Negative Interest Rate Absurdity and How It Screws Up the Economy (Video)

Negative-yielding debt surged to over $15 trillion earlier this month. This pile of negatively-yielding paper includes government and corporate bonds, along with some euro junk bonds.

In a recent episode of the Wolf Street Report, Wolf Richter called this “NIRP absurdity.” And it could be coming to America.

Negative interest rates started out as a short-term emergency experiment during the Great Recession. Now it has turned into the new normal. How will this end?

Last week, the European Central Bank began hinting at another, “shock and awe stimulus package,” as Richter called it. In an interview with the Wall Street Journal, Finnish central bank governor Olli Rehn raised the prospect of new easing measures. He said, “It’s important that we come up with a significant and impactful policy package in September. When you’re working with financial markets, it’s often better to overshoot than undershoot, and better to have a very strong package of policy measures than to tinker.”

This, of course, would be on top of the shock and awe stimulus that the ECB has already unleashed. The entire German bond market, including the 30-year, now has negative yields. And yet the German economy has contracted two out of the last four quarters, despite negative rates from the ECB and negative yields on its own government bonds.

In other words, the German economy, the fourth largest in the world, is hitting the skids despite, or because of, negative yields. And now the ECB wants to flex its muscles to get yields to become even more negative.”

And as Richter points out, there are already folks who want the same prescription for the US economy.

So, what’s the problem?

For one thing, negative yields destroy the business model for banks.

They make future bank collapses more likely because banks cannot build capital to absorb losses.”

Richter pointed out that the European Bank Stock Index has dropped 11% since rumors of another big ECB stimulus package began circulating. The recent plunge wasn’t from some bubble high. It has dropped 78% from its peak in 2007.

As Richter says, banks are a crucial factor in a modern economy.

European banks are sick, sick, sick. And with negative yields, they’re getting the exact opposite of what they need.”

We’re seeing a similar phenomenon in Japan. The Japanese bank index peaked at 1500 in 1989. It is currently at 129. That’s a 91% drop.

Zero percent interest rates, and worse, negative interest rates, are terrible for banks for the long-term. And because they’re bad for banks, by extension, they’re bad for the real economy that relies on banks to provide the financial infrastructure so that the economy can function.”

Richter said one bank can fail, but if the whole banking system collapses, it’s like turning out the lights on the economy.

Richter goes on to explain exactly how negative rates disrupt the fundamental business model of banks and drives them to take riskier actions.

Negative interest rates don’t just impact banks. They have an even more profound destructive impact on the real economy.

They distort or eliminate the single most important factor in economic decision making — the pricing of risk.”

Richter notes that some junk bonds in Europe are now trading with a negative yield. This indicates the risk-pricing system in Europe is kaput.

When risks cannot be priced correctly anymore, there are a host of consequences, all of them bad over the longer term for the real economy. It means malinvestment and bad decision-making. It means overproduction and overcapacity. It means asset bubbles that load the entire financial system with huge risks because these assets are used as collateral and the value has been inflated by negative yields.”

The longer negative rates persist, the more screwed up an economic system becomes.

How will this end? Nobody really knows because nobody has done this before. But we do have some idea and so far, the outcomes are already bad.