David Comerford considers what would happen if interest rates were negative
When considering extreme events in, for example, the run-off approach to individual capital assessments, are the interest rate risks being considered carefully enough? I think a significant risk could be that interest rates fall by far more than anyone deems possible that nominal interest rates are negative.
Negative interest rates are deemed to be impossible since it means that investors would rather put their cash under the mattress than put it on deposit only to be certain of its dwindling. The possibility of negative nominal interest rates is looked upon as being a major flaw in the Vasicek interest rate model, so much so that the CoxIngersollRoss model was proposed as a significant improvement.
However, money is increasingly being stored electronically. There have recently been moves by governments to require banks to offer accounts to low-income groups. It is perfectly conceivable that, some time in the near future, everyone will have access to electronic forms of money and we can get rid of hard currency. Once we do away with 'zero-interest-rate bonds', or coins and banknotes as they're more commonly called, an arbitrage opportunity is removed. There is then nothing to stop negative rates of interest being applied to the balance in our accounts and the money that we hold exponentially decaying away. Cash on deposit would be held on a use-it-or-lose-it basis. For savings, financial economics would still hold in that risky returns would still be expected to be higher, although not necessarily positive in nominal terms, than the certain negative nominal risk-free return.
Negative nominal interest rates are perfectly possible in a world where arbitrage is removed through the removal of zero-interest rate notes and coins. But why would markets or monetary policymakers set interest rates at a negative level? The answer lies in the looming environmental crises that the world faces.
Consider a fishery that can yield £100k-worth of fish every year in perpetuity (that is, there is no inflation on fish prices) or £5m-worth of fish this year followed by total collapse. Interest rates of anything greater than 2% imply that, in order to maximise value, the fishery should be fished to collapse. You can't argue with the mathematics. If you argue that the way to maximise value is to fish every year, then the logical outcome must be that interest rates need to be less than 2%.
A fishery is an example of natural capital, as are many other resources like land, soil fertility, metal and mineral deposits, breathable air, and drinkable water. Natural capital is the assets created by nature, as distinct from human capital, which is the assets created through human effort and ingenuity, or financial capital, which is the claim of ownership of natural or human capital. The natural capital can be either renewable, like a fishery, or non-renewable, like oil (in principle renewable, but taking millions of years to do so). Renewable natural capital yields 'interest' which we can capture without depleting the amount of capital. Human capital can lead to more profitable usage of natural capital. For example, stairs, lifts, and high-rise buildings can lead to more efficient use of land. But the two are distinct.
Of course, the above example is oversimplified. The renewable natural capital, like the fishery, is not faced with a choice between steady consumption of the interest and immediate consumption of the whole capital. It is true, however, that we are choosing to consume more than the interest and are depleting the capital. In a world of perfect markets and rational consumers, the balance between interest rates and expectations of future prices determines the split between current and deferred consumption. In general, the lower the interest rate, the more we value the future. The example above can be generalised to consider any renewable natural resource with any current value. There always exists a ceiling to interest rates, above which it makes economic sense to overexploit the resource.
If we take the statements 'humanity should live off the interest of the earth's natural capital and not deplete the natural capital itself' and 'resource allocation should be managed via market mechanisms rather than micromanaged through laws and regulation' as axioms, then monetary policy is constrained. There is an upper bound to interest rates that is a function of the rate of inflation on the payments that accrue from the renewable natural capital. Given arbitrarily low inflation rates, this implies a need for negative nominal rates of interest. Future environmental catastrophes could lead governments to deem the above statements axioms of public policy. It may well be that a future monetary policy committee determines interest rates, not on the basis of controlling inflation, but on the basis of controlling the split between current and deferred natural resource consumption. The aim of this would be to stabilise the usage of renewable natural resources at the level of interest on the renewable natural capital, or at a level even less than this allowing the renewable natural capital to regenerate.
The effects on society
Investment opportunities would be affected in different ways. For example, net present value would be increased and discounted payback periods reduced for projects with large initial outlays, followed by proceeds which are almost certain to be greater than expenses; for example, equipping residential property with energy-efficiency measures and microgeneration appliances such as solar panels. Conversely, the net present value of projects with large deferred costs that are currently discounted would take huge hits, for example, new nuclear plants that have storage costs for waste stretching for tens of thousands of years.
The value of natural resources, including land values which can provide income in perpetuity, would rocket. It would be up to future democratic societies to decide whether they are prepared to see landowners pocketing this huge new wealth or whether they would look to socialise the income from natural (as opposed to human) capital.
The use-it-or-lose-it feature of money in the negative nominal interest rate world could increase rates of consumption and depress savings rates. However, the increase in value of natural resources would skew this consumption towards human capital, such as information. Therefore, although people would be trying to spend their money immediately on earning it, they'd be more likely to consume human capital, with a low or zero environmental impact, than consume natural resources that may now cost relatively much more. Current consumption would also be used as a form of saving. That is, we construct human capital now that reduces cost of living in the future. For example, as mentioned above, people would spend their money now on energy-efficiency measures and microgeneration appliances.
Governments would have to buy out perpetuities before implementing a monetary policy with negative nominal interest rates (or even hinting about such an implementation, so as to avoid spooking the markets and sending the price rocketing) otherwise the national debt would become infinite. Negative nominal interest rates would cause the value of the national debt to rise, but to the extent that the outgoings are matched by tax income, this is not a problem. The future costs of the pensions crisis would rise and it would become even more imperative to ensure demographic stability. Given we have a problem with overconsumption of natural resources, a slowly declining global population with a constant age profile would probably be ideal. Negative interest rates are, however, a market solution to the crises caused by an ageing population: by lowering the return on capital, workers are forced to work longer. People would not, and would not expect to, retire while still able-bodied and we would return to the situation of generations past to whom our current expectations must seem unbelievably optimistic and unrealistic.
There is a historical precedent for negative interest rates. In mediæval Germany, rulers called in metal currency on a regular basis, took some for themselves, and then returned it to its owner. This was, in effect, negative interest. This system led the population to value the long term and the ultimate long term at the time was the afterlife. The results of this can still be seen in the magnificent cathedrals constructed during this period.
The effects on actuarial work
I don't think that negative interest rates would change the nuts and bolts of what actuaries do at all. They would change the range of products offered with, for example, individual annuities becoming extremely expensive, but the fundamental need to pool risk would be as relevant in a negative nominal interest rate world as in a positive nominal interest rate world. However, in our current work I do think we need to recognise the possibility of the movement to such a world, especially in the context of considering extreme events. Climate change and natural resource depletion could make extreme events more extreme than anything currently envisaged by the actuarial profession.
The article was first published in 2006.