Expert Commentary

Deflation and Negative Interest Rates

As Germany issues 30-year bonds at a negative yield, a world of interest rates below zero is becoming normal. Welcome to the as-yet-unheralded deflation era.

The big news last week was the German 30-year Bund auction at an historic yield of minus 0.11%. Investors, though, were only willing to buy less-than-half of the €2 billion bonds on offer. Nevertheless, the fact that a sovereign government was able to issue 30-year debt at a negative yield was lauded by many, including U.S. President Trump. The President wrote, "So Germany is paying Zero interest and is actually being paid to borrow money, while the U.S., a far stronger and more important credit, is paying interest..."

That comment is extremely interesting when put in context of a recent article by Dr. Thorsten Polleit (here) in which he lambasts the European Central Bank's policy of negative interest rates. Although he points out that the new theory of the natural rate of interest being negative is wrong, he says,

"...it is highly attractive to the state and those groups closely associated with it because if the central bank forces interest rates into negative territory, running into debt becomes a profitable business, and financially ailing states and banks can reduce their debt burden at the expense of creditors."

Bingo. What better way to get rid of your massive debt pile -- get other people to pay it off. The problem is, that disincentivizes the private sector from economic growth.

Dr. Polleit's argument is that central banks manipulate interest rates throughout the yield curve. Although we disagree with that, instead taking the view that bond yields are driven by herding behavior, the effects of negative interest rates throughout the yield curve are the same. The article raises an interesting question about credit rationing. If governments and corporates can borrow money at negative rates, then surely everyone will be clambering over themselves to borrow money, creating a massive supply of credit. Dr. Polleit says that the ECB will have to ration credit and decide who gets to borrow. Which governments or corporates or banks will get to borrow? What is the criteria for deciding? An Orwellian vision is painted where "the monetary policy of zero and negative interest rates -- if it is consistently thought through -- leads to the demise of (what little is left of) the free society as we know it in the Western world." Heady stuff.

The article suggests that negative interest rates create a massive speculative bubble which is eventually burst in a destructive debt deflation. That is possible but the evidence from Japan suggests otherwise, where rates have been zero or negative for decades and yet no bubble has manifested. Perhaps more apt is Larry Summers idea of "Black Hole" monetary policy where, when rates go to zero or negative, the energy required to sustain the private sector economy can't get out.

One thing is for sure. The gargantuan amount of debt in the world cannot be sustained and will be deflated in the future. Whether that process is a violent, existential moment or a slow deflationary process lasting decades remains to be seen.