Today, we want to say two things about negative interest rates. The first is really simple. Anyone who believes in a theory of interest that says “the savers demand interest to compensate for inflation” needs to ask if this explains negative interest in Switzerland, Europe, and other countries. If not, then we need a new theory (Keith just presented his theory at the Austrian Economics conference at King Juan Carlos University in Madrid—it is radically different).
Second, negative interest perversely incentivizes some very perverse behaviors.
For example, suppose you could borrow at -1% and just hold the cash. Your asset stays the same, while your liability is going down. You are making a positive return for doing nothing productive! It should be obvious to an 8th grader, though perhaps not a PhD economist, that there is something wrong with this. Grossly, monstrously wrong.
Of course this example is an oversimplification. Banks pay negative interest (i.e. charge) on cash deposits in countries with negative borrowing cost. So your asset is going down along with your liability. Withdrawing paper bank notes in large quantity—major institutions have negative unsecured borrowing cost, not individuals—is impractical. We’ve been told that in Switzerland, there are fees both to withdraw large amounts of paper notes and to deposit them. There is no free money to be had this way.
As an aside, the monetary authority has to impose a cost on the holding of paper which is greater than or equal to the cost of negative interest on a deposit. If they don’t, then as the rate of interest falls, they are offering an increasing perverse incentive to withdraw paper notes. This would create a perverse incentive to run on the commercial banks.
OK, it’s not that simple. How can we add a bit of complexity to achieve the goal of the simple example? Instead of holding cash, you must buy an asset. If the asset has a yield, so much the better. But even if—net of all carrying and maintenance costs—the yield is zero, it still works.
At this point, the reader might be thinking to buy gold. Alas, gold incurs the risk of its price dropping. Suppose you borrowed $100,000,000 on September 4 and bought 64,516 ounces of gold. Today, that gold is worth $94,709,677. You would have negative equity of over $5 million.
You need an asset that is practically guaranteed not to go down. Real estate seems suitable for this purpose. So you borrow that $100,000,000 and build an apartment complex. In a normal world, you would care about occupancy and rent. Whether you are investing your own, or borrowed, money you are trying to make a good return on capital. But this is a negative-interest world. You don’t need to make a profit. You just need an asset without a carrying cost that holds its value. The negative cost of borrowing provides your profit.
In other words, you don’t make a profit by providing something needed by customers in the market, such as a home for rent. You make a profit off the back of the lender, who forfeits 1% of his principal to you every year.
The predictable result of this perverse incentive is that institutions will continue to borrow and build more and more housing, driving down rents and occupancy rates so that the net return on capital for landlords is zero. Note that this happens to all landlords, even those who borrowed during the halcyon days of positive interest rates. Housing is a competitive market, and tenants do not know or care which landlord has higher interest expense. They care only about the location, size, interior finishes, and of course the rental rate.
The return on capital in all other endeavors will also be driven down. It will go down to marginally above the interest rate. In our examples, we are guessing +1% spread above the interest rate as a good first guess, but this is not necessarily the right number.
We leave it as an exercise for the reader to answer what will happen to the return on capital when the interest rate falls another point, to -2%.
As an aside, consumer advocates and putative defenders of free markets cheer the whole way. Consumer advocacy is based on a fundamental Marxist premise: that there is a class conflict between the class of tenants and the class of landlords (and more generally, the class of consumers vs. the class of producers). They see soft or falling rent (or rising quality of interior finishes with same rent) as occurring despite the greed for exploitation of the class of landlords. The government, in their view, must have found the right ways to nudge the class of landlord exploiters to lower their rents.
Free-marketers have a different premise. They know that whenever the government interferes in markets, it does so by force. And they know that nothing good comes out of the barrel of a gun. But they have an oversimplified view of this as a single scalar, which could be thought of as friction. So in their view, soft or falling rent occurs despite friction. The landlords, in their view, must have found ways to become more efficient, and lower rent.
The former are closer to correct. Not about the absurd materialist idea that everything is class conflict. They are partially right that the government has found a way to nudge landlords. In central bank socialism, that way is: to lower the interest rate. And keep lowering it to zero, to “euthanize the rentier” as Keynes said. And even beyond, to negative rates.
The latter are just wrong. The government can do things that are simply not a kind of friction. Such as lower the interest rate.
And everyone who accepts the Quantity Theory of Money is marveling that rent is falling despite the increase in the quantity of what they think of as money. The drop in rents is occurring because of the drop in interest rates, not despite the increase in M0 or M2 or whatever measure of quantity of dollars.
All three of these groups believe that the fall in rent is occurring despite whatever it is that they are primarily obsessed with. However, the phenomenon is not occurring despite those things. They are simply wrong in obsessing over those things that they obsess over.
By the way, note that we do not use the word bubble. Bubble implies that a price has temporarily spiked. What we are describing is a perverse incentive offered to all market participants to borrow to buy and/or build new real estate. This incentive is durable, and growing with the falling of the interest rate (well, as durable as the regime of irredeemable paper currency itself).
The Strong Economy
Note also that the construction of half-filled apartment buildings—to be rented at a price that barely covers costs—adds to GDP and employment. Those who are inclined to cheer the strong economy can point to employment and GDP numbers that rise despite the tax and regulatory environment.
We can only say that, whatever the word is for an economy where the certain losses of the investors incentive and enable borrowers to build unneeded overcapacity that they rent at no profit, that word is not strong.