Practical analysis for investment professionals
10 January 2020

Negative Interest Rates: The Logical Absurdity

It is not uncommon for the word “absurd” or its derivatives to accompany discussions of negative nominal interest rates. A healthy proportion of financial opinion makers describe the phenomenon as a fundamental violation of the first principles of finance. Not that a financial background is required to conclude as much. Explaining the concept to the layperson produces a raised eyebrow and crinkled forehead: It just does not feel right.

Nevertheless, this author does not think it precisely right to say that negative rates are absurd. In and of themselves, upside-down rates — almost exclusively restricted to the sovereign bonds space — do make sense. They reveal the high cost of staying solvent — a cost borne by the financial institutions that purchase these securities.

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The modern monetary system operates on credit. But after the financial peripeteia of 2007–2008, extending credit on an unsecured basis became inconceivable. Therefore, the post-2008 monetary order funds the global machinery of international commerce and investment almost exclusively on a collateralized basis. Secured funding only.

No-Collateral Damage

But here is the problem: There is not enough collateral. So financial institutions will pay “anything” for it, including “guaranteed” losses on sovereign debt, assuming the government obligation is held to maturity, which it is not. These negative-yielding bonds are not investments but balance-sheet management tools.

Think of the Phillips-head screwdriver in your toolbox. You do not keep it for its intrinsic value in steel, nickel, and chromium. In the same way, financial institutions do not own negative-yielding nominal bonds for the future cash flows. The bonds, like the screwdriver, are held for what they can do. The bond serves as collateral for a short-term loan to tide over the bank because, by the very nature of the business, there is a timing mismatch between liabilities (e.g., short-term cash withdrawals) and assets (e.g., long-term mortgages).

Tile for The Incredible Upside-Down Fixed-Income Market: Negative Interest Rates and Their Implications

‘Tis just having been the season, the example of It’s a Wonderful Life should lend itself to your analyst’s mind. George and Mary Bailey sacrificed their honeymoon savings on an unsecured basis to keep Bailey Bros. Building & Loan Association solvent until the bank run panic ended. But outside of their town of Bedford Falls and after 2008, banks need to put up collateral to access honeymoon savings — or any other kind of short-term funding. They do so to meet obligations and regulatory requirements without being forced to sell their long-term investments.

Thus, the hamartia is exposed. A global monetary order, organized over the course of five decades around access to unsecured, interbank short-term funding, is now obliged to secure its funding. At the same time, the expectations of politicians, monetary technocrats, and the public are unchanged. The whole creaking locomotive is all supposed to puff along as it always has.

It is an open question as to whether there was enough collateral for the world economy to function at the exalted levels it had achieved on a collateralized basis before 2008. But it’s clear in early 2020 that the gap has only widened.

It’s been a dozen years of one form of collateral after another being demonetized (mortgage-backed securities in 2007–2008), nearly repudiated (sovereign bonds of Europe’s Mediterranean-rim countries in 2011–2012), or heavily discounted (emerging market bonds and currencies in 2014–2016). As the Financial Times reported:

“According to research by Oxford Economics, the resultant global shortage of these safe assets is going to get worse. The consultancy calculates that the supply of these assets will grow by $1.7tn annually over the coming five years — with a $1.2tn issuance of bonds to fund the US budget deficit the largest driver. But demand for these assets is estimated to grow more rapidly, creating a $400bn annual shortfall . . . ‘The largest buyers are relatively price-insensitive and will continue to accept low returns in exchange for safety,’ said Michiel Tukker, global macro strategist at Oxford Economics.”

And, of course, all of this was financialization and not the “real” thing. True collateral is created from economic progress, rule of law, human advancement, and national development in the present and expectations of it in the future. These beautiful concepts are hard to come by during an economic depression.

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What Depression?

The one we’re living through right now. Mervyn King, the former governor of the Bank of England, said as much in his 2019 Per Jacobsson Lecture at the International Monetary Fund (IMF)’s annual meeting. Though he avoided the “D word.” Here is how he put it in a column for Bloomberg:

“The International Monetary Fund just lowered its estimate of world growth both this year and next. Every data release seems to bring gloomy news. If the problem before the crisis was too much borrowing and too much spending, then the problem today is too much borrowing and too little spending. The world economy is stuck in a low-growth trap.”

It is no wonder then that those who have access to the most liquid, fluid, and important collateral are hoarding it like the past holiday season’s most popular children’s toy. Except that in this sempiternal season, “It is always winter, never Christmas,” to quote C. S. Lewis.

It is a self-reinforcing cycle: no trust, not enough new collateral, hoarding of existing collateral, impeding economic potential, further reducing trust, further dimming economic potential, etc. Negative interest rates are a “logical” consequence of the larger, absurd picture: an unacknowledged, silent depression.

Weltschmerz-suffering readers are encouraged to follow this author’s lead and drown your sorrows in leftover seasonal mulled wine. Perhaps in this more contemplative state, you will notice that by rearranging the letters of “depression,” a solution to the problem is revealed: “I pressed on.”

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

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About the Author(s)
Emil Kalinowski, CFA

Emil Kalinowski, CFA, is employed in the metals and mining industry writing about how socioeconomic and geopolitical trends affect the supply, demand, and price of base and precious metals. His present focus is on the 2007 malfunction of the monetary system and its continuing disorder. Presently living in the Cayman Islands, he is also radio talk show host (@MoneySenseRadio) and newspaper contributor (@cayCompass) but ratings and letters to the editor suggest he's probably going to have to keep his regular job. When he's not attending Flight of the Conchords performances, you can find him on Twitter @EmilKalinowski.

15 thoughts on “Negative Interest Rates: The Logical Absurdity”

  1. Professor Prem raj Pushpakaran says:

    Professor Prem raj Pushpakaran writes — 2020 marks the birth centenary year of Lawrence Robert Klein!!!!

    1. EMIL KALINOWSKI says:

      There was an interesting (and blessedly short) podcast on MacroVoices yesterday (13-Jan-2020) during which econometric models were discussed. Jeff Snider, the interviewee, indicted economists for being infatuated with their models (to their detriment). That for all their beautiful, complex math they are nowhere near complex enough to capture reality. It was a theme that Danielle DiMartino Booth – an outsider working inside the Fed – brought up in her book Fed Up as well.

      It seems to me that while the field of mathematics has over the past century embraced uncertainty, limits to knowledge, and truth outside the equation/system (e.g. Poincaré, Gödel, Tarski, Chaitin, Turing, Svozil, Heisenberg) economics has gone the other direction. I am not up to the task in understanding these mathematical theories of incompleteness nor econometric equations of equilibrium; nevertheless sense that the former philosophy, not the latter, is wiser.

  2. Kirk Cornwell says:

    One should not have to pay extra for essentially infinite fiat money. It is good form in a financial institution to pretend otherwise. Euro-governments are desperate for someone (besides government) to borrow some and spend some.

    1. EMIL KALINOWSKI says:

      I believe you are implying that infinite fiat money is worthless; that these pieces of paper will be revealed as merely the fig leaves covering the immodest financial and budget mess our governments are in. Agreed. But, that is tomorrow’s problem; insolvency is on, or over, the horizon somewhere.

      Today’s problem is illiquidity and banks don’t have the luxury to make a stand about the state our countries’ finances. If the market is accepting these sovereign bonds as the best form of collateral, so as to access short-term funding, then that’s what banks will use (even though we all ‘know’ the chances of being paid back in full in real terms is not a winning investment decision). As I attempted to explain in the article, these are not investments but merely tools.

      1. Kirk Cornwell says:

        I am pleasantly surprised any time I hand over a Federal Reserve Note for a product, it is accepted, and the price is the same. Have I heard money is a “shared illusion”? Never more than now.

  3. Paul O'Brien says:

    Negative interest rates are not absurd, Emil. They are a good policy step to solve the problem you describe.

    The problem is an excessive unwillingness to lend without good collateral. That may be rational for the individual risk-averse saver, but leads to an equilibrium with too little investment and growth.

    Don’t think of negative interest rates as interest rates. Think of them as a small positive rate of interest plus a tax on excessive liquidity. (That’s why negative discount rates don’t cause infinite asset prices.). The negative rates correctly penalize excessive hoarding of liquidity and drive investors to take more risk.

    Of course, I would rather this was all explicit. Central banks should not be tax collectors. Negative rates have unfortunate distributional effects – all taxes do – and these would better be imposed transparently by the political process.

    1. EMIL KALINOWSKI says:

      Hello Paul. Thank you for taking the time to read (I thought only my mom read these) and post a thoughtful challenge. I won’t disagree with the points you made with one exception: “a good policy”. They certainly sound like a good policy for reasons you describe but if they actually were then why had they never been thought of before? Jim Grant (of the Interest Rate Observer) has popularized a claim that has been repeated many times now over the years: these are the first negative nominal interest rates (short-term policy rates) in human history. He’s relying on Sidney Homer and Richard Sylla’s book, A History of Interest Rates.

      Economics is neither organic chemistry nor materials science, it is not a field where the advancement of human knowledge leads to breakthroughs. Economics is the study of human behavior through a particular lens (money), like politics through the lens of power or religion through the lens of faith. I bring all this up in a long-winded attempt to say that in economics – like in other fields relating to the human character – we can rely on the great texts, philosophers, playwrights of the ages for guidance. Nobody had come up with this idea before.

      Now, that’s either because our monetary technocrats are wiser than all the generations before or, more likely, they are more unwise. To paraphrase John Kenneth Galbraith, ‘There can be few fields of human endeavor in which history counts for so little as in the world of modern central banking. Past experience, to the extent that it is part of memory at all, is dismissed as the primitive refuge of those who do not have the insight to appreciate the incredible wonders of Haruhiko Kuroda and Mario Draghi.’

  4. Deepak Hemnani says:

    Superb and extraordinary information presented in easy to understand language😄

    1. EMIL KALINOWSKI says:

      This is a very unusual note for me to receive, thank you. Typically I receive notes that lie somewhere on the spectrum between “backhanded compliment” and “ransom demand”. So I do appreciate it.

  5. Alexis Nass says:

    Great paper. I just dont get the collatéral thing : Aa govies are cash like because they can be repoed any time against cash.
    So, saying that you need govies as collatéral for short term borrowing is saying that you need cash to have cash ?? But you already have it !

    1. EMIL KALINOWSKI says:

      Thank you Alexis. Perhaps it has to do with leverage. Whereas cash (well, really deposits at the bank) is not readily useful for multiplying one could put up X in German Bunds and receive X + Y in deposit credits. Also, if one was so inclined, you could relend the same piece of collateral a few times and earn some extra profit off of one security.

      It’s all rather murky but sometimes collateral is more valuable than cash itself. I believe the best real-world example of that are repurchase agreement failures to deliver and receive. Both the Depository Trust & Clearing Corporation and New York Federal Reserve produce a report on this. My interpretation of the data suggests that during periods of illiquidity banks refuse to hand over the collateral they promised they would. They are so in need of it that they would rather pay a penalty rate than hand the security back over. They rather hold the security then receive cash.

      1. Jan Wlosowicz says:

        Thank you Emil for interesting article and everyone for a good discussion.
        Although I really like the unconventional approach to the problem leading to nontrivial conclusions, I have an impression that the whole problem was “overengineered”, (for a lack of better word). Negative yielding collateral is a result of negative yielding cash held with central banks. One could rightly point out to advantages of risk-free asset collateral over cash (I’d primarily relate to interest rate risk; I’m not too familiar with leveraged repos or collateral repledging), but this extra utility doesn’t suffice to enforce negative yields. In my perhaps simplistic view yields on sovereign bonds are negative as a consequence of introduction of negative rates which commerical banks have to pay to central banks for holding cash on their balance sheets. Am I missing something?

  6. Sophia says:

    Amyn and Sophia were discussing the difference between the price of a product and its worth.
    Sophia mentioned she had bought a new dress in a charity shop, but thought it was worth a lot
    more than she had paid. Amyn said that the price Sophia had paid was the result of market forces.
    He explained the effects of competition between charity shops on the prices of their products.
    Sophia produced a table showing the demand by her friends for dresses from charity shops.

  7. Paul OBrien says:

    Hi, Emil, thanks for your response to my comment. Good arguments, but I want to push back on one because it is so important.

    Jim Grant is wrong about negative rates being a novel policy. Sovereigns have imposed negative interest rates on money at least since the first Roman emperor debased his coinage. My favorite negative rate story comes from my wife’s grandfather. During WW1 in Hungary he watched the Emperor’s troops ride into town, collect everyone’s cash, stamp half, and confiscate the rest. And, of course, our own Franklin Roosevelt abolished gold clauses in contracts and made the holding of bullion illegal.

    Negative interest rates may be a bad policy. They certainly are not first- or even second-best. But they are a policy tool with a long history and are sure to be used whenever the sovereign so chooses.

  8. Emil,

    Here’s another comment that’s not on the spectrum between “backhanded compliment” and “ransom demand.” I think your essay is a very thoughtful one.

    In holding securities with negative interest rates, banks are following the logic of their own circumstances. As you say, they view these not as investments but as collateral that enables them to lend. If they didn’t think they were assured of being bailed out, they might think differently.

    You and I no doubt agree with Jim Grant that it’s a warped state of affairs when homo economicus is willing to accept less in the future in return for putting capital at risk today. It’s not natural and won’t last.

    By the way, I’m still in suspense about Comment #6 above. Do we know what happened to Amyn and Sophia? Were they able to reconcile their differences over price theory and find happiness?

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