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!
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…
Afterword
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.
