Negative Interest and Economic Uncertainty

Governments around the world, in all shapes and sizes, are struggling to come to grips with crushing levels of debt. France, for instance, has delayed the early retirement age of its public pension plan and is facing angry street protests as a result. And here in the United States, California and other states are slashing their expenditures for public education and other services.

This past week, the United States government successfully implemented a far more innovative strategy, one that promises to raise additional funds to close its budget deficit. Namely, it borrowed money from investors who were willing to lend it money at a negative rate of interest.

That’s right; negative interest! To be precise, Treasury bonds were sold to the public at a cost of $105.50 for every $100.00 to be repaid in the future. In other words, investors paid the government $5.50 to lend it $100, effectively flipping the lender / borrower relationship into reverse.

But why would any investor want to lend money to the federal government on these terms? In fact, why would any lender accept a negative interest rate from any borrower? And what does their willingness to do so say about the current state of our economy?

A Few Mitigating Factors

There are, to be sure, a few mitigating factors that help explain why investors were so willing to pay (and not charge) the federal government to borrow their money. One reason, for instance, is that the government sells bonds through an auction based system, thereby requiring investors to bid against each other for the right to loan money to Uncle Sam. Whenever many parties face off and bid against each other for any contract, the possibility of a winner’s curse outcome is relatively high. After all, each bidder is aware that the only sure-fire method for securing a winning bid is to over-pay the seller.

Another reason is that the Treasury bonds carried a special guarantee that the government will compensate investors if an unexpected outbreak of inflation eats away at their proceeds. These specially crafted Treasury Inflation Protected Securities (or TIPS) are intentionally designed to attract much higher bids from auction participants who are very concerned about the risk of inflation.

Furthermore, prior to the staging of the auction, Federal Reserve Bank Chairman Ben Bernanke and other Fed governors announced plans to inject additional liquidity into the national economy by purchasing certain types of assets. Such transactions flood the economy with capital through a technique called quantitative easing, thereby encouraging economic growth and yet raising the specter of inflation in the process.

Can you spot the cause-and-effect relationships among these various factors? First, the government publicly announces a policy to generate economic growth in a manner that raises concerns of inflation. Then it invites these concerned investors to partake in a financial auction, one that employs a format that encourages them to over-bid to win contracts to loan money to the government.

Finally, it offers an inflation protection clause that is designed to address the very concern that was generated by its previous policy announcement. It then sits back and smiles as the bidding process drives the interest rate down into negative territory.

Exploiting Uncertainty

Logical, isn’t it? In fact, one might be tempted to assume that negative interest rates on federal government debt may represent relatively common events. However, such rates are only rarely employed to “cost out” Treasury debt throughout American history, most recently during the great financial panic of late 2008. That was a highly unusual period of time, though, when the imposing threat of a second Great Depression drove panicky investors to seek the safety of government securities at any cost.

Back in 2008, however, the federal government did not intentionally create a public perception of economic risk that drove the demand for treasury debt. Instead, it was scrambling to adapt to the rapidly collapsing economic landscape in the same manner as the investing public. This week’s negative interest event, though, appears to have been encouraged by a deliberate (and, in fact, somewhat aggressive) decision by the Federal Reserve to adopt a policy that would create expectations of inflation and thus generate demand for inflation protected bonds.

Ben Bernanke, of course, would undoubtedly argue that his primary motivation was the generation of economic growth and not the creation of inflation psychosis.  Nevertheless, growth and inflation inevitably go hand-in-hand when the means of achieving economic growth is quantitative easing; Bernanke was certainly aware that inflation anxiety would grow as a result of his actions.

Thus, last week’s re-occurrence of negative interest rates on federal debt arguably represents a governmental exploitation of the inflation uncertainty that grips American markets. That very uncertainty may yield additional revenues for Washington politicians in the short term, but it cannot bode well for the health of the American economy in the long term.