Something weird is happening in Europe: negative interest rates.
Some $2 trillion, about 16 percent of the world’s government bonds, now offer negative yields, according to John Apruzzese, partner and chief investment officer at Evercore Wealth Management.
European governments, including Austria, Finland, Germany and Sweden, all have issued new bonds at negative yields in the past 12 months. This means investors are paying to lend to those governments rather than receiving an income.
Who are the main actors in creating this Alice and Wonderland world? Europe’s central banks, such as Denmark’s and Switzerland’s, and the European Central Bank itself have promoted policies that push rates into negative territory in order to revive their slowing economies.
But it’s not just the central banks. European and American commercial banks are now charging their big institutional customers to keep money on deposit. JPMorgan Chase recently announced it might charge institutional clients on certain deposits in order to remove as much as $100 billion of these deposits.
Why are banks charging for holding large deposits? Because the central banks are imposing a fee on large deposits, banks must charge their customers negative interest rates to defray these costs.
Negative interest rates defy the common-sense wisdom that interest rates cannot go below zero. Historically, savers have demanded and received a positive return for providing their money for lending to others. This positive return provides households and businesses with an incentive to save rather than spend their money today.
Traditionally, central banks stimulated spending by lowering the real interest rate, which is the nominal interest rate, minus inflation. Since inflation is now close to or below zero in Europe, negative real rates are needed to stimulate spending and business investment.
Why is the rate charged by central banks pivotal in a capitalist economy? Central banks’ rates provide a benchmark for most of the borrowing costs across a country’s economy. Stated differently, the yields on a range of fixed-income securities move in response to the interest rate policies of their central bank.
Negative interest rates are important because policymakers worry that companies can have such low expectations about the viability of new projects that only negative rates can push them to borrow, hire new employees and expand their operations.
When did negative interest rates begin in the modern era?
Sweden adopted a negative- interest-rate policy in 2009. It was followed by Denmark.
Switzerland and Denmark now have pushed their key policy rate to minus .75 percent. The European Central Bank introduced negative interest rates last year.
While there is no guarantee that negative rates will be able to achieve what they are meant to, Mario Draghi , president of the European Central Bank, pledged during the height of Europe’s sovereign-debt crisis in 2012 to do “whatever it takes” to save the area’s common currency and to stimulate growth.
But the negative interest rates throughout Europe are severely testing the continent’s financial system. Negative interest rates are a sign of desperation, a signal that traditional policy options have failed and new solutions need to be explored.
Negative interest rates pose a serious problem because they reflect widespread deflation — falling prices. When people expect prices to fall, they become less willing to borrow. Lower borrowing and postponement of spending can create a downward economic spiral.
If Europe is unable to shake off its economic malaise, the result will have ominous implications for the U.S., because our economies are so intertwined.
About 40 percent of profit for firms listed in the S&P 500 stock index now comes from overseas.
