The invention of money fundamentally changed economies forever. In pre-modern society, individuals could only transact by swapping goods. Barter transactions were comprised of extremely specific, personalized transactions based upon the needs of two groups. This posed obvious issues as a group with one particular need could only successfully transact with a different group if their offers were mutually beneficial. Transaction volume was resultantly minuscule relative to the transaction volume we witness today. For instance, there were 28 billion shares transacted for Nasdaq listed stocks in July of 2019.
In order to circumvent the constraints of
Enter paper money. As John Lancaster of the New Yorker writes,
“When the Venetian merchant Marco Polo got to China, in the latter part of the thirteenth century, he saw many wonders—gunpowder and coal and eyeglasses and porcelain. One of the things that astonished him most, however, was a new invention, implemented by Kublai Khan, a grandson of the great conqueror Genghis. It was paper money, introduced by Kublai in 1260.”
Kublai was able to implement this paper money system by punishing individuals who refused to accept or counterfeited his currency with death. The creation of paper money facilitated transactions – different denominations made it easy to transport and Kublai enforced acceptance of the currency among his subjects. Paper money was initially backed by physical assets such as gold, but after Richard Nixon removed the United States dollar from the gold peg in 1971, a new form of money was created: fiat money.
Fiat money has no intrinsic value. Indeed, it has been defined as:
- Any money declared by a government to be legal tender.
- State-issued money which is neither convertible by law to any other thing, nor fixed in value in terms of any objective standard.
- Intrinsically valueless money used as money because of government decree.
- An intrinsically useless object that serves as a medium of exchange (also known as fiduciary money.)
Fiat money is accepted because governments declare it to be valuable and ensure it will be accepted for transactions within their realm of governance. Consequently, fiat money is only as valuable as the stability of the government that issues it. Additionally, governments that ineptly employ fiscal and monetary policy will devalue their fiat money accordingly. Indeed, this observation likely served as motivation for the anonymous Satoshi Namakmoto to create Bitcoin after the 2008 financial crisis. Indeed, in a world where the efficacy of fiat money is questioned, a decentralized digital currency tha
To understand the future of fiat money, and its relationship to interest rates, it is important to develop some historical context. To outline the historical relationship between money and interest rates, we will first take a look at the development of credit. Indeed, credit existed well before its widespread adoption in modern economies. In A History of Interest Rates, Richard Sylla writes:
“Credit was in general use in ancient and in medieval times. Credit long antedated industry, banking, and even coinage; it probably antedated primitive forms of money. Loans at interest may be said to have begun when the Neolithic farmer made a loan of seed to a cousin and expected more back at harvest time.”
To illustrate the discussion above, consider the following scenario: two farmers are sowing their fields in preparation for their next harvest and one farmer lacks the capacity to plant more seeds. The other farmer is short a few seeds and requests a loan from her neighbor, promising to return his seeds plus an additional few. Thus, the interest rate for this loan was a positive one; the creditor values the seeds he has today more than he values his seeds tomorrow and consequently expects to be compensated for parting with his valued seeds. By making this loan to his neighbor, he facilitates economic development.
But what if we alter the previous example slightly? For instance, suppose one farmer has met the capacity of his farm and already has enough seeds for the next 1000 harvests. In essence, this farmer has generational “harvest wealth.” This individual pays for the right to store his seeds in a local storage which charges the equivalent of two harvests worth of seeds per year. However, the storage ensures that he will have access to his seeds for all subsequent harvests. If this rich farmer is approached by farmers who ask for one harvest worth of seeds, the rich farmer may be hesitant to make this loan – he has no need for additional seeds, and there is a non-zero probability that his counterparty defaults on their loan. Thus, he abstains from making a loan and elects to harbor his seed in storage instead, failing to make a positive impact on economic output as in the previous example.
What is the distinction between the two examples shared above? In the first example, the farmer makes the loan at a positive interest rate, whereas in the second, he elects to store his seed in the storage facility at a negative interest rate. We stated that a positive interest rate implies that the farmer values the seeds he has today more than he values his seeds tomorrow. Conversely, a negative interest rate implies that the farmer values the seeds he has tomorrow more than he values the seeds he has today. Indeed, since the farmer has already obtained generational wealth in terms of harvests, he is mostly concerned with ensuring he has enough seeds to sustain subsequent harvests, and perhaps the harvests of his children and then their children. Unfortunately, his unwillingness to lend detrimentally affects economic output.
While negative interest rates may have been novel from a historical contextes, they are increasingly prevalent today. The European Central Bank lowered its deposit rate to -0.1% (or -10bp) in 2014. As of this writing, ten-year German Bunds are yielding -68bp – one now pays 68 cents to lend 100 euros to the German government.
Why would people pay to lend money? For the same logic outlined in the second farming example: they value the money they will have tomorrow more than the money they have today. One may also invest in negative
Critics of negative rates claim they are the result of misguided central bank policy. Yet, I think negative rates may be a natural phenomenon given the state of the modern economy. We live in the most affluent society the world has ever seen and are in the midst of a global savings glut. Thus, if there are an increasing number of entities with ample cash, they may value their future wealth more than their current wealth, justifying negative interest rates when viewed through the lens of the time value of money.
The demographics spurring the increase in savings can be attributed to an aging population, heightened standard of living, and increased wealth disparity. As people live longer, the future becomes more valuable to them relative to the present. New technologies have also significantly increased the standard of living; technology is cheaper and more efficient than it has ever been, providing consumers with more excess cash. Unfortunately, savings have not increased for a large portion of our debt
The individuals who have accumulated massive sums of wealth are not simply concerned with saving for their own retirement – they have the means to ensure that their children, and even future generations, are taken care of. This is the ultimate form of favoring the future over the present, as one assigns significant weight to the value of their future money relative to its present value when accounting for future generations. These developments serve to place downward pressure on rates. Indeed, assuming all rates are negative across every maturity, it even justifies an inverted yield curve if one heavily prefers the future to the present.
The global savings glut is just one component driving interest rates lower, however. Technology companies have altered our framework for understanding how businesses should employ capital. If one views the balance sheets of Facebook and Alphabet (Google’s parent company) their current accounts completely cover their total liabilities – not just their current liabilities – with room to spare. This drives the cost of capital down as less overhead is required to generate an acceptable return, serving as a form of leverage and justifying the “expensive” multiples that these technology companies have traded at throughout the most recent bull cycle. In essence, one need only invest a fraction of their capital, relative to historical precedence, to generate an equivalent nominal return since these businesses are not as capital intensive. With excess capital on hand, one can either continue deploying their capital into investment opportunities, or they can elect to save it. If one elects to save it due to an unattractive investment universe, downward pressure is once again placed on rates.
There are a limited number of levers central banks can pull on to stimulate risk appetite in the current monetary policy regime. The European Central Bank (ECB) and Bank of Japan (BoJ) have already accumulated massive balance sheets through their asset purchase programs and have set their interest rates near historic lows. The Federal Reserve (Fed) began liquidating its asset holdings and increasing the fed funds rate during its brief quantitative tightening stint but reversed course this year under global growth concerns. This leaves the Fed with more ammunition than the ECB and BoJ to combat a potential recession, but the amount ammunition the Fed has accessible is limited relative to past cycles. The fed funds rate sits at 225bp as of this writing; the Fed eased 550bp when the tech bubble burst in 2000 and 525bp in 2008. While the next recession may not call for as much stimulus as the previous two, one must be aware that there is a non-zero probability that the fed funds rate turns negative in the future.
Central banks play a very important role in dictating how capital is deployed. If investors are saving capital because they find the investment universe to be unattractive, lowering the central bank interest rate is not a prudent monetary policy decision when the economy is healthy. If interest rates are lowered to increase an investor’s risk appetite, it incentivizes investors to allocate capital at a time they would not do so otherwise. In effect, central banks push interest rates below the level established by the market to bolster investment activity, causing investors to extend further out along the risk spectrum.
Lowering interest rates in a time of general economic health is akin to central banks being short a put option. Economic growth has a relatively defined upper bound – there are few large surprises to the upside. Indeed, the upside of promoting economic activity today is “capped,” whereas the downside of preventing a prolonged recession is much more pronounced. Consequently, central banks forfeit their ability to prevent an economic calamity if monetary policy is utilized inefficiently. One must be concerned about the monetary policy’s ability to prevent a recession at this juncture given the lack of gunpowder currently accessible to central banks.
While modern monetary policy is not the sole cause of the negative rate regime we witness today, it could affect the magnitude of interest rate negativity. The easy monetary policy maintained throughout this expansion increased investor risk appetite at potentially imprudent times and investors are now concerned with protecting their future capital due to global growth concerns. When these concerns are coupled with the demographic trends identified earlier in this piece, downward pressure is being placed on interest rate levels which were already suppressed due to monetary policy initiatives. While negative interest rates may be natural given the modern economic environment, the lower bound that interest rates could reach is certainly lower due to the policies pursued by central banks during this cycle.
Since negative rates are likely to be seen in our lifetime, where can one place their money to avoid the holding tax that is charged when placing money in negative-yielding bonds, or in bank accounts offering a negative interest rate? One could invest their capital in stocks or other assets, but what if too much risk is embedded in that decision? This is where our discussion of currencies at the outset of the piece becomes pertinent. Gold has been viewed as a safe-haven asset that fares well during economic turmoil. Since fiat money is tied to the health of the governments that back their currencies, gold offers an escape from devaluations in a specific currency. Physical gold is currency agnostic. But owning physical gold poses its own storage costs; it fluctuates in value (it is not a riskless store of wealth) and one may find it impractical to store physical gold in bulk.
The modern world offers an escape from this predicament through the advent of cryptocurrency. Indeed, cryptocurrencies offer individuals a virtual store for their wealth which is similarly currency agnostic, while circumventing the issue of physically storing the asset. But prices of cryptocurrencies are highly mercurial and are consequently not riskless stores of wealth. While their adoption may increase as individuals use them as a mechanism to escape negative yields, it remains to be seen if this will quell their massive price fluctuations.
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