Authored by Wolf Richter via WolfStreet.com,

Now they’re clamoring for this NIRP absurdity in the US. How will this end?

This is the transcript from my podcast last Sunday, THE WOLF STREET REPORT:

Now there is talk everywhere that the United States too will descend into negative interest rates. And there are people on Wall Street and in the media that are hyping this absurd condition where government bonds and perhaps even corporate bonds, and eventually even junk bonds have negative yields. All of that NIRP absurdity is already the case in Europe and Japan.

There is now about $17 trillion – trillion with a T – in negative yielding debt in the world, government and corporate debt combined.

This started out as a short-term emergency experiment. And now this short-term emergency experiment has become the new normal. And now more short-term emergency experiments need to be added to it, because, you know, the first batches weren’t big enough and haven’t worked, or have stopped working, or more realistically, have screwed things up so badly that nothing works anymore.

So how will this end?

The ECB rumor mill over the past two weeks hyped the possibility of a shock-and-awe stimulus package, on top of the shock-and-awe stimulus packages the ECB has already implemented, namely negative interest rates, liquidity facilities, and QE.

The entire German government bond market, even 30-year bonds have negative yields. And the German economy shrank in the last quarter. That gives Germany two out of the last four quarters where its economy shrank – despite negative interest rates from the ECB and despite the negative yields on its government bonds, and despite the negative yields among many corporate bonds.

In other words, the German economy, the fourth largest in the world, is hitting the skids despite or because of negative yields. And now the ECB wants to flex its muscles to get yields to become even more negative.

And there are folks who want to prescribe the same kind of killer application to help out the US economy – which is growing just fine.

Since the ECB’s shock-and-awe package started to appear in the rumor mill at the beginning of August, the European bank stock index – it includes banks in all EU countries, not just those that use the euro – well, since that shock-and-awe rumor appeared, the stock index for those banks has dropped 11%.

Negative interest rates are terrible for banks. They destroy the business model for banks. They make future bank collapses more likely because banks cannot build capital to absorb losses. But banks are a crucial factor in a modern economy. It’s like an electric utility. You can somehow survive without electricity, but a modern economy cannot thrive without electricity. Same thing for the role commercial banking plays.

So that 11% drop of the bank-stock index wasn’t from some bubble high, but from a hellishly low level. The index is now down 78% from the peak in 2007. And it’s back where it had first been in 1990. So that was, let’s see, nearly three decades ago.

European banks are sick, sick, sick. And with negative yields, they’re getting the exact opposite of what they need. No wonder that bank stocks reacted skittishly to the threat of more deeply negative interest rates.

In Japan, same thing. Japan used QE to bring down interest rates long before the term QE was even used. And Japan has had near-zero or below zero interest rates for 20 years. But the bank index has fallen 8% since August 1, when the renewed stimulus rumors started, and closed on Friday at a new multi-year low. And the index is down 73% from where it had been in 2006.

I didn’t even want to look at the bank index going back to Japan’s bubble years in the 1980s. Because that would have been masochism. But I did look. The TOPIX Banks Index peaked at 1,500 in 1989, and now it’s at 129. Let that sink in for a moment: It has plunged by 91% over those 30 years.

So zero-percent interest rates and worse, negative interest rates, are terrible for banks for the long term. And because they’re bad for banks, by extension, they’re also bad for the real economy that relies on banks to provide the financial infrastructure so that the economy can function.

Commercial banks need to take deposits and extend loans. That’s their primary function. This credit intermediation, as it’s called, is like a financial utility. One bank can be allowed to fail. But the banking system overall cannot be allowed to fail. That would be like the lights going out. So, there needs to be special regulations, just like there are regulations on electric utilities.

And banks need to make money with their primary business. The profit motive needs to make them aggressive on lending, and the fear of loss needs to make them prudent. Those two forces are supposed to balance each other out over time, with banks swinging too far in one direction and then too far in the other direction as part of the normal business cycle.

And this generally works, with some hiccups, as long as banks can do this profitably – meaning they make enough money and set aside enough capital during good times to be able to eat the losses during bad times without collapsing.

In this basic activity, banks make money via the difference between the interest rates they charge on loans to their customers and their cost of funding those loans. This cost of funding is mostly a function of the interest the bank pays on its deposits, on the bonds it has issued, and the like.

If interest rates go negative, the spread the bank needs in order to make a profit gets thinner. But risks get larger because prices of the assets used as collateral have been inflated by these low interest rates. At first this is OK, but over a longer period, this equation runs into serious trouble.

Negative interest rates drive banks to chase yield to make some kind of profit. So they do things that are way too risky and come with inadequate returns. For example, to get some return, banks buy Collateralized Loan Obligations backed by corporate junk-rated leveraged loans. In other words, they load up on speculative financial risks. And as this drags on, banks get more precarious and unstable.

This is not a secret. The ECB and the Bank of Japan and even the Swiss National Bank have admitted that negative interest rates weaken banks. The ECB has even been talking about a strategy to “mitigate” the destructive effects its policies have on the banks.

So that’s the issue with negative interest rates and banks. They crush banks.

In terms of the real economy, negative interest rates have an even more profoundly destructive impact: They distort or eliminate the single-most important factor in economic decision making – the pricing of risk.

Risk is priced via the cost of capital. If capital is invested in a risky enterprise, investors demand a larger return to compensate them for the risk. And the cost of capital for the risky company is higher. If capital is invested in a low-risk activity, the return for the investor and the cost of capital for the company should both be lower. And the market decides how that pans out.

But if central banks push interest rates below zero, this essential function of an economy doesn’t function anymore. Now risk cannot be priced anymore. The perfect example of this: Certain junk bonds in Europe are now trading with a negative yield. This shows that the risk-pricing system in Europe is kaput.

When risks cannot be priced correctly anymore, there are a host of consequences – all of them bad over the longer term for the real economy. It means malinvestment and bad decision making; it means overproduction and overcapacity. It means asset bubbles that load the entire financial system up with huge risks because these assets are used as collateral, and their value has been inflated by negative yields.

So you get these strange combinations – for example, of massive housing bubbles in cities like Berlin and Munich and other places, while at the same time Germany has one foot in a recession.

And as a remedy to this situation caused in part by negative interest rates, the ECB wants to do a new shock-and-awe package, on top of the ones it has already done, driving interest rates even deeper into the negative.

The longer negative interest rates persist, the more screwed up an economic system becomes. And the more deep-seated the dysfunction is, the harder it is for this economic system to emerge from this screwed-up condition without some kind of major reset.

And a major reset is of course precisely what every central bank fears the most.

How will this end? No one knows because no one has ever done this before. But we have some idea: So far, the outcomes are already bad, and now, because the outcomes are already bad, they’re wanting to drive interest rates even lower to deal with the bad outcomes that these low interest rates have already caused.

When you start thinking about it long enough, cooking up negative interest rates is like making hugely important economic decisions purposefully in the worst possible way, in order to disable the proper functioning of the economy. And when the economy stops functioning properly, these folks are surprised and then cook up even more deeply negative interest rates to solve the problem these negative interest rates have already caused.

It’s like watching some cheap slapstick farce, and you want to laugh at all this idiocy going on in Europe and Japan. But this isn’t a farce. It’s central bank policy making in all its glorious worst.

You can listen to and subscribe to my podcast on YouTube.

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