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Investing In A Negative Interest Rate Environment

|Includes: SPDR Dow Jones Industrial Average ETF (DIA), GLD, QQQ, SLV, SPY, USO, UUP
Navigating Negative Interest Rates

Negative Interest Rates and Deflationary Banking Part 1 By Dr. Van Tharp Trading Education Institute

Many readers have heard of negative interest rates, but few are familiar with them, understand what they mean, and know their ramifications going forward. How is it possible to have negative interest rates on a mortgage, or even a credit card? The bank would pay me money? How is that even possible? The short answer is yes, it's quite possible. Here's how and why.

But before we go there, it is necessary to explain some things about money, and why negative interest rates have become a policy option.

Money is a portable storehouse of value. By putting an intermediate step in the barter system, early merchants had a means to store buying power for the future. How did the merchants know that the future buying power they stored would retain its value? The money itself, coinage, was made of precious metals and had an intrinsic value in and of itself. Banks originally were depositories. A merchant received a receipt for his deposited gold, and this receipt could be exchanged for goods and services. The bearer could cash it in at any time.

Some banking houses were financially stronger than others. They had more gold and a better reputation. The latter was important because once a house was trusted, it could create more receipts than the amount of gold on hand and issue them as loans. This is called Fractional Reserve Banking.1 The practice had the potential for abuse. A depositor might demand his deposit back only to find it was not available. This is an old, if not ancient, story.2 The Orazione Trapezitica, written in 393 BCE, records a legal speech by Isocrates (436-338 BCE), one of the foremost Greek orators of his time. In it, he argues for redress on behalf of his client who is seeking the return of deposits from Passio, an Athenian Banker, who refused, for whatever reason, to return them.3 In spite of the risk of abuse, Fractional Reserve Banking has its pluses. It allows loans to be made to those who need funds to start businesses, which create additional economic value in the form of employment and future production of goods and services. Without the initial funding, the potential positive economic benefit would never be realized.

Money, therefore, represents many things: physical goods, labor, as well as the amount of work necessary to make something. It is also a storehouse of future value in that it has the potential to create and purchase goods in the future. It has buying power. Beyond what it represents, money is also a commodity that can be bought and sold like any other. When one gets a loan, one is buying money. When one is a lender one is selling money. If you are buying flour, it is so much per pound. When you buy money, the price you pay is so much interest per thousand expressed as an annual percentage rate.

Money is cheap when interest rates are low and expensive when interest rates are high. Cheap money in the past has usually led to economic growth and inflation.

Inflation is defined as too much money representing too few goods, and deflation as too little money representing too many goods. In an inflation, prices of things go up. In a deflation, the prices of goods fall.

Whether prices go up or down depends on the economic forces that are dominant.

If money is plentiful and inflation is widespread, market participants, including consumers and corporations, go on buying binges. It becomes economically wise to move money into physical things such as cars, gold, and real estate as fast as possible. The longer you hold onto money, the less it can buy. The more physical things you own, the more valuable they become. In such a system, money moves rapidly from consumer to merchant to wholesaler, and around and round. Debt is of benefit because not only does one buy things that are rising in price and retaining their value, but the money purchased in the form of loans is paid back with funds that are less valuable based on their buying power. This is a powerful incentive to spend.

Controlling this tendency is the province of central banks such as the US Federal Reserve. Central banks have a mandate to maintain economic stability. One of the tools for that purpose is setting the level of short-term interest rates. By raising rates, money becomes expensive, economic activity is slowed, and inflation is halted. If the economy slows too much, interest rates are lowered to make money easily available, and the economy speeds up.

The last several decades can be characterized as a long period of inflation. Inflation promotes spending and thus consumerism. Consumerism has been one of the most prevalent paradigms in Western and developing economies for well over thirty years. The attitude flourished during the long-term inflationary environment that started in the 1960s. During inflationary times, thrift, savings, and fiscal responsibility actually work against the individual, while conspicuous consumption and excessive debt are rewarded.

Economies, contrary to much academic teaching, are cyclical. Growth is neither constant nor is it guaranteed. It occurs in cycles. Deflations have followed periods of inflation over and over until the last century. The 1930s marked the last time the world has seen a prolonged deflation. Much of the praise for this long inflationary stretch has been given to central bank policies and actions that steered a middle course between economies that are too hot or too subdued, until now.

Today, deflation is much more pervasive, and deflations are very different economic environments from inflationary ones. Operating in a deflation requires that you put off a purchase for as long as possible since whatever it is will be cheaper in the future. Immediate gratification becomes not only unwise but a distinct liability. Cash money earns interest sitting in the wallet because it will buy more and more over time. Notice this is the opposite mindset to consumerism.

Deflation is not new. It has happened many times throughout history. Why is this time different?

In the past, economies routinely moved into inflationary credit bubbles that led to excessive spending, unwise investment, and overextended borrowers. (The US during the 1860s and 1930s.) As these economies reached their apex and started to contract, debtors could no longer support their debt and defaults became prevalent. Loans are potential assets to a bank since they generate income in the form of interest payments. When there is a default, the asset value of the loan is reduced, often to zero. Banks close (they become bankrupt) just like the depositories and banking houses of long ago. Bankers stop lending. Money becomes scarce, prices drop (deflation), and the economy grinds to a crawl until the bad loans are written off and a new cash infusion is provided. After a time, with the start once again of easy credit, the cycle repeats.4

In the past, deflationary cycles were a fact of life. There were no central banks. Since their inception at the start of the 20th century, there has been only one deflationary period of significance: The Great Depression, and central banks did not handle it well. Nothing worked over the long term. WWII is said to have pulled the US out of the depression more than any particular policy or action taken alone or altogether. Being aware of this, current central bank policy is to prevent a deflationary economic slowdown by any means possible with the intention of recreating an inflationary environment while avoiding the defaults of past cycles.

Pushing money into the financial system to provide liquidity, providing as much easy money as possible by lowering interest rates to minimal levels, and preventing significant defaults are actions that were not taken in the 1930s. Banks closed in record numbers during that time and defaults were common, including sovereign debt issued by governments throughout the world.

Today the world's financial and banking structure is very different from over a century ago. There are safeguards in place such as deposit insurance, but global financial institutions are significantly more interconnected. In the 30s, banks were isolated businesses, but not so today. A large loan default in one bank could lead to a cascade of counterparty defaults in others, precipitating a worldwide banking crisis. Although the effects of such a collapse are impossible to know with certainty, the Global Financial Crisis (NYSE:GFC) of 2008 was an indication of how easily it could happen. The US was days away, in the autumn of 2008, from no available cash for payrolls. What would have happened had a large segment of the US population not been paid is a nightmare scenario that nobody holding economic responsibility dares risk finding out. Thus, providing liquidity by any means and avoiding major defaults have become the two overarching central bank policies because, in essence, there are no alternatives.

To add to central banks' difficulties, much of their ammunition in the form of room to lower rates (rates are already close to zero), swapping bad debt for good debt, and cash infusions, has already been used up with limited success. The crisis, although eight years past, is to some extent, still with us.

After several rounds of the above, widespread inflation has failed to appear. Rather, the results have been a disparity of wealth and an asymmetric US economy that shows inflationary pressures occurring in only certain segments such as housing, healthcare, education, and stock market valuations, while deflationary pressure remains persistent in others such as commodities and wages.

In part two of this article next week, we will learn the reasons why widespread inflation has failed to appear in the United States. Ivan will explore a lesson learned from Japan and what we might learn about that country's negative interest rates and deflationary banking experience.

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