates lower the debt hangover, but they have a wide range of potentially devastating consequences. Negative rates are an unstable solution to the problems the U.S. and Europe are facing.


Reuven Brenner holds the Repap Chair at McGill University's Desautels Faculty of Management. He's the author of numerous books, including Force of Finance.  

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