29 September 2020

There are no positives to negative interest rates

By

The Bank of England is engaged in a charm offensive to pave the way for Negative Interest Rate Policy (NIRP). The story they’re telling is that negative rates will stimulate economic activity and push a post-pandemic recovery. They are so wrong. The evidence points to little effect, except to push up already over-inflated financial asset prices, listed stocks and shares. Maybe the Bank hopes negative rates will create inflation – the worst possible news for savers.

The reality for the whole financial system is NIRP will create a tidal wave of negative consequences. Negative rates force investors to seek ever diminishing returns from increasingly risky asset classes – moving from low-risk bonds into higher risk equity and increasingly illiquid ‘alternative’ investments. We all know what happens when investors get sucked into investments they don’t understand – it never ends with a smile. Low rates already mean asset managers can’t meet their future liabilities, real pensions savings are in decline, and risk across the investment sector is climbing. Indeed, much of the current stock market price bubble is driven by the consequences of NIRP.

Last week, Monetary Policy Committee (MPC) member Silvana Tenreyro gave a wide-ranging Sunday Telegraph interview where she said the evidence from other countries on the effectiveness of negative rates was “encouraging”.

“We have been discussing our toolkit in recent months, including how effective negative rates might be in the current context,” she said. “The evidence has been encouraging. Banks adapted well – their profitability increased with negative rates largely because impairments and loss provisions have decreased with the boost to activity and the increase in asset prices.”

That’s not what the market sees when it weights the value of banks – one of the worst performing stock market sectors. Banks are in trouble as margins evaporate and losses rise. Although EU banks are now being paid by the ECB to borrow money, they aren’t lending because they fear rising losses. Instead they arbitrage the free money by churning government bonds.

A key point here is that low interest rates aren’t proven to work as a stimulant for flaccid economies. Look at Japan (a bit of a special case) and Europe (a basket case) and explain the evidence for just how successful NIRP has proven? It’s created precious little economic regeneration and the only thing it’s succeeded in is propping up legions of zombie companies, while not creating many new jobs.

If negative interest rates are so effective, why has the whole Western economy been bouncing along so weakly and skirting recessions these last 12 years of ultra-low declining interest rates? For all the talk of low rates and synchronous recovery, growth across Europe and Japan has been lethargic and sub-optimal for years.

The reason is simple. Negative interest rates do not obey the conventional physics of money.  As rates approach zero – NIRP causes conventional economic behaviours to go into reverse, acting as a disincentive to considered investment. Zero rates cause the normal flow of money and investment returns within an economy to hit stall speed.

Why?

When money costs nothing it is worth nothing. Companies see little point in investing in new plant, output, new jobs or capacity through low-rate periods, when greater returns can be obtained from leveraging themselves up with ultra-cheap debt to convert equity into debt via stock buybacks. To management it’s the most ‘efficient’ use of capital and satisfies the Friedman’s diktat about the sole function of a shareholder economy being to create value for the owners (plus, it ensures the largest bonuses for clever management who’ve been able to raise the stock price).

Long-term that’s destructive behaviour: replacing equity with debt reduces the solvency of any business concern, and limits its future ability to borrow for growth. A lack of access to new capital (caused by leverage) restricts the ability of business to respond to new opportunities and threats. The arteries of finance become clogged with fatty debt.

If interest rates were to rise, many firms who have borrowed heavily will become insolvent, i.e. the cost of their interest and redemption payments exceeds their ability to pay. That process of companies failing is, of course, a vital life-cycle aspect of capitalist economies. Evolution means established firms fight to stay ahead or are replaced by nimbler competition. Zero rates slows that process, meaning bad companies stay afloat longer, while better new ones struggle to emerge and the economy is ultimately surpassed by foreign competition. Productivity and competition falls by the wayside.

Investors know companies buying back their own stock are creating zero-value-added, but favour these companies only because they expect the stock price to rise. Rational investment objectives like growth strategies (i.e. new products or factories) likely to create new wealth are corrupted by zero rates, away from real world growth towards the illusory value of financial assets. Today’s stock markets are trading at record P/E ratios despite economic mayhem – a disconnect which clearly illustrates how capitalism is breaking down in the low rate environment.

The end result is that negative interest rates directly fuel financial asset inflation while adding zero to economic value or growth. That creates three effects: 1) ever-increasing government intervention which is inherently distorting, 2) distorted entrepreneurial spirits and investment objectives, which ultimately create massive income inequality and destabilise society as the rich owners of financial assets get richer, while the toiling classes see less and less, and 3) the impossibility of rates ever rising again without completely crashing markets and triggering recession.

What would work better is real interest rates and carefully applied fiscal policy directing support for jobs and growth in the economy – direct from government. Target growth – even if it will create fury in Europe (why? Oh the ECB rules won’t let them) –  and subsidise and support new industry.

And don’t worry where the money is going to come from. Unlike Europe, the UK has the keys to the printing presses, and there is a magic money tree growing in the Bank of England’s court! (We can worry about sovereign debt vs corporate debt later.)

Of course, I might be wrong. When a distinguished Harvard economics professor and member of MPC says NIRP is a good thing, who am I to argue?

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Bill Blain is market strategist and head of alternative assets at Shard Capital. He writes a daily market commentary called The Morning Porridge (www.morningporridge.com).

Columns are the author's own opinion and do not necessarily reflect the views of CapX.