Keynesian Economics and the End of Central Bank Credibility

Keynesian Economics and the End of Central Bank Credibility

It is an axiom of Keynesian economic theory that lower interest rates mean more lending and borrowing, more spending in the near term and a stronger economy. That's the theory that has led central banks to drive down interest rates to record lows, destroy the value of savings and explode bond and stock prices higher.

The application of this theory is most advanced in Europe and Japan where key interest rates have fallen below zero and much of the sovereign debt now offers negative yields to maturity. On June 5, 2014 the ECB officially announced that the interest rate on its deposit facility for commercial banks would go negative. NIRP (Negative Interest Rate Policy) was born. This extreme form of financial repression should be forcing households into saving less, increasing household debt and spending more. It is not.

All the evidence tells us, ultra-low interest rates actually increase savings, not borrowing and spending. Europe's economies have experienced an unexpected surge in savings since the European Central Bank began to crush interest rates, which is actually logical if you think about it. As interest rates fall, retirement becomes more difficult and people feel the need to save more. Individual investors become more risk averse in a NIRP environment.

Instead of opening their wallets, many consumers and businesses are setting aside more money. Recent economic data show consumers are saving more in Germany and Japan. In Denmark, Switzerland and Sweden, three non-Eurozone countries with negative rates,savings rates are at their highest since 1995. Central bankers have failed again. Ultra-low interest rates are "working"in precisely the opposite way of what was intended.

t was only a question of time before the impact of NIRP worked its way down to the consumer. And now it has. Earlier this month, Reiffeisenbank, a German cooperative savings bank in Bavaria, became the first to give in to the ECB's monetary repression, announcing it will charge retail customers to hold their cash. Starting in September, Raiffeisenbank will charge a 0.4% interest rate on savings in excess of €100,000 euros. Other European banks are considering the same move.

"People only borrow and spend more when they are confident about the future," says Andrew Sheets, chief cross-asset strategist at Morgan Stanley. "But by going negative, into uncharted territory, the policy actually undermines confidence."

Central Banks do not seem to understand that continual manipulation of the monetary system won't get households to do their bidding. Savers want security and stability. The less they have them, the more risk averse they become. Will they pay for the privilege of lending money to their free-spending governments in a currency their central bank is trying its best to depreciate? Or will they turn increasingly to gold? We think the answer is obvious.

In our view, global monetary authorities are not yet done with Keynesian experimentation. We expect one more round of massive monetary stimulation in an effort to lift the economy back onto a growth path. We predict it will not work for the same reasons it has not worked to date. This time, however, we expect a more immediate consequence...a collapse of the wildly over-priced bond market.

"With our business clients there's been a negative rate for quite some time, so why should it be any different for private individuals with big balances?," Josef Paul, a director of the bank told Bloomberg last Thursday.

NIRP has already had a dramatic impact on the EU banking system. The ECB imposes a 0.4% negative rate on commercial bank deposits with the central bank. Deposits by European banks at the ECB now stand at more than 850 billion euros, generating a 3.4 billion euro annual cost to the banks. The Bundesbank estimated last year that the low-rate environment would cut the pre-tax profit of German banks by 25 percent by 2019. This is designed to encourage banks to lend money rather than sit on it, but loan demand is flat; a poor global economic outlook means weak demand for loans on the terms banks require and they therefore have little option but to hoard cash.

Meanwhile, now that a German bank has finally breached the retail depositor NIRP barrier, expect more banks to follow. The implications? European savings rates will soar even higher, bond yields will tumble even lower and gold will continue its steady move higher as it offers a real rate of return compared to bank deposits.

Could Negative Interest Rates lead to a Bank Run?

As I wrote on June 10, yes. With negative interest rates, it obviously makes sense to take your money out of the bank and hold cash or gold. I'm guessing many of us will become our own bank. Would you be surprised to learn that sales of safes are at record levels in Europe and Japan? But not in the U.S. of A., you say. Well, Janet Yellen, head of the Federal Reserve, recently said negative interest rates aren't "off the table" in the U.S. either.

The problem is that there is not enough physical currency to cover even 15% of the money held in bank deposits. And it could get much worse. Former Treasury Secretary Larry Summers and others are recommending that the $100 bill should be taken out of circulation.

Here's the chart courtesy of Casey Research:

Recently, we reported on the actions of Munich Re, one of the largest reinsurance companies in the world, overseeing €231 billion in investments. The German company confirmed that negative rates are making physical cash a more valuable holding. If large conservative institutions such as Munich Re are increasing their holdings of cash, shouldn't you, dear reader? Or would you rather wait until there is none to be had?