The Central Bankers' Greatest Blunder Yet: Negative Rates = Deleveraging

In a world which has long since crossed the monetary twilight zone of negative rates, and which is spiraling ever deeper into NIRP, below we present some quite fascinating observations on debt, NIRP and how the latter leads to the deleveraging of the former, and thus encourages global deflation - something which in retrospect will be (and in many cases already has been) seen as a central bank fatal flaw, and confirmation said central bankers have zero understanding of the process they have unleashed.

From HSBC's Anton Tonev.

Negative rates = deleveraging

  • Negative interest rates on developed world sovereign bonds could reduce debt burdens and may be a market solution to overleveraging
  • While the side effect of extreme money creation is inflation, the side effect of extreme debt creation is deflation
  • We argue that the need for further deleveraging may be a reason why negative interest rates persist in sovereign bond markets

Bonds and deleveraging

While conventional theory suggests that central banks set base interest rates and that negative rates are a result of low inflation and slow economic growth, we suggest there may be an alternative explanation. Drawing on historical and cultural analogies, we view negative rates as a possible market response to the growing levels of debt and inequality in income and wealth.

In April last year, Switzerland became the first country to issue a 10-year sovereign bond at a negative yield. By the end of 2015, about a third of newly issued eurozone sovereign bonds came with a negative yield. Investors who buy these bonds and hold them to maturity will receive less than they put in and the issuer will ultimately pay back less than borrowed. Through this mechanism, we believe that negative interest rates can be a useful tool for deleveraging.

We recognise that the challenge to this view is that the objective of this policy has been to encourage even more leverage; the case of the Swedish housing market comes to mind. The majority of the countries with negative yields on their government bonds have high levels of either government or private debt (or in some cases both). Historically, one would expect government yields to go up to discourage the issuance of more debt. This is not happening now. Why? We suggest that, precisely because of the high level of debt and the need to deleverage, nominal yields in those countries have become more and more negative to encourage the issuance of more debt and slowly roll down the existing debt stock.

This suggests the market may be indicating there is too much debt. But this has an implication for the creation of new money, which is essential for the normal functioning of the economy. Most of the money creation in the developed world is done by the private banking  system through issuing loans. If there is no demand for new debt, the money creation process stalls. In other words, while under the gold standard our money creation was constrained by the availability of gold, in the current “fiat” monetary system, we cannot issue new money without the issuance of new debt. However, the system after 1971 was much more flexible than the metallic standard before because, as long as the economy was expanding, the banks could always find someone willing to borrow from them and thus increase the money supply.

Nevertheless, there is a natural limit to how much debt an economy can sustain. The time after the financial crisis of 2008 coincided with ever decreasing rates of growth and, as a result, not only could the banks not find people to lend to (thus money supply growth slowed down) but people started deleveraging (which caused total liquidity to contract – see Figure 12).

The US, and by extension most of the developed world post 2008, was in a very similar situation to where it was for most of the nineteenth or the early twentieth centuries, i.e. a deflationary environment characterised by intense progress (in our case we are starting to finally see the benefits of the Internet) and the inability to boost the money supply and thus create inflation.

Figure 12. Total US liquidity decreased after the 2008 crisis

It is this economic necessity and the mathematical impossibility of paying interest continuously which has created the present situation of negative interest rates: in our view the market has found a way to keep the monetary system going but this time without the risk of ever increasing debt.

In the past, we used to deal with too much debt either using market forces, like growth and inflation, or non-market forces, like debt jubilees, debt restructurings or excessive seigniorage. History is full of examples which reinforce the notion that putting an unbearable burden on debtors would ultimately send the whole economy into a depression. Debt jubilees were very common in Mesopotamia, for example, where, by some accounts there were around thirty episodes of general debt cancellations from 2400 to 1400 BC.

In 1819, as agriculture prices dropped, US state governments imposed moratoria on farmers’ debt payments and some debt was even completely forgiven. During the Great Depression, the US government, through the Home Ownership Loan Corporation, helped struggling homeowners by sometimes substantially lowering their mortgage payments. “One of the largest transfers of wealth (from creditors to debtors) in the history of the world”, however, happened when the US government broke off the gold standard in 1933. This was equivalent to restructuring its debt as, by removing the gold clause in US Treasury securities and devaluing the dollar, creditors’ claims were cut by more than 40%.

None of these options was used after the Great Recession of 2008. In addition, the developed world economies seem unable to generate growth and inflation sufficient to offset the rise in debt. Without a policy response, the market is taking the matter in “its own hands” by starting to reduce the level of debt (in present value terms) via negative yields on sovereign bonds.