"Negative Interest Rates: An Uncharted Land"

Sydney M. Williams

Thought of the Day

“Negative Interest Rates: An Uncharted Land”

September 15, 2016

“No pessimist ever discovered the secret of the stars,

or sailed to unchartered land, or opened a new doorway for the human spirit.”

                                                                                                            Helen Keller (1880-1968)

Uncharted lands are not always doorways to a better life. While I believe that confidence is essential to success, I also feel that Ambrose Bierce was onto something when he defined optimism in The Devil’s Dictionary: “It is held most firmly by those most accustomed to the mischance of falling into adversity…”

I am not an economist and profess no real knowledge of that dismal science; however, when I think of the Federal Reserve over the past several years I am reminded of the Apostle Paul writing to the Romans: “Professing to be wise, they became fools.” In the years since the end of recession in 2009, central bankers have marched into Robert Lewis Stevenson’s “Land of Nod:” “The strangest things are there for me, both things to eat and things to see, and many frightening sights abroad till morning in the Land of Nod.” Was it morning that brought today’s ‘new normal,’ with its pitiful economic results?

Since 2006, the balance sheets of central banks have risen from just under $5 trillion to almost $17 trillion. Two weeks ago Mario Draghi, Chairman of the European Central Bank suggested they were running out of assets to buy. When central banks borrow reserves from the banking system, they are, in effect, removing credit from the private economy. Asset prices have increased, but growth has been feeble.

Two weeks ago, Sanofi, the French pharmaceutical company borrowed €1,000,000,000 for three and a half years with an interest rate of minus 0.5 percent. On the same day, the German consumer goods company Henkel borrowed €500,000,000 of two-year debt at the same rate. According to Grant’s Interest Rate Observer, there are outstanding about $13 trillion worth of negative yielding bonds – most of it sovereign debt issued by governments of Germany, Japan and Switzerland. Think about that for a minute. An investor willing to lend $1,000,000 for two to three years would receive back a mere $950,000! That’s an easy way to run out of money. Is Hans Christian Anderson’s Emperor naked?

Both Sanofi and Henkel have good balance sheets. (We cannot say the same for governments, but they have the power to tax.) Neither company needed the money. They were not looking for investment opportunities. The money was raised because they could. In his A History of Interest Rates, which covers 5,000 years of lending, Sidney Homer does not mention any period of extended negative interest rates. During the 1930s some U.S. Treasury Bills were issued with rates close to zero, but at that time the world was in a world-wide Depression, Fascism and Communism were on the rise and a world war was in the offing. Today, despite aggressive and innovative tactics by central banks, global growth has been anemic. Last week, in the U.S., the Administration proudly promoted last year’s household wage increase of 5.2%, but only noted in whispers that the number was still below inflation adjusted income for 2007. We are in an uncharted land, and have been led there by creative central bankers and deceptive politicians!

Consider the consequences of near-zero and negative rates in just four areas: personal savings; national debt; pension and entitlement accounting, and life and long-term care insurance.

My generation was the first to live in an age of abundance. We came to maturity in the years after Depression and War. For most of the fifty-five years after 1945 the economy did well – unemployment was low, consumer products became ubiquitous and ever-cheaper, stocks rose, credit became common and, if one worked for a large company, pensions were provided. Sometime in the late 1970s and early 1980s businesses began to abandon defined benefit pension plans due to costs, and turned to defined contribution plans. That meant workers had to save for retirement. The single biggest victim of the Fed’s policy of pursuing low interest rates has been the nation’s savers and elderly. Reduced rates hinder savings, which has had a fundamental impact on the economy. As John Tamny writes in his recent book, Who Needs the Fed?: “True economic advantage results from entrepreneurial ideas being matched with savings.”[1]   

U.S. federal debt exceeds U.S. GDP by a trillion dollars. As a percent of GDP, it is at record levels for peacetime. Mitch Daniels, in last Wednesday’s Wall Street Journal, wrote, “Our national debt…is heading for territory where other nations have spiraled into default...” Low rates make borrowing less painful, and therefore easier for prodigal politicians. Interest expense, as a percent of the federal budget (roughly 6%), is no higher than it was ten years ago, but when rates normalize, which they will at some point, interest expense will be three times larger. Entitlement spending, plus other safety-net programs and benefits for federal workers and the VA, along with interest expenses consume 73% of the budget. When (not if) interest costs rise to normal levels, 85% of the budget will go to those two areas, leaving little for defense, education, infrastructure, research and national parks. Is this where we want to be?    

Besides having the obvious consequence of deterring those saving for retirement, negative rates effect the way pension liabilities are calculated. When calculating pension obligations (the same math is used for determining entitlement obligations) a “risk-free” rate of return is assumed – historically the yield on the U.S. Ten-year, currently 1.7 percent. The problem is most acute in the public arena, as most companies have abandoned defined benefit plans. Public pension plans, which cover roughly 20 million workers, have reduced assumed returns to 7.68%, a rate four times that of “risk-free” returns. Any shortfall – as the mayors and governors responsible for these plans well know – will have to be made up by taxpayers. The hope of these ‘fiduciaries’ is that the problem will not surface on their watch. It is the same math that informs us that unfunded liabilities of myriad entitlement programs are a problem of growing intensity – that Americans have been misled about the promises of our fundamental social welfare programs.  

Life and long-term care insurance rates are rising – another consequence of central bank’s policies of keeping interest rates at sub-normal levels. Insurance companies take in premiums, invest them and then pay out obligations. Actuaries are employed to determine investment returns, as well as life expectancies and myriad health risks; premiums are priced accordingly.  Obligations, while fixed in life insurance, are a moving target in long-term health plans. Policies that were sold a few years ago, when interest rates were five or six percent, are now at risk. When profits disappear, so do companies.   

It is the abandonment of free market principles that is concerning – letting markets set interest rates. The motives may be honorable – hoping to prevent economic hardships and to smooth out inequalities – but the unintended consequences of penalizing savers, minimizing the effect of our national debt, ignoring pension accounting discounting rules, and increasing insurance premiums is devastating. Just as universities cannot protect students against language they find disagreeable, no system can protect all investors and employees, but free-markets, with their accountability and self-discipline, have been the most beneficial to the greatest number. The path we are on leads to an uncharted land where tears outdo smiles.

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[1] While I disagree with Mr. Tamny’s conclusion that the Fed should be abolished. The Fed was founded in the aftermath of the Panic of 1907; it has and it should continue to serve as lender of last resort.