How can central banks impose negative interest rates without causing cash hoarding?

or

A primer on negative interest rate policy as a new tool in the monetary policy toolkit

or

Eliminating the Zero Lower Bound on Interest Rates

(I recommend that readers not follow any of the links until they had read this blog post in its entirety. The links are intended to provide supporting evidence and make further exploration possible.)

(I have provided key dates so that readers can get a sense of the time lag associated with the dissemination of a new idea such as the one being discussed in this article.)

I performed a Google search on "negative interest rate policy theoretical underpinnings". The 4th highest result was a link to an academic paper by Harvard-educated economist Miles Kimball, published by National Institute Economic Review in Nov. 2015.

Here's my own concise summary of negative interest rate policy.

Why impose a negative interest rate as monetary policy? 

In order to lower the profitability hurdle on investment projects: it reduces the cost of debt financing. For example, in housing, mortgage rates would drop as a result. 

On some level, it's the same old matter of cutting interest rates to stimulate growth.  During serious recessions, negative interest rates are the key to quick economic recovery. 

Which interest rate are we talking about? 

The shortest term interest rate, the one that can be set by a central bank. Whatever happens to yields on longer maturity bonds is a separate matter, i.e. a matter of market clearing.

But won't this cost savers and depositors? 

No, because having, say, a negative 4% interest rate for one year is better than essentially a 0% interest rate from 2009 and ongoing. Once economic growth resumes, a central bank can raise interest rates into the positive range.

But won't this cause hoarding of cash? 

No, because paper money will be "made" to be less valuable than electronic money. E.g. A $100 bill would be made to have the purchasing power of, say, $96 of electronic money. By analogy, today when a consumer uses a credit card to make a $100 purchase, the retail store receives about $97 because of the cut taken by the credit card company.

How will they "make" paper money less valuable than electronic money? 

By imposing a deposit fee on paper money. I.e. Depositing paper money into a bank account will incur a fee. (Kimball says that this fee would need to be charged only when banks deposit cash at the central bank. I'm guessing that banks would charge savers a similar fee when they make deposits into their bank accounts.) This fee ought to reduce savers' incentive to hoard cash. 

This deposit fee should grow with time so long as negative interest rats are in effect. Kimball says, "From a technical point of view, we know how to eliminate the "zero lower bound"".

What will happen to other asset prices such as gold? 

Any asset whose price is free to fluctuate will rise under negative interest rates in order to result in a lower future rate of return. Examples: gold, IG (investment grade) corporate bonds, consumer staples equities, telecom equities, utilities equities. (I ask myself how this is different from hoarding; it may not be hoarding, but it would be shifting out of cash.) 

This is also bullish for the US dollar as an international currency if we believe that other countries will implement negative interest rate policies before the US, as is the case today in 6 countries.

List of countries with negative interest rates today

Japan, Euro area, Sweden, Switzerland, Denmark, Hungary. A total of six.

Earliest to implement was Sweden sometime after May 2015. 

Largest negative interest rate today is -0.75% in Switzerland. 

Japan announced negative interest rates in Jan 2016, but they didn't become effective until April 2016, but they didn't implement a deposit fee on paper money.

None of the others in the above list have depreciated paper currency relative to electronic currency. If Twitter postings are good evidence, they are watching and monitoring cash hoarding. (The hashtag #NegativeRates is a good one to search on. Click here to perform this search in Twitter.)

Here's a list of countries by central bank interest rates, possibly not up to date.

(This begs the question as to why the Japanese yen has been strengthening given a negative interest rate policy in that country since last April ... Alternatively, it could be that negative interest rates are a tool for countering a country's appreciating currency ...)

What is the essential idea behind implementing negative interest rates? 

The essential idea is to make paper money separate and distinct from electronic money; to make paper money less valuable than electronic money. In a sense, the real money would be electronic money. There would be an exchange rate between the two types of money. In normal times, this exchange rate would be 1:1. Whenever negative interest rates prevailed, the exchange rate would be something like 1 unit of electronic money being worth 0.96 of paper money.

Political & psychological hurdles

All of the following have to come on board: economist community, the public, legislature, the central bank. 

Ben Bernanke's primer on negative interest rate policy fails to mention that paper money would take on an inferior role (less valuable) to electronic money. This may be the biggest hurdles.

Discussion

It's not clear whether we should try fiscal policy before trying negative interest rates. Perhaps "helicopter money" will be tried first. 

It's also not clear whether investment rates will increase as a result of a lower cost of debt financing: if there's no aggregate demand, who is going to buy the newly produced goods and services? Nevertheless, cutting interest rates in order to stimulate economic growth is standard monetary policy, but in the past, this has always entailed dropping rates from a higher positive rate to a lower positive one (but never to a negative one).

Negative rate policy assumes that the long run equilibrium interest rate is positive (which is a reasonable assumption), meaning that negative short term interest rates will be nothing but transitory.

Further exploration

Coming up to speed on negative interest rate policy

1. Kimball's 5-minute video on negative interest rate policy, May 2015. 
2. Economic underpinnings of negative interest rates, blog article dated July 2013. Conceptually important!
3. A qualitative introduction to the economics of negative interest rate policy, blog article dated Oct. 2013.
4. Kimball's 20-minute video on negative interest rate policy, June 2016. This was a talk given at the Brookings Institute in the presence of Ben Bernanke and other central bankers and economists. Kimball thinks that the US won't need to go to negative interest rates for another five years, i.e. not before 2021. The moderator thought it wouldn't happen in his lifetime and he stated his age as 73. Ken Rogoff has a relevant book coming out in August 2016 entitled "The Curse of Cash" which calls for eliminating paper money; it is apparently endorsed by Ben Bernanke and Mohammed El-Erian. 

Dissemination of this idea

1. Total of 36 talks given by Miles Kimball over 33 months from May 2013 to Jan 2016. See list here.
2. Central banker support for negative interest rate policy, as of July 2015. 

Academic papers authored or co-authored by Miles Kimball on the subject

1. IMF working paper, Oct. 2015. 
2. Paper published in National Institute of Economic Review, Nov. 2015.

Information vault

1. Kimball's homepage for "crossing the zero lower bound" on interest rates. 

Author is also on Twitter

Effect of Debt on Economic Growth:

Is it positive or negative?

or

Is Austerity the Right Policy Response to High Debt Levels?

This article introduces Miles Kimball, a Harvard-educated macroeconomist. It also shows how current macroeconomic thinking is in flux.

(I recommend reading this blog post in its entirety before following any of the links. The links are intended to serve as supporting evidence and provide the opportunity to explore further.)

Around 2009, Harvard economists Carmen Reinhart and Kenneth Rogoff performed data analysis to conclude that high debt levels slow down economic growth. I happened to read about this in their 500-page book entitled "This Time Is Different", published in 2009 and reprinted in 2011, wherein they examined 8 centuries worth of historical evidence. 

Later, in 2013, Reinhart and Rogoff's conclusion was refuted through further data analysis by Amherst researchers and also by Harvard-educated economist Miles Kimball and colleagues. (Link to Kimball's profile on Wikipedia; link to his home page; link to his blog.)

The controversy itself is described in Wikipedia here.  At the end of this Wikipedia article, there's a quote from Nobel Prize-winning Princeton economist Paul Krugmann indicating that he agrees with Kimball's and others' refutation of Reinhart and Rogoff's assertion.

• Kimball's first blog on this matter. (This was the starting point for my article. Before that, I stumbled upon Miles Kimball through the following Tweet and listened to him firsthand in this podcast dated May 9, 2016. There, I found out that he had recently spoken at the Bank of England along with Kenneth Rogoff who had sided with him, apparently.)

• Kimball's second blog on this matter. 

• Kimball's blog home page containing both blogs. This home page is a subset of his blogs and is confined to "short run fiscal policy".

My summary of Kimball's analysis is the following.

Although low economic growth causes high debt levels, it's not true that high debt levels cause low economic growth. 

Policy implication: austerity is not the right policy response to high debt levels.

Kimball isn't all out in favor of debt either. He ends his second blog with the following:

"It is painful enough that debt has to be paid back (with some combination of interest and principal), and high levels of debt may help cause debt crises like those we have seen for Ireland and Greece. But the bottom line from our examination of the entrails is that the omens and portents in the Reinhart and Rogoff data do not back up the argument that debt has a negative effect on economic growth." [emphasis mine]

Author is also on Twitter

Excerpts from James Grants' 

Talk at Google

I Tweeted about James Grant's Google talk here.

The following are some excerpts. 

Material in blue font is Jim's. Material in black font is mine.

In the old days, when a bank needed additional capital, its shareholders would provide it. This was a legal requirement. Nowadays, it's the government that provides it from taxpayer money.

We need to restore individual responsibility on Wall St. Those who benefit from the upside are not bearing any of the costs on the downside. Interpretation: This is testimony to the power of Wall St. Note the array of public officials who have worked on Wall St. before assuming public office.

The only banking institution that didn't receive or require any government bailout during the 2008/2009 Great Financial Crisis was a New York bank named Brown Brothers Hariman. Why? Because they are a partnership where the partners are personally liable for the bank's liabilities. The partners are individually responsible for the risks taken on by the bank.

The 1920/1921 depression self-corrected in 18 months. The 2008/2009 Great Financial Crisis hasn't been set right after 7-8 years of Fed intervention.

The US no longer believes in Adam Smith's invisible hand. Instead it believes in command and control. It's like Poland in the 1950s.  But it's not working!

The Fed employs 700 PhD economists. They are well-intentioned and well-trained, but lack in common sense. Why? Because they missed the subprime mortgage crisis not by 5 miles but by 5,000 miles.

The Swiss national bank creates Swiss francs with the click of a mouse. It then buys shares in American companies. Thus, it gets "something from nothing." How does this make any sense? Money needs to be tied to some kind of material object that has value. Grant is a self-declared gold bug.

Prices, in this case the interest rate (which is the price of credit), need to be "discovered" through the market mechanism, not "administered". The Fed has been doing the latter! Yet the Fed continues to believe that it is better for society that interest rates be administered rather than discovered. This isn't a market economy, but this is the US that we're talking about! 

On US defaulting on its debt. It has already defaulted twice: 1933 and 1975. When inflation exceeds the Treasury bond yield, that's also a form of default.

The present value of US public unfunded liabilities is $120 trillion. Source: Cato Institute, Jeffrey Miron. The US is bound to default in some nuanced form, but it won't necessarily be perceived as outright default.

The US Fed is a monopoly and we all know that monopolies aren't good for society. So why not create competition for it and see what happens? The competition would be to allow, for example, for gold and silver to act as money.

In 1979/1980 when long-term Treasuries were yielding 15%, investors were scared to buy them because previously, they had yielded 9% or less. This meant that bond holders looking backward in time had suffered capital losses due to the fall in bond prices; bond prices fall when yields rise. However, that would have been a great buy because the investor would be locking in a 15% annual yield for 25-30 years. Incredible returns by today's standards.

Today, Treasuries are yielding around 2% and investors still scramble to buy them because since 1980, bond yields have been dropping and so bond holders have experienced capital gains due to a rise in the bond price level; bond prices rise when yields fall.  Interpretation: humans aren't good at detecting turning points in the market. They think that the future will be a continuation of the past. 

Today, there's over $10 trillion worth of government bonds around the globe that have a negative yield. (See the evidence here.) This means that holders of these bonds are paying the issuer for lending it their money! Why is this happening? Because many institutions (insurance companies, pension funds) are mandated to invest in nothing but "safe" securities. There's nothing safe about a negative yielding bond! Central banks are another buyer.

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James Grant gave the above talk in May 2016. In the prior month, he wrote an article that appeared in Time Magazine which I wrote about. See my Tweet and blog post about that article.

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Added on June 7, 2016.

The British author Trevor-Roper has said that the history of thought has not been a straight path from darkness to lightness. Grant seems to be suggesting that monetary policy today may be in the dark and that the US economy in 1920/1921 was in some ways operating better than today.

Description of 1920/1921 Depression

The following description is interesting because it shows how market forces when left unrestricted can lead to self-correcting adjustments that lead to economic recovery and coming out of a depression.

Industrial production fell by 30% between 1920 and 1921 from peak to trough. There was severe unemployment, certainly in the double digits. The stock market was down by half. Commodity prices were down by 40 odd percent. Corporate profits were down by 90%.

The government met this situation with a balanced budget, and with higher not lower interest rates. The latter was perhaps a mistake. 

What proceeded to happen was that markets adjusted.  Prices fell. Wages fell. Because wages fell, profit margins were restored at lower levels of selling prices. So, prices came down. Wages came down too. Equilibrium was restored at lower levels of activity. Because things were cheap, profit seeking individuals sought opportunities. Foreigners sent money to the US for that very purpose.

The gold price was fixed. But the cost of mining it fell. And because the cost of mining it fell, profit margins for the miners increased, and they proceeded to produce more of what in a depression the world needs more, which is money. So automatic forces, or quasi-automatic forces in the marketplace proceeded to do what government actions in this particular long-running cycle -- i.e. 2008 to 2016 -- have so far simply failed to do.

Author is also on Twitter.

My Personal Reaction

to Stanley Druckenmiller's Presentation

at Sohn Conference

So, if Druckenmiller sees the world this way (see full article at ZeroHedge or my excerpts of it), why doesn't the mainstream media see it his way? By reading the mainstream media, you would think that everything was normal ...

Maybe that's not their job ....

Or maybe they aren't independent ....

-------

So, what is an investor to do? Maybe, borrow cheap capital and invest in private projects. Maybe, invest in income-producing hard assets.

Or, short the equity market(s)?

Or, buy gold? Which is what Druckenmiller claims to have done.

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Easy questions to ask. Answers, not that easy. 

Which reminds me: 

When they asked Soros in an interview what he has learnt when he looks back at history and his own investing experience, he answered, "I learnt to expect the unexpected." It's a hard lesson to digest because our natural tendency as humans is to think/believe that tomorrow will be the same as today.

Author is also on Tweeter

Excerpts from Stanley Druckenmiller's

Talk at the Sohn Conference,

May 4, 2016

Stanley Druckenmiller spoke at the Sohn Conference recently. ZeroHedge printed an article on it which I Tweeted. See link to that article here.

Below, I present excerpts from that article which I have prefaced with my own questions. So, it's as though Druckenmiller was answering my set of questions. I think this makes for a more interesting read.

Anything in bold or underlined is from the original article except, of course, the questions themselves which are mine.

What has been the goal of most policymakers since the 2008/09 Great Financial Crisis? Has it been to leverage or deleverage?

Druckenmiller: The policy response to the global crisis was, and more importantly, remains so forceful that it has prevented any real deleveraging from happening. Leverage has actually increased globally. Ironically from where I stand, that has been the intended goal of most policymakers today.

Is the Fed being as "data dependent" as they claim to be?

Druckenmiller: If the Fed was using an average of Volcker and Greenspan’s response to data as implied by standard Taylor rules, Fed Funds would be close to 3% today. In other words, and quite ironically, this is the least “data dependent” Fed we have had in history. 

How does today's investment environment compare to the early 1980's? Which one promises superior returns to investors?

Druckenmiller: When I started Duquesne in February of 1981, the risk free rate of return, 5 year treasuries, was 15%. Real rates were close to 5%. We were setting up for one of the greatest bull markets in financial history as assets were priced incredibly cheaply to compete with risk free rates and Volcker’s brutal monetary squeeze forced much needed restructuring at the macro and micro level. It is not a coincidence that strange bedfellows Tip O’Neill and Ronald Reagan produced the last major reforms in social security and taxes shortly thereafter. Moreover, the 15% hurdle rate forced corporations to invest their capital wisely and engage in their own structural reform. If this led to one of the greatest investment environments ever, how can the mirror of it, which is where we are today, also be a great investment environment? 

What seems to be the vision of today's central bankers?

Druckenmiller: The obsession with short-term stimuli contrasts with the structural reform mindset back in the early 80s. Volcker was willing to sacrifice near term pain to rid the economy of inflation and drive reform. The turbulence he engineered led to a productivity boom, a surge in real growth, and a 25 year bull market. The myopia of today’s central bankers is leading to the opposite, reckless behavior at the government and corporate level. Five years ago, one could have argued it was in search of “escape velocity.” But the sub-par economic growth we are experiencing in the 8th year of a radical monetary experiment and in Japan after more than 20 years has blown that theory out of the water.

What is the Fed's end game?

Druckenmiller: The Fed has no end game. The Fed’s objective seems to be getting by another 6 months without a 20% decline in the S&P and avoiding a recession over the near term.

What is the major divergence between EBITDA and corporate debt today?

Druckenmiller: As you can see, the growth in operating cash flow peaked 5 years ago and turned negative year over year recently even as net debt continues to grow at an incredibly high pace. Never in the post-World War II period has this happened. 

How would you summarize the American corporate sector today?

Druckenmiller: The corporate sector today is stuck in a vicious cycle of earnings management, questionable allocation of capital, low productivity, declining margins, and growing indebtedness. And we are paying 18X for the asset class.

How would you summarize the Chinese debt situation today?

Druckenmiller: China: As a result, unlike the pre-stimulus period, when it took $1.50 to generate a $1.00 of GDP, it now takes $7. This is extremely rare and dangerous. The most recent historical analogue was the U.S. in the mid- 2000’s when the debt needed to generate a $ of GDP increased from  $1.50 to $6 during the subprime mania. 

Do you perceive the US stock market as overvalued or undervalued today?

Druckenmiller: If we have borrowed more from our future than any time in history and markets value the future, we should be selling at a discount, not a premium to historic valuations. It is hard to avoid the comparison with 1982 when the market sold for 7x depressed earnings with dozens of rate cuts and productivity rising going forward vs. 18x inflated earnings, productivity declining and no further ammo on interest rates.

What are your recent observations on global equity markets?

Druckenmiller: The lack of progress and volatility in global equity markets the past year, which often precedes a major trend change, suggests that their risk/reward is negative without substantially lower prices and/or structural reform. Don’t hold your breath for the latter. While policymakers have no end game, markets do.

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US stock market: How much can it drop?

The Historical Context

The following is an excerpt from John Hussman's weekly commentary dated April 18, 2016 (link). It lists the relative drop in the US stock market when previous bubbles burst.

Based on valuation measures having the strongest correlation with actual subsequent market returns across history, equity valuations have approached present levels in only a handful of instances: 1901 (followed by a -46% market retreat over the following 3-year period), 1906 (followed by a -45% retreat over the following year), 1929 (followed by a -89% collapse over the following 3 years), 1937 (followed by a -48% loss over the following year), 2000 (followed by a -49% market loss over the following 2 years), and 2007 (followed by a -57% market loss over the following 2 years). A few lesser extremes occurred in the 1960’s and 1970’s, followed by market losses in the -35% to -48% range.

Note added on Aug. 14, 2016: I Tweeted a relevant chart. Click here.

Author is also on Twitter

Market Topping Process

US Equities

The following is an excerpt from John Hussman's weekly commentary dated April 25, 2016 (link). The excerpt appears in blue font and my comments appear in black font.

Still, even if the major indices were to register fresh highs, my impression would remain that the market is in the process of tracing out the arc of an extended top formation.

2000 Top Formation

It’s largely forgotten that during the 2000 top formation, the S&P 500 lost 12% from July-October 1999, recovered to fresh highs, retreated by nearly 10% from December 1999 to February 2000, recovered to fresh highs, experienced another 10% correction into May, recovered to a new high in total return (though not in price) on September 1, 2000, retreated 17% by December, and by January 2001 had recovered within 10% from its all-time high, and was unchanged from its level of June 1999.

Total time taken = June 1999 to January 2001; 20 months

2007 Top Formation

Likewise, during the 2007 top formation, the S&P 500 corrected nearly 10% from July to August, recovered to a fresh high in October, corrected over 10% into November, recovered nearly all of it by December, followed with a 16% loss, and by May 2008 had recovered within 9% of its all-time high, and was unchanged from its level of October 2006.

Total time taken = October 2006 to May 2008; 20 months, again!

Prediction. The current cycle: peak was May 2015. Add 20 months. Result is Dec. 2016.

1928 Top Formation

In 1954, John Kenneth Galbraith offered a similar narrative of the top-formation leading up to the 1929 crash: “The temporary breaks in the market which preceded the crash were a serious trial for those who had declined fantasy. Early in 1928, in June, in December, and in February and March of 1929 it seemed that the end had come. On various of these occasions the Times happily reported the return to reality. And then the market took flight again. Only a durable sense of doom could survive such discouragement. The time was coming when the optimists would reap a rich harvest of discredit. But it has long since been forgotten that for many months those who resisted reassurance were similarly, if less permanently, discredited.”

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