How to Protect Yourself from Negative Interest Rates

In our modern world of central banking and fiat money, nothing should surprise us anymore.

It wasn’t long ago that the European Central Bank (ECB) announced a negative interest rate, where banks would be charged money for their deposits. The ECB just raised this negative rate (or is it lowered?) to -0.2% from its previous rate of -0.1%.

The ECB wants banks to lend more money so that more money multiplies through the system. This is one of its strategies for getting higher price inflation.

Now we have the Bank of Japan (BOJ) joining in on the monetary madness. This past Tuesday, the Bank of Japan bought short-term government debt that has a negative interest rate.

This coincided with news that Japan’s economy shrank 1.8% in the second quarter of 2014. On an annualized basis, the Japanese GDP fell 7.1%.

Of course, in a normal world, most investors would never buy a bond with a negative yield. Why would anyone loan money just to be repaid with less money in the future?

But then, the BOJ is not an investor.

The reason the BOJ is purchasing Japanese government debt, even at negative rates, is that it has a goal of creating inflation. It is creating money out of thin air in order to “achieve” a price inflation rate of 2%.

Japanese Government Debt

It is amazing that interest rates are as low as they are in Japan. The 10-year yield there is around 0.5%. Can you imagine loaning out money for 10 years, only to receive half a percent of interest each year for the next 10 years?

This is in a country with a debt-to-GDP ratio well in excess of 200%. It makes both the U.S. and Greece look highly solvent. With the big negative GDP number that just came out, the debt-to-GDP ratio went up even more in Japan.

How is it possible that a country with such massive debt can have interest rates that are so low?

The situation there is nothing like the U.S. in terms of debt holdings. The U.S. has some of its government debt bought up by other countries, particularly Japan and China. The U.S. also has the world’s reserve currency, which can help keep price inflation and interest rates down compared to what they would be.

In Japan’s case, it would seem there should either be really high price inflation or the government should be on the verge of default… or both. But with interest rates so low, there is obviously little fear over inflation or default.

Instead, Japanese investors continue to buy up Japanese government debt. I can’t explain the reasoning for this. Perhaps it has something to do with national honor or patriotism.

The Japanese people tend to be better savers than Americans, but that doesn’t mean they have to buy government bonds with the saved money.

Inflation Doesn’t Just Affect Consumer Prices

The Bank of Japan has been getting more aggressive in creating more money. This is even more obvious now that it has bought short-term debt at negative rates. But consumer price inflation remains relatively low there.

First, it is ridiculous that these central bankers and central planners are trying to get prices to increase. They think that is the problem with the economy. How does making consumer goods and services more expensive help people’s standard of living?

The 19th century in America was one of the greatest periods of growth in history, yet prices actually went down during much of this time. A deflation in prices is actually good when it comes about because of increased production and advancing technology.

Many people associate falling prices with a bad economy because of what happened in the Great Depression. But this was in an era of failing banks, which reversed the fractional reserve lending process. It was also a time of great economic fear during which the demand for money was very high and people tried to avoid spending.

Interestingly, in 1929 — the year of the initial stock market crash — consumer prices were not rising rapidly. Yet there was previous monetary inflation, which drove up asset prices, particularly in stocks.

Americans and Japanese alike should learn this lesson well for today: You can still have artificial bubbles that go bust, even in a time of seemingly low price inflation.

When a central bank, whether it is the Fed or the BOJ, creates new money out of thin air, this causes dislocations in the economy. It misallocates resources and diverts money away from consumer demands because of false signals and government spending.

Money is diverted into resources it wouldn’t go into in a free market — creating unsustainable bubbles.

We can’t imagine just how much there is in misallocated resources. It is bad in the U.S. and in Europe, and in percentage terms, it is probably even worse in Japan. Yet the central bank there continues to build up the problems and make things worse, even to the extent of buying negative-yielding debt.

When Will This Madness End?

It is always impossible to predict when things will end. Sometimes things can go on a lot longer than what seems possible.

It would seem that Japan’s economy should come crashing down before it happens in the U.S. But maybe the Japanese people will continue to work harder, save more, and put everything they have into their government’s debt.

Meanwhile, the Japanese government raised its national sales tax in April from 5% to 8% and is considering upping it again next year — this time to 10%. This isn’t going to end nicely… but again, sometimes things can drag out longer than expected.

In some ways, the U.S. is more vulnerable in the short term. Americans do not save much, and the primary buyers of U.S. government debt are the Fed and foreign central banks.

But Janet Yellen and the Fed are “tapering” right now, meaning the current monetary inflation is being reduced. It is predicted to end at the end of October. Since the U.S. economy, and especially stocks, has been so dependent on the Fed’s money creation, what will happen when it stops?

The Fed’s ultra-easy monetary policy has helped Wall Street and the big banks, but it hasn’t really helped middle-class America. Instead, it has just set us up for another fall.

We can’t be certain when that will happen, but the previously misallocated resources will have to be corrected at some point. When that happens, you’ll want to be ready.

This is why I recommend a permanent portfolio — to weather any economic environment and to protect your hard-earned capital.

In the meantime, let’s watch for the next crazy move by a major central bank in the world. Perhaps the Fed will move next.

Until next time,

Geoffrey Pike for Wealth Daily