The World Better Get Used to Negative Rates

(Bloomberg Opinion) -- Today, around $10 trillion of bonds are trading at negative yields, mainly in Europe and Japan. In the next recession, U.S. interest rates, too, may enter negative territory: Short-term rates are currently running around 2.5 percent, and cuts of between 3 percent and 5 percent are commonly needed to restart economic activity. In markets where rates are even lower or already negative, rates will need to go deeply into into the red.

Negative real rates refer to returns below inflation. Negative nominal yields involve a guaranteed loss of capital invested. In other words, if an investor places a deposit with a bank, she will receive at maturity an amount less than the original investment. In the case of bonds, negative yields mean that investors lose the difference between the price paid and the face value.

The only way to avoid losses in such a situation is to physically withdraw cash and hold it, or to purchase real assets or equities. There are a host of reasons why that’s easier than it sounds. Those worried about security and safety will have little choice but to invest in government bonds or insured bank deposits. Also, returns are relative; it’s possible that purchasing negatively yielding securities may be the least-bad alternative available.

Some investors may be attracted by the opportunity for capital gains if they expect yields to become more negative; foreign investors may see possible currency appreciation. Others may focus on real rather than nominal returns, as even negative returns may preserve or increase purchasing power under deflationary conditions.

Some investment mandates force fund managers to purchase bonds, even if yields are negative. Similarly, liquidity regulations require banks and insurance companies to hold high-quality securities no matter what. Central banks that face restricted investment choices may also be customers.

Negative rates are supposed to work through the same economic channels as low or zero rates -- boosting asset prices to enhance the wealth effect, increasing the velocity of money and encouraging greater borrowing. In theory, savers facing the threat of losses should increase investment and consumption, helping to boost economic growth and inflation. Yet, where negative rates have been implemented, they’ve been singularly ineffective, even as they’ve created serious economic and financial distortions.

The real reason the world is in this predicament is the failure to deal with unsustainable debt levels. Debt can only be reduced in one of four ways: through strong growth, inflation, currency devaluation (where the borrowing is from foreigners) or default. All the strategies other than growth involve some level of transfer of value from savers, either by reducing the nominal value returned or through decreased purchasing power.

Growth and inflation are weak. Devaluation is difficult if every nation tries to reduce the value of its currency at the same time. Debt defaults on the scale required would destroy a large portion of the world’s savings, not to mention affect the solvency of the financial system, triggering a collapse of economic activity. That’s why policymakers resist write-downs of trillions of dollars’ worth of debt that cannot be paid back.

So, central banks must instead covertly use negative rates to reduce excessive debt levels by transferring wealth from savers to borrowers through the slow confiscation of capital.

What negative rates are telling us is that the global economic system cannot generate sufficient income to service, let alone repay, current debt levels. The latter are so high that even current, artificially depressed rates only allow them to be barely managed.

The fact remains that someone has to pay the price of the financial excesses of the last few decades. With low and negative rates, that “someone” will be savers. 

To contact the editor responsible for this story: Nisid Hajari at nhajari@bloomberg.net

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Satyajit Das is a former banker and the author, most recently, of "A Banquet of Consequences."

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