Negative Interest Rates

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Since the 2008 financial crisis, the policy of central banks to forcibly push down interest rates, followed by the rapid expansion of their balance sheets in order to attempt to “stimulate” economic growth has, to say the least, been something of an abysmal failure. Unemployment is still high, economic growth barely makes it any higher than a rounding error and real wage rates continue to stagnate as they have done for the past ten years or more. Benefitting only Wall Street, the new money has pushed stock markets to record highs and bond yields to record lows, so much so that owning these assets over the past five years has been the closest one can get to a sure bet. Main Street, however, having had to deal with the reality of the fact that the debt-fuelled consumption mania is no longer sustainable and that real savings to grow businesses are in short supply, continues to languish in what seems like a completely separate realm from the casino operations of the financial markets. With positive interest rates now as low as they can possibly go and with little to show for it, it is no surprise that the prospect of negative interest rates in order to force everyone to spend their way into a recovery is now a real one. Indeed, it is already very much a reality in Switzerland and Denmark.

The proposal for negative interest rates rests on a typical Keynesian plea that the government and central banks did not act “drastically enough” in attempting to defibrillate the economy back to growth. Contrary to understanding the lack of any meaningful recovery as a failure of their policies, they instead turn around and say “if it is this bad now then imagine how terrible it would have been had we done nothing at all!” The patient is therefore prescribed ever greater doses of bad medicine in spite of the fact that it is the medicine that is killing him. (Has it not also been said often that the definition of insanity is to repeat an act continuously with the expectation of a different outcome?) Indeed, the economy is so saturated with debt that only paying people to get deeper into it has any prospect expanding the volume of spending.

Negative interest rates are, of course, a praxeological absurdity and could not come about through anything except government force. It is tantamount to placing a premium on future goods as opposed to present goods, so that the prospect of receiving £100 today is less valuable than receiving £100 in a year’s time. Practically, what this means is that, if you deposit £100 in the bank today with an interest rate of -5%, you will have only £95 in one year’s time. You are, therefore, quite literally paying the bank to borrow your money, a proposition absurd to anyone except a tenured professor of economics. Since when, to invert a popular proverb, has a bird in the bush been worth two in the hand? The idea, of course, is that you will be so keen to avoid the interest charges that you will cease to be an “evil” saver and rush out to spend all of your money as soon as you can. Thus the magical Keynesian multiplier will burst into life, restoring us to the land of milk and honey. What’s more, they hope that it will encourage a flurry of borrowing as all the excess reserves piling up in bank vaults (or, rather, on their computer screens) are now lent out to those eager to be paid to hold cash. Traditionally, of course, banks earn their revenue by paying depositors a lower interest rate than they charge to borrowers. With negative interest rates it seems as though the situation will reverse: the bank will make its money by charging its depositors more than it has to pay its borrowers.

Such a ridiculous idea does, of course, run into the unfortunate fact that every unit of money has to be in someone’s cash balance and if all cash balances attract a negative interest rate there can only be an incentive to borrow if the rate on your deposit account is less than the terms of the loan – in other words, you have to pay less to hold the cash than you get paid for taking out the loan. Further, if someone can only get rid of their cash by passing it onto someone else and that latter person can then only do the same then the logical end of the proposal is hyperinflation. That aside, however, what will be the likely effects of the introduction of such a policy?

The first likelihood is that, with bank deposits now charging an interest levy, holding hard cash under the mattress becomes an attractive alternative. In both inflationary and deflationary environments it will lose less and gain more than a bank deposit. Indeed, at first blush, libertarians should welcome this possibility. After all, it is free deposit banking that has resulted in people willingly stashing all of their cash in fractional reserve banks, enabling them to pyramid loan upon loan on top of them and thus causing the disastrous business cycle. When money consisted of gold or silver stored in full reserve banks it was natural for banks to levy a charge for this storage service. People could either choose to accept the charge in return for the safekeeping of their assets, or prefer to keep the cash in their own storage provisions at no cost. Viewed this way, negative interest rates give the appearance of a return to something more akin to cash handling as it would be in a libertarian world. Unfortunately, of course, the negative interest rate is an arbitrary figure and does not represent the true value of storage services to holders of deposit accounts, and having been accustomed to the provision of such services for free anyway a mass withdrawal will be the most likely response. Indeed, it would not be unsurprising if something akin to Gresham’s Law emerged where, legally, bank deposits and cash notes trade at par but where undervalued cash becomes hoarded and people keep only a minimum amount of overvalued bank deposits with which to use for their exchanges. Such an outcome would, of course, utterly defeat the purpose of negative interest rates which is to swell the volume of spending through electronic exchange. In other words, the point at which negative interest rates begin a flight into cash will mark the true limits of monetary policy in creating a spending splurge.

Needless to say, of course, the likely government response is to restrict cash holding with a view to eliminating cash altogether in order to concentrate as much money as possible in commercial bank deposits. Such an end has, in and of itself, been a cherished aim of government, as it permits oversight of and control over every single financial transaction. Under the guise of “combating terrorism” such restrictions have already been tightened recently in France, where, from September of this year, cash payments in excess of €1000 will be illegal. Similar restrictions have appeared, in the last few years, in Spain, Italy, Russia and Mexico. Where cash remains less restricted, any attempts to convert deposits into cash may be met with refusal and obstinacy, as a Swiss pension fund discovered recently when it attempted to switch its deposits to paper notes stored in a vault. Indeed all of this harkens back to the era when banks overinflated on a monetary base of redeemable gold. Back then, redemption in gold was restricted to concentrate people’s cash holdings in paper notes. Now, redemption in paper notes is restricted to concentrate cash holdings in deposits.

The likely reaction to this is that, with deposits and fixed income securities losing value in both nominal and real terms, people will abandon these assets in pursuit of safer stores of value – probably gold and silver. In other words, shorn of the ability to withdraw hard cash, people will keep on deposit only the amount they need to meet their current expenditures while the rest of their savings will be ploughed into harder assets. A flight out of debt instruments would trigger a deleveraging and usually, in such circumstances, the safe home for such funds would be cash. But if cash will also be subject to a negative interest rate and with no ability to withdraw paper notes, then movement of the money into gold would cause the gold price to rise. We would therefore have the peculiar effect of increasing asset prices during an era of deflation. Such are the ways in which monetary policy can turn the world upside down.

The likely effects of a negative interest policy as outlined here demonstrate the limits of a monetary policy that attempts to kick the economy back into gear through spending. You can print all of the money that you like; you can lower interest rates as far as they will go; you can make it impossible for people to withdraw their cash; but like the proverbial horse to water, you cannot force people to borrow and spend. In short, you cannot cheat the market with increasingly absurd tricks that would have baffled even the monetary charlatans of yesterday. Only liquidation of the existing debt and a return to sound money with interest rates determined by the supply of and demand for saved funds will create a proper, sustainable recovery on the path to prosperity.

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Ethical Banking – the Woes of The Co-operative Bank

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The Co-operative Bank, one of Britain’s smaller financial institutions, has recently gone through several spectacular stages of self-destruction that has left many of its advocates, having trumpeted the fact that the bank initially emerged from the financial crisis of 2008 relatively unscathed, eating hearty slices of humble pie. Earlier this year its planned acquisition of more than six hundred branches from Lloyds Banking Group fell through when it was revealed that the bank was harbouring a large capital shortfall, most of it stemming from bad debts that were incurred as the result of an earlier merger with Britannia Building Society. The resulting rescue attempts by The Co-operative Group – its outright owner – left seventy per cent of the bank in the control of its bondholders, many of whom, such as US hedge funds, are precisely the kind of outfits that this “ethical” institution did not wish to emulate. Then, in November, the bank’s chairman at the time of its crisis, the Reverend Paul Flowers, was filmed allegedly purchasing illegal drugs from an acquaintance days after his appearance before a Treasury Select Committee during which he was unable to answer basic questions about the bank’s operations during his tenure, and had apparently organised drug fuelled orgies with rent boys from his bank email address, in addition to other past indiscretions. To make matters worse it has been alleged that Reverend Flowers’ influence extended to the leadership of the British Labour Party, expanding the Co-op’s in-house crisis into a political one. This succession of events has highlighted not only the hypocrisy of The Co-operative Bank in striving to maintain and promote an ethical stance and status (an aim that it is shared by its parent and the wider Co-operative movement) but also those who have used this institution as a political tool in holding it up as a paragon of virtue in the wake of the havoc and destruction caused by those greedy and unethical city banks. But this raises a very pressing and pertinent question – precisely what is ethical banking?

The Co-operative Bank’s ethical pride appears to centre on its mutual, member-owned status (or at least that of its parent) that allegedly offers an alternative to the shareholder model, and its Ethical Policy that prevents it from extending banking services to arms dealers, polluters, oppressive regimes, animal testers and so on. Having apparently brought itself to the brink of collapse through over-expansion and bad loans on the watch of a junky chairman who didn’t even know the size of the bank’s loan book does not appear to give much credit to this. Nevertheless, as far as the basic ethics of banking are concerned, all of this is pretty irrelevant. Rather we must conclude that banking, as far as it is practised in most of the world today, is inherently unethical. The Co-operative Bank, regardless of its ownership or its lending policy, was still engaged in the fraudulent cartel of fractional reserve banking under the aegis of a central bank and in that overriding respect it was no different from any other financial institution – and it was this fact that is at the foundation of its weakness. It took money from depositors and lent that very same money with which it had been entrusted to borrowers, expanding the supply of money, lowering the rate of interest and diverting resources to otherwise unsustainable capital projects and investments. It is this that marks the grossly unethical conduct of The Co-operative Bank and one cannot claim to be an ethical institution while at the same time engaging in this kind of fraud, the outcome of which can only be to lead the economy on to a destabilised path. Thieving depositors’ money is not made any better simply because it is lent to politically correct, environmentally friendly and do-gooding borrowers (indeed given that Co-operative Bank has apparently extended several million pounds worth of loans on favourable terms to the Labour Party some might say it makes it much worse).

Genuine, ethical banking can only come about only when a deposit institution issues one, single title to each penny that is on deposit. Where a bank extends a loan this must be met either from its own funds, or from fixed term deposits that mature at a date specified to coincide with the repayment of a corresponding loan. Naturally a bank can specify that it will only lend to certain borrowers in order to attract a certain class of saver, but that is only a distraction from a bank’s basic ethical duty – to safeguard the funds of its depositors. Any bank, regardless of the characters and qualities of its borrowers, puts these funds at extreme risk under the fractional reserve system if those same borrowers cannot repay the loans. Whatever went wrong with The Co-operative Bank’s particular peculiarities, one should not allow them to detract from this central fact of the banking system and focus should be diverted to its direction if we are ever to have truly ethical financial institutions.

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