KOLB: The Looming Negative Interest Rate Disaster

(Photo by JOHANNES EISELE/AFP via Getty Images)

Charles Kolb Deputy Assistant to George H.W. Bush
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Founding Father Benjamin Franklin advised Americans: “[i]f you would be wealthy, think of saving as well as getting.” Franklin also counseled our young nation that “[a] penny saved is a penny earned.” Today, we’re all about “getting.”

Not only is Franklin’s advice considered quaint nowadays; it is, unfortunately, downright irresponsible: with the Federal Reserve holding interest rates near zero (and below zero in real terms after considering modest inflation), today’s economic incentives favor spending, not saving.

What are negative interest rates? Negative rates mean you pay your bank to hold your money. In short, a penny saved is a penny devalued. And yet, nearly one quarter of the global economy (Sweden, Switzerland, Denmark, the European Union, and Japan) has embraced negative interest rates for several years.

In most cases, the charges have either been absorbed by commercial banks or passed on to deep-pocket corporate customers, rather than consumers. But that situation could change on a dime, especially if bank profits are threatened.

United Kingdom financial authorities have been studying the prospect of instituting negative interest rates, and there have been discussions about adopting them here. While many experts discount the possibility of negative rates in the U.S., growing deficits and the ballooning national debt may ultimately limit the scope of fiscal policy, thereby further enhancing the (naïve) appeal of seemingly “cost-free” negative rates as a way to stimulate additional borrowing and spending. With negative rates, the bank is paying you to borrow.

The COVID-19 pandemic has seen extraordinary fiscal and monetary policies deployed to combat the severe economic downturn triggered by the virus. Yields on Treasuries (government-issued debt instruments) are so low that there’s now a global scramble for higher-yielding investments. This scramble, in turn, has created massive asset bubbles in higher-risk equities, real estate, junk bonds and cryptocurrencies.

What does it signal when investors flock to negative-yielding investments (which guarantee a loss) as a measure of enhanced security?

Former Council of Economics chairman Herbert Stein famously quipped that if something is unsustainable, it will stop. One cannot repeal the fundamental laws of economics, namely, relationships between demand and supply; the importance of savings and investment in promoting future economic growth, prosperity and productivity; and the ultimate ability of markets (not governments or central banks) to establish realistic asset prices.

Historically, the average price/earnings ratio of the S&P 500 stock index has ranged between 13 and 15. A stock with a P/E ratio of 25 means that stock is trading at a price 25 times its actual earnings. Higher P/E ratios like we saw just before the 2000-2001 dotcom market crash often signal highly overvalued stocks.

Carmaker Tesla’s current P/E ratio is an astronomical 1,767.11. You be the judge.

Clearly, we must prevent the American economy from collapsing as we continue to battle the COVID-19 pandemic. At the same time, we should begin addressing today how best to handle the structural changes wrought by the emergency monetary and fiscal policies needed to combat the virus’s economic impact.

Negative interest rates signal an effectively maxed-out monetary policy. With a debt-to-GDP ratio exceeding 100 percent (the largest since the end of World War II), there may well be limits as to how much deeper we can go into debt. Is fiscal policy now on the verge of maxing out, too?

As the issuer of the principal global reserve currency, the U.S. enjoys the “exorbitant privilege” of being able to borrow in its own currency. But is such a privilege unlimited? The steadily falling U.S. dollar and rising price of gold suggest otherwise.

Are there upper limits to such borrowing? What are the lowest limits for interest rates already hovering near the zero bound?

Modern monetary theory suggests that the U.S. government can borrow without limit as long as economic growth exceeds interest rates.

Before the Great Recession, Wall Street’s algorithms assumed that housing prices would never fall. Today’s reigning assumption that underpins modern monetary theory is that interest rates will never rise. Assumptions have a rich history of being upended by reality.

History suggests that sustained, long-term economic growth doesn’t result from government fiat, be it ultra-loose monetary policy or ultra-expansive fiscal policy. Even so-called “helicopter” money has to come from somewhere.

Many economists argue that we should take advantage of today’s low interest rates to borrow heavily to support infrastructure, climate change and other policies intended to boost economic growth. These economists keep on assuming that deficits don’t matter.

Until one day they do.

Charles Kolb served as Deputy Assistant to the President for Domestic Policy from 1990-1992 in the George H.W. Bush White House