“If you have the power to print money, you’ll do it. Regardless of any ideologies or statements, that you should limit your counterfeit operations to three percent a year as the Friedmanites want to do. Basically you print it. You find reasons for it, you save banks, you save people, whatever, there are lot of reasons to print.“ [1]
Murray Rothbard
We live in truly explosive times. Lingering economic stagnation makes possible what was previously unthinkable. While economists wondered for a long time where the (positive) lower boundary for interest rates was[2] – which John Maynard Keynes suspected to be in a range of 2.0% to 2.5%[3] – this debate has evidently become obsolete today: Reality shows that negative interest rates can be imposed and enforced by central banks, without triggering great upheaval in the population. We are gravely concerned by and highly critical of the currently rampant negative interest policy: a monetary Rubicon has been crossed. We have strayed unto terra incognita.
In the following section we therefore want to discuss the consequences of zero interest rate policy in detail.
Source: Nesta.org.uk
The Marshmallow test is probably the most famous experiment testing people’s patience, which is reflected in the concept of time preference in economics. Psychologist Walter Mischel tested the “delay of gratification” by offering a desired object – such as a Marshmallow – to a child.[4]The examiner told the child that he was about to leave, and that the child would receive a second Marshmallow if it did not eat the first one before the examiner returned. The examiner returned after 15 minutes – but in most cases the temptation had proved too strong. In a variety of versions of the experiment, children’s waiting time amounted to approximately six to ten minutes (with wide dispersion in evidence).[5]
Why is this experiment relevant to us? We obtain economic gratification if we rein in our impatience with respect to consumption. Interest is the most important gauge for this – it is essentially equivalent to the second Marshmallow in the experiment. Interest is the return for time, the return for people who decide to wait although they would actually prefer to get everything immediately. Eugen Böhm-Bawerk recognized that interest is not the “price” of money. Rather, interest is the return for the exchange of “money available today against money available tomorrow”. One could also refer to it as the “price of impatience”.
Just as the prices of goods convey important information about scarcity in the economy, and are signaling to entrepreneurs which products are demanded most urgently, interest rates convey information about the population’s inter-temporal preferences. Aside from long-term thinking, existing reserves are needed in order to be able to postpone consumption. More capital-intensive production methods allow for greater output, but they require resources and time in order to be established. Whether entrepreneurs can afford to take up this time is signaled by the height of interest rates.
When someone forgoes use of something today and makes it available to others, he does so primarily in order to receive more tomorrow. If one were not concerned about the future, which occasionally even has a second Marshmallow in store, it wouldn’t make sense to abstain from consuming the first one. No one would be prepared to wait. Consequently, there has to be an originary (or “natural”) interest rate, which can be attributed to the impatience of human beings. According to the Austrian School, this interest rate cannot be observed in the market (even in a non-interventionist monetary system). A free market interest rate is composed of the natural interest rate (time preference) plus a price (or inflation) premium and a risk premium (which at the same time represents the entrepreneurial profit of the lender). If risks are high, higher interest rates will be demanded. If a rise in price inflation is expected, interest rates demanded by lenders will increase as well.
Ludwig von Mises summarized the decisive point in Human Action as follows:
“[…] there cannot be any question of abolishing interest by any institutions, laws, and devices of bank manipulation. He who wants to “abolish” interest will have to induce people to value an apple available in a hundred years no less than a present apple. What can be abolished by laws and decrees is merely the right of the capitalists to receive interest. But such laws would bring about capital consumption and would very soon throw mankind back into the original state of natural poverty.” [6]
A few years ago, negative interest rates were still unthinkable. Nowadays public debate is solely concerned with the extent of negative interest rates. The feasibility and the long-term consequences of the so-called “negative interest rate policy” (NIRP) are rarely discussed. We consider it alarming that such measures are implemented without any sound empirical or theoretical proof showing that they will work.
In our opinion, the introduction of zero or negative interest rates by central banks represents a fatal central planning intervention. Negative interest rates contradict the logic of human action and lead to numerous distortions as well as a gradual zombification of the economy. Moreover, a world in which it no longer matters when exactly one consumes a Marshmallow promotes a “culture of instant gratification” and thwarts the virtues of thrift and restraint.
For many years it has been evident that interest rates are lowered far more in times of crisis than they are raised in the subsequent recoveries. Professor Schnabl aptly refers to this as “monetary policy asymmetry”.[7] In this way one is sooner or later bound to reach an interest rate of zero.
Source: RealForecasts.com, Federal Reserve St. Louis, Incrementum AG
As several central banks are now standing with their backs to the wall in terms of monetary policy, they are now attempting to revive the economy by means of negative interest rates. In July 2012 the Danish National Bank became the first central bank to impose a negative deposit rate of -0.2%, with Sweden’s Riksbank following suit in July 2014 by setting its deposit rate at -0.5%.
In June 2014, the ECB fixed the interest rate on its deposit facility at -0.4%. In Switzerland negative interest rates have in the meantime become commonplace as well. In order to choke off capital flows into Switzerland and keep the Swiss franc from appreciating too strongly, the SNB decided in December 2014 to introduce a negative interest rate of 0.25%, which it lowered to -0.75% in January 2015. Japan is in the meantime also cruising through the interest rate waters in a submarine, so to speak. This step was especially controversial, as only a few weeks earlier BoJ governor Kuroda had vehemently denied that a negative interest rate policy would be adopted.
At this juncture it seems appropriate to analyze the successes, as well as the consequences of negative interest rate policies to date.
The most obvious consequence is the creation of an intrinsic “state of investment emergency”. Both private and institutional investors are faced with a veritable problem: Even maintaining the nominal value of capital (after deducting all fees) is only possible by taking risks. In order to generate real capital growth, significant risks have to be taken by now.
This creates a perverse dilemma for investors: they either have to resign themselves to the steady erosion of their capital, or they must take capital market, liquidity, credit and other risks well beyond their individual risk tolerance levels. Investors are thus damned to either slowly lose their capital or to invest in a risky manner contrary to their personal preferences.
Particularly in the insurance industry, cataclysmic events are predestined if this state of affairs is maintained. In times of over-indebtedness and financial repression, institutional fiduciaries administering large capital investments are obvious funding sources for government debtors anyway.
However, the insurance industry is not the only industry in the institutional sector that is strongly affected. The traditional banking business depends on interest rate spreads and suffers from zero and especially negative interest rates. As though the low level of interest rates in absolute terms were not already causing enough trouble for the banks, negative rates have contributed to an even more pronounced flattening of the yield curve. This in turn erodes the income of financial intermediaries further, as the universally popular “maturity transformation” can now only be performed at ever tighter spreads. In recent years it was still possible to generate some measure of return by using short term refinancing from the central bank to invest in longer term assets – this is now becoming ever more difficult as well. As a result, bank stocks are plunging: since the introduction of negative interest rates in the euro area in June 2014, European bank stocks have underperformed the broad stock market index by 25%.
The following chart compares the ECB’s balance sheet total to the trend in European bank stocks. It can be clearly seen that QE – which puts pressure on yields and flattens the yield curve – is fundamentally damaging for banks and their business model.
Source: EZB, Federal Reserve St. Louis, Incrementum AG
Outside of the euro zone the effects of low and/or negative interest rate policies are also not seen to be particularly successful:
Whether the Federal Reserve will ever implement negative interest rates appears questionable. However, Janet Yellen recently confirmed in a written comment that negative interest rates are at least considered to be an “option”:
“While I don’t want to completely rule out negative interest rates in a future very unfavorable scenario, monetary policy makers have to think through a multitude of factors before they employ this tool in the US, including the possibility of unintended consequences.” [8]
In our opinion the US financial elite is divided over the issue of introducing negative interest rates. At the moment it appears as though the prevailing opinion is that it would be better to rather return to “well-worn QE” as soon as recessionary clouds appear on the horizon. On the one hand, this conclusion was supported by the rather modest successes achieved by NIRP trailblazers overseas – especially in Japan – on the other hand, one must not underestimate the importance of the money market fund industry in the US. Keeping the value of money market fund units at par is a core accounting principle, undercutting par values – i.e., “breaking the buck” [9] – would in many ways be considered fatal.
Alarmingly, one instead reads in the context of economic stimulus ever more often about good old deficit spending as a “policy instrument”. From there, the mental step to helicopter money is probably only a small one. We can be certain about one thing: should economic growth weaken, interventionist measures will once again increase significantly. Leading politicians once again assured us of this at the last G7 summit in Japan in May 2016:
“With respect to the economy, the participants of the summit have promised to use all political instruments – including monetary, fiscal and structural instruments – in order to achieve a pattern of sustainable and balanced economic growth” [10]
Even though we have not (yet) seen negative interest rates in the US, they have by now arrived in five currency areas, which represent a fifth of global economic output in the aggregate. This means that lenders there are paying to make their funds available (or in the case of negative yielding bonds, they will book a certain loss if they hold such bonds to maturity). Why are they doing this?
We want to take a closer look at the latter case. In a fascinating study[11] Nomura has examined how deeply into negative territory interest rates could possibly be pushed and has arrived at the conclusion that the storage cost of gold could actually represent a benchmark for this:
“Theoretically, negative interest rates’ lower bound depends partly on the cost of holding cash in the form of physical currency. When people hold cash out of aversion to negative interest rates, they risk losses due to theft and the like. The cost of avoiding this risk could be a key determinant of negative interest rates’ lower bound, but it is hard to directly quantify. As a proxy for the cost of holding physical currency, we estimated the cost of storing gold based on gold futures prices. This cost has averaged an annualized 2.4% over the past 20 years, though it has varied widely over this time frame.”
Source: Nomura
A study by JP Morgan comes to the conclusion that negative interest rates could decline significantly below the storage cost of gold. The explanation for this assumption is that in a layered system (similar to Japan’s) only a part of reserve deposits will be subject to negative interest rates. This lowers the cost of keeping funds with the central bank and negative rates could be pushed to even more extreme levels. JP Morgan’s analysts estimate that the ECB could manage to push negative rates to -4.5% if reserves in the amount of 2% of GDP were affected. They calculate a possible lower bound for negative rates for the US and Great Britain, of -1.3% and -2.5% respectively, as the ratio of reserves to assets is higher in these countries.
The recent abolition of the 500 euro banknote is connected to this as well. The hypocrisy of the argument that criminals will be thwarted by the abolition of large-denomination banknotes is hard to surpass; studies cited in support of the effectiveness of such a measure consist largely of politically motivated pseudo-science. In an addendum to an article by well-known cash opponent Larry Summers in the Washington Post, the latter’s editors felt obliged to point to his conflicts of interest with respect to the issue:
“Summers serves as an advisor or board member to a number of financial technology and payments companies”.[12]
However, the most important motive of these hypocritical cash opponents is crystal clear: The costs of storing cash are to be increased in order to create a lower bound for negative interest rates. The abolition of the 500 euro banknote primarily affects banks, which can henceforth only fill their vaults with €200 banknotes, which significantly increases the cost of holding cash – and this in turn enables the ECB to push its deposit facility rates significantly further into negative territory.
In order to go “whole hog” with negative rates, cash currency would have to be abolished entirely. This would make it possible for commercial banks to pass negative interest rates on to savers without having to fear that they will resort to the weapon currently most feared by banks: the mattress, in which grandma already used to hide her Reichsmarks in.
A study by the Flossbach von Storch Research Institute came to the conclusion that German savers would react quite forcefully to negative interest rates. Only 7.6% of respondents would tolerate it if their bank were to charge negative interest rates. 44% would want to switch to a different bank, 28% would store their money physically, and 21% would invest their funds in different assets. In short, the abolition of cash would be a sine qua non condition if the interest rate wizards really wanted to go to town with negative rates. However, in that case they would be counting their chickens before they have hatched, as there would still be alternatives available, such as forms of money that have originated in the free market, like the crypto-currencies and gold.
“If the store of value function of all major currencies is substantially undermined, as indeed it is by negative interest rates, then investors are going to have to look for a non-national currency alternative. Historically, gold and silver have most frequently served as reliable, stable international stores of value, protecting against devaluations and default generally.”
John Butler
Negative interest rates represent a never before seen dimension of monetary policy. We believe their effect on the gold price has to be assessed as clearly positive. Overall prosperity will by contrast suffer in the long term, as negative interest rates undermine traditional incentive structures which form the basis of wealth creation, and are distorting the capital structure in the process. Rising inflation, lower productivity, greater volatility and uncertainty in financial markets are consequences to be feared. Gold is likely to be a tower of strength in this situation. We list the most important arguments for this below:
Negative interest rates shrink the pool of attractive investment alternatives, which increases the attractiveness of gold. Particularly in the current low interest rate environment, gold is increasingly interesting for central banks as well. Thus they purchased 336 tons of gold in the second half of 2015 alone. The World Gold Council moreover estimates the monthly return of gold to be significantly higher in a negative interest rate environment than in an environment of moderate, or high real interest rates.
Source: World Gold Council, Incrementum AG
2.) Negative interest rates erode confidence in paper currencies and central bank policy
Based on the insights of the Austrian School of Economics, we regard the consequences of negative interest rate policies as fatal. A distorted production structure will gradually bring about a decrease in real productivity. Asset prices continue to be boosted concurrently, resulting in financial boom-bust cycles which destabilize the financial system and will eventually lead to bankruptcies and rescue operations. The currency’s store of value function will be undermined ever further. Eventually the point could be reached when citizens lose confidence in paper money and consumer goods prices begin to take off. At that juncture an allocation to gold will be highly advantageous.
3.) Negative interest rates increase uncertainty and volatility in the markets and lead to an interventionist spiral
Interest is a price ratio, and fixing interest rates is therefore akin to price controls. Given that interest is not just any price, but the price of credit and with that the lifeblood of the economy, it is all the more devastating that its fate is in the hands of central planners. The fact that negative interest rates appear necessary indicates that the economy has already suffered considerable damage as a result of previous interventions.
This confirms an insight shared by many Austrian economists: namely that one intervention invariably leads to another. The production structure and fundamental incentive structures are distorted – markets barely react to fundamental data anymore, but are highly sensitive to all sorts of monetary policy decisions. In view of the increasingly messy situation of the monetary system, in which ideas which were previously considered crazy (such as negative interest rates or helicopter money) can suddenly be regarded as being without alternative, is makes more sense than ever to stand with (at least) one leg on solid ground outside of the system.
We believe that NIRP creates a completely new environment for investment decisions. Since it cannot be expected that central banks will raise rates again anytime soon, negative interest rates are likely to become a persistent phenomenon, which will have an extraordinarily positive effect on gold. Demand for gold is likely to increase particularly among central banks and institutional investors. Pension funds and insurance companies, which normally invest a large share of their portfolios in bonds, will have to fundamentally rethink their investment policies. Gold should play a major role in this context.
Zero and negative interest rates have an effect akin to the effect that laxatives have on constipation: In the short term, everything appears to work well again, but as soon as the (economic) organism has become used to them, it becomes dependent on artificially created liquidity and is further away than ever from becoming truly healthy.
We have frequently discussed the negative long-term consequences of low interest rate policies in recent years. If one looks at the situation more closely, it becomes clear that the underlying problems couldn’t be resolved by global zero interest rate policies, and that instead the market’s natural selection processes have been undermined. Governments, financial institutions, entrepreneurs and consumers that should actually be in bankruptcy are kept on artificial life support. As these consequences are devastating and can hardly be avoided, because the monetary system has become hopelessly entangled in the low interest rate trap, we want to focus on the issue again in detail.
The rate of interest at which money can be invested is the basis for the valuation of all financial assets. Every form of investment involves spending money in the present in exchange for receiving an uncertain return in the future. Since investors have the choice of investing their funds at the prevailing interest rate at relatively low risk instead of buying risky assets, future returns have to be discounted by the interest rate. Thus investments have to be valued in relation to market interest rates. The discounted cash flow model calculates the net present value of investments based on the sum of all discounted future costs and returns. It is therefore in the nature of financial mathematics that a seemingly small change in interest rates will go hand in hand with large effects on the valuation of financial assets – especially in the case of long-term investments.
More than 30% of all government bonds (approx. USD 8 trillion) are in the meantime trading at negative yields to maturity, while 40% are trading at yields of less than 1%. Adjusted for inflation, the figures are even more dramatic: 51% of all government bonds valued at a total of USD 15 trillion exhibit negative real yields and only 16% of all bonds offer a real yield higher than 1%.[13]
Should serious concerns about inflation rear their head in coming years in the current interest rate environment – which we expect – bond investors who buy now or have already bought will have made a bad deal indeed. And should inflation actually begin to gallop, the consequences for banks, insurers, pension funds and particularly their clients will be devastating.
This points undoubtedly to massive overvaluation of these securities. At the same time most market participants – in line with portfolio theory as it continues to be taught – regard these securities as risk-free.
Source: Hedgeye
The low level of interest rates since the financial crisis has in the meantime boosted both bond and stock markets enormously and has prevented a downward correction. A return to the level of interest rates that prevailed prior to the crisis would bring the markets to their knees purely from the perspective of mathematical finance – due to the difference in interest rate levels, stock markets could quite possibly slump by 50%. Bond markets would also be strongly affected by a normalization of interest rates. 10-year Treasury notes had a yield of 5% prior to the crisis, while it currently stands at a mere 1.65%. Returning to a rate of 5% would entail a price decline of approximately 30% for 10-year Treasury notes.[14]
Rating agency Standard & Poor’s (S&P) has calculated that budget deficits in the euro area would on average be 1-2% of GDP higher if the average level of interest rates prevailing between 2001 – 2008 were applicable today. Germany would have a deficit of 1.5% of GDP instead of a slight surplus, the deficit in France would amount to approximately 5.5% (instead of 3.5%), in Spain to approximately 7% (instead of 5%), in Italy to approximately 4.5% (instead of 2.5%) and in the Netherlands to approximately 4% (instead of 2%). The deficits of the four largest economies of the EU behind Germany would therefore exceed the deficit threshold of 3% of GDP prescribed by the Maastricht treaty.
Moreover, due to low interest rates and the high degree of marginability of sovereign bonds, more and more leverage is employed in these investments. So-called “risk parity” strategies, which have become highly popular in recent years, have inter alia taken advantage of this. However, bonds are asymmetric assets: Investors cannot receive more than the interest payments and the principal amount upon redemption – the maximum return is capped, while the risk of loss is not. Furthermore, the lower yields are, the greater interest rate risk becomes. The potential for losses in the event of a rapid rise to a higher (once considered normal) level of interest rates is therefore enormous (particularly for assets widely considered to be perfectly safe).
The population is not only affected by the low interest rate policy because almost no interest is paid on savings deposits anymore. Similar to investments, funded retirement systems also depend largely on the interest return that can be achieved on paid-in capital. Since both pension contributions and payouts are performed over long time periods, it is of crucial importance at what rate they are discounted. Among funded retirement insurance plans one distinguishes between defined contribution and defined benefit plans. In a defined benefit plan the insurer promises to pay a specific amount as a pension to the policyholder once he retires. The portfolio risk is borne by the insurance company. In the case of a defined contribution plan, the height of the policyholder’s pension contributions is agreed upon in advance. The pension payments depend on the performance of the portfolio. The risk is therefore borne by the insured, who as a rule has little chance to hedge against low interest rates.
Source: Towers Watson, Incrementum AG
If e.g. a 30 year old enrolled in a defined contribution plan is only able to achieve a return of 4.5% from a portfolio of stocks and bonds compared to a return of 6.5% that used to be common in the past, he must either work for 7 years longer in order to receive the same pension, or must double his contribution (one needs to keep in mind here that an average return of 4.5% is actually an optimistic assumption in view of the growth prospects of developed countries). Defined benefit plans are already facing great difficulties. For example, around 90% of all government pension plans in the US are currently underfunded. The aggregate funding gap amounts to USD 1.2 trillion and therefore represents a great risk to US tax payers.[15]
Additional collateral damage of zero and low interest rate policies
The current zero interest rate policy leads to numerous negative consequences and false incentives. Due to the importance of interest rates for the valuation of assets (discounted cash flow model), changes in interest rates have a sizable effect on the trend in stock and bond markets. In our opinion, ZIRP and NIRP are leading to the gradual ruin of pension funds and insurance companies.
Asset prices that have been artificially inflated by zero interest rates have raised the sensitivity of financial markets with respect to rising rates even further since the crisis. Central banks are caught in a lose-lose situation: Both keeping the zero interest policy in place, as well as implementing rate hikes represents considerable risk. The still outstanding adjustment of asset prices harbors the potential to become a severe confidence crisis. The point at which confidence will begin to crumble is difficult to forecast. We are strongly convinced that gold represents a sensible hedge against such crises of confidence.
[1] https://www.youtube.com/watch?v=Ta7q1amDAN4
[2] See: Baionovski, Mauro: “The IS-LM Model and the Liquidity Trap Concept: From Hicks to Krugman”, History of Political Economy, 2004 (36), pp. 92-126
[3] See: Keynes, John Maynard: Allgemeine Theorie der Beschäftigung, des Zinses und des Geldes [engl. Theee General Theory of Employment, Interest and Money], Duncker & Humblot, München/Leipzig, 1936, 11th edition (2009), p. 184.
[4] See: Mischel, Walter, Yuichi Shoda, and Monica L. Rodriguez: “Delay of gratification in children”, Science, 1989, pp. 933-939
[5] See: Shoda, Yuichi, Walter Mischel, and Philip K. Peake: “Predicting Adolescent Cognitive and Self-Regulatory Competencies From Preschool Delay of Gratification: Identifying Diagnostic Conditions”, Developmental Psychology, 1990 (26), pp. 978-986
[6] See: von Mises, Ludwig: Human Action: A Treatise on Economics, Part 4, “Originary Interest”, ed. Bettina Bien Grieves, Liberty Fund Inc., Auburn, 2007
[7] See: “Der Goldpreis und seine Einflussfaktoren”, philoro Gold Round Table, 03/2015, p.8
[8] See: “Fed Chair Yellen Says She Won’t Rule Out Negative Interest Rates”, Fortune
[9] See: “Breaking The Buck”, Investopedia
[10] See: “The G7 Summit in Japan on 26 and 27 May 2016: the European Union’s role and actions”, European Commission Press Release, May 20, 2016
[11] See: “How Low Can the Bank of Japan Cut Rates? Ask Gold”, Zerohedge.com, February 3, 2016
[12] See: Sands, Peter, and Lawrence H. Summers: “In defense of killing the $100 bill”, Washington Post, February 25, 2016
[13] See: “Market Update: Gold in a world of negative interest rates”, World Gold Council, March 31, 2016
[14] See: Mikhailovich, Simon: “Central banks are trapped by the math“, Tocqueville Bullion Reserve, March 22, 2016
[15] See: “QE and ultra-low interest rates: Distributional effects and risk”, Discussion Paper, McKinsey Global Institute, November 2013
[16] See: Tögel, Andreas: “Die Kultur der Inflation”, mises.org, September 18, 2015
[17] See: von Mises, Ludwig: Nationalökonomie: Theorie Des Handelns und Wirthschaftens [Human Action], Wirtschaft und Finanzen, Genf, 1940, p. 510 – Special thanks to Michael Ladwig and his wonderful book “Ludwig von Mises – Ein Lexikon: Von A wie Anarchismus bis Z wie Zwang”
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