The end of the world is nigh. Ok, not the world, but at
least the Western civilization as we know it. Forgive me, but that is what I am
tempted to conclude based on the panic I hear about a world with negative
And to put a fine point on it, the catastrophe that is to
befall us is world central banks’ fault. If it wasn’t for their misguided actions,
it would all be ok.
Not a day goes by when I don’t see a chart telling me how
many trillions of dollars of assets have negative yields.
That is, of course, a fact that you can’t quarrel with too
much. But the commentary that comes along with it, in regard to its
implications for the global economy and what the root cause is, was getting hard to take.
However, now that the prospects of negative rates is
becoming a possibility (a very small possibility in my view), things are
getting out of hand.
To wit, this story on Bloomberg1 with an alarming
title. Financial Vandalism. Really
None of this is to downplay the significance of negative
yields per se. Of course, negative yields are unpleasant. If you are a saver,
negative yields are not a good thing. It does not allow you to meet your
financial goals without taking a significant amount of risk. That can make your
life uncertain and quite worrisome. If you are a partially funded pension plan,
negative yields are making an already tough job even more untenable. I get all
And, of course, negative yields are not normal. Paying someone
to borrow money from you does not make any sense. But then again, we are not operating
in a normal world.
What I don’t get is this infatuation with how the economy, under
all circumstances, is supposed to provide positive returns on savings through risk
free assets to make it all work.
Again, if you read the Bloomberg article, what the author is
lamenting is the fact that Pension Funds are not being allowed to earn an
adequate return on their assets by Central Bankers and someone ought to do
something about it
The problem with this line of reasoning of course is
misunderstanding how savings work in a real economy.
In an aggregate context, financial assets are really not
savings. They are claims against the future growth of an economy. The only
savings in an economy are the skills, plant and equipment, and infrastructure
built up over time. It’s these assets that will create growth and pay off all
of those “savings” that will be consumed. If the economy is not going to grow
fast enough to handle whatever structural issues it may face, the value of
financial assets won’t be enough to meet the corresponding liabilities of
financial “savings”. So negative returns on all assets, including safe assets,
cannot be ruled out. Because it hasn’t happened before, doesn’t make it
Furthermore, to ensure that the low growth or no growth
environment does not become permanent, some policy action must be taken. So, central
banks in that sense are mere conduits of policy initiatives to ensure that the
economy grows. And, therefore, temporarily sacrificing risk free returns to
keep the economy growing is a worthwhile effort.
The goal of the central bank at the end of the day is to
focus on growth and employment, and not to ensure that enough high yielding
assets exist in the economy to meet some threshold of claims. In other words,
returns on financial assets are going to be what they are going to be. Focusing
on adequate returns on financial assets at the expense of economic is a moot
point as asset returns cannot be generated without underlying economic growth.
If you frame the argument along these lines, you can see why
in a low demand environment that low and even negative yields may be needed to
support growth. There is nothing magically different about negative nominal
yields. Nobody was crying bloody murder when the real yields were
negative for an extended period of time over the past decade.
The ongoing criticism of negative rates these days, really
does not hold water. First, the fractional banking system can exist just fine
in a negative interest rate environment. In fact a study by the European Central
Bank (ECB)2 concluded that they did not find any evidence of lower
profitability “once we control for the endogeneity of the policy measures to
expected macroeconomic and financial conditions”. In other words, yes,
low or negative rates may hurt bank profitability. But bank profitability would
be hurt even more if the economy tanks in the absence of those negative rates.
Second, worrying about the efficacy of valuation models is important, but
cannot be a matter of supreme importance. Finally, there are a myriad of challenges
that come about because of negative rates. But for a central banker, the prize
is still generating growth in the economy, not just solving the problems of
market participants. Without a growing economy, the challenges of low growth
will become even more challenging.
That is not to say, there are no valid criticisms of a
negative interest rate policy. The biggest and perhaps the most valid criticism
of negative interest rate policy is simply that the central bankers have taken
the entire onus of saving the global economy from falling into sustained low
growth entirely on their shoulders, and their shoulders may not be broad enough
for that challenge. As Summers et al argue in a recent essay3, at
this point the global economy may be better off by the central bankers simply
punting it on to the politicians and forcing their hands for some fiscal
measures. This of course is true, but the real world is a much crueler and
harder place. Just look at Germany. This is a country that has those fiscal
tools available in spades but instead has chosen not to do anything with these
tools while inflicting economic pain on the European economy. A central bank
watching all that play out in real time will be forced to do something more,
which is what the ECB will do in the not too distant future. So, cut the central
bankers some slack. They are trying to do a very suboptimal thing but that is
the only tool they have available.
Of course, negative rates are painful for everyone. But if
we didn’t have negative rates in an environment with a lack of political will
to something on the fiscal front, the global economies would certainly tank.
And then we will be pining for the good old days of negative yields.
Blog header image: Raphael Koh/Unsplash
The opinions expressed
are those of the author as of September 4, 2019, are based on current market
conditions and are subject to change without notice. These opinions may differ
from those of other Invesco investment professionals.
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