Negative Interest Rates: Rewarding Profligacy
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Presently there are trillions of dollars of bonds throughout the world with negative interest rates. This is an unprecedented turn of events, and one that has many nonprofessional investors confused. Savers are understandably puzzled as to how it is possible for bonds to carry negative interest rates. After all, would an intelligent person really lend $1,000 to someone only to be paid back $950 one year from now?
Economists historically have taken it as a given that people prefer current consumption over the promise of an equivalent amount of consumption at some specified date in the distant future. If you ask anyone whether they would like $1,000 today or $1,000 in ten years, or even in a year, the choice is uniformly for the immediate cash. The future is uncertain, and the preference is always for the immediate reward. Indeed, this preference for current over future consumption is why interest rates exist: people need to be compensated for postponing consumption to a future point in time.
How is it, then, that so many of the world’s bonds are presently carrying negative yields?
Who is buying these securities? The answer is that they are being purchased by various central banks using new fiat money created with the express purpose of decreasing their yields. Central banks, having the luxury of legally and effortlessly creating new money, are not much concerned with the matter of whether bond prices are too high to make them a prudent investment. Rather, they purport to be actively managing interest rates for macroeconomic reasons such as to stimulate growth, encourage employment, and ensure that inflation is near its long-term “target.”
Consider how the process works through a simple, albeit fictitious, numerical example. A rational investor would find it folly to pay $1,030 for a bond that promises to pay back $1,000 one year from now. But a money-printing central bank, having no profit or loss concerns, would not hesitate to buy such a security—profit is not an issue when bonds are bought with money that is created out of thin air. If the Federal Reserve chooses to create new money and buy bonds, it can drive prices up as high as it would like. In the case of our numerical example, if the Fed drives the price up to $1,030, it has imposed a –3 percent interest rate on the market. If the central bank wants the rate to go even lower, say to –4 percent, then it is a straightforward matter of creating more money and buying more bonds to drive the price up to $1,040.
Thus far, the Federal Reserve has stopped short of pushing rates into negative territory. Nevertheless, following the financial crisis of 2008, the Fed stepped up its purchasing of US government bonds and drove interest rates close to zero. The Fed continued to hold short-term rates well below what would prevail in an unhindered market and has doubled down on its monetary expansion amid the COVID-19 lockdown. Alternatively, foreign central banks have pushed beyond zero and driven interest rates into negative territory. In fact, there is mounting political pressure in the United States for the Federal Reserve to follow suit. The motivation for this intrusion into financial markets is the widely held belief that ever decreasing interest rates are necessary to expand real economic activity. In addition, politicians like low interest rates, because the latter make the payments on the large and growing national debt less of an immediate concern.
Throughout history governments have seen new money creation as a clever way to increase spending without having to increase taxes. In the United States the central bank is, at least in theory, “independent” of the federal government. This separation has tended to prevent runaway inflation resulting from excessive new-money financing of government spending programs. Of course, the federal government is still able to finance its spending by selling bonds. And, to the extent that the bonds are purchased by the Federal Reserve with newly created money, it is essentially equivalent to having the federal government print the cash to finance its spending on its own. The only catch for a spendthrift government is that the Fed is not required to buy the government’s bonds. Should the Fed decide not to continue buying the bonds, their prices would fall and interest rates would rise to a market-determined level. The US government is fortunate that this has not happened. Since the financial crisis the Federal Reserve has for the most part been a willing buyer of government debt, and interest rates have been driven to all-time lows as a result.
As central bankers have continued to push interest rates on bonds ever lower, savers are forced to search elsewhere for a decent rate of return. This has been especially true for retirees, who historically have looked toward government and corporate bonds as relatively safe investments for their retirement portfolios. Now, since these securities generate little to no return, they seek riskier investment options. The process begins by moving money into blue chip stocks and then later into shares of startup companies. Thus, we increasingly find them investing in shares of Spotify, Uber, and Tesla on the off chance that these companies eventually make a profit. (If this strategy doesn’t work, the blackjack tables in Las Vegas present another alternative.)
Stock prices have been bid up ever higher as investors have been forced to flee from bonds whose yields are close to zero or even negative. Although the Federal Reserve did not buy stocks directly, its massive bond purchases over the past decade have distorted stock prices by pushing people out of bonds and into equities. Foreign central banks are driving up stock prices in a more direct manner. Many of them have no qualms about creating new money and purchasing stocks outright. An inspection of foreign central bank balance sheets will show a variety of assets, including shares of Apple, Microsoft, and so forth. Even with the current downturn in economic activity and the resulting drop in stock prices, many are still overpriced.
Higher stock prices are generally applauded as a sign that an economy is in good shape. And, there is an erroneous but widely held view that high stock prices are “good” for investors. One should be careful with such generalizations. More accurately said, high stock prices are “good” for those investors who are at or near the end of their work life and are already in possession of a large stock portfolio. A young person who is a new entrant into the labor force and is working feverishly to save enough cash to buy her first share of Apple does not benefit from having a pumped-up stock market. High stock prices are good for some people, and bad for others. Of course, a collapsing stock market will reverse these roles in short order and would certainly occur should the Fed eventually decide to allow interest rates to revert to actual market equilibrium.
In addition to this imposition on retirees, the Fed's downward manipulation of interest rates has another effect. Indeed, the move is simply a price ceiling keeping interest rates well below what would prevail in an unhindered market. Like all such price controls, this one creates a shortage of actual savings, which provide the sustenance for the capital investments beings made. That is, savers have less incentive to save and borrowers have a greater incentive to borrow funds. Such borrowing is only made possible by the creation of this new money that did not require greater actual savings. Eventually, this disconnect in the market must be realized, and bad capital investments will have to be liquidated.
This can be seen happening as students continue to mount up student loan debt. As of this writing student loan debt stands at a little over $1.6 trillion. In 2008, when the financial crisis began, that figure stood at around $600 billion. Beyond student loan debt, there is a constant barrage of advertising for older people to take out loans via reverse mortgages. Again, these represent a heavy amount of dissaving in the economy as people consume future resources and past savings.
So where does the current reality of central bank activism leave us? Through the purchase of bonds and stocks central banks are able to manipulate financial markets and real economic activity. To a great extent a company’s success or failure hinges upon its ability to obtain financial capital through the issuance of securities. A company whose shares are readily gobbled up by a money-creating central bank is going to be advantaged over a company whose shares are not treated as favorably. By lowering the cost of capital of one company and not another, central banks can ultimately determine who stays in business and who fails. This ability to pick winners and losers can work its way through markets to determine the collection of goods and services available for the consumer to choose from. This turns traditional thinking upside down. In the traditional view of free enterprise, those companies whose goods and services are valued most by consumers will see growth in revenue and earnings, and ultimately a higher stock price. The higher stock price is the reward to owners, generated by producing those things most desired by consumers. Those companies whose products are not as desirable will run short on cash, will not be able to sell shares of stock or borrow money, and will be driven out of business. But central banks can alter the process by providing costless financial capital to one company over another. An advantaged company can lower the price of its output when compared to its competitors, ultimately driving the competitor out of business. This then determines what goods and services will be available for consumers to purchase in the marketplace.
Recently there has been increased discussion as to whether central banks should expand their activities into environmental concerns, rather than merely focusing on the historical objectives of stable prices and maximum employment. From the foregoing discussion, one can see how companies that are deemed to be doing the “right” things could be advantaged and be the survivors in the marketplace, regardless of whether the goods and services that are being produced are things consumers actually want. Initial stock offerings that are greedily bought up by central bankers with the printing presses will always be a success. A competing company whose bonds and shares of stock are shunned will likely not be able to stay in business for long. Free markets and individual liberty cannot exist in a world where governments, working hand in hand with their central banks, determine which companies survive and which fail.
The financial crisis of 2008 provided the justification for ever greater intrusion into financial markets by the world’s central banks. COVID-19 has only added fuel to that fire. Ideas and policies that were previously thought of as preposterous, such as negative interest rates and outright stock purchases by central banks, are now increasingly accepted as the norm. Market manipulation through bond and stock purchases provides a less-than-transparent means whereby governments can take ever greater control over economic activity. As long as fiat money exists, and is readily created by governments through their central banks, free enterprise is at risk. The financial crisis of 2008 opened the door, and governments and central bankers cheerfully walked through it. Whether the current direction can be reversed remains to be seen. In the United States the Fed can strive to maintain a degree of independence, but this is going to be difficult given that the Fed chairman and the Board of Governors are ultimately political appointees. If politicians want negative interest rates, the Fed chair and Board of Governors can provide resistance only so long as they remain in their respective positions. New governors who wish to be more “accommodative” to the needs of the federal government and its spending programs can always be appointed. Freedom advocates find some encouragement in the nascent market developing for Bitcoin and other forms of free market money. Although digital currencies are still not widely used for the purchase of consumer goods and services, the development of private money is not subject to the whims of politicians. They do provide some hope for rational interest rates, security prices, and economic liberty.