While the financial and political media were panicking about the 10-year, 2-year treasuries interest rate inversion and the possibility of a recession on the horizon, former Federal Reserve Chairman Alan Greenspan was making a few headlines of his own, predicting that U.S. treasuries’ interest rates could very well go into negative territory in the near-future.
“There is no barrier for U.S. Treasury yields going below zero. Zero has no meaning, beside being a certain level,” Greenspan told Bloomberg News in a phone interview.
Here Greenspan is noting the fact that interest rates are very much set by markets. There is a limited supply of treasuries, and the greater the demand, the lower interest rates tend to go, and the higher the price. In theory, then, buyers on treasuries markets could outbid one another, driving prices ever higher and even push interest rates into negative territory.
That would mean that to own U.S. treasuries, at a negative interest rate, you’d have to pay for the privilege. Instead of earning interest, holders of U.S. treasuries would owe interest back to the federal government. Who would want to do that? When there are other asset classes that would presumably yield a positive rate, like equities, that would be a good question.
So, then a better question might be, under what circumstances would holding a negative interest rate bond be a good idea?
During the high inflation period of the 1970s and 1980s, high interest rate bonds were used as a safe haven asset to guard against inflation.
So, in a deflationary environment, the reason to hold bonds would be to offset even greater asset price decreases elsewhere. For example if inflation was at -4 percent, holding a -2 percent bond could make sense in order to offset the deflation. Or if you purchase the bond with a -2 percent yield, and then the going rate drops to -3 percent, you could make money by selling the -2 percent bond, because it had increased in value.
For institutions that buy and sell bonds routinely and do not necessarily hold them to maturity, negative interest rates are a way to remove the maximum price caps on positive yielding bonds. Meaning, if you were to bought positive yielding bonds today, and then rates were to go negative, their values would soar in a world desperate for yield.
That’s not a great place to be. That sounds a lot like Japan, whose economy has barely grown in the past couple of decades while its national debt has skyrocketed to 200 percent of its Gross Domestic Product. Japan’s treasuries have gone into negative territory, along with other economies like Germany. There, the causes appear to be aging demographics and the slowdown and even contraction of the working age population, which harms growth and is deflationary. In the U.S., we’re running into the same problem and are not too far behind Japan and Europe.
Meaning, if interest rates are going negative, it could very well be forecasting slower economic growth or no growth at all, low inflation or even negative inflation, and so forth. Unemployment tends to spike in deflationary environments. The reason to do it, if there is one, is because deflation is unavoidable and this would be the only way to incentivize continued purchases and jumpstart spending.
So far, the negative rates have extended to government bonds. Now, one way to make the government bond purchases profitable even in an inflation-neutral environment would be if a financial institution borrowed money from the central bank at a negative rate to make the purchase, it would be paid interest for doing so. So, in theory, a central bank might lend at -4 percent, and the financial institution could then be incentivized to go off and buy the -2 percent government bond, in the process earning 2 percent for borrowing from the central bank.
But in theory, it could go further and do the same thing, borrowing at the discount window, to lend money for mortgages, credit cards, and so forth. That in turn might incentivize borrowing at the consumer level, since that would earn interest, too.
Now, considering how amortization works, where interest is paid first, in theory, for a certain portion of a loan, an interest payment for a mortgage or student loan from the bank would exceed the principal owed on a monthly basis, meaning the interest owed by the financial institution to the borrower could in theory be use to satisfy the principal on the loan.
In short, if all interest rates were to go negative, it would be helicopter money. But why allow that? It might disincentivize working for a living and instead advise going deep into debt and simply consuming.
In every case besides borrowing to earn interest, the incentive would also be to hoard cash, since that won’t depreciate in value. But economists have already figured out the “solution” to that, which is to ban cash, or at least to ban larger denomination bills, such as proposed by Andrew Lilley and Kenneth Rogoff of Harvard University in an April 2019 paper entitled, “The Case for Implementing Effective Negative Interest Rate Policy.”
These are all treating the symptoms, though, of the underlying problem. Just as hyperinflation is a problem of too much money stock chasing too few goods, deflation is its opposite, a problem of not enough money chasing too many goods causing prices to drop. Then, purchases are forestalled.
Interest rates tend to be symptomatic of these disorders but are not the cause. In principle, if inflation is a big problem, higher interest rates are there to soak up the additional currency. Negative interest rates, if implemented fully, could do the opposite, by adding money to the economy in deflationary circumstances. Neither addresses the root cause, either having a currency that is too weak or too strong, but the purpose of central banks is to address inflationary or deflationary forces utilizing interest rates as a policy tool.
In the case of negative interest rates for government bonds, what markets are saying is that there is too much currency chasing down the asset, which is driving interest rates down. The market wants more bonds. The dollar being the worlds’ reserve currency — 62 percent of central bank reserves are dollar-denominated — dictates a higher demand for U.S. treasuries, which central banks tend to stockpile, that has helped drive interest rates to their currently super-low levels of the past few decades. This in turn incentivizes deficit-spending in order to produce more debt so there are more bonds to purchase. Even with a $23 trillion debt and almost a $1 trillion deficit this year alone, rates are still plummeting — and now policymakers are signaling could be allowed to go negative.
What this is all symptomatic of is that there are simply not enough dollars and treasuries to meet current demand.
These leaves few options to restore normal inflation and keep the economy growing over the long haul. On one hand, policymakers might lean on negative interest rates as a cure-all, but over the long-term it might generally be conceding to deflationary conditions and lead to dependency on helicopter money or universal basic income to sustain the population, in the meantime disincentivizing work and harming production.
On the other hand, policymakers might choose a combination of robust Keynesian fiscal stimulus coming in the forms of vast infrastructure projects, national industrial policies or war and tax cuts in order to stimulate spending and government debt creation, producing more dollars to meet demand. But advanced economies are already producing too much government debt and not enough economic growth to sustain it.
So, are those the only options, really? Negative interest rates and printing press welfare that destroys capitalism or massive government debt creation to wrecks any pretense of limited government?
At the center of this debate about the symptoms we ignore the root causes that are monetary, which is that there is a global shortage of bonds and currency that is exerting deflationary pressures. The U.S. and China right now are discussing a potential trade deal that would include a monetary component. China, which uses an artificially low fixed monetary peg to the dollar to maintain a devaluation against the dollar, currently accounts for 16.6 percent of global manufacturing market share according to World Bank data. Other countries, too, use competitive devaluations against the dollar to boost exports, making the dollar strong in comparison, and fueling the global shortage of dollars as assets are hoarded in the chase for yield.
Negative interest rates or massive deficit spending might appear to be cures to these troubles, the best option remains for President Donald Trump and Chinese President Xi Jinping and their teams to sit down with their teams and hammer out an agreement addressing currency valuations and the incentives they create while we still can. What is really needed is an international monetary accord that can address these disorders for the time being, taking into account global trade flows and to deal with the imbalances that have been allowed to build for decades before we wind up in a situation that sweeps out of control and neither side can talk. How the U.S. and China and other developing countries come to terms on currency in many ways is going to dictate how we deal with the implications of those decisions. The solution is to address the root monetary cause with an international monetary accord.
Robert Romano is the Vice President of Public Policy at Americans for Limited Government.