The German government should go spend a bunch of money on something. Ideally a critically useful infrastructure project, given the country's large apparent needs on that front — but failing that, even a pretty blah project would be good. Or if Germany can't think of anything worth spending money on, it should enact a large cut in its national sales tax. How to pay for it? Easy.
Don't. Because the weirdest story in the economics world just keeps getting weirder.
German 10-year bond yield to go negative, says Citi. Targets -0.05%, vs current record low 0.15%.
— Jamie McGeever (@ReutersJamie) April 9, 2015
European governments are being offered free money
Right now on the European continent there are several countries, including Germany and Finland, that have sold bonds that pay negative interest rates. In other words, you give the Finnish government 1,000 euros today and several years later they give you back fewer than 1,000 euros.
This is an extraordinary event, the impact of which has been somewhat blunted by the fact that for years now some government bonds have traded at negative real rates.
That means the rate of interest charged is less than the projected rate of inflation, giving governments the opportunity to essentially borrow for free. That's an unusual situation, but it's always been clearly something that might happen every so often. What's playing out right now where some governments are selling bonds at negative nominal rates — and a much larger group including Netherlands, Sweden, Denmark, Switzerland, and Austria have seen bonds trade at negative rates in the secondary market — is considerably weirder.
Indeed, the interest rate situation in Europe is so strange that until quite recently, it was thought to be entirely impossible. There was a lot of economic theory built around the problem of the Zero Lower Bound — the impossibility of sustained negative interest rates. Some economists wanted to eliminate paper money to eliminate the lower bound problem. Paul Krugman wrote a lot of columns about it. One of them said, "The zero lower bound isn't a theory, it's a fact, and it's a fact that we've been facing for five years now."
Why did economists think negative interest rates were impossible?
Well, think about it. A bond with a negative interest rate is a guaranteed money-loser. Why would you buy one if you can just hold cash instead?
The traditional view has always been that no one would. People thought the interest rate on bonds couldn't fall below zero because at that point people will just hold on to their money.
So why are negative interest rates happening?
Well, back in January the Eurozone's central bank launched a program of quantitative easing — in other words, printing money and using it to buy government bonds. This was supposed to reduce interest rates, and it's working.
But here's the catch. The Eurozone has one central bank — the European Central Bank — but there's no consolidated Eurozone debt, no "eurobonds."
So when the ECB goes out and buys bonds, it needs to buy the bonds of its member states — a little Belgium, a dollop of Portugal, a smattering of Finland, a dose of Italy, etc. But one consequence of the Eurozone crisis of 2010–2011 is that people think the Eurozone might break up. If the Eurozone does break up, you're going to be way better off owning the debt of a rich and stable country like Germany than the debt of a country like Spain that's much poorer and facing an uncertain political situation. So whatever the interest rate on Spanish bonds, the rate on German bonds is sure to be lower.
In other words, if the ECB takes steps to make Spanish interest rates really low, then the interest rate on more creditworthy Eurozone countries has to go below zero.
But why would anyone buy a negative-interest bond?
That is the real mystery. The mechanics of pushing interest rates down are easy to see. But why not just hold cash in your bank account? It's not entirely clear what's happening, but here are three major motivations that market insiders say are in play:
- Safety: A bond is backed by the full faith and credit of the government that issues it. Bank accounts are only government-guaranteed up to a certain extent — most European countries cover 100,000 euros. Very rich people and big companies have more money than that and need to do something with it. Obviously you could fill shoeboxes with paper money, but there are safety risks with that, too.
- Passive funds: Because people thought negative interest rates were impossible, few institutions have rules in place that were designed to accommodate this situation. Pension funds, mutual funds, and other impersonal investment vehicles have rules and formulae they're supposed to be following. To the extent that those rules call for the holding of safe bonds, some bond buying can simply happen on autopilot.
- Banks: Banks can't store their spare money in a bank account. Instead, they store reserves with a government-run central bank. A certain amount of reserves are required by regulators. But banks can also store "excess" reserves. The European Central Bank is currently charging a fee on excess reserves, which means it makes more sense to park excess cash in government bonds.
This is interesting, but what's the takeaway?
The main practical short-term takeaway is that Germany (and other smaller creditworthy European nations) is hurting both itself and the world economy by declining to run a larger budget deficit. As Ben Bernanke explained in a recent blog post, Germany's huge trade surplus is a problem for the global economy because it means Germans aren't buying enough stuff to create job opportunities for non-Germans.
When German politicians hear their surplus criticized, they typically become defensive and say it's absurd to blame them for manufacturing great products that the world wants to buy. But the issue isn't what Germany sells to the world, it's how little Germany buys.
What's more, fixing the problem requires absolutely zero sacrifice on Germany's part. What the world needs from Berlin is for Germany to buy itself a bunch of nice shiny new transportation and energy infrastructure, or else for Germany to give itself a huge tax cut. Not only would shiny new projects and lower taxes be fun, but the message of the negative interest rates story is that by borrowing more money today Germany will improve its long-term fiscal situation.
What are the implications for the United States?
For the USA, the main implication is that back in 2009 and 2010 the Federal Reserve made a mistake. All the objective economic metrics at the time said the "right" interest rate to curb unemployment would be negative. But negative interest rates are impossible! The Fed tried a few tricks to get around that problem, and also told Congress to try fiscal stimulus as a workaround.
The implication of the European experience, however, is that the Fed could have generated negative interest rates through a mix of Quantitative Easing and negative interest rates.