Monday, April 25, 2016

ZIRP And NIRP Pervert The Financial System

We are seeing an unusual phenomenon (very low interest rates) nowadays that is only partly being discussed in the press.  Many savers, however, are very aware of low interest rates as they receive next to nothing (or worse) for their money in the bank.  The general reason given for low interest rates is that they encourage economic growth (in that people would borrow more to invest).  Indeed, our own Federal Reserve (America’s central bank, the “Fed”) has lowered and kept rates low since the Great Financial Crisis of 2008/2009. 

Recently (December 2015) the Fed raised their overnight rate some 0.25% (a small amount), but since 2008 the trend has been to lower rates.  Until very recently most observers expected the Fed to RAISE rates perhaps four times in 2016 because of an improving economy and somewhat higher inflation.  The Fed’s latest opportunity (March 16) was to NOT raise rates, and most observers (including members of the Federal Reserve itself) believe that the Fed will not aggressively raise rates.

In fact, we are nearly at “ZIRP” (Zero Interest Rate Policy) here in the United States.  This has numerous effects (discussed below), most of them actually negative.  There is even talk here of instituting “NIRP” (Negative Interest Rate Policy”), following the lead of central banks in Europe and Japan.

Perverse Effects of ZIRP

In financial history, ZIRP is rarely seen.  In fact, this acronym only became well known in just the past year or two.  ZIRP has now been tried in all of the Western industrial countries with the idea of “stimulating” borrowing and investment to “get the economy moving” (the economy has grown very slowly since 2009).

Easily seen is one big effect: very low rates paid to savers in bank savings accounts and for CDs.  The rates that we receive hover around 0.1% (one tenth of one percent).  Yet there is inflation, the figures are disputed (and vary considerably), but price inflation is probably in the range of 2% - 4%.  This means that savers are LOSING money (in real terms taking into account inflation), and those losses are perhaps about 3% per year!  It is now very hard to get any real income, the 10-Year Treasury Bond currently yields under 2%.  And tying up money for 10 years seems risky for that 2% which at best matches inflation…

In fact, the picture is even worse for savers.  Pension funds, insurance companies and even Social Security are affected by low rates.  There are no good ways for the insurance companies, pension funds and even the “Social Security Trust Fund” to make any returns that they need to receive to be able to complete their financial commitments.  Social Security (already with separate financial problems) invests in Treasury Bonds, which do not make nearly enough interest income to be able to pay out to people in their coming retirements…

There is another effect that is rarely discussed but is important t understand.  In a financial environment that has interest rates going down, capital is actually destroyed rather than being created!  This can be explained as follows:

n  As money is borrowed in a declining interest rate environment, the “new borrower” gets a financial advantage versus his competitors: his borrowing costs are lower than his competitors who borrowed earlier (at higher rates, and so has to pay more than the new borrower).
n  As rates keep going lower, this effect magnifies, the “old borrowers” are at an even worse disadvantage.
n  There are ALWAYS more “old borrowers” than “new borrowers”.

Thus, the capital of “old borrowers” is destroyed at a faster rate than capital being created by “new borrowers”. 

The respected financial authority Dr. Antal Fekete has discussed this at length, many of his theories are easily available on the Internet.

If ZIRP is Bad, Then NIRP is Even Worse!

Again, NIRP (for regular people) means that you must PAY the bank to deposit (hold) you money.  You do not get paid interest, you pay.  This has not yet happened in the US (with a few quiet exceptions).  Negative interest rates are now seen in Europe and Japan.  Europe has been experimenting with NIRP since 2014, Japan has followed a roughly similar path.

Think about this for a moment: if you save money, you will LOSE some of it paying the banks!  Yet the economists say that what the USA (and Europe & Japan) need is more savings (and so investment, to invest there must be savings to put to work).  NIRP introduces a perversion to the financial system not yet seen in history.

The pension funds, insurance companies and Social Security all need to make money to pay their future obligations.  This becomes even harder under NIRP than with ZIRP.  Many pension funds and government obligations are already under-funded, NIRP makes it harder for them to come up with the money to pay.  Savers take note!  Do note, however, that BORROWERS like us would NOT get any “negative rate”, there is no way the banks would pay us to borrow from them!

Another perverse effect of NIRP would be that the lower rates going even lower means that even more capital gets destroyed.  Edward Chancellor recently wrote (in February:, that companies would likely NOT invest money in a NIRP, in that their expected profits of making products in the future would be less.

An even more interesting effect of NIRP would be the unusual one of saving cash, as in CASH money.  Holding cash itself means that that cash would not be losing money in a bank account (or CD).  Holding cash yourself means one would “earn more” than paying the bank for the privilege.  Similarly, having cash in the bank (that costs you money) means that there is an incentive to pay bills immediately rather than waiting (the opposite effect that is more familiar in inflationary times when it is better to WAIT on paying bills because inflation causes future dollars to be worth less after inflation’s effects).  An over-simplified example:

n  Let us assume a “Negative Interest Rate” of 2% (the approximate rate in Switzerland).
n  Let’s say you just bought a car for $20,000 and you have the cash to pay now.  You are given the choice to pay now or pay later (paying the $20,000 in one year let’s say).
n  If you pay now, you pay $20,000.
n  If you decide to put the money in the bank, and have to pay 2% for the “privilege”, than in one year you have only $19,600.  You would then have to pay that AND come up with $400 more to complete your obligation to pay $20,000.
n  You will likely pay the $20,000 right away, or hold the cash at home and then pay the $20,000 after that year.

Think that’s perverse?  It gets worse.  As implied in the above example, one way to avoid paying the bank under NIRP is to NOT deposit your money into the bank, and just to hold on to it.  If you would only have $19,600 after one year (in the above example) in the bank, while you would keep your $20,000 by holding the cash itself, many people will just hold onto the cash and be $400 “ahead”.

This effect of people holding cash has been discussed by the central banks (and even the Bank for International Settlements (the little known but very powerful institution in Switzerland that is considered “the central bank’s central bank”).  The talk among central bankers and other financial pundits (ex-Treasury Secretary Larry Summers and Harvard professor (and author) Ken Rogoff have discussed banning $100 bills, and even banning cash itself!  Sweden has a proposal to ban cash in five years, but in mid-March 2016 they are walking that back, as the elderly and the disabled would have problems not having the option of using cash.

Banning cash itself?  That idea is worth exploring:

n  Almost all payments would have to be by credit cards or debit cards.  Note that most retail sales involving credit cards incur a cost of about 3% (less for debit cards).  This 3% is now just “eaten” by the merchant.  This means, in essence, that prices would be up to 3% higher than now.
n  If all transactions had to be done by credit card (or debit card) that would make it very easy for the government (and the banks and card companies) to monitor your purchases!  Would you like that loss of privacy?  And, yes, the banks and credit card companies would be an even further juicy target by malicious computer hackers looking for big money.
n  There have been some examples of what happens when the power goes out, and gas stations (etc.) cannot take credit card payments because the machines don’t work due to storms, etc.  If there were a hurricane that came roaring through a city knocking out power in an environment where cash was banned, then you would not be able to pay!  No electricity, no credit cards would work.  And with a ban on cash, how would you buy food or groceries?

It gets even more perverse.  If the governments of the world decided to ban cash, then all money (not counting gold) would be in banks.  That introduces two other problems: the risk of money in the banks being frozen (as in Greece in 2015) or even seized (the “bail-in” that happened in Cyprus in 2013, the bail-in was a partial seizure of depositors’ money).  ALL money would be at risk of being frozen or “bailed-in”.  And bank account holders could do nothing about it.

Finally, scary as ZIRP and NIRP could wind up being, it is not clear that those policies would even work!  Japan and much of Europe have not gotten any better in the past year or two despite ZIRP and NIRP.  They have lowered rates to below zero in several cases, with apparently no good results!

In sum, the current policies of the major central banks to lower interest rates to zero (already here in the USA) and even to NEGATIVE interest rates (seen in Europe and Japan) create perverse incentives, incentives to NOT invest money (which the Western economies need), incentives to hold cash to protect savings, and incentives to pay bills more quickly with “hot potato” money in the banks are all unprecedented and perverse effects.  Yet, the central banks are reluctant to RAISE rates (which they probably should have done a few years ago) because of fears that the financial markets and the economies themselves would be wrecked.  The central banks are in a tough spot…


I asked to interview an officer of one of the local banks on this topic so I would have his views.  He told me that he would not talk, that to talk with “the press” would have to go through their corporate offices.