Economic policymakers are like children in that they are held only partially accountable for their mistakes and misdeeds. And just as children learn to selectively deny responsibility to get away with naughty behaviour, so policymakers learn that they, too, can conveniently disown the ‘unintended consequences’ of their actions. It is thus refreshing to see that a recent paper by the NY Fed explores some possible unintended consequences of negative interest rates—an extreme, unconventional monetary policy action under discussion by central bankers. Yes, central bankers apparently will stop at nothing to artificially stimulate what they call ‘growth’, which in recent years has resulted in money and debt growth rather than real, sustainable economic activity. Among other things, this money and debt growth has propelled the price of gold higher. But how high is it really? Let’s take a closer look: It’s not as high as you might think.


In an Amphora Report published in 2010 I posed the then-provocative question, “Has the Fed become pathological?” Well, time moves on, another iteration of quantitative easing (QE) is announced—apparently an ‘open-ended’ one this time—and I suppose we have now reached the point where I doubt that anyone re-reading that particular report would find much with which they would disagree. Yes, the Fed and certain other central banks are pathological.1 They will stop at nothing in order to artificially reflate their economies, damn the consequences. Here is a relevant excerpt from that report:

[W]e read the same neo-Keynesian rubbish over and over, that the solution to excessive debt and consumption is even more debt and consumption. And if the private sector is not willing to co-operate in such insanity–and quite clearly it is not–then the Fed and the government must step in to provide it. It’s for our own good. It’s as if a government-run rehab clinic were prescribing progressively larger rather than lower doses of a drug in a chimerical effort to help an addict. It can’t possibly work. With each larger dose, the patient will remain addicted as before while the side effects, anticipated or not, grow and grow.

Regular readers of this report know that I have written frequently about the negative consequences of artificial reflation, ranging from resource misallocations in the economy, to a concentration of wealth in the financial sector, and in the case of the US, to an eventual, sudden undermining of the dollar’s lingering reserve currency status and the low  For those still scoffing at my use of this term, please refer to Webster’s New World Dictionary: Pathological: being such to a degree that is extreme, excessive, or markedly abnormal. Rather fine words to describe today’s Federal Reserve, no? 2 Amphora Report vol I (September 2010). The link is here.

interest rates this provides. Well, I’m afraid I’m about to flog this particular dead horse again in this report, albeit this time with some convenient if peculiar help from members of the NY Fed research staff, who in a recent paper explore how the introduction of negative interest rates would cause potentially undesirable distortions in the financial system and the economy.

As it happens, in the same Amphora Report cited above, I discussed specifically why I believe that negative interest rates—something advocated by a number of prominent economists, including Alan Blinder, a former Fed vice-chairman—would have unintended negative consequences for the economy. In brief, they would wreak havoc with the banking and payments system, as I explain in this excerpt:

Let’s now focus on what we regard as Mr Blinder’s most provocative suggestion for how to provide effective additional monetary stimulus, namely, negative interest rates on excess reserves. Imagine a bank that is holding substantial excess reserves at the Fed given a lack of attractive lending opportunities. Currently those reserves are earning only 0.25%, but at least that is risk-free. But what if this bank suddenly learns that these reserves will now pay a negative 1%?

Naturally, the bank will seek to avoid paying this 1% fee without taking incremental credit risk. After all, it is not as if this 1% fee makes potential borrowers more creditworthy. In practice, there is only one way to lend money without taking incremental credit risk: Lend it to the US government through purchases of Treasury securities. So as a first step, should the Fed impose a 1% fee on excess reserves, banks are likely to move a substantial portion of these reserves into the Treasury market. Given that excess reserves are currently about $1tn, this implies a large rise in Treasury prices and thus large decline in yields.

While no doubt convenient for the government, already running a huge deficit which is destined to grow exponentially as the economy weakens, should we assume that lower government borrowing costs will be passed on to the private sector? And to the extent that they are, is the private sector going to decide to leverage up again? And even if they do, are banks going to want to lend to these risky borrowers? With the monetary transmission mechanism as damaged as it already is by excessive debt and leverage, it is far from clear that the Fed would get much bang for its printed buck even if Treasury yields plummeted to near zero, as indeed Japanese government bonds did many years ago. It wasn’t much if any help for Japan and we doubt it will provide much if any help for the beleaguered US private sector. But while negative interest rates are unlikely to provide much if any support for the economy, they might in fact do serious damage via unintended consequences. What Mr Blinder fails to consider is how depositors would be affected by his negative rate scheme.

In response to a 1% fee on excess reserves, banks are unlikely to just purchase Treasury securities. They are also likely to reduce interest rates paid on deposits. But with demand deposit rates already slightly negative after fees and with savings account rates necessarily plummeting along with Treasury yields–as banks seek to maintain positive margins–depositors are going to be increasingly reluctant to hold large cash deposits. Why bother paying banking fees when you can just use cash? Why not keep cash in a safe at home for free rather than in the bank for a fee? It is highly probable that, the longer negative interest rates on excess reserves remain in place, the more depositors begin to withdraw funds from the banking system to avoid incurring fees.

This is where it gets interesting. As banks begin to lose deposits, they also lose their capital base. As capital erodes, banks must either reduce lending or passively accept higher leverage. In either case, the monetary transmission mechanism will break down by even more. In an extreme scenario in which households move en masse into physical cash, there will be a general run on the banking system, something the Fed would no doubt want to avoid. But what could the Fed do in response, other than return the interest rate on excess reserves to positive? Would the Fed seek to prohibit the hoarding of physical cash? Require electronic payment for everyday transactions?

I highly doubt it. Much more likely is that the Fed would back down and allow interest rates to adjust higher, notwithstanding the short-term pain it might cause for the economy. But just for fun, what if the Fed did indeed prevent the use of physical cash for savings and everyday transactions? If hoarding physical cash was made illegal, what would households hoard instead? Gold? Silver? Scotch? Cigarettes? Ammunition? A private sector that wants to save and de-leverage will find a way to save and de-leverage regardless of whatever shenanigans the Fed decides to pull.3


As it turns out, my discussion of how negative interest rates could have some nasty consequences was somewhat incomplete. In the recent NY Fed paper mentioned above, the authors point out that a policy of negative interest rates could have quite a broad range of negative effects including:

* [T]he U.S. Treasury Department’s Bureau of Engraving and Printing will likely be called upon to print a lot more currency as individuals and small businesses substitute cash for at least some of their bank balances.

* [A] variety of interest-avoidance strategies might emerge in connection with payments and collections. For example, a taxpayer might choose to make large excess payments on her quarterly estimated federal income tax filings.

* Commercial banks might find their liabilities shifting from deposits (on which they charge interest) to certified checks outstanding (where assessing interest charges could be more challenging). If bank liabilities shifted from deposits to certified checks to a significant degree, banks might be less willing to extend loans, because certified checks are likely to be less stable than deposits as a source of funding.

So there you have it, straight from the flogged horse’s mouth: Negative interest rates will result in a preference for physical cash and checks rather than bank deposits, actions that will destabilise banks’ funding base and impair their ability to make loans. Now what do you think that will do to the economy? What effect will it have on global trade, given the dollar’s central position as the pre-eminent reserve currency? Well, probably not what the Fed supposedly intends, but pathology is pathology. Facts are but a mere inconvenience for the ruthless.

Finally, in what might be considered a stunning act of thoughtful policymaker candour, the authors of the paper conclude:

[I]f interest rates go negative, we may see an epochal outburst of socially unproductive—even if individually beneficial—financial innovation. Financial service providers are likely to find their 3 Amphora Report vol I (September 2010). The link is here. 4 The link to the NY Fed paper is here. products and services being used in volumes and ways not previously anticipated, and regulators may find that private sector responses to negative interest rates have spawned new risks that are not fully priced by market participants.

Ah yes, socially unproductive. Well that’s really just par for the pathological course now, isn’t it? After all, the Fed is the institution that has slashed interest rates on savings rather than allow the economy to de-leverage and grow on its own; that has bailed out numerous financial entities while allowing them to continue paying outsize salaries and bonuses to executives; that subsidises financial speculation with low rates and bailouts; that reduces real incomes through inflation while pushing middle-income taxpayers into higher tax brackets; that subsidises record peacetime deficit spending and the associated accumulation of debt that children, grandchildren and the as-yet unborn will struggle to pay back.

With its latest, greatest, open-ended round of QEn+1, the Fed certainly has “spawned new risks that are not fully priced by market participants,” to quote again from the above. Even the price of gold, which surged on the announcement, remains somewhat depressed in a historical and value-based comparison. What, you ask? Isn’t the price close to a record high? Well, looked at correctly, no it is not. Consider the following:

– Deflated by US government measures of consumer price inflation, the price of gold is lower today than it was at the end of the stagflationary 1970s, the last time the US economy was in a prolonged slump with high unemployment comparable to today;

– The price of gold is low relative to the ongoing surge in both the narrow and broad dollar money supply, relative to the exponentially growing US government debt burden and low relative to the future entitlement burden which implies an even faster rate of debt growth in future;

– It is low given that real interest rates are negative, implying a positive yield for holding gold or other real assets;

– It is low relative to the current, rather optimistic valuation placed on the US stock market in the face of sharply weakening leading indicators and the looming ‘fiscal cliff’;

– Finally, and arguably the most important, the price of gold is low given that the current set of US economic and monetary policies, pathological as they are, threaten the dollar’s reserve currency status, a legacy of when the dollar was, in fact, backed by gold and the US economy’s share of the global economy was much larger than it is today. Lose reserve status and the US loses much of its foreign investor base, something that would send interest rates soaring, thereby triggering a financial crisis an order of magnitude larger than 2008.

That said, I wouldn’t claim that gold is ‘cheap’ when compared to other real assets. It is the dollar,

other fiat currencies, most bond markets and some stock and regional housing markets that are expensive. But does gold look a bit pricey relative to, say, silver? Perhaps. To platinum? Yes. To other metals? Maybe. What about non-metallic commodities such as energy? Or grains, or other agricultural products? A strong possibility. A look at history shows that gold does occasionally become unusually expensive in what I would call ‘purchasing-power’ terms, that is, how big a basket of various commodities you can purchase with a given amount of gold.

Even in the depressed 1930s, when there was a lack of demand for just about everything other than gold and the safety it provided, gold’s purchasing power relative to a basket of US goods peaked in 1934, when the US devalued the dollar. Thereafter, notwithstanding the prolonged depression, there was a relative underperformance of gold. So even amidst real economic hardship and uncertainty, the price of gold, viewed in purchasing-power terms, can go down as well as up.

I would thus advise my readers, some of whom might consider themselves to be dyed in the wool gold bugs, to take a look at a broad range of historical charts showing various commodities or other real assets denominated in gold rather than in dollars or other currencies. A wonderfully handy website for doing just this has been developed by Mr Charles Vollum, at Note, for example, that oil looks ‘cheap’ at $100. Even grains, following the surge in prices over the summer, do not look expensive versus gold at present.


Crude oil vs gold

Any prudent investor considering holding gold as a way to minimise the risk accruing to unstable, devaluing fiat currencies should also consider the benefits of diversification. Energy, various other metals and agricultural products are widely traded and consumed the world over and are not going to see demand evaporate just because the US or global economies are underperforming due to excessive debt and pathological policy responses thereto. Consider also that a relative lack of investment in new productive capacity implies potential supply constraints down the road.

copper vs gold

wheat vs gold

cotton vs gold

Viewed in this way, there is much cheap real asset diversification out there and I advise taking full advantage of what amounts to ‘insurance’ against pathological policymakers.

As former Fed Chairman Alan Greenspan once said, monetary inflation is a form of wealth confiscation. Only in an Orwellian world could current Chairman Bernanke and his colleagues speak and act as if somehow inflation not only didn’t confiscate wealth, but that it somehow enabled the economy to create wealth: In other words, to grow. To paraphrase Forrest Gump: Pathology is as pathology does.

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AMPHORA: A ceramic vase used for the storage and intermodal transport of various liquid and dry commodities in the ancient Mediterranean. JOHN BUTLER [email protected]

John Butler has 19 years’ experience in the global financial industry, having worked for European and US investment banks in London, New York and Germany. Prior to founding Amphora Capital he was Managing Director and Head of the Index Strategies Group at Deutsche Bank in London, where he was responsible for the development and marketing of proprietary, quantitative strategies. Prior to joining DB in 2007, John was Managing Director and Head of Interest Rate Strategy at Lehman Brothers in London, where he and his team were voted #1 in the Institutional Investor research survey. He is the author of The Golden Revolution (John Wiley and Sons, 2012), a regular contributor to various financial publications and websites and also an occasional speaker at major investment conferences.

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