NIRP, its likelihood and effect on commodities

In last week’s article I pointed out that negative interest rates should lead to a general shift in consumer preferences from money towards essential goods.

Central bankers may wish for this outcome on a controlled basis to allow them to hit their price inflation targets, and this could happen quite quickly. If people face a tax on their cash and bank deposits, which is what a negative interest rate amounts to, they will simply reduce these balances, artificially boosting demand.

There can be little doubt that negative interest rate policies (NIRP) are now a distinct possibility after the Fed backed down from raising the Fed Funds Rate at their September meeting, having prepared markets well in advance for the event. In fact, many mainstream analysts still expect the Fed will raise rates in the coming months. However, external factors are rapidly changing everything, with China’s economy succumbing to a credit crunch, and all the countries supplying China with raw materials suddenly facing a fall in demand. The bad debts in commodity financing (including energy) are a growing concern, as the collapsing share price of Glencore attests. International trade is now contracting for the first time since the wake of the Lehman crisis.

The welfare states have spent the last seven years in the economic equivalent of suspended animation, with the reallocation of capital from unproductive, unwanted and over-indebted businesses impaired by zero interest rate policies. Even though ZIRP didn’t work, central banks undeterred will probably opt for NIRP. We now know the Bank of England is examining the possibility of NIRP at the most senior levels, in which case it is almost certainly being considered by all the major central banks.

It would be a bold step. This is not Switzerland, or Denmark, whose experiments in this direction are frankly irrelevant to the big picture. So how likely is the Fed to introduce NIRP for the world’s reserve currency?

There are two events likely to make NIRP a possibility: firstly, if the global economic outlook deteriorates to the point that the balance of expectations at the Fed tips towards deflation, and secondly if the mounting losses in commodity financing and associated derivatives threaten financial stability. Because the first usually begets the second, we shall focus on the possibility of deflation, and here we are juggling with two further issues. As well as the Fed’s phobia of deflation, the statistics the Fed relies on are badly flawed, under-reporting inflation while exaggerating employment.

Whatever the private misgivings of the Fed’s rate-setters may be, they are mandated to be guided by the statistics. We can be reasonably certain the Fed knows the quality of jobs gained over the last two years is relatively poor, and that the percentage of the workforce actually in employment is at historic lows. That being the case, we are left focusing on inflation (CPI), which is being undermined by both lacklustre demand and falling commodity prices, including energy.

Falling commodity prices will force the Fed to take the global position into consideration. Emerging market economies now account for the majority of world output on a purchasing power parity basis, and they account for about 40% of world trade. Gone are the days when America sneezes, we all catch a cold; now if China sneezes, America catches a cold, along with the rest of us. However it would be a mistake to think China cares overly much.

China’s deflating credit bubble is not her overriding concern, because she has another agenda. She will embrace her economic downturn in order to pursue her thirteenth five-year plan, which comes into effect next year. Put another way, China is a mercantile state, which regards itself as a business to which her citizens have a duty to cooperate. This contrasts with the welfare nations whose priority is the maintenance of welfare. It is a common mistake to confuse the economic policies and outcomes we take for granted in the welfare states with the very different ones in China.

President Xi Jinping is mandated to refocus China’s economy from being the world’s source of low-cost goods into services, technology, and the development of infrastructure throughout Asia. She needs her labour force, of which only about 5% are actually unemployed, to be continually re-educated and redeployed to these ends. Contrast this with the welfare states, which cannot afford to see tax revenues decline under any circumstances.

Because of this difference, it is the US economy that faces the greater problem, and in the planners’ minds the ever-present danger is deflation. Therefore, the likelihood of NIRP being introduced will probably increase in the coming months, as recent falls in commodity prices and the contraction in world trade have their effect on the CPI. Capital markets and commodity prices will have to accept the possibility of negative interest rates.

The effect on commodities
If NIRP looks like becoming a reality, commodity markets should begin to adjust to a general state of backwardation, reflecting the anticipated cost of holding cash deposits compared with owning physical commodities. Speculators holding short positions and therefor long of dollars will expect a cost arising from negative interest rates to replace the positive interest rate return normally reflected in futures pricing. In other words, all market participants would be better off being long instead of short. The effect could be dramatic, as recent experience of the oil price attests, which last year more than halved over a brief period of a few months, driven mainly by shifts in speculative positions. The reversal of commodity price weakness could be equally unexpected and sharp.

This is not something industry will necessarily be happy about, if rising commodity prices end up squeezing operating margins. Businesses are bound to more rigorously control manufacturing costs by limiting wages and stock levels. So talk of NIRP ahead of its implementation could end up increasing prices and unemployment at the same time. Its actual introduction would be a different matter, because at that point the public will be directly affected through their bank accounts. The hoarding of necessities, reflecting a decrease in the general public’s level of preference for money relative to goods, would then become the dominant effect on prices. It would be similar to the development of the stagflation of the 1970s, with the additional risk of prices spiraling out of control.

A very serious problem would almost certainly arise in the gold market. Futures prices are already often in backwardation, and NIRP would make this situation worse. But the real trouble would become apparent in the balance sheets of the bullion banks, which traditionally have positioned their dealings to benefit from the higher interest rate in the interbank market, compared with the gold lease rate. Admittedly, ZIRP has reduced the interest rate spread between the two to virtually nothing, but there is a legacy of unallocated gold accounts which gave the banks this benefit on a geared basis, exceeding the bullion banks’ capital by as much as ten times. Nobody yet has woken up to this crisis-in-the-making, but if they do, NIRP, or even the threat of it, could plunge the international monetary system into crisis by exposing the lack of physical gold in western vaults.

The effect NIRP would have on the gold price and the crisis it would generate at the heart of the financial system is an obvious reason why it should not even be considered, the other being the danger that it could trigger a series of events leading to the early destruction of the dollar itself. It would be the final experiment by central bankers on an unsuspecting public.


The sudden end of the Fed’s ambition to raise interest rates above the zero bound, coupled with the FOMC’s minutes, which expressed concerns about emerging market economies, has got financial scribblers writing about negative interest rate policies (NIRP).

Coincidentally, Andrew Haldane, the chief economist at the Bank of England, published a much commented-on speech giving us a window into the minds of central bankers, with zero interest rate policies (ZIRP) having failed in their objectives.

Of course, Haldane does not openly admit to ZIRP failing, but the fact that we are where we are is hardly an advertisement for successful monetary policies. The bare statistical recovery in the UK, Germany and possibly the US is slender evidence of some result, but whether or not that is solely due to interest rate policies cannot be convincingly proved. And now, exogenous factors, such as China’s deflating credit bubble and its knock-on effect on other emerging market economies, are being blamed for the deteriorating economic outlook faced by the welfare states, and the possible contribution of monetary policy to this failure is never discussed.

Anyway, the relative stability in the welfare economies appears to be coming to an end. Worryingly for central bankers, with interest rates at the zero bound, their conventional interest rate weapon is out of ammunition. They appear to now believe in only two broad options if a slump is to be avoided: more quantitative easing and NIRP. There is however a market problem with QE, not mentioned by Haldane, in that it is counterpart to a withdrawal of high quality financial collateral, which raises liquidity issues in the shadow banking system. This leaves NIRP, which central bankers hope will succeed where ZIRP failed.

Here is a brief summary of why, based on pure economic theory, NIRP is a preposterous concept. It contravenes the laws of time preference, commanding by diktat that cash is worth less than credit. It forces people into the practical discomfort of treating physical possession of money as worth less than not possessing it. Suddenly, we find ourselves riding the train of macroeconomic fallacies at high speed into the buffers at the end of the line. Of course, some central bankers may sense this, but they are still being compelled towards NIRP through lack of other options, in which case holding cash will have to be banned or taxed by one means or another. This would, Haldane argues, allow them to force interest rates well below the zero bound and presumably keep them there if necessary.

One objective of NIRP will be to stimulate price inflation, and Haldane also tells us that economic modelling posits a higher target of 4%, instead of the current 2%, might be more appropriate to kick-start rising prices and ensure there is no price deflation. But to achieve any inflation target where ZIRP has failed, NIRP can be expected to be imposed for as long as it takes, and all escape routes from it will have to be closed. This is behind the Bank of England’s interest in the block-chain technology developed for bitcoin, because government-issued digital cash would allow a negative interest rate to be imposed at will with no escape for the general public.

Fortunately for the general public this remedy cannot be implemented yet, so it can be ruled out as a response to today’s falling stock markets and China’s credit contraction. What is deeply worrying is the intention to pursue current interest rate policies even beyond a reductio ad absurdum, with or without the aid of technology.

In considering NIRP, Haldane’s paper fails to address an even greater potential problem, which could easily become cataclysmic. By forcing people into paying to maintain cash and bank deposits, central bankers are playing fast-and-loose with the public’s patient acceptance that state-issued money actually has any value at all. There is a tension between this cavalier macroeconomic attitude and what amounts to a prospective tax on personal liquidity. Furthermore, NIRP makes the hidden tax of monetary inflation, of which the public is generally unaware, suddenly very visible. Already ZIRP has created enormous unfunded pension liabilities in both private and public sectors, by requiring greater levels of capital to fund a given income stream. Savers are generally unaware of this problem. But how do you value pension liabilities with NIRP? Anyone with savings, which is the majority of consumers, is due for a very rude awakening.

We should be in no doubt that increasing public awareness of the true cost to ordinary people of monetary policies, by way of the debate that would be created by the introduction of NIRP, could have very dangerous consequences for the currency. And once alerted, the public will not quickly forget. So not only are the central banks embarking on a course into the unknown, they could also set off uncontrollable price inflation by creating widespread public aversion to maintaining any cash balances at all.

The only reason any particular form of money has exchange value is because people are prepared to exchange goods for it, which is why relative preferences between money and goods give money its value. Normally, people have a range of preferences about a mean, with some preferring money relative to goods more than others and some preferring less. The obvious utility of money means that the balance of these preferences rarely shifts noticeably, except in the event of a threat to a complacent view. For this reason, monetary inflation most of the time does not undermine the status as money of central bank issued currency.

The trouble comes when the balance of these preferences shifts decisively one way or the other. At an extreme, if no one wants to hold a particular form of money, it will quickly become valueless, irrespective of its quantity, just like any other unwanted commodity. This is the logical outcome of negative interest rates, and subsequent increases in interest rates sufficient to stabile the purchasing power of currencies is no longer an option, given the high levels of public and private debt everywhere.

Therefore, we need to watch closely how this debate over NIRP develops. If the Bank of England is looking at ways to overcome the zero bound on a permanent basis, it is a fair bet that it is being looked at by other central banks in private as well. And if NIRP gains traction at the Top Table, the life-expectancy of all fiat currencies could become dramatically shortened.

 * How low can you go? – Speech given by Andrew Haldane at the Portadown Chamber of Commerce, Northern Ireland.

Equity markets and credit contraction

There is one class of money that is constantly being created and destroyed, and that is bank credit.

Bank credit is created when a bank lends money to a customer; it becomes money because the customer draws down this credit to deposit in other bank accounts and to pay creditors. It is not money that is created by a central bank; it is money that is created out of thin air by commercial banks to lend. Its contraction comes about when it is repaid, or if a customer defaults.

The recent sharp fall in equity markets is leading to two levels of contraction of bank credit. Brokers’ loans to speculating investors are being unwound from record levels, notably in China and also in the US where in July they hit an all-time record of $487bn. Then there is the secondary effect, likely to kick in if there are further falls in equity prices, when equities held as loan collateral are liquidated. This is when falling stock prices can be so destructive of bank credit, and as the US economist Irving Fisher warned in 1933, a wider cycle of collateral liquidation can ensue leading to economic depression.

Fear of an escalating debt liquidation cycle is always a major concern for central bankers, so ensuring the secondary effect described above does not occur is their ultimate priority. Macroeconomic policy is centred on ensuring that bank credit grows continually, so since the Lehman crisis any tendency for bank credit to contract has been offset by central banks creating money. The bald fact that equity markets have now lost upside momentum and appear to be at risk of a self-feeding collapse will be viewed by central bankers with increasing alarm.

For this reason many investors believe that a bear market will never be permitted, and the combined weight of central banks, exchange stabilisation funds and sovereign wealth funds will be investing to support the markets. There is some evidence that this is the direction of travel for state intervention anyway, so state-sponsored buying into equity markets is a logical next step.

The risk to this line of reasoning is if the authorities are not yet prepared to intervene in this way. When the S&P 500 Index halved in the aftermath of the last financial crisis, the subsequent recovery appeared to occur without significant US government buying of equities. Instead the US government might continue to rely on more conventional monetary remedies: more quantitative easing, reversing current attempts to raise interest rates, and perhaps attempting to enforce negative interest rates as well. If, in the future, state jawboning accompanying these measures does not stop the bear market from running its course, the next round of quantitative easing will have to be far larger than anything seen so far.

Alternatively, if states by buying equities attempt to kill the bear, it will have to be through massive market intervention, aiming helicopter-distributed money at investors as well as rigging the alternatives to make them relatively less attractive. Either way, the shake-out in equities we have seen so far is a wake-up call for mainstream economists and commentators who believe in the comfort of government statistics, which seem designed to convince us all that economic growth is perpetually on its way.

Since the Lehman crisis, investors have bought into this bullish argument to the exclusion of any likely risk that a bear market will happen. Consequently, considerable amounts of speculative money are committed to the concept of a perpetual state-guaranteed bull market; so if the destructive forces of reality do intervene, the potential for a severe fall in equity prices will be much greater than before.

Meanwhile global bank credit looks like it is already contracting in key markets, such as China, in which case global fundamentals are definitely deteriorating. This being the case, it will take increasing amounts of newly-issued money from the central banks to perpetuate the illusion that markets are rising, and that the economy is still growing, with or without state-directed buying of equities.

This article is due to be released one week before the Fed’s September interest rate decision, which might result in a small interest rate rise, but it is time to put the Fed’s interest rate dilemma aside and instead think beyond it about the wider economic consequences of the monetary inflation necessary to ensure a perpetual bull market.

The danger of eliminating cash

Alasdair Macleod
03 September 2015

In the early days of central banking, one primary objective of the new system was to take ownership of the public’s gold, so that in a crisis the public would be unable to withdraw it.

Gold was to be replaced by fiat cash which could be issued by the central bank at will. This removed from the public the power to bring a bank down by withdrawing their property. A primary, if unspoken, objective of modern central banking is to do the same with fiat cash itself.

There are of course other reasons for this course of action. Governments insist that they need to be able to trace all private sector transactions to ensure that criminals do not pursue illegal activities outside the banking system, and that tax is not evaded. For the government, knowledge of everything individuals do is necessary control. However, in the monetary sense, anti-money laundering and tax evasion are not the principal concern. Central banks are fully aware that the financial system is fragile and could face a new crisis at any time. That’s why cash in their view must be phased out.

A gold run against a bank or banks, in the ordinary course of banking, is no longer a systemic threat, but the possibility that depositors might queue up to withdraw physical cash from a bank in which they have lost confidence is very real. Furthermore it is a public spectacle associated with monetary disorder of the most alarming sort. It is far better, from a central banker’s point of view, to only permit the withdrawal of a deposit to be matched by a redeposit in another bank. That way, a bank run can be hidden through the money markets, with or without the intervention of the central bank, and the deflationary effects of cash hoarding are avoided.

This is commonly understood by followers of monetary matters. What has not been addressed properly is how a cashless economy behaves in the event of a significant alteration in the public’s preferences for money relative to goods. Normally, there is a balance in these matters, with the large majority of consumers unconcerned about the objective exchange-value of their money. There are a number of factors that can change this complacent view, but the one that concerns us for the purpose of this article is the speed at which the relationship between the expansion of money and credit and the prices of goods and services can change.

There is no mechanical link between the two, but we can sensibly posit that the extra demand represented by an increase in the money quantity will eventually drive up prices, setting the conditions for a potential shift in public preferences for money, which would drive prices up even more. When the general public perceives that prices are rising and will continue to do so, people will buy in advance of their needs, increasing their preference for goods over holding money.

This is currently desired by central bankers wishing to stimulate demand, but they are under the illusion it is a controllable process. Furthermore, increases in the money quantity are being driven by factors not under the direct control of monetary authorities. Welfare states are themselves insolvent and require the issuance of money and low-interest credit to balance their books. Commercial banks can only continue in business if the purchasing power of money continues to fall, because their customers are over-indebted. Unless the expansion of the money quantity continues at an increasing rate, the whole financial system will most likely grind to a halt. It is now required of central banks to ensure the money quantity continues to expand sufficiently to prevent systemic failure.

It is therefore only a matter of time, so long as current monetary policies persist, before it dawns on the wider public what is happening to money. Preferences will then shift more definitely against holding money, radically altering all price relationships. If this leads into a hyperinflation of prices, which is the logical and unavoidable outcome, the speed at which money collapses will be governed in part by physical factors. In the case of Germany’s great inflation in the 1920s, the final collapse can be tied down to a period of six months or so, between May and November in 1923, after a last-ditch attempt to control monetary inflation failed.
The limiting factor in this case was the time taken to clear payments through the banking system, and when prices began to rise so rapidly that cheques lost significant value during the clearing and encashment process, the economy moved entirely to cash. When prices rose faster than cash could be printed, the limitation on the purchase of necessities then became one of cash availability.

It is in truth impossible to isolate all the factors involved, and the course of events during the destruction of a currency’s purchasing power is bound to vary from case to case. Today the situation is very different from the hyperinflations in Europe over ninety years ago. A society which uses electronic transfers spends bank deposits instantly. The merchant, who is subject to the same panic over the value of the payment received looks to dispose of his cash balances as rapidly as possible as well. In other words, the electronic transfer of money has the potential to facilitate a collapse in purchasing power at a rate that is far more rapid than previously experienced.

The most obvious delaying factor left becomes the speed with which the public realises that government money has no value at all. People are generally ignorant of monetary matters, and a majority of them have no alternative but to believe in their money, because without it they are reduced to barter. It is entirely human to wish these concerns away. For a minority of the population lucky enough to have a combination of wealth and foreign currency bank accounts the problem was not so great in the past, but the interconnectedness of the global monetary system suggests that all today’s fiat currencies face the same problem contemporaneously, and there is no refuge in foreign currency.

These concerns have encouraged the development of alternative solutions, such as our own Bitgold/GoldMoney payment and storage facility, which will allow both consumers and producers to reduce their exposure to the banking system and continue to trade. There are also private currency alternatives such as bitcoin. Whether or not alternative currencies have a future monetary role for ordinary people at this stage looks unlikely, primarily because they are less stable than government currencies; however that might change in the future. They represent a work-in-progress that has the power to undermine the state monopoly on money, not least because they lie outside a government’s ability to manage capital controls directed through the banks.

What fascinates many of those with an understanding of anticipatory private sector solutions, is the potential for triggering a seismic change in the money used today. They have the ultimate potential to free commerce from the whole concept of a state-directed monetary policy. Rapidly developing technological solutions are therefore another factor that could accelerate the public rejection of government money and the state-licensed banking system, simply by offering a practical alternative to a debasing currency. With the progress being made to eliminate cash and the private sector’s ability to develop an alternative financial system in advance, if the collapse of government money comes, it could be very swift indeed.

1.Von Mises, The Theory of Money and Credit, (Yale University Press 1953) page 254.

Economics of a crash

Alasdair Macleod
27 August 2015

This month has seen something that happens not very often: it appears to be the early stages of a global stock market crash.

For the moment investors are in shock, seeking reassurance and keenly intent on preserving their diminishing assets, instead of reflecting on the broader economic reasons behind it. To mainstream financial commentators, blame for a crash is always placed on remote factors, such as China’s financial crisis, and has little to do with events closer to home. Analysis of this sort is selective and badly misplaced. The purpose of this article is to provide an overview of the economic background to today’s markets as well as the likely consequences.

The origins of a developing crisis are deeply embedded in the financial system and Continue reading Economics of a crash