Why Negative Interest Rates are a Retardation of the Essence of Capitalism

Financial portfolio review

When retirees and ordinary savers complain about low interest rates, it barely rates a mention. What would these simpletons know about financial markets?

But when the ‘bond king’ pipes up, it’s front page news. From the Financial Times:

The $10tn pile of negative-yielding government bonds is a “supernova that will explode one day”, according to Janus Capital’s Bill Gross, underscoring the rising nervousness over the previously unthinkable financial phenomenon.

Bill Gross earned the moniker ‘bond king’ through his long association as head of the world’s largest bond fund manager, PIMCO. Keep in mind though; the biggest bond bull market in history helped his rise to greatness.

But it’s not only Gross joining the plebs in warning about this very serious financial retardation. The article goes on…

Mr Gross joins a mounting chorus of big investors who fret that this phenomenon will end in tears. Capital Group — which manages about $1.4tn — has warned that negative interest rates were distorting financial markets and economies, and might lead to “potentially dangerous consequences”.

Jeffrey Gundlach, the head of Los Angeles-based bond house DoubleLine, recently told a German newspaper that negative interest rates “are the stupidest idea I have ever experienced”, and warned that “the next major event [for markets] will be the moment when central banks in Japan and in Europe give up and cancel the experiment”.

Larry Fink, the head of BlackRock, warned in his latest letter to investors that while low borrowing costs were a boon to many companies and countries, they come at a heavy cost to savers.

It takes people of financial distinction to tell us this?

Well, yes. And yet nothing will change. The market will have to find its own solution, because it certainly won’t come from policymakers.

The Fed recognises the danger, but can’t get out of first gear in trying to raise rates to even a semblance of normality. It had to pull its plans to do so last week after poor employment data.

Negative interest rates are a retardation of the essence of capitalism. That is, you need to get a reward (expressed as a rate of interest) for handing your money over to another party.

That there is now $10 trillion in bonds trading on a negative yield is an abomination.

How did things get like this?

Well, without the constant interference of central banks, the decisions of savers and spenders determine the rate of interest.

The banking system creates credit by lending. This lending increases the amount of ‘money’ flowing through the economy.

But the amount of credit creation in the first place is determined by how cheap or easy it is to get. That is, the rate of interest on credit, or money.

In a non-central bank dominated world, low interest rates reflect a surplus of savings in the system. This is because previously higher interest rates encouraged people to defer consumption and save instead. This increases the supply of money in the system, pushing the price of it (the interest rate) down.

The low interest rates then stimulate consumption and investment through increased borrowing. Borrowing is just consumption brought forward. This goes on until the ‘savings’ in the system start to fall.

The fall in savings brought about by low interest rates means demand is greater than supply. What happens then? The price of money — the interest rate — goes back up to balance supply and demand.

In this way, an unmolested financial system breathes in and out, matching the demand from investors and borrowers with the supply coming from savers. The interest rate is the regulator of this natural rhythm. Leave it alone and the economy and financial system will stay in balance.

It won’t be all smooth sailing. You’ll get the occasional overshoot of activity followed by recession to clear away poor investment decisions. But downturns would not be prolonged.

Now, let’s bring the all-knowing and omniscient central bank into the equation…

When it looks like the system naturally wants to put a higher price on money to discourage consumption and encourage saving, central bankers wave their wand and create more money.

But there is more to it than simply ‘lowering interest rates’. The way in which they do so is crucial to understand. When a central bank ‘cuts rates’, they do so by shoving more ‘money’ into the commercial banking system. The system thinks this newly-created money is real savings. It then reacts to this increased supply of money by lowering its price — the interest rate.

This in turn sends a signal that borrowing, investment and consumption needs to increase, and saving needs to decrease.

In other words, it’s a completely false signal that creates the opposite effect of what is really needed.

And yet central banks keep pushing the button. They have created so much money now that the weight of it is pushing nominal rates into negative territory. Investors (like the bond king) must actually pay some governments a small fee when buying their bonds!

The absurdity is mindboggling. No wonder some of the world’s biggest and best investors are turning to gold. From The Australian:

Soros Fund Management, which manages $US30 billion for Mr Soros and his family, sold stocks and bought gold and shares of gold miners, anticipating weakness in various markets. Investors view gold as a haven during times of turmoil.

Risks are mounting. Yet the retardation of the price of credit/money by the world’s central banks means there are few warning signs. Gold is perhaps one of the few genuine signals left to warn of these rising monetary distortions.

I’m amazed it’s still trading below $US1,300 an ounce.


Greg Canavan,
For The Daily Reckoning

Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.

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