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THE MIRROR WORLD OF NEGATIVE INTEREST RATES
IN A SUSTAINED DEFLATIONARY ENVIRONMENT
Kenneth W. Faig, Jr.
Twentieth-century economic theory expresses nominal interest rates as:
NOMINAL_RATE = REAL_RATE + EXPECTED_INFLATION_RATE
where REAL_RATE is the baseline “cost of money” in a stable price environment with no
inflationary/deflationary expectations. If EXPECTED_INFLATION_RATE is allowed to go
negative when expectations are deflationary, economists add a zero floor for the
NOMINAL_RATE based on the argument that consumers can always elect to hold cash rather
than invest. The REAL_RATE is presumed to be non-negative on the grounds that there should
be a premium for foregoing consumption even in a steady price environment with no
inflationary/deflationary expectations.1
Sustained deflationary periods are relatively rare but can nevertheless be identified. The
United States underwent sustained deflation while it adhered to the “gold standard” in the late
nineteenth century and underwent another episode of sustained deflation in 1930-33 in the wake
of the Great Depression.2 More recently, Japan has undergone a sustained period of approximate
1% general price deflation per year. In effect, however, the availability of cash as an investment
alternative has historically maintained the “zero bound” on nominal interest rates.
Federal Reserve Board Governor Ben S. Bernanke delivered an address on “Deflation:
Making Sure ‘It’ Doesn’t Happen Here” to the National Economists Club in Washington DC on
November 21, 2002.3 In his address, Governor Bernanke emphasized the many tools available to
the government to prevent deflation and to control it should it occur. The government’s ability to
infuse money into the economy (e.g., through public works programs such as were utilized by the
Roosevelt administration) is among the most powerful weapons available to prevent and to
control deflation. Governor Bernanke stated:
I am confident that the Fed would take whatever means necessary to prevent significant
deflation in the United States and, moreover, that the U.S. central bank, in cooperation
1
Some religions consider any REAL_RATE usurious and insist that any return-yielding
investment must involve enterprise risk (above and beyond the default risk for bonds or savings
deposits).
2
The deflation rate in 1930-32 was 10% per year. After President Roosevelt devalued the
dollar by 40% against gold in 1933-34 (a program enforced by gold purchases and domestic
money creation), the inflation rate went from -10.3% in 1932 to -5.1% in 1933 and 3.4% in 1934.
The text of Governor Bernanke’s address may be found at
http://www.federalreserve.gov/boarddocs/speeches/2002/20021121/default.htm.
3
with other parts of government as needed, has sufficient policy instruments to ensure that
any deflation that might occur would be both mild and brief.
A substantial arsenal of economic policy tools exists to fight and to control deflation.
However, there are two factors to consider: (1) the increasing globalization of the economy
means that sustained deflation in other countries could induce deflation in the United States and
(2) individuals and corporations with significant accumulated wealth will usually oppose the
exercise of inflationary policy tools. Faced with declining prices worldwide and individuals and
corporations resistant to the erosion of accumulated wealth, the author believe that “any means
necessary” to control deflationary threats could include a currency recall and replacement of
“perpetual” paper money by “expiration-dated” paper money (consumption drawing rights
[CDRs] if you will). If the “zero bound” on nominal interest rates created by the option to hold
cash is removed, there is no barrier to nominal interest rates falling below zero. If the government
decrees that all income from investment or employment be received in the forms of CDRs
(expiring say within 30-90 days of receipt) then there is no barrier to negative nominal interest
rates. If the expectation is that prices will continue to fall by 5% per annum, a savings account
which will produce a $95 end-of-year balance on a $100 beginning-of-year deposit (particularly
if still backed by government guarantees against default) becomes an attractive investment
alternative for the consumer. A one-year zero-coupon bond with repayment amount $1000 would
sell for $1,052.63 ($1,000 / 0.95) at issue.
Surely, one would expect that indexed “constant purchasing power” investments would
become common in a sustained deflationary environment (just as they become common in
sustained inflationary enviroments). Depending upon degree of economic contraction in a
sustained deflationary environment, barter for goods and services (perhaps facilitated through
electronic “exchanges”) could become more common. Fraternal and protective societies might
see a renaissance. While negative nominal interest rates would dramatically change the
investment marketplace, non-indexed CDR-denominated financial security contracts do not
become impossible. The following table shows 1980 CSO net level premiums for $1,000 whole
life insurance on a male age nearest birthday 35 across a range of interest rates from -10% to
+10%4:
4
The net level premiums are curtate, which reduce the cost in positive interest rate
environments, but increase the cost in negative interest rate environments, since $1 payable at the
end of the policy year is worth more than $1 payable at the instant of death in a negative interest
rate environment.
Interest Rate
Net Level Premium
Interest Rate
Net Level Premium
10%
5.51
-10%
112.04
9%
6.16
-9%
100.35
8%
6.96
-8%
89.15
7%
7.95
-7%
78.52
6%
9.18
-6%
68.54
5%
10.71
-5%
59.27
4%
12.60
-4%
50.81
3%
14.95
-3%
43.19
2%
17.83
-2%
36.44
1%
21.34
-1%
30.58
0%
25.57
Any CDR-denominated insurance product design with “pre-funding” of mortality risk
would involve greater business risk in a negative interest rate environment because of the
increased value of the “mortality” tail. Most tax deferral leverage would probably be reversed in
a sustained deflationary environment which could affect consumer demand for permanent life
insurance. Various forms of indexed or variable insurance coverages would probably secure a
substantial market share in a sustained deflationary environment, because of corporate marketing
and risk management preferences. Annual, monthly, weekly or even daily renewable term might
become popular because of the absence of mortality risk prefunding. The need for protection
against deprivation of economic resources by death, illness or superannuation would not
disappear in a sustained deflationary environment. If prices are expected to continue to fall across
a broad range of economic sectors, negative interest-bearing investments will be competitive
with alternative consumption.
If the prices of gold and other precious metals move asymmetrically to the general price
deflation, their ownership (if lawful) could offer a powerful alternative to negative interestbearing investments in a sustained deflationary environment. However, the economic contraction
often associated with sustained deflation could eventually impact the prices of gold and other
precious metals. A predominant holder of precious metals or of precious metals-denominated
investments would be exposed to tremendous potential loss of value if the market’s perceived
value of precious metals changed dramatically. Holders of wealth would undoubtedly continue to
see cash substitutes or proxies in a sustained deflationary economy where CDRs had replaced
“perpetual money.” There would probably be secondary markets of various kinds in CDRs unless
prohibited by law. Trading CDRs with expiration date N for CDRs with expiration date N+K
(K>0) would reflect both deflationary expectations and the term premium for extended CDR
expiration dates.
Substituting CDRs for “perpetual” cash is probably outside the current authority of the
U.S. government; but faced with sustained worldwide deflation and an operating system of
CDR’s in other economies, the law might have to be changed to address economic necessities.
Many areas of public policy would be strongly impacted by the substitution of CDRs for
“perpetual” cash. Gift and estate taxation might well have to be revisited to prevent inordinate
concentration of wealth in the hands of a small minority of corporations and individuals. Real
estate (particularly productive agricultural land)–as the ultimate source of all created wealth-would probably become a very attractive investment in a sustained deflationary environment and
limitations on concentration of ownership might become necessary. The substitution of CDRs for
“perpetual” cash would certainly result in major restructuring of the entire investment
marketplace.
Could the nation or the world ever emerge from such a “mirror image” negative interest
rate environment? The transition from a positive interest rate environment to a negative interest
rate environment would be very trying, but the author suspects that relatively steady or
equilibrium states are possible on both sides of the zero mark. Wherever the movements of
interest rates and prices and the actions of governments, corporations and consumers lead,
human ingenuity will prevail. Thinking about the unthinkable can help prepare for the
challenges facing humanity in the twenty-first century and beyond.