Negative interest rates and the road to Hell

The ancient Roman philosopher, Seneca, said “travel and change of place impart new vigour to the mind”. But perhaps central bankers should not be allowed to travel?

Take the Bank of Japan’s governor, Haruhiko Kuroda. Just two weeks ago, he gave a speech to Japan’s parliament which was the essence of Japan’s shimaguni konjo – its independent, insular mindset.

Despite continued economic weakness, Kuroda said he would not be influenced into adopting negative interest rates by his counterparts in the eurozone, where interest rates are already negative: “There are pros and cons of adopting negative interest rates”, he said. “The Federal Reserve didn’t adopt negative interest rates, and yet its policy succeeded in stimulating the US economy.”

But the day after giving his speech, Kuroda breached ancient Japanese precepts: instead of staying at home, he flew to Davos, where one imagines he found himself amid a melée of panicking bankers and CEOs, all coming to terms with January’s severe global correction in risk assets.

Kuroda returned to Japan with new mental vigour – and last Friday morning took the unexpected and “nuclear” step of cutting Japanese interest rates to minus 0.1%, with the threat of deeper cuts into negative territory to come.

And today Kuroda spoke again in praise of his new policy: “The constraint of the ‘zero lower bound’ on a nominal interest rate, which was believed to be impossible to conquer, has been almost overcome by the wisdom and practice of central banks, including those of the Bank of Japan. It is no exaggeration that [ours] is the most powerful monetary policy framework in the history of modern central banking.”

Earlier this week, I was dining with a hedge fund manager. We were discussing the “wisdom and practice” of our great conquering central bankers. We are not sure they are so wise. We were imagining what a future of strongly negative interest rates – government bond yields of minus 3%, and equity dividend yields of close to zero – might look like. It is a grim future which seems to be getting closer every day.

“Of course, it can work”, says my friend. “But getting there from here won’t be pretty.”

Getting there won’t be pretty because negative interest rates breach an implied social contract between a government and its citizens. That social contract contains the moral idea that an individual lending money should be rewarded with interest (even if, in an inflationary world, our savings are in fact being eroded by inflation). In a negative interest-rate world, the only reward for lending to a state is the ability to protect at least part of one’s capital, at the cost of a fee (the negative interest rate).

But one artefact of the previous era stands in the way of enforcing negative rates: the existence of cash. In an era of negative rates, people will eventually take money out of banks. Perhaps they may not do so at minus half a percent or so – because the costs of protecting and insuring cash at home are higher than that – but as rates get progressively more negative, they surely will abandon deposits in banks.

Even before last week’s interest-rate decision, in low-crime Japan so many people stash cash under their proverbial mattress that physical cash in issue amounts to fully 20% of Japan’s GDP – a multiple of any other country’s banknote issuance.

So, in the mad, mad world of negative interest rates, to keep the banking system solvent, an essential component is, as the Bank of England’s Andy Haldane has suggested, to ban cash – or at least to make storing it outside banks highly unattractive.

Perhaps this week’s suggestion that the ECB should ban the €500 note is just the beginning. Why not ban all banknotes, apart from the very smallest denominations, so the amount of space required to store value becomes incredibly high? How many £5 notes can you fit under a mattress anyway?

Or why not give banknotes an expiry date – so that they can’t be stored for long? Perhaps, as a sop to the median voter, allow people to put a modest amount – perhaps £10,000 – in the bank at a zero rate; but amounts above that will be subject to strongly negative rates?

Banning cash means the end of privacy. It grants the state – or Google, or some other overseer – the ability to witness every single transaction a citizen makes. That itself is a horror – yet the slide to negative rates will have worse features.

It will be socially corrosive. Pensioners who have imagined a retirement funded at 8% yields will find themselves impoverished – and needing to sell assets to survive. Companies which have guaranteed defined-benefit pension schemes will find those schemes helping themselves to ever larger slices of the company’s equity, to the detriment of shareholders. Students who have taken out debts to fund their education will discover their debts are an inescapable burden.

And for all these horrors, despite Kuroda’s enthusiasm, it is not clear that negative rates will create growth. Under one scenario, the grim view of economic prospects negative rates portray might make consumers even less willing to spend. And one can imagine another scenario, where deeply negative rates suddenly work all too well and set off a path to hyperinflation.

Just as hyperinflation is a social disaster because it creates winner and losers – the winners are those who hold real assets. The losers are savers – negative rates will also be corrosive because amid the many losers there will also be winners, in particular anyone who is lucky enough to have locked in a high-interest, risk-free interest rate from the old inflationary era.

A friend’s mother-in-law is the happy owner of Italian Postal Savings Bonds. These were issued in the late 1990s, in highly-inflationary Italian lira, with a 20-year term, and currently yield 14% in euros to 2019 with the guarantee of the Italian state. Few of us will be as lucky.