The dangers of negative interest rates

Negative interest rates could spark the next financial crisis. And central bankers could end up the object of the public's wrath, says Merryn Somerset Webb.

Mario Draghi © Dursun Aydemir/Anadolu Agency via Getty Images

Who do you blame for the last great financial crisis? Just off the top of your head. I bet the phrase that pops up first is "the banks". If it isn't that, it will be something to do with whoever invented subprime mortgages or started "slicing and dicing" risk.

Unless you are a finance professional, it will not be the regulatory or rate-setting failures of central bankers. In the past decade, they have mostly been portrayed as the saviours of the global economy. Forced by the widespread political failure to provide fiscal stimulus, central bankers went into overdrive and tried to do everything themselves, showering the global economy with easy money and saving the world, and, in European Central Bank president Mario Draghi's case, the euro.

Subscribe to MoneyWeek

Become a smarter, better informed investor with MoneyWeek.

Their use of quantitative easing might have merged fiscal and monetary policy together. (By raising asset prices artificially, QE has wealth distribution implications.) It might have looked more than a little political: the euro is a political project, so doing "whatever it takes" to save it is also political. And it might have some negative side effects but, the story goes, at least monetary policy did its job of preventing a global meltdown.

But now the problems they created are becoming obvious, as even Draghi noted in an interview published earlier this week. "The negative side effects as you move forward are more and more visible," he said. Indeed they are.

Advertisement - Article continues below

Take negative interest rates, something that had almost no precedent when first Sweden, Switzerland and then the ECB deployed them after the 2008 crisis. The Swiss National Bank had charged de facto negative rates on non-resident deposits in the 1970s but that was it.

Negative interest rates undermine a country's banks and, by extension, its entire economy. Their effect is visible in the share prices of European banks. The Euro Stoxx banks index is down near the 2012 lows it set during the eurozone crisis. By charging fees for deposits, negative rates turn assets into a kind of liability. That is already visible to some wealthy clients of European banks as well as any one with a business account. There is something shocking about actually seeing interest as a cost set against your cash.

Negative rates also destroy the stability of pension and insurance funds. At a conference in London this week, Peter Spiller of CG Asset Management provided a nasty little example of the damage they can do. Imagine, he said, that you want to have an inflation-adjusted £1 for your retirement in 2068 (49 years away). You could look to achieve this perhaps by investing in a gilt that matures then. Right now, you would need to put in £2.60 for every £1 you get out. Why? Because that is the compounding effect of investing for 49 years on the miserable minus 2.05% yield that the bond is offering investors today.

The effect may not be as visible as negative nominal rates on deposits, but when rates are negative in either real or nominal terms, cash is no longer helpful to anyone saving for retirement. The lower rates go, the more investors feel they must save.

There are less immediately obvious problems stemming from very loose monetary policy. The main one is the huge build up in public and private debt across the developed world (the highest ever in peacetime) and the low quality of much of that debt.

If we were seeing the end of QE and negative interest rates, all these very visible problems could be dismissed as probably temporary and, perhaps, even worth the pain. But we are not.

Advertisement - Article continues below

Draghi is leaving the ECB being hailed as a hero, but he is also leaving it with rates at minus 0.5% and a new round of QE bond buying under way. He isn't alone: in the month of August, a quarter the G20 central banks lowered their policy rates. And the chat among central bankers is not about how to end it but instead how to make it even more extreme to address the next recession. Chairman Jay Powell recently asked whether the US Federal Reserve should be expanding its tool kit.

Interest rates can go lower. Outside Japan and the eurozone, most are still in positive territory. And central banks can go direct: merging monetary and fiscal policy with various versions of helicopter money. It might work.

But this time it might come back to bite. Most people didn't notice the role of the central banks in the last financial crisis. Why would they? Old style monetary policy was important but it was also complicated and boring and hence more or less invisible.

But negative rates are a different thing altogether. While you can explain the problems they create in complicated ways, there is no need to do so. Most people intuitively feel that negative interest is somehow unnatural. If negative rates cause the next crisis by distorting capital allocation and encouraging unmanageable levels of debt, central bankers will discover that the real danger is to them personally. The whole idea that they are politically independent good guys will come tumbling down.

Instead ordinary people will see them as dangerous creatives who set in motion an experiment they have no way of reversing or controlling. Just like the bankers in the early 2000s.

  • This article was first published in the Financial Times



How long can the good times roll?

Despite all the doom and gloom that has dominated our headlines for most of 2019, Britain and most of the rest of the developing world is currently en…
19 Dec 2019
Personal finance

The benefits of sitting tight with your savings

Agreeing to lock up your cash can boost the interest rate on your savings significantly. Ruth Jackson-Kirby reports.
20 Aug 2019

Brace yourself – the global economy might be healthier than it looks

Investors have been worried about a global recession since the start of the year. But the latest indicators suggest things might not be so bad. John S…
2 Apr 2019

The power of mean reversion

When it comes to investing in funds, don’t chase the top performers – look for the cheapest ones.
1 Apr 2019

Most Popular

Stocks and shares

Do you own shares in Sirius Minerals? Here’s what you need to do now

Mining giant Anglo American has proposed a cash takeover of Yorkshire-based minnow Sirius Minerals. Unhappy shareholders must decide whether to accept…
20 Feb 2020
House prices

The biggest risk facing the UK housing market right now

For house prices to stagnate or even fall would be healthy for the property market, says John Stepek. But there is a distinct danger that isn't going …
17 Feb 2020

The euro’s slide against the US dollar looks set to continue

The euro has been in a bear market against the US dollar for two years now. And on a broader scale since 2008. A decline like that is telling us somet…
19 Feb 2020

The rare earth metal that won't be a secret for long

SPONSORED CONTENT – You can’t keep a good thing hidden forever; now is the time to consider Pensana Rare Earths and the rare earth metals NdPr.
31 Jan 2020