What do Negative Interest Rates “Mean”?

An opinion piece by Ross Healy, CFA

Let us start with a very simple truth (that, we think, often gets lost when people chatter mindlessly about Trillion Dollar Deficits as if, well, there it is: nothing that we can do about it and who cares anyway): Money is an obligation, specifically, it is debt obligation of the government that issues it. When a dollar is spent/lent, whether to a local merchant or your neighbourhood bank, it is done so in the assumption that tomorrow’s purchasing power will be more or less the same. The interest rate paid (by your bank) is the ‘allowance’ for the natural growth rate which exists at the time (adjusted for inflation). While that has clearly not been the perfect case much of the past 30 years, that is the theory of money and it sort of works pretty well. All the rest of the baggage that accompanies the standard definition of money – ‘medium of exchange’, ‘store of value’, and so on – follows from the “fact” that under normal temperature and pressure, a dollar spent/lent today will be worth the equivalent purchasing power tomorrow. If it were not so, one would put one’s money under the mattress (if the purchasing power, or ‘value’ were increasing), or spend it as fast as one could get rid of it (if one thought that the  value was decreasing).


Following logically, if the interest rate paid today is negative, then the future purchasing power of money must be assumed to be greater compared to today’s. In which case, if I put a dollar into the bank, or lend it to a corporation at a negative rate of interest, then the assumption must be that the returns going forward will be positive based on the rising value of the currency alone. We could safely assume that this could only be true in a deflationary environment. [And this is precisely the environment that the ECB – for one – seems to be terrified may be about to occur.]


Think of this from the point of view of your banker. If I, as your banker, accept your deposit and the value of money in and of itself increases, I am committing myself to repay you tomorrow a value, excluding interest, that is greater than today. But unless I just hold your deposit in cash,  or unless I pay you a negative rate of interest, how can I ‘afford’ your deposit? I have to pay you back in that rising purchasing power (compared to today), but now I would need to earn enough on your deposit to repay you that extra amount. Now, if other interest rates are negative, all that I can do is sit on your cash – which does not pay my expenses involved in safekeeping your money, so I must stop being a bank or go broke. Unless I require that a negative rate of interest be paid on your money.


What sort of environment produces deflationary rates of return – i.e. a negative interest rate? Clearly, this environment has no growth in it because if there were growth, there would be a rate of return available to allow someone to borrow money so that they could earn whatever the rate of growth may be (adjusted for inflation – of which, in this case, there would be none). In other words, the whole pie would be shrinking.


Now, if the pie is shrinking, what role would a central bank have to play? Creating more money isn’t going to help, nor is lowering any positive statutory interest rates (the “Fed Fund Rate” etc.). However, what the central bank can do is to print so much money that inflationary forces build to counteract the deflation in evidence. And that is what all of the central banks have been focused on in recent years: trying to create that ‘magic’ 2% inflation rate target!


Historically, this is what happened in Germany and Zimbabwe, to name only two. Their central banks printed money (loaded more debt on to the economy) to get the economy going. Prices did start to rise alright, but because the countries were deeply insolvent (as we measure it) what also happened was that the value of their currencies began to fall, and eventually did so endemically, until their value was eventually erased. Given that Japan, Europe and the US are right on the verge of insolvency (as we show in Black Hole Economics) if such policies are pursued in Japan, the US and Europe, as appears to be very much the case of stated intent, then sooner or later, the value of those currencies tomorrow will be worth much less than the value today. And at the point where the market realizes this, we will start to see interest rates rising – not because there is any growth – there still isn’t any – but because the value of the currency is falling, that is, being debased. What looked like “deflation” suddenly turns into “inflation”.


The question is, how on earth did we ever manage to get into this situation in the first place? The sad answer is that we have been pursuing this course of action for the past 38 years under a regime of cutting taxes but not expenditures, all the while loading more and more debt on the economy. That added debt has not been ‘costless’. In 1980, a dollar of additional GDP “cost”

$1.45-.50 in additional debt. Today that same dollar “costs” $3.50. Examining the mathematics  in Black Hole Economics (see our blog site, The Occasional Contrarian), you will see that a total debt load greater than $3.50 per dollar of GDP causes GDP growth to start to become negative. And beyond that, as GDP reverses (goes negative), then while it may “cost” $3.50 now, it won’t take long for the Total Debt numerator to escalate upwards relative to GDP, usually because the efforts of central banks to get some additional GDP in a “no-growth environment” only results in more money (debt) being ‘needed’, but GDP will continue to fall under the increasing weight of debt anyway.


What we see over the past 38 years is that the dead weight of the existing load of debt has risen until it has become so high now that the growth of the economy cannot be sustained and it starts to reverse course. Initially, with a negative growth rate, the value of money tomorrow seems to be worth more than the value today, because with no growth,the demand for goods, services and money falls, and the environment is (apparently) deflationary. And it is at this point that in the past, the attempt by the central banks to push the economy back into action by money creation begins. The problem is that this only spills into debasement of the currency, but it cannot stir the economy into renewed growth. This is the beginning of “inflation”. Whereas before, we thought of inflation as prices rising, we can now focus on what has really been going on (and going on for a long time): the value of the currency has been falling. But now there is no change in economic activity (except for the worse) for comparison purposes so our focus can be direct.

This, of course, is the preamble to a currency collapse. Germany suffered this in the early 1920s and excellent records exist that show clearly what the authorities thought was happening. Real growth has ceased, but as inflation sets in and prices rise, nominal “growth” appears. Having set the money printing exercise in motion to get the economy moving, the Bundesbank was then afraid to stop lest economic activity revert back into the contraction that started the whole stimulation process. (It’s all in those records, by the way.)


Let’s stop and go back for a moment to the beginning of the process. If my currency were worth more tomorrow than today because of the apparent deflation, why would “I” not simply hold on to my money and put it under my mattress as tomorrow I will have something worth more than


today? With no economic growth initially and prices falling, that is what people initially tried to do in Germany (and later Zimbabwe). But the actual problem is that once over that $3.50:$1.00 Debt/GDP ratio, it does not take long before the decline in the value of money caused by central bank intervention combines with the decline in economic activity into a self-reinforcing ‘do- loop’ which pushes the value of money down even faster – and prices up even further. Now when I sell my goods (or my labour) – which I must now do in order just to survive – then I have to get rid of my money increasingly quickly, to realize what value there is left in it.


Of course, if you do not have to sell your product – if you are a farmer and grow your own food, for instance – then you won’t sell for cash money, or will only exchange for barter, and the shelves in the cities will soon be barren, unless alternative methods of payment (via the black market) get underway – which always happens in such situations.


At the outset of the process, and at the point where interest rates start to become negative, what the central banks ‘see’ is an economy that has stalled and turned negative along with interest rates, which looks like a classic deflation. And so the central banks intervene and start to push harder and harder to kickstart GDP growth, except that real GDP cannot respond. In this case, the only thing for the central bank to do is to try even harder. The economy still does not start to expand, interest rates start to rise instead, and the value of the currency starts to fall in earnest.


What happens today when Japan, Europe and the US are all in the same condition and all central banks take their cue from the Fed (in all probability) and begin the stimulation process in deadly earnest? Well, the simple answer is that we can’t know until it happens, but our deep suspicion is that the value of the currencies will fall (against whatever countries are not insolvent and have an independent currency). GDP in those areas will not “recover” and start to rise again, but interest rates are likely to go on a trajectory which cannot be controlled by those self-same central banks.


If central banks do not understand the issue of a Total Debt/GDP ratio that rises above 3.5 as being the threshold when GDP reverses course and begins to fall endemically – and they do not, we can say unequivocally – then those same central banks will push credit expansion beyond that threshold on the assumption that something positive must eventually start to occur, which can only serve to crush GDP ever further down.


The bottom line is that negative interest rates are a symptom of an economy on the brink of an endemic decline (and a coming surge in interest rates when central banks start to ‘work’). One can forget standard economic theory (and, if I may add, Modern Monetary Theory is pure bunk) to explain this phenomenon. While the overall event itself is well documented, the brief “window” in which interest rates can become negative is short and, because it appears to be benign, I would guess is therefore largely undocumented.




What do negative interest rates imply? The value of the currency will be worth more tomorrow than it is today.


If this is true, what does that imply? The only apparent way that this is possible is if we are in a deflation.


Well, are we in a deflation? No. We are in a virulent inflation, but that must now be defined very carefully. What is now inflating is the cost of a $1.00 of addition GDP, which has risen from $1.50 in 1980 to $3.50 at the present time.


If that is the case, why does it appear that we are in a deflation? The economies of the US, Japan and Europe (for three) have reached a solvency condition (total debt to GDP) whereby the dead weight of debt has pressed the growth potential of GDP to zero, or very close to it. [See our analysis, with the accompanying mathematics, Black Hole Economics.] With zero growth, marginal demand for both goods and services and money must fall to very low, and then to negative (i.e. “deflationary”) levels. If there is no growing or even stable demand goods and services and money, then their prices should fall to zero and even below. Which is what they are now doing!


Well then, what now? If the dead weight of debt on the economy exceeds $3.50 of debt per $1.00 of GDP, the mathematics of Black Hole Economics warns us that GDP growth will turn negative.


And then? Here’s the unknown part. However, we think that we can guess at the rest. If the GDP turns negative in those three massive economies, it is likely that their central banks will join in the political panic and start to stimulate – in spades. But loading addition debt onto that kind of economy only makes the debt situation, and hence the growth outlook, worse – triggering a more massive and urgent attempt to use more stimulation in a relentless failing do-loop.


Has this ever happened before? Many times. 55 countries experienced this condition in the last century and several in this one.


 And…? Their economies collapsed along with their currencies.


Could this actually happen to such massive economies in this day and age, not to mention given the collective wisdom of our expert central bankers? We are about to find out. It has been our central bankers, with their recurrent bouts of monetary stimulation to resolve every twitch in the economy since 1987, that allowed the debt situation over the past 32 years to get where it is today, so we do not actually hold out that much hope that “collective wisdom” is the right term to apply here.


So what can I do to protect myself – assuming that all this really takes place? Gold has been the classic answer to profligate governments for millennia. Investing in things that have value and are likely hold it is a good thing to do (forget art and stamps). Unleveraged real estate is good, and shares of productive enterprises have historically preserved wealth, while allowing for a very considerable amount of volatility.


Why should anyone get concerned now? Hasn’t this been going on for some time – and those currencies and so on have not collapsed and even gold hasn’t done much. This is the beauty (if I may use this word in this context) of the current negative interest rate environment: it is now signalling that something is imminent. Japan and the US have been cruising along right at that 3.50:1 Debt/GDP ratio for some time – Japan for 20 years and the US for 10, and Europe has now joined the group. Rates have been falling, but it is only very recently that trillions of dollars in debt are yielding negative values. The economy rarely does something spontaneously: it usually provides a strong warning well in advance. It is when central banks become really twitchy when confronted with a situation like this that one has to believe that something big is about to occur. No central bank, and certainly no politician, is talking about fixing the situation, only accommodating it. With very low – or no – growth and virtually no inflation, the easy attractiveness of monetary stimulation is obvious – but as discussed above, is now badly misplaced.


Finally, there is clear evidence that this can happen in very large, mature economies because it has already happened in the US! In 2007-8, the US debt/GDP ratio crossed that boundary condition and the US suffered its worst recession since the Great Depression, accompanied by the collapse of housing, autos and the banks.


Do we really want an encore?



Ross Healy, CFA

Chairman of Strategic Analysis Corporation

Portfolio Manager, MacNicol and Associates Asset Management August 2019