This piece is not original or revolutionary. It is a distillation of various discussions and illustrative of a current somewhat unique situation.
Post commencement of writing this article, the author has read an excellent piece by David Merkel in the Aleph Blog, http://alephblog.com/2015/04/21/on-negative-interest-rates/. This explains negative interest rates perhaps more eloquently than the current.
In the current economic environment, the European Central Bank (ECB) and other central banks including those of Switzerland, Sweden and Denmark, have set interest rates on cash deposits below zero. Certain bonds are also trading at negative yields. This means that a depositor or lender, instead of being paid for access to their money, is actually paying for it. Expressed another way: Lenders are accepting less than their initial principal for their funds. Or, “I will lend you my money and pay you to hold it”. Such a situation, far from “normal”, is linked to times of economic uncertainty. Ironically, at such times, one would expect borrowers to line up, to take money and be paid to do it. One does not even have to do anything with the money – just hold it – to generate a return. However, such borrowers are not being inundated with cash. Lenders, concerned with risk, are prepared to pay (a relatively small amount) to keep their money safe. The universe of borrowers who meet safety criteria is small. These borrowers, institutions like the Central Banks, are for various reasons not able to deploy the money they borrow. Indeed, they are probably “printing money”, through various mechanisms including quantitative easing, themselves. The result is that they end up imposing what is effectively a holding or storage cost. This manifests as a negative interest rate.
Negative interest rates are also associated with periods of deflation, stagnant economies and other gloom and doom situations. The current time is no exception. Denmark is using negative rates to keep the Danish Kroner pegged to the Euro. The ECB is trying to stem deflation, while other countries are attempting to depreciate their currency and to reduce borrowing costs to stimulate the economy. Quantitative easing, and other Central Bank initiatives which are effectively the “unlimited printing of money” also contribute to pushing rates down and into negative territory.
To understand what is happening, it is useful to revisit the basic premises of interest rates. Conventional explanations break interest into several components:
• A time or utility element. This is the value of having money now rather than in the future
• A risk premium, seen as the return required to offset the risk of lending money to another party, or the risk associated with possible loss of part or all of ones principal
• An inflation component, wherein creditors require compensation for the erosive effect of inflation
Under this framework, negative interest rates are completely counter intuitive. Cash is valuable. There will always be parties willing to pay for it. Why would there ever be a time when the holder of cash should has to pay to deploy it. If this were the case, the anecdotal “put it under the mattress” – a zero interest scenario – would be a better outcome. If the lender not being rewarded for time value, risk, or for inflation, then holding cash should be the worst case outcome.
Various explanations for negative interest rates exist. They are the topic of discussion and debate. The reader is encouraged to the references below for more information.
Negative interest rates can be explained as a “storage cost for money”. We are well accustomed to paying for storage of various items. This includes furniture, valuables or assets like wine, which require special holding conditions. There is nothing counter intuitive about this. However, why would one pay to store cash. There is nothing unique about cash (other than the currency it is denominated in). Antique furniture is to some degree a parallel. Antiques are generally regarded as items of value. Over time they are likely to appreciate. However, unless one uses antiques, or finds a party who can use them, they take up space, may be non practical, non functional. They need to be stored, and for this, there will be a cost (especially if the storage is secure, temperature controlled etc.). The owner may lend their antiques out, or find a party who can use them. They may be paid for this. However, their is risk – that the party using them will destroy or damage them, and will not keep them safe. Perhaps, this risk is too high, and it is better just to pay to store them. There is nothing counterintuitive about this at all. Exactly the same holds for money. In the current environment, there is in a sense “too much” available. Central banks are providing excess liquidity at low cost. Like antiques, money has a value, but right now, it can’t be deployed without taking on excessive risk. So to store money safely, the owner (or in this case lender) must pay. Keeping it under the mattress – to avoid paying for storage – is a limited solution. Small amounts of cash can be stored. Large amounts (think a hundred million dollars, a billion dollars or more) are in no way storable, without specialist facilities. The solutions are either to find a party who will pay to use the money, or to pay to store it. Currently, there are limited options for the former. A slow economy and Central Banks printing money, means that there is a shortage of borrowers of the right quality (whatever that is). Rather than take excessive risk for a positive return, lenders are prepared to pay a storage cost (at least for the short term) to warehouse their money.
A simplistic illustration, but nonetheless something to ponder ….
One further observation: If negative interest rates are indeed a holding cost for money, their magnitude should be capped. The balance point would be the cost of creating a viable storage facility (real estate, security etc.) vs. using what is already available (ie the Central Bank). So negative interest rates of >1%, 2% etc would definitely be counterintuitive.
References and sources for further reading:
•http://www.bloombergview.com/quicktake/negative-interest-rates
• http://www.forbes.com/sites/markhendrickson/2015/03/06/negative-interest-rates-a-brilliant-concept/
• http://alephblog.com/2015/04/21/on-negative-interest-rates/
• http://www.nab.com.au/personal/privatewealth/insights/negative-interest-rates
• http://www.zerohedge.com/news/2015-04-21/european-banks-are-paid-borrow-first-time-ever-euribor-goes-negative?destination=node%2F505076
• https://www.stlouisfed.org/publications/regional-economist/january-2013/how-low-can-you-go-negative-interest-rates-and-investors-flight-to-safety
April 22, 2015
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