Negative Interest Rates Present a Threat

In response to former Fed Chairman Alan Greenspan’s reported comments that negative interest rates wouldn’t be “that big of a deal,” a recent Bloomberg article rebuts, “it’s wrong. Negative interest rates represent a threat to the financial system.”

The article explains, “the fractional reserve banking system is leveraged to interest rates. This works when rates are positive.” It adds, “in a negative rate environment, the bank must pay to hold loans and securities. In other words, banks would be punished for providing credit, which is the lifeblood of an economy.”

The article also highlights the fact that valuation models would need to be adjusted since “when a negative value is assumed for the risk-free rate in these types of models, fair value shoots off toward infinity.” Similarly, it says, pensions use interest rates as a gauge of whether they are properly funded, so negative rates would render all pensions technically underfunded.

“To see the results of low or negative rate environments,” the article argues, “look no further than the euro zone and Japan. They account for 87% of the negative rates worldwide. Europe is essentially in recession with negative GDP in Italy, Germany and elsewhere. Its banking system is a mess, thanks to negative rates.”