Deflation!

It can steal your wealth and rock your world!

The financial world is turning upside down! Can you imagine a world where banks make you pay interest on your savings, and pay you to take out a loan? While most people have been worried about "hyper-inflation" a new trend—deflation—is being felt in Europe, and is even having an impact on the United States. What will this mean for you and your future?

Recently in Spain, Portugal and other parts of Europe banks have actually paid interest to their borrowers—instead of to the depositors! This phenomenon is called "negative interest," and although it is a bit complicated, you need to know how it works!

Negative interest can occur in a variety of ways. In Europe, some nations and corporations have issued debt securities that repay less than was borrowed, resulting in a negative yield to the investor.

In early 2015, the Washington Post reported that "in Europe's brave, new, deflationary world… France, Finland, Belgium, Denmark, the Netherlands, and Germany are all getting paid by investors—that is, bond yields are negative—to borrow for up to four, and sometimes six, years. Switzerland is even getting paid to borrow for ten years. That's never happened anywhere before. But it's not just governments that people are paying for the privilege of lending to. It's companies, too. Or at least one of them: Nestlé. Its €500 million debt that comes due in October 2016 became the first corporate bond of a year or longer to have a negative yield… Why would you ever pay Nestlé, or anyone else for that matter, to borrow money from you? Well, because there's not enough inflation and not enough bonds. This makes more sense if you look at what currency Nestlé is borrowing in: the euro. Prices are falling 0.6 percent in the Eurozone right now, so a euro will be worth more tomorrow than today. And that means it can make sense to lend money for nothing or even negative amounts. That's because the euros you'll get paid back with will be worth more than the euros you're paying with right now. So you can lose money but still make money, as long as its value is going up" (Matt O'Brien, "This is crazy: Nestle is getting paid to borrow money." WashingtonPost.com, February 4, 2015).

The Bible says that "the borrower is slave to the lender" (Proverbs 22:7, NIV), but negative interest sounds like the reverse! In fact, negative interest rates are a symptom of a much larger economic problem that economists and governments are struggling to understand and cope with. It is a problem that can spiral out of control and crush national economies that have loaded up on sovereign debt in recent years. The wisdom of God's word does not change, and just as the proverb states, the borrower can indeed become the slave of the lender!

Why Pay a Borrower To Take a Loan?

Why would anyone lending money pay the borrower to accept the loan? The answer is deflation. Deflation is the opposite of inflation, and for much of the last century, most world economies have experienced only inflation. Inflation occurs when the value of money declines, and the prices of various goods and services increase. A dollar, peso or euro buys less and less in this situation, because inflation reduces the purchasing power of money.

But with deflation, the value of money increases and the prices of things decline. Your money buys more and more. That may seem like a good thing, but in practice, that can lead to a "deflationary spiral" and serious economic decline. The Great Depression of the 1930s was characterized by deflation. Could the possibility of deflation have negative implications for the U.S. economy, particularly considering the massive debts that the U.S. has piled up in the last decade? That is worth considering.

In deflationary times, it pays investors to hold cash or invest in high quality bonds. The reason is that the cash will be worth more and more over time, or the debt will have to be paid back with dollars, pesos or euros that are more valuable than the ones that were borrowed. With inflation, lenders tend to lose because the value of the principle amount of the loan decreases, but with deflation, lenders tend to gain—at the expense of the borrowers. In a deflationary economy, lenders will often be willing to accept a negative interest rate, because the appreciation of the money still gives them their "yield" on the investment. Negative interest rates are often a symptom of deflationary expectations.

The financial reference, Investopedia, explains, "During deflationary periods, people and businesses hoard money instead of spending and investing. The result is a collapse in aggregate demand which leads to prices falling even farther, a slowdown or halt in real production and output, and an increase in unemployment" (Article, "Negative Interest Rate Policy"). That is a deflationary spiral, and it can be difficult for a government to reverse. The deflation and economic contraction can feed on each other, deepening recession or even depression.

Governments often try to combat deflation by lowering interest rates. "A loose or expansionary monetary policy is usually employed to deal with such economic stagnation. However, if deflationary forces are strong enough, simply cutting the central bank's interest rate to zero may not be sufficient to stimulate borrowing and lending. A negative interest rate means the central bank and perhaps private banks will charge negative interest: instead of receiving money on deposits, depositors must pay regularly to keep their money with the bank. This is intended to incentivize banks to lend money more freely and businesses and individuals to invest, lend, and spend money rather than pay a fee to keep it safe" (ibid.).

But this approach can have limited economic effectiveness, and there is only so much a zero or negative interest rate can do to stimulate demand. Deflationary spirals can be difficult to control, and as a result, governments are very afraid of deflation. Most would rather have low inflation—perhaps 2 percent or so—because they feel it is more manageable.

On its Web site, the U.S. Federal Reserve explains its inflation policy: "Why does the Federal Reserve aim for 2 percent inflation over time? The Federal Open Market Committee (FOMC) judges that inflation at the rate of 2 percent… is most consistent over the longer run with the Federal Reserve's mandate for price stability and maximum employment. Over time, a higher inflation rate would reduce the public's ability to make accurate longer-term economic and financial decisions. On the other hand, a lower inflation rate would be associated with an elevated probability of falling into deflation, which means prices and perhaps wages, on average, are falling—a phenomenon associated with very weak economic conditions. Having at least a small level of inflation makes it less likely that the economy will experience harmful deflation if economic conditions weaken. The FOMC implements monetary policy to help maintain an inflation rate of 2 percent over the medium term" ("Why does the Federal Reserve aim for 2 percent inflation over time?" Federalreserve.gov, January 26, 2015).

But how successful has the Fed been with implementing this inflationary policy? Not very! The Wall Street Journal reported, "The Federal Reserve's preferred measure of inflation in February fell short of the central bank's 2 percent target for the 34th straight month. The price index for personal consumption expenditures was up only 0.3 percent from a year earlier, the Commerce Department said… The last reading above 1 percent came in November" (Jeffrey Sparshott, "U.S. Inflation Undershoots the Fed's 2 Percent Target for the 34th Straight Month," Blogs.WSJ.com, March 30, 2015).

Why the "Real" Interest Rate Matters, Not the "Nominal" Rate

To understand negative interest rates, it is important to know the difference between "nominal" and "real" interest rates. The nominal interest rate is the specific percentage interest rate that is contracted for payment. Simply put, a 30-year U.S. government Treasury bond might have a "nominal" (contractual) interest rate stated at 3 percent on the bond. It pays this rate until its maturity, at which time the entire principal amount is repaid to the bondholder.

The "real" interest rate of the same bond is a bit more complicated and may vary from the nominal rate stated on the bond. The "real" interest rate—or yield—is usually thought of as the yield the investor receives after the nominal rate is adjusted for inflation. For instance, if you hold a 3 percent bond during 2 percent inflation, your "real" yield is only 1 percent. That is because the interest you are being paid has 2 percent less value due to inflation.

Real Interest Rate = Nominal Interest Rate minus Inflation.

So inflation reduces real rates of return. But what happens to real yields when there is deflation? Real yields increase. Deflation is "negative inflation" so…

Real Interest Rate = Nominal Interest Rate plus Deflation.

So if a bond has a negative return of minus 1 percent and deflation is 3 percent, the real rate of yield is a positive 2 percent for the investor. If you want, you can make money just holding cash! And during deflationary times, people often do just that—but it depresses the economy further.

Negative Interest Rates in Europe

Some European Union countries have stumbled into unexplored financial territory due to deflation and below-zero interest rates. The Wall Street Journal reported the situation in some European countries. "Tumbling interest rates in Europe have put some banks in an inconceivable position: owing money on loans to borrowers… At least one Spanish bank, Bankinter SA, the country's seventh-largest lender by market value, has been paying some customers interest on mortgages by deducting that amount from the principal the borrower owes" ("Tumbling Interest Rates in Europe Leave Some Banks Owing Money on Loans to Borrowers." WSJ.com, April 13, 2015).

This may sound crazy, but deflation works that way!

And it gets crazier! In Portugal, some bank loans float over an index, as they often do in the U.S and other countries. When the index went below zero, the rate became negative for many borrowers and the banks owed their borrowers interest!

The Wall Street Journal reported, "Banks set interest rates on many loans as a small percentage above or below a benchmark such as Euribor. As rates have declined, sometimes to below zero, some banks have faced the paradox of paying interest to those who have borrowed money from them… Portugal's central bank recently ruled that banks would have to pay interest on existing loans if Euribor plus any additional spread falls below zero. The central bank, however, said lenders are free to take 'precautionary measures' in future contracts. More than 90 percent of the 2.3 million mortgages outstanding in Portugal have variable rates linked to Euribor" (ibid.).

Have the banks become the slaves of its Portuguese borrowers? Hardly. The negative interest helps, but the borrowers' incomes are deflating, and they are paying off a numerically fixed loan amount with pesos that are more valuable than the ones that were borrowed. Not a good deal. In deflation, the fixed debts can crush a borrower.

Negative Interest Rates in the U.S.

Some U.S. Treasury Inflation-Protected Securities (TIPS) yields have been in negative territory since 2011. And that refers to nominal yields. And many U.S. Treasury securities have had negative real yields for years. Consumers are affected also. If your money market account is yielding 0.2 percent when there is 2 percent inflation, that is a negative real yield of minus 1.8 percent. Although the U.S. is not currently experiencing deflation, negative real yields are common in the U.S. today.

Deflation Can Bring Ruin!

Inflation and deflation affect people very differently. In the 1970s and 1980s, there was a lot of inflation in the U.S. economy. People who owned real estate saw the values of the properties increase dramatically while the amounts of the loans on the properties remained fixed. The borrowers profited while the lenders lost. But in deflation, the situation reverses. The fixed debt amount must be paid off with currency that is appreciating in value, causing the weight of the debt to grow and grow. In deflation, debt can crush borrowers as it did in the Great Depression of the 1930s. When there are deflation worries, businesses and households tend to pay down their debts—called "deleveraging"—as has widely occurred in the U.S. and some EU countries in recent years.

In the early 1930s, deflation sank below 10 percent, which meant that the effect of individual, business and sovereign debt on borrowers became intolerably heavy. The rate of unemployment jumped to a staggering 25 percent in the U.S. and worse in other countries. There was great suffering. Anyone who had a little money hoarded it, so there was less and less in circulation. The situation seemed intractable. But World War II took some economies back to full employment, and when the war was over, many economies recovered and saw good growth in the 1950s.

In modern times, the nation of Greece has seen their sovereign debt load soar, and when they finally ran out of credit, the Greek economy experienced deflation of over 2 percent. Could that happen to other Western nations?

Deflation and the U.S. Debt: Danger Ahead?

As previously mentioned, the U.S. Federal Reserve has a targeted annual inflation rate of 2 percent but has not been able to achieve it. It has engaged in a monetary policy called "Quantitative Easing" in which the economy has been flooded with trillions of dollars. Normally, this would have produced soaring inflation, but to the amazement of most analysts, inflation has remained very low. Concerns about the U.S. economy going into deflation have been widely expressed. But it should be noted that some analysts still foresee inflation in the future. No one knows for sure.

In recent years, the total sovereign debt of the U.S. has been soaring. It is now above $18 trillion and with no end of its growth in sight. That amount reflects what is owed to both foreign and domestic obligations and is almost 100 percent of the nation's gross domestic product. It is about five times the government's annual tax receipts.

The U.S. Treasury issues debt with a variety of terms—some short term, some medium term and some long term. Long-term bonds may have maturities going several decades into the future. Because interest rates have been at historic lows, the trend has been to move from the shorter maturities to the longer maturities. What will happen to the U.S. debt load in a deflationary environment? The weight of that debt will increase, and the "real interest rate" will soar. That could be a crushing load for the U.S. Treasury and the U.S. taxpayer.

Bible prophecy tells us the "future history" of this present world and the roles that the major nations of our day will play as the biblical narrative of the end of this age plays out. Tomorrow's World has long predicted the rise of a great European economic power that will dominate the world economy in those days. However, Tomorrow's World does not predict the specific course that the U.S. and various world economies will take—or the timing—and this article does not attempt to give investment advice. But our readers should be aware of today's very unusual world economic conditions, and how they are being affected by the twin phenomena of deflation and negative interest in some countries. As the sudden crashes of 1929 and 2007 showed, the economy can change quickly!

The Bible states, "…the borrower is slave to the lender" (Proverbs 22:7, NIV). Can a nation that is a "slave to sin" (John 8:34) find itself in some form of physical slavery? Will deflation produce a crushing debt burden for the U.S.? Can the U.S. ever repay $18 trillion, especially in a deflationary environment? Time will tell, but something we can be confident of is that eventually, lenders will insist on being paid!