Negative Interest Rate Neverland


For any good or commodity, if supply increases and there are too few takers, the price will fall.

If supply increases further and demand is still low, prices can fall all the way to zero.

If supply increases thereafter, and there are still too few takers, the supplier can offer a cash incentive to those willing to take the accumulated goods off their hands.

This is a negative price, so it turns out that zero is not a lower-bound price for anything.

The implication for the supplier is that the good generates negative revenues and earnings, so doing business at negative prices dissolves the supplier’s net worth. Offering products at negative prices is not a good business to be in, and if you are, you won’t be for long.

As absurd as it might seem, this has become the business model for banks in countries that are persevering under negative interest rates, primarily in Europe and Japan — and the US is not far off.

Banks and other financial institutions supply credit within the credit markets, and if there is great supply and soft demand, the interest rate (as the price of credit) can fall to zero, as in the example above.

The US and most developed countries have been at the borderline zero price of credit since the Great Recession. But it turns out that zero is not a lower bound in financial markets either.

In a sense of desperation, the European Central Bank (ECB) and the Bank of Japan are pushing the interest rate into negative territory because they are supplying credit at a negative rate to their governments and banks. That is, they are offering the borrower a zero interest rate and, in addition, paying the borrowers to borrow by requiring less repayment for the funds loaned.

So, given the need for financing ever-expanding government debt accumulation, and being scarcely able to afford its already existing interest carry, the interest meter for government borrowing goes into negative territory thanks to central bank generosity. This means governments receive more cash with each borrowing than they are required to pay back on the bonds originally purchased by the central bank.

And those terms are also being extended to private borrowers by their banks.

From the central bank’s point of view, negative rates are in vogue because they seemingly kill two birds with one stone: First, they are seen to revive a weak economy (if only the economy behaved as in Keynesian textbooks) and second, it reduces the government’s interest carry, which is great news for debt-strapped governments.

But think what that does to the lenders who are caught in the middle. Earning a negative interest rate on their assets is a net cost for lenders, so instead of receiving investment income, they are instead subsidizing borrowers.

Hence, negative interest rates are an unlegislated wealth transfer from lenders to borrowers, something, no doubt, The Bern would approve of.

In this upside down world of negative interest rates, you might ask why banks lend money with the certainty of getting less in return. This is compelled to some extent via bank asset regulation and central bank pressure to hold government bonds and deposit at the central bank at negative interest rates.

The net of it is that lenders are resisting as bank shrinkage is taking place and bank capital is being run off the books — and the equity market, understanding this, has marked down European bank stocks by 25% since the beginning of this year.

This is a financial extremum, and it doesn’t just undermine banks.

Banks are on the pathway to insolvency, and the same calculus affects all financial institutions that generally live on investment income. In addition to banks, this includes: savings banks, insurance companies, pension funds, endowment funds, and a variety of trusts (both government and private), all of which are being force-fed very low and even negative returning assets.

So you should now see the larger picture of what’s unfolding before our very eyes.

Low and negative interest rates have become the new means to subsidize broke governments and broke businesses with debt outstanding.

Now then, why have central bankers (Draghi of the European Central Bank and Kuroda of the Bank of Japan) recently renewed the pledge for yet a deeper plunge into negative interest rate Neverland? And Yellen is studying it.

Is their loyalty to government subsidization above their responsibility to their own central banks’ balance sheets and the commercial banks they regulate? Or are they fools who have been seduced by Keynesian central bank ideology in which lower interest rates are seen as always better for the economy? And that includes Ben Bernanke.

There is a mindlessness going on ­— a failure to pay attention to the blatant damage to financial institutions that investors in bank stocks more clearly see. Where are the thinkers who can think beyond the dusty textbooks of the post-WWII era in which lower interest rates are applied but fail to result in the usual positive multipliers of bank credit, investment expenditures, and job creation?

Moreover, do the central banks — responsible for driving the negative market interest rates — warn the governments that all stripes of lenders will not be able to survive on such low rates on invested assets and, furthermore, expect they will come knocking on the door for major bailouts that cannot be afforded by already debt strapped governments?

This is the road we are on, and it’s a road that leads to promises made and never delivered by commercial banks, by insurance companies, by pension funds, by saving banks, and by trust funds.

When citizens come to realize that their bank deposits or pension fund payments or insurance annuities are worthless pieces of paper, will they not take to the streets in anger? From there, will not the military be called in to contain the destructive anger of its citizens and, in turn, suspend statutes and Constitutional law and place the country under a military dictatorship? It’s happened before — not in the US, but in many places in the Americas. The alternative would be to merely fire up the printing presses and satisfy those private obligations with more printed money.

So when the history book is written, who will be seen as the villain for devising negative interest rate Neverland? Will the mad genius be seen as a Treasury official of a broke government seeking an interest cost subsidy, or will it be the misguided central bankers for being enablers with their zeal for Keynesian orthodoxy?

Those are the issues and stakes involved. However, there is a positive way out, and that is for the government to change the economic environment (via regulation, taxation, or by winning the globalism competitive battle as a national goal). Sufficient economic incentives and the elimination of barriers can bring about an environment in which businesses are born and prosper and become viable borrowers and employers that can pay off loans at positive interest rates as in the good old days of yore.

These changes are within the domain of the government — not the central bank — so the upcoming elections are of extreme importance to the future of the economy, financial institutions, and the government as we know it.

Incenting and allowing businesses to be able to borrow and repay with positive rates needs to be the new operational objective of public policy. No more, “Let’s reduce the interest rate, even if already negative, as long as there are some remaining unemployed.”

Central bankers stuck in negative interest rate Neverland are naively undermining the very foundation of governments, retirement promises made, and even democracy in the process. This is darn profound stuff and well beyond being merely a Keynesian fix that has been overcooked so that it generates major adverse side effects.

The only constructive thing left for central bankers is to stand up in unison and in public and let the government know that they have done all they can and the ball is in their court. Only the legislative and executive branches can change economic incentives and remove impediments to business success so that business borrowers are once again willing and able to pay positive interest rates.


The views expressed are those of the author and not necessarily The University of Texas at Austin.

About The Author

Lew Spellman

Professor, Department of Finance, McCombs School of Business, The University of Texas at Austin

Lewis Spellman received his BBA and MBA from the University of Michigan and his MA and Ph.D. from Stanford University. His research interests include...

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