Europe, Japan and the Fallacy of Negative Interest Rates

Europe, Japan and the Fallacy of Negative Interest Rates
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Working too many hours in a light deprived office painted mental hospital beige can skew the judgement for even the most talented. Econometric forecasting is an arcane practice usually with imprecise results. As world economic growth projections are now regularly revised downward, some pointy-headed European and Japanese central bankers have excogitated downright dumb solutions to ignite their moribund GDP numbers. Negative interest rates are but theoretical instruments that should have no place in any rational policy discussions.

A short primer. One general orthodoxy is that as interest rates decline and borrowing is cheaper, demand for credit axiomatically increases, capital expenditures happen, new businesses are created, jobs formation occurs, and the growth turbines start moving the boat.

Carrying to illogical extremes, as rates remained locked at 0 in Europe and Japan, attaining few or none of the intended stimulative effects, Mssrs. Draghi and Kuroda divined their kooky negative interest rate schemes.

Primer number two. Negative interest rates require commercial banks to pay for the privilege of depositing excess reserve funds overnight in the central bank. As of March 10, EU institutions pay 40 basis points (4/10 of a percent) while the Bank of Japan charges ten basis points. These may appear small amounts but because of years of quantitative easing undertaken by both central banks, excess reserves just in European and Japanese banks total in the trillions. Therefore, these charges, effectively a tax burden on banks, annually total in the billions of dollar equivalents in Euros and Japanese yen.

Promulgated also on March 10, Mr. Draghi announced ECB monthly bond purchases would be increased from 60 to 80 billion euros. Since banks themselves hold many bonds, this so-called quantitative easing only increases banks cash reserves and thus more overnight deposits at onerous negative rates. Along with this release, there was the usual further downward growth and inflation forecasts.

Late Nobel Prize winning economist Milton Friedman postulated that inflation was a monetary phenomenon; print enough of it and prices will rise. The current deflationary spiral is perhaps the exception to this rule. Global economic malaise manifested by across the board commodity oversupply and slowing Chinese growth and attendant deflation fears are where we are today. Far from encouraging economic expansion, negative rates are a retrograde path to recession. We find ourselves in a classic Liquidity Trap. You can lead the horse to water, but you can't make him drink. It becomes like pushing on a string. Financial systems are awash in funding at historically low rates with few takers. Europe, Japan, and America have been running printing presses overtime for years with little upward price movement; Frightening to me is that feckless bureaucrats cannot see that credit is a demand driven event.

Negative rates are designed to encourage banks to lend. Punitive measures like these are a rather perverse methodology to attempt to force money out of bank vaults. These are the same central bankers who eight short years ago castigated banks for reckless real estate lending, levying fines in the aggregate hundreds of billions of dollars (euros too). The best thing that happens to a bank when a loan is established is to get paid back with interest. It is three yards and a cloud of dust business; no long pass plays. After expenses, the return on overall assets is one or one and a half percent. Why would any intelligent banker risk making a reckless loan, risking default or even litigation, rather than simply play safe and pay the ECB or Bank of Japan the negative interest toll on excess reserves?

Laws of Unintended Consequences

Europe has been at this chemistry experiment since June of 2012. From a recent Bloomberg commentary, "In the first year of quantitative easing, the Euro Stoxx 50 Index fell 17 percent, and volatility reached levels not seen since 2008. The gauge has dropped in each month but one following an ECB meeting since April." Realizing Draghi's worst fears, inflation has turned negative, consumer confidence is plummeting, and manufacturing has retreated to levels not seen since 2013.

Consumer confidence is a key metric here. Two-year German government notes were issued in February at rates as low as negative 50 basis points (-1/2 percent). An investor would need to go out about eight years on the German yield curve to start to get a positive return. The ten-year Bund yields a miserly ¼ of one percent. And with money market and other bank depository rates hovering at zero, what incentives does the citizenry have to participate in the banking system? Hence, the recent rapid run-up in gold bullion prices.

Sweden, Finland, Denmark, Switzerland all are participants in the negative rate alchemy, matching the lackluster metrics notched at the ECB. With a toe in the negative rate waters for barely six weeks, and after a sharp 2% fourth quarter GDP contraction, Japan also shows no signs yet of any salutary effects.
Other perversities abound. Swiss bank Julius Baer is considering charging customers for Euro deposits. Mitsubishi UJF Financial pays depositors 1/1000 of one percent on their money. Cash hoarding is a new rage. Safe sales are thriving in Japan, and the 500 Euro note is less bulky under a mattress than fifty 10 Euro denominated notes.

The EONIA, or the overnight unsecured interbank borrowing rate for eurozone banks, is the analogue of the Fed Feds rate here in America. EONIA currently stands at about -23.9 basis points. At the end of each business day, European banks can park excess funds at the ECB and incur a negative 40 basis point charge or lend unsecured to another bank short of reserves and pay them about 30% less for the privilege. Banks are overwhelmingly choosing the most expensive safety of the ECB over issuing unsecured credit. Once a large highly liquid and dependable mechanism for the ECB to carry out its monetary policy EONIA volumes are but a fraction of what they were several years ago. It signals a severe lack of trust among financial institutions.

More Pernicious Effects

Besides severely squeezing commercial banks profitability, insurance companies and pension funds suffer tremendously under low rate scenarios. Each has a high percentage of long term fixed rate or fixed amount liabilities to pay out. With many high quality fixed income products trading at negative yields, it becomes very difficult to meet obligations. It is a scenario that cannot continue indefinitely without destroying the insurance industry and causing pension funds to miss payment obligations to retirees.
In textbook Beggar Thy Neighbor schemes, central banks around much of the planet race to lower and lower rates. The theory holds that money flees low (especially negative) rates of return thus devaluing the currency. The now weakened currency, in turn, may spur demand for now cheaper exports and make imports more costly, potentially creating some desired inflation. December marked the United States first interest rate increase from the zero policy in 7 years. It was this long anticipated event, rather than the actual event itself, that saw the dollar, in the past year or so, appreciate more than 25% against the euro and even more against the Japanese yen. Our more expensive dollar has punished multinational corporate profits. But the point is, even with all the gerrymandering to rock-bottom interest rates and attendant currency devaluations, European and Japanese growth remains anemic.

What to Do?

Ordinary savers, the middle class, are the most punished by these central bank machinations. Between Japan, Europe, and the U. S. there are many trillions of savings earning little or no return. Whether in money market funds, bank deposits, the Japanese Postal Savings Bank, consumers have no place to turn. If German Bunds, the ten year JGB, and ten year Treasuries paid a more normal 3 or 4 percent, it would unleash hundreds of billions in dollar equivalent purchasing power. That creates demand for products, allowing businesses to expand, the precursor to loan demand and job creation.

The most powerful way to unlock economic potential in Europe and Japan is to undertake job reform and reduce regulatory hurdles to new business formation. The ability to freely hire and terminate employees, also, tearing down protective barriers to encourage small company startups is the sin qua non to reviving credit demand and GDP growth. These types of policy suggestions are anathema to unions, many politicians, and much of the general population but without them, Europe and Japan are dying a slow death. Viewed through this lens, it is ultimately the politicians who have lacked the fortitude to fight for change. The central bankers are but the misguided minions tasked with cleaning up their mess. Negative interest rates are tantamount to beating your head against a wall. It is stupid, counterproductive, and it hurts. The time is past to declare them a failure.

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