Next? – Negative Interest Rates

Negative Interest Rates (NIRs) are the next step in the Central Bankers’ medicine cabinets.  Simply put, A NIR, is a “tax on money”: that a depositor is paying a bank to keep one’s money; and a borrower is being paid to receive these funds. NIRs are the penultimate financial vaccine in the Central Bankers black medical bag. NIRs may revert to plague – an example of unintended consequences and risks poorly assessed.

We created this problem, the vaccine and now let it loose. Yes, as citizens and consumers we bear part of the burden of blame for putting our trust in systems we rely upon and choosing the leaders we do. Next? We have a choice!

QE/NIRs dissected

NIR policies are a result and last-ditch effort by Central Bankers to close the door on the 2008 crisis. One that they inadvertently sanctioned through ineffective management of regulation and compliance. The use of NIRs is a direct result of the blunter medicine: Quantitative Easing (QE).

The belief was that QE, as an expansionary measure, would inoculate the economy, and counter the current, long standing stagflation that afflicts the world’s economies. A ‘kick-start’ for growth.

Yet with over USD 15 trillion of new money expensed so far, QE has failed to boost consumer and business confidence, especially in the EU and Japan. There has been no start to stimulating borrowing and lending activities. Rather just another kick where it hurts – citizens’ pockets. Universal banks are unwilling to take the credit risk of lending – a decision of based on self-interest and self-preservation. Lending has fallen as research shows.

The net effect of QE has been to release this ‘hot money’ into the economy to find a home in a sea of unattractive alternatives; thus chasing limited investment opportunities. This dismal search perverts intent; stoking as well as inflating equity and property prices, while expansion into bonds has pushed yields down to negative levels. The Trump Administration’s decision to end QE has temporarily envigorated the Dollar, a (short) term consequence. America’s QE experience is neutral, at best. The markets seem concerned. Next?

NIRs have escaped from the lab. Gesell’s original thought paper has not often been applied. Sweden, which has championed successful ‘bad banking’ practices, claim that NIRs are safe to use, as reported in the ‘Financial Times’. The Swiss authorities are less sanguine. Others are not convinced.

Some at UBS even see NIRs as bone-corroding steroids. Banks’ profitability already battered by the 2008 crisis, fines, increasing compliance costs a weak economy and low interest rates mean that their NIMs are under threat. Maybe NIRs are the catalyst to force through the next wave of bank restructurings.

The Central banker’s doctor’s bag may not be quite empty, if the ECB really states to offer out TLTROs – aka Targeted Long-term Refinancing Operations.

But what about the patient- the Economy?

Next?

Continuing concentrations add to volatility and economic distress

NIRs could well add to the already increasing levels of uncertainty and volatility.

  • Capital market flows are driven by algorithmic, AI-enhanced, trading programs of global institutions. Their share of the market has risen to 80%, with ordinary investors’ direct participation being less than 10%. ETFs alone account for 30% of daily trades, raising systemic risk levels, as ESBA concluded.
  • ’Wealth is increasingly concentrated, with 70% of the world’s assets being owned by less than 10% of the population, as research cited by the Washington Post.
  • The rise of the middle class, while a source of demand, has seen a mismatch of expectations.
  • Furthermore, cognitive behaviour suggests that the increasingly frantic ‘hunt for yield’ will see in increase in more risky investment decisions, according to ‘Fortune’.
  • Some authours argue that low interest regimes can encourage innovation. The issue remains have risks been properly quantified?
  • The pre-2008 patchwork system of international arrangements is now morphing into a single one global order, much of it without holistic coherence.
  • The combination of the above factors with the unfolding Digital Revolution, with its speed, transparency, seeming productivity (with a related drive to commoditization) and machine logic can overwhelm national governments, even supranational bodies; bruising currencies. Switzerland provides a case example. This unitary structure, as currently configured, risks being inherently unstable.

Capital has no national home – it is the ultimate global citizen. It can break national markets and thus, by its inherent nature, can just as well weaken (or strengthen) the whole remaining system.

Demography to a medium-term rescue?

Demography has direct impact on capital. The structure of traditional families atomises with the associated changes in spending and saving habits. These demographic changes at home will lead to less savings.

Without those inflows, capital costs will rise: they must. The year 2022 represents the peak of the fertility curve. As a species we are ageing and dwindling.

Capital is set to become scarce and this demographic dynamic will return rates to positive levels within 5 to 10 years. Yet, a week is a long time in politics; markets turn on a trading session, if not less.

There are impediments to this development: time being one, plus others.

Genie of  X-flation

The immediate effects of NIRs could be deflation followed by depression; a deepening of our current state of affairs.

Yet the inevitable rise in capital costs risks the maelstrom of inflation. The next step in the “cure” could well be rampant inflation. Such a development may well save today’s borrowers but would destroy the asset value of prudent savers.

The effects of hyper-inflation are insidious and have been shown to be throughout history. A weak economy begets a weak society and thus exposes it. NIRs increase that exposure.

Latin American economies have never really escaped from hyperinflation’s debilitating grip (read Argentina). The ardour of Nazi Germany was fuelled by the flames of hyperinflation that consumed the Weimar Republic. Such fears led to subsequent interventions – armed and otherwise.

The revitalised countries of Russia and Eastern Europe (such as Poland, the Czech Republic and Eastern rump of Germany) were saved by intervention of their western brethren.

But money is itself a fiat currency; and is itself debased. Hence the allure of cryptocurrencies – a tulip for the digital age or flower from the Garden of Eden?

Revolution – at many levels?

The world is beset by revolutions: technological; industrial; economic; political; religious; environmental; social; etc.

The social implications of NIRs are far-reaching. The political revolutions all tend to be based on wealth disparity and the weakness of the prevailing economic system. Revolutions don’t require many protagonists, according to the BBC. Net Interest Rates may well be a precursor, the proverbial canary.

The social contract, however loose, is at risk of being torn-up. Fueled by Millennials’ frustrations and environmental necessities. How these revolutions are expressed varies in their: objectives; efficacy and impact – intended or otherwise.

The role of government is to promote a nation’s wealth: providing growth and employment. Yet, the liberal democratic/free market governing classes and institutions (education-health-infrastructure-justice) are under siege. Rightly so in a world of QE and NRPs with a failure to provide adequate social services; employment and growth. Confidence is at an all-time low. Fake news reigns!

More worryingly, today’s generation of decision-makers in government and business have no experience of such a volatile world. Grey-haired opinions are not to be found on the Internet; hence not welcomed nor “trusted”.

Scenarios

The inexorable return to positive interest rates assumes a world of calm waters; based on some heroic assumptions.

Such assumptions would call for certain domestic dramas to play out well: BrExit; Japanese transition from grey hair to silicon chips; Chinese political moderation holds; population growth shrinks to nil; easing Trade Wars.

But no Sarajevo-August-1914-spark. The “Broken Window” dynamic is a fallacy. Just as much as modern financial concepts are at measuring the needs of a sustainable “Green Economy”.

The genie of Inflation is not easily harnessed to avoid an Argentinian-Weimar outcome and an atomised world.

Next?

Take stock!

Malthus understood the dynamics three hundred years ago. All of these trends have an impact on capital and its interest rate. Next?

So one arrives at a point of reflection. We citizens who choose to objectively observe our current reality, review our past path to it and consider alternatives will have an insight with regard to what might come to pass.

Some advisors offer their opinion. Owning land, means of producing food and staples, as well as infrastructure in a country where property rights are observed would seem a pragmatic approcah.

As Negative Interest Rate policies work their nefarious effects the financial markets will have to come to terms with a level of risk and risk-pricing that few today, and fewer in positions of authority, have any expertise in managing.

Caveat emptor!

Justin Jenk is business professional with a successful career as a manager, advisor, investor and board member. He is a graduate of Oxford and Harvard universities. Justin can be found at justinjenk.com or www.raktas.ee