More than $13 trillion worth of debt is paying a negative interest rate. Bloomberg’s Joe Wiesenthal caused a stir over the weekend when he tweeted that negative rates are in fact the natural order of things, arguing that assets are a store of value that provide a service. According to this thinking, it makes sense for investors to pay someone to hold their money. In economics, “natural” is the market price that reflects risk, risk tolerance, supply, and demand. An unnatural rate suggests a distortion either from the government or a market failure. Negative rates seem unnatural because they are, contrary to Wiesenthal’s argument, unusual. But negative rates could be natural if the world has changed, and it it may have.
Natural order
Interest rates are market prices and historically rates have been positive. Wiesenthal asserts that prior to the advent of financial assets like savings accounts and securities, the rich stored their wealth in things like castles and art instead. Those assets had a negative rate of return because of the cost of maintaining them, he says. It’s not clear this argument is correct, however, because these assets paid dividends to their owners, for example, in the case of castles, in the form of shelter, protection and status. They also offered capital gains when sold. And even if financial assets weren’t so common, they were available and paid a positive return.
According to economist William Goetzmann’s book on the history of financial assets, loans that paid positive interest dates back to 2,400 BCE. Goeztmann argues the ancient Mesopotamian invention of debt was the most significant invention in finance because it gave borrowers the use money from the future to pay for things today. It saved farmers from starvation and created the foundation for modern commerce. But lending money wasn’t a sure thing: A farmer might have a bad harvest or a government (medieval Venice pioneered government bonds) may go bankrupt fighting a war. Lenders need to be compensated for their risk or they won’t make loans and, until recently, all lending was risky. In addition to default, lenders gave up access to their money for the loan’s term and there was the possibility inflation will erode the value of the loan. The riskier the bond, the more it paid. Historically, a negative yielding bond was extremely rare, if unheard of.
The 20th century saw the emergence of risk-free bonds. The bond market has become much deeper and more liquid. Now it is unthinkable that some debt, particularly those issued by highly rated governments, could default. Inflation since the 1980s has been low and predictable. If there is effectively no risk to some debt and investors are willing to pay for a store of value, that means a negative rate may have become natural.
Is the current rate distorted?
It is possible the market could produce negative rates, but it’s also worth asking if the market has been distorted. Central banks have had low-rate policies for more than a decade and, it could be argued, they created the negative rate environment. The evidence does not support it is entirely the fault of central bankers. The Federal Reserve currently targets positive rates and two of the three rates set by the European Central Bank are non-negative. True, the rates they target could be below the “natural rate” (the rate that would prevail if central bank policy were neutral) which would cause distortions, but it is impossible to know for sure because the natural rate is impossible to measure precisely.
There are reasons to believe the natural rate is lower than it was 20 years ago, during the days of 5% bond yields. There is more demand for bonds because there are more foreign buyers and corporations face regulatory constraints, which is another form of distortion. Aging populations may demand more safe assets as they enter retirement and if investors believe inflation is no longer a concern, you’d also expect lower rates. Central banks also only influence short-term rates, and longer-term rates are also much lower than normal, suggesting more demand for low risk assets.
Negative rates may have been unthinkable for most of civilization, but they are now part of our reality. The evidence seems to suggest much lower, and perhaps even negative, rates are being driven by market forces, which makes them natural. But this only shows things change, and one day the old order could return.