We live in strange economic times. Depositors in Denmark are paying interest to their banks and borrowers are being paid when they take out a loan. The basic principles of finance have been turned on their head.
One commentator has noted that 'something economists thought was impossible is happening in Europe'. Interest rates on government bonds in Denmark, Switzerland and Germany – along with some corporate bonds like Nestlé – are negative. We are not talking about negative real interest rates, namely the nominal rate adjusted for inflation, but the nominal rate itself. Investors are lending money to governments knowing that they will not be fully repaid.
It may be six years since the global financial crisis, but its legacy continues to take us into uncharted waters. As the Reserve Bank of Australia's Deputy Governor, Phil Lowe, recently observed: 'The global monetary environment is quite extraordinary'. Mohamed El- Erian has noted that there are few analytical models, and even fewer historical examples, to help us understand the broader implications of all this, particularly for a global financial system based on the assumption of positive nominal interest rates.
An indication of the peculiarity of this ultra-low interest rate environment was provided in a recent speech by Andie Haldane from the Bank of England, when he presented the following chart showing interest rates over the past 3000 years:
A chart plotting interest rates over 3000 years should receive an award for the 'most ambitious economic chart of the year'. Nevertheless, it highlights that interest rates, both long and short-term, are the lowest they have ever been – with the emphasis on 'ever'.
When interest rates get into negative territory, why are investors prepared to pay governments to look after their money?
One answer may be that given the dire outlook for the European economy, and a lack of confidence in other opportunities, investors are willing to tolerate negative yields on relatively safe bonds. Mohamed El-Erian suggests that with the European Central Bank just starting its quantitative easing program (where it prints money to buy government bonds), investors believe they may be able to make capital gains if the prices of the bonds keep going up in response to the bond buying program.
The central banks in Switzerland, Sweden and Denmark have set negative rates because they are actively trying to discourage capital inflows. This is an effort to prevent their exchange rates from rising when the euro falls following the ECB's quantitative easing.
Some hedge funds are warning that Australian savers and investors may not escape the world of negative interest rates. This was a topic at a recent superannuation forum in Australia, with Danny Yong from hedge fund Dyman Asia Capita noting that 'sitting tight and doing nothing is not an option when deposit rates are negative'
In the absence of historical precedent, no one can predict the full implications of negative interest rates. For some time the BIS and the IMF have warned about the dangers of an extended period of ultra-low interest rates. These dangers include investors increasingly moving into riskier investments in search of yield and asset price bubbles.
The ultra-low interest rates are also a challenge for banks and providers of long-term insurance products. Some banks are charging for deposits: in short, they want depositors to take their money elsewhere. The National Australia Bank has warned that if interest rates become too negative, depositors will pull their cash from the banks and either place it under a mattress, in a safe deposit box or invest in riskier assets like shares. If enough people do this, the bank warns, there could be a run on bank deposits which could create a crisis.
The insurance industry, pension funds and money market funds all depend on positive yields to operate. Wolfgang Munchau points out that life insurance companies sell products and annuities with guaranteed returns. They invest the money they receive from policyholders in government or corporate bonds. For this model to work, it requires positive interest rates from safe investments.
Then there are the adjustments that are required when interest rates eventually rise. In a prolonged period of low interest rates, both investors and lenders may not adequately take into account the inherent risk of the investment, and both will be caught out when rates eventually head north.
We are living through an economic experiment, and this alone imposes significant uncertainty as to the outlook for the global economy. If history is our guide to the future, then we are flying blind.
However if there is one thing that is certain, it is the limited policy flexibility available to respond to the next crisis. This should make us all concerned.
Photo courtesy of Flickr user ECB.