by Alasdair Macleod, GoldMoney:

Growing evidence of a severe global recession is sure to provoke more aggressive monetary policies from central banks. They had hoped to have the leeway to cut interest rates significantly after normalising them. That hasn’t happened. Consequently, as the recession intensifies central banks will see no alternative to deeper negative nominal rates to keep their governments and banks afloat through a combination of eliminating borrowing costs and inflating bond prices. It will be the last throw of the fiat-money dice and, if pursued, will ultimately end in the death of them. Gold and bitcoin prices are now beginning to detect deeper negative rates and the adverse consequences for fiat currencies.

The problem

Central banks face a dilemma: how can they cut interest rates enough to stop an economy sliding into recession. A central banker addressing it will note that the average cut required to put an economy back on its feet is of the order of 5%, judging by the experience of 2001/02 and 2008/09 and what their economic models tell them. Yet, in Euroland the starting point is minus 0.4% and in Japan minus 0.1%. In the US it was 2.5% before the recent reduction and in the UK 0.75%. The solution they will almost certainly favour is deeper negative nominal interest rates.

Given mounting evidence that the global economy is entering a significant recession and drifting towards a cyclical credit crisis, this topic is suddenly relevant. Regular readers of my articles will know that I have highlighted empirical evidence that a combination of trade protectionism and a turn in the credit cycle are the recipe for an economic slump. In combination these were the two factors that collapsed the US stockmarket in 1929 and led to the great depression of the 1930s. The economic theory behind it is clear. Today, American trade tariffs come at the end of the longest and most aggressive period of credit expansion ever seen. It is not an overestimation to expect that a credit crisis combining with American trade protectionism this time has the potential to be worse than that of nine decades ago.

Furthermore, we have arrived at this point through increasing injections of fiat money and credit over successive credit cycles, because central banks do not permit credit distortions to unwind. Instead, in their mission to protect commercial banks from defaults they encourage malinvestments to persist. It will not be just a case of unwinding the credit distortions following the Lehman crisis, there is a long legacy to deal with from previous credit cycles as well.

Following the collapse of the Bretton Woods Agreement in 1971, the freedom granted to central banks to print money is the framework for current monetary policies. As well as funding government deficits, monetary expansion has been used to protect the financial and commercial establishment at everyone else’s expense. We are told moderate price inflation is good for us when it obviously impoverishes society’s disadvantaged. The true purpose is to permit monetary and credit expansion. Furthermore, price inflation is always quantified by governments keen to suppress unfavourable evidence. The combination of monetary inflation and the suppression of evidence of the effect on prices is now the backbone of monetary policy.

It is a policy which has added viciousness to the credit cycle, leading to ever greater credit crises. You would think that progressively greater failures of monetary policy over succeeding credit cycles would cause rational humans to stop and think. But united in their groupthink, central bankers incline to the view that it is not the policy that’s wrong and it’s not their fault: it is the fault of businesses (they call it a business cycle) and more intervention is the solution.

Rational individuals know that there is another credit and economic crisis in the wings, and they already know how central bankers will respond. They will want to reduce interest rates to rescue their economies by cuts at least as aggressive as in the past, which means having the leeway to slash rates by a minimum of five per cent. What our rational individuals have yet to realise is it takes monetary policy into deeply negative rates everywhere. Entire AAA-rated bond yield curves are likely to be forced into negative territory, following the Swiss government bond market, which is already there. The denial of time-value will mean a government bond with no final redemption date priced at less than infinity will be technically a bargain. That is the measure of distortion.

There can be no doubt that central bankers feel increasingly trapped. Reading between the lines, it was hard to escape this conclusion following last week’s reduction in the Fed Funds Rate. Mario Draghi at the ECB will be glad to hand over the reins on 1^st November. His replacement is a lawyer and socialist politician who reinvented herself as the head of the IMF. Christine Lagarde’s only qualification for the job is the same as Mark Carney’s at the Bank of England: she is regarded as a safe pair of hands and is expected to steer the ECB along familiar monetary tramlines.

She knows little about economics. Worse, she is hampered by having been a French finance minister, where knowledge of free market economics is a disadvantage. But conveniently, the IMF, which she is leaving to head up the ECB, recently published a working paper showing her and her fellow central bankers how to enable deep negative nominal interest rates.[i]

This working paper, to which we will return later, follows another written in 2015 by the same authors, again published by the IMF, entitled Breaking Through the Zero Lower Bound.[ii] The first paper comes up with fifteen “misconceptions” about eliminating the zero bound. None of these deal with the problem of time-preference, nor, more remarkably, the fact that deeply negative rates will put the whole commodity complex into backwardation and risk a wholesale run on bank deposits from large depositors. Nor are there more than just oblique references to the true objectives of negative rates: to facilitate government funding and to rescue the banks.

The most important economic issues are simply ducked.

The origin of the belief in negative rates

The two authors mention the history of the desire to reduce interest rates, commencing with the work of Silvio Gessel (1862-1930), who proposed the introduction of a stamp duty on physical paper currency: paper money would only retain its value if it was endorsed every month with stamps purchased at a post office. This would in effect impart a negative yield on paper cash set by the cost of the monthly stamps.

By giving paper cash a negative yield, Gessel believed interest rates on loans could be made to move towards zero. The obvious flaw was interest rates were interest rates on lending and borrowing gold, which backed most currencies at the time. It would require at the least coordinated action by all issuers of gold substitutes and was impractical even before one considers transgressions of price theory.[iii]

In fact, interest always had a bad name, termed usury by the Christian church and banned at various times through its long history. It is still banned by the Moslem faith. People cannot get their heads around the idea that money appears to be able to earn money without any effort expended by its owner. Keynes was tormented by this problem as well and gave over five pages in his General Theoryto Gessel, after initially dismissing his work and then admitting to becoming profoundly impressed. Gessel appears to have provided Keynes with the bones for his argument that savers did not deserve the remuneration of interest and could be written out of the future as providers of monetary capital.

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