Negative interest

Modern finance has seen many innovations in the last 20 years. The Black-Scholes-Merton theory promised risk-free investment if it was properly hedged, or insured through market based options. That spawned a whole new category of investment in derivatives, or re-selling of insurance that nearly anything might go wrong. There were always new places to put money through the last generation as new concepts of “investment” were created. But through it all, there was one constant: there is a time value to money, which is to say that money today is paid for tomorrow plus a little bit more – call it “interest”.

No longer. Debt from large, secure nations is being sold at net negative interest rates, meaning that those with money are actually paying to lend it. Money today is worth less than money in the future. The implications of this are staggering.

The phenomenon has only taken off this year, starting with Germany and spreading to the UK. As it stands right now, some investors have paid a net negative interest on US Treasuries (T-Bills) in the secondary market where they are re-sold, but our government has not benefited from this. But sales of T-Bills at net negative rates from the outset are being contemplated, meaning that a source of revenue for the US Government might soon be how much it needs to borrow.

If that sounds like bizarro world to you … well, it is. And it may be a sign of serious trouble to come, mainly as Deflation.

The reason this is being considered is not simply that the Treasury thinks it can get away with it. They want to encourage investors with a lot of cash to go out and take risks in the world, investing their money in opportunities that will boost the economy, create jobs, and so on. Investors, however, are scared and want to sit on their money and wait, hoping that some day there will be better investments than they can find now. So they tend to park it in T-Bills, using them as big warehouses for money. And they may have to start paying for that privilege.

Note that in days long gone this is money that would probably be stuffed into a mattress somewhere, but it is not today. This is money that has never been in printed form, but is only a set of digits in a computer. If it is not parked somewhere, it does not exist.

Traditionally, there are two kinds of money on any balance sheet – capital investments and expenses. One of the great innovations recently has been creating liquid markets where money can move back and forth between these two easily, blurring the distinction – and making arguments for lower tax rates on investment a lot more dodgy than they used to be. We are seeing something like a new category of money on balance sheets – idle money that has no place to go at all. It is neither invested nor spent, generally liquid but set aside, simply waiting.

Manufacturing and other productive sectors of the economy used to have a fair amount of this kind of money sitting in their vaults, but it was smaller in scale, scattered, and always in support of their operations. Farmers liked to have cash when they could as a reserve, and manufacturers typically kept a few months’ payroll on hand. These reserves were often stripped from companies if they started to look too large by predatory “capital management” firms when the assets of an operation became larger than their net value as a going concern. This is how Mitt Romney, among many others, made a lot of dough in the 1990s.

Today, the idle capital is not sitting in the hands of farmers, craftsmen, and manufacturers who make stuff. It is in the hands of the financial industry, and they have no idea what to do with it. They are actually willing to pay to keep it safe, which gives us negative interest rates. The final innovation in finance appears to be breaking the cardinal rule of finance in order to wrest money back out of the hands of an industry that innovated itself to uselessness.

There are many reasons why negative interest is appealing to the government, but it is still a sign of financial apocalypse. That’s why the Treasury announced they were considering the idea first – to see what happened to markets and opinion generally. It appears likely to be implemented – timidly at first, and then who knows? But the point remains that money tomorrow is more valuable than money today, which is to say that there is nothing deemed worthy of investment right now. That, alone, is scary enough.

Erik Hare

Copyright 2010 by Erik Hare. All rights reserved.