After the financial crisis of 2008, American consumers had to grudgingly get used to receiving no interest income on their savings accounts. Many thought—and still think—that this will soon change with a recovering economy.
If the trends in Europe and Japan are any indication, however, and people like former Secretary of the Treasury Lawrence Summers have their way, savers will soon have to pay for putting money in the bank.
Most experts agree that the monetary experiment of having a negative rate of interest will come to the United States sooner rather than later. So before you have to pay for keeping money in the bank, Epoch Times looks at the real reasons for implementing the policy and the possible effect on you and your retirement.
The Reasons
Central bankers are obsessed with inflation. The Federal Reserve has the official target of creating 2 percent inflation every year in its mandate and says it’s good for the economy: “Although most Americans apparently loathe inflation, Yale economists have argued that a little inflation may be necessary to grease the wheels of the labor market,” Federal Reserve Board Chair Janet Yellen said years ago in a speech at Yale University.
However, the real reason the central banks need inflation is the mountain of debt in the private and public sectors that has accumulated over the years. As inflation robs money of its value, it also makes that debt easier to repay.
Take this example in regards to the federal government: Even if output adjusted for inflation doesn’t change over the year, but prices rise 100 percent, tax revenues should also rise 100 percent. All things being equal, the federal government would be able to eliminate the budget deficit and even repay some debt. The same is true for private debtors.
After the Great Financial Crisis of 2008, inflation in the developed world has been anemic and so has growth. But debt, whether public or private, hasn’t gone down significantly, so central banks have kept pushing interest rates lower in a concerted effort to create inflation.
“For a number of years, at every sign of a slowdown in the economy, the central banks have lowered rates to stimulate the economy. Every academic will suggest [that] the lower the cost of money, the more people will want to borrow and spend,” says Grant Williams, strategy advisor to Vulpes Investment Management and the founder of RealVisionTV.
They haven’t been very successful: Consumer prices in the United States rose only 0.85 percent from March 2015 to March 2016.
With interest rates at or near zero in the short term in most countries, central banks and commercial banks are now pushing the envelope to lower interest rates to negative: first, negative rates on deposits the commercial banks keep with the central banks; then negative rates on deposits the consumers keep with commercial banks.
Don’t believe it? This bank in Switzerland is already doing it: Alternative Bank Schweiz AG is the first bank in Switzerland to pass on negative interest rates charged by the central bank to the consumer. Clients have to pay 0.125 percent per year to keep their checking and saving accounts with the bank.
According to the proponents of this novelty, this will force people to save less and spend and invest more, thereby moving up prices. At least according to the theory, they will act this way—after all, who would lose money rather than spend or invest it?
The Consequences
Let’s assume you want to retire on $1 million in 20 years, do nothing, and accept the negative rate. Whether you want to have a lump sum at a particular point in time or choose an annuity, the mathematics of negative interest rates are the same.
If the interest rate was a positive 5 percent, as it was not all too long ago, you would need to save $395,734 right now to make that happen. Guess how much money you would need right now at a mere negative 1 percent: $1,210,407, difference of $814,673, which you would have to get from elsewhere to make up for the difference. This is not even considering the loss of buying power of the $1 million if the central banks succeed in creating inflation.
Although, the -1 percent sounds inconceivable right now—after all, Bank Schweiz is only charging 0.125 percent—we could get there eventually if the central banks don’t generate the inflation they want. Already, shorter-dated government bonds in Japan have been trading at -0.6 percent, and Danish and Swiss Central banks had their deposit rates as low as -0.75 percent in 2015.
“Where do you draw the line, do you take rates to minus 4, minus 5?” Williams asks. At some point, human psychology breaks the academic models.
“What you have to put into the equation is human reaction. In a crisis, humans tend to hoard and pay down debt rather than spend more. Human behavior doesn’t fit in any model,” Williams says.
Indeed, according to a survey undertaken by the Dutch bank ING, 77 percent of respondents said they would take their money out of the bank if interest rates went negative, and data compiled by Bank of America suggests that savings rates go up as interest rates go down.
In Switzerland, for example, as the deposit rate moved from a bit less than 1 percent in 2008 to close to 0 percent in 2015, the savings rate increased from 21 percent to 24 percent. The same move can be seen in Denmark and Sweden in more recent years. The motto: If I am getting a lower return on my savings, which lowers my total savings goal, I just have to save more to achieve my target.
“People would rather be guaranteed a loss rather than take it out and borrow more or invest in something that’s risky,” Williams said.
This dangerous experiment could even threaten the global life insurance industry, which has fixed obligations on contracts signed years ago when interest rates were still very positive.
“This rate is what all insurance companies and pension funds use to arrive at the present value of their liabilities. The lower the discount rate, the greater the liabilities which thus have to be funded with ever greater contributions. There is no money available for such contributions, and thus, what is the largest pool of obligations in the nation risks bankruptcy. This would be the 2008 disaster times 1,000,” said Woody Brock of Strategic Economic Decisions Inc.
Possibly people could squeeze out a penny here and there for larger insurance premiums or private savings to be able to afford their retirement (remember the $1.2 million?). But this certainly won’t help inflation or growth, as intended.
“In order to be able to retire [they] must quadruple their annual savings rate. This cripples consumption and thus growth,” said Brock.
Save or Risk
The good news: Whereas a negative interest rate on bonds and bank deposits kills your savings, it does magic for the valuation of stocks. Money the company earns in the future becomes worth more today if you apply a negative interest rate to value the future cash flows today.
Other factors like the overall level of company debt influence the rate at which to value future cash flows in the present, but a negative general interest rate significantly increases a stock’s value today, all other things being equal.
So if you want to retire comfortably, or if the insurance companies want to be able to pay out their contractual obligations, you are facing the choice between saving a lot more or investing into a lot riskier assets.
“They want to force you out on the risk curve so you have a positive return,” said Dan Oliver, principal at Myrmikan Capital.
Some home owners or future home-buyers may think negative rates will lower their mortgage bill or in some extreme cases give them a mortgage credit. This happened to one person in Denmark whose mortgage rate is now at negative 0.0562 percent, according to a Wall Street Journal report.
It’s true, lower interest rates have also lowered mortgage rates to about 3.67 percent for a 30-year fixed contract. However, most U.S. mortgages are benchmarked not to shorter-term government bonds or commercial bank deposits at the Federal Reserve—both of which could turn negative soon—but to the London Interbank Offered Rate (LIBOR), which currently stands at 2.6 percent for 30 years.
It would take more extreme short-term negative interest rates to put long-term LIBOR and mortgage rates into negative territory. And while mortgage rates should decline further, there is a price to pay.
“Lots of easy credit is terrible for the person who doesn’t yet own a house because it pushes up the price of houses to a level where they can only afford it by taking on levels of debt which are a threat to their sustainability,” says Lord Adair Turner, the former chief British banking regulator.
Cash Ban
What happens if you don’t want to buy stocks and just want to protect your savings as best as you can? You'd have to withdraw your money and hoard cash.
“You can see the whole thing tumbling down if people withdraw all their money,” Williams said. This is because banks only keep much less than 10 percent of their deposits in cash at the vault. If only 10 percent of depositors came and withdrew their money, the banks would have to close down.
Even some large insurance companies have started to hoard cash. The world’s largest reinsurer, Munich Re AG, with around $250 billion in assets just added an eight-figure amount in physical cash.
“We are just trying it out, but you can see how serious the situation is,” Chief Executive Nikolaus von Bomhard said at a news conference on March 16.
This and only this is the reason governments around the world have started the discussion to ban cash. They say it’s about terrorism, drugs, and money laundering, but Grant Williams finds this hard to believe, as there were more terror attacks in Europe during the 1970s and 1980s, and the war on drugs as well as money laundering has been going on for decades without authorities thinking and saying banning cash would solve the problem.
“By banning cash, you avoid the problem of taking the cash out, and the government can dip into your bank account and impose negative rates,” Williams said. “High denomination bills are the thin edge of the wedge. The one that’s most in the firing line is the 500 euro note.”
European Central Bank president Mario Draghi said this year the central bank is thinking about scrapping the note to prevent hoarding as well as crime.
But even if physical cash is banned, there is another option, according to Williams: “There is only one place this is going to push people, and this is gold. There is not going to be any cost to own gold if interests are negative. It’s not anybody’s liability, it’s perfectly logical.”
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