That is what the legendary investor, Howard Marks titled one of his memos on Negative Interest Rates.
Marks’ contemporary Warren Buffet has been quoted as saying, “When I see memos from Howard Marks in my mail, they're the first thing I open and read.” Which is exactly what we want you to do to emails from the Turnaround newsletter. So this week we decided to dive into a topic that is likely to have some important implications for startups and VC across the world - Negative Interest Rates!
Like many modern stories, this all began when Donald Trump tweeted this.
If Donald Trump has his way and the United States, a big source of capital and technological innovation for the world decides to implement it, we’d soon see a lot of changes to the economies we know of.
So this week we decided to dive deep into the question: what does negative interest rate mean for startups, venture capital, and innovation?
I’d like to thank Rachita Kumar, who works as Private Equity investor for her inputs (she tweets @RachitaKumar7, go ahead and follow her!) Also, a big shout out to Gaurav Sharma, whom you might have heard discussing Neobanking on the Use Case Podcast, Shitij Gupta, who has spent more than 10 years working with interest rates at UBS in the US, and JPK for reviewing this piece.
Please note that the information provided below is for informational purposes only and should not be considered as an investment or financial advice or be used as a basis for any decisions.
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Okay, so here goes. Stay with me till the end.
In 1960, DC Comics introduced the “Bizarro” planet of “Htrae”. Htrae is the opposite of Earth where people do everything opposite to how it’s done on earth. As John Hawkins summarises: They go to bed when the alarm clock rings. They eat only the peel of a banana. They earn degrees by failing subjects. And they invest in “bizarro bonds” that are “guaranteed to lose money”.
Conventional wisdom dictates that if you put your money to work, especially in safe assets like bonds, you should be paid for doing that. However, in today’s world, a bizarro bond more real than fantasy.
In mid-2019, there was an excess of $17 trillion (about 12% of the global GDP in 2019) worth of negative-yielding bonds floating in the global financial system.
These negative yields are a direct result of the negative interest rates that the world saw after the 2008 financial crisis (a more detailed reading of how this happens).
But wait! What are negative interest rates and why the hell do we have them?
Now, there are many ways an economy can grow - an increasing population, ergo more labor and demand; with technological advancement, ergo better production, or forcing more capital into the economy, ergo encouraging more consumption/investment by people/businesses.
Central bankers and economists can’t do much about the first two, so they like to experiment with the third.
In ordinary times, if a bank deposits reserve money with a central bank, the bank earns interest. But after the 2008 recession, in order to encourage banks to lend more and prop up the economy, central banks across the developed world dropped their interest rates - with some going all the way into the negative territory.
Source: New York Times, September 2019
And so, instead of earning interest from the central bank for parking funds in these cases, banks have to pay the central banks if they don’t lend that money forward to the people/ firms.
(A note that many articles on the topic forget to mention: central banks apply a tiered system of interest rates and negative rates apply only to fresh money created by them as part of the quantitative easing process, not the money commercial banks had already deposited with central banks. The goal is that commercial banks lend the new money created forward to the people. If that wasn’t there, the banking system would have collapsed. A suggested read on how this works by The Economist: How to make negative interest rates less painful.)
The central bank of Denmark was the first to issue negative interest rates in 2012. Central banks in Switzerland, Sweden, the Eurozone, and the Bank of Japan followed suit. In fact, about 70 percent of these negative-yielding bonds belong to the Eurozone and Japan.
Last month, for the first time in recent history, the British government sold a negative-yielding bond and in the US, the White House has been increasingly pushing for negative interest rates as well, much to the Fed’s resistance that it would not implement it any time soon.
So now we get to the part where we ask: How does it impact the world of technology and innovation?
1. It impedes the process of creative destruction
Noted 20th-century economist Joseph Schumpeter defined the process of creative destruction as: “the process of industrial mutation that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one.”
Dropping interest rates can’t be a one-time thing. Otherwise, everyone will tolerate low rates for a while and continue to save instead of spending- in the hopes that interest rates will go back up in the near future. So the central banks continue to cut rates until they see that the economy is picking up momentum and consumption is back for good.
But the drawback of this is that if banks continue to push credit in the markets, unprofitable companies without healthy cashflows continue to raise more and more debt, and instead of going broke and dying out, they continue operating.
These “zombie companies” defy the process of creative destruction. Many such zombie companies have a major share of the market, compared to young startups and they block markets for new tech-enabled or more innovative companies to flourish.
As Ryan Banerjee and Boris Hofmann argue: Zombie firms are less productive and crowd out investment in and employment at more productive firms.
Since the 1980s — as the interest rates have been reduced— the number of zombie companies in the system has continued to grow in the US.
This can’t be a good sign for the startup and venture capital ecosystem. The old needs to die to pave the way for the new. Negative interest rates artificially keep these giant zombies alive.
2. But wait, it also means more money will flow into startups!
The retirement and pension assets in the United States alone is $19.1 trillion. For perspective, that’s more than six times India’s nominal gross domestic product of $2.94 trillion.
These pension funds manage people’s savings and help millions of Americans retire with savings. But what happens when returns on bonds and other safe assets (where pension fund managers allocate a significant share of their portfolio) turn negative?
Fund managers start “Searching for yield” — investing in riskier assets because safer asset classes have a lower yield. If you take into account inflation and their fund management fees, it gets worse!
This means more money into the riskier business of venture capital and startup funding. It is the reason why Softbank’s Masa Son can create an asset valuation fiasco like WeWork but still be entertained by fund of funds. I don’t want to infer causation here, but Softbank has very close ties with Japanese banks who often come to the rescue of the former’s portfolio companies. Perhaps these ‘banks’ are too ‘soft’ on ‘Softbank’ after BoJ’s tryst with negative interest rates?
However, one can argue equally well that this is good for startups because it means more funding. Truth be told, no one can say for sure. Anyone who says they do probably will also tell you that homeopathy works.
3. It will boost the crypto economy
The crypto-lending economy already accounts for $4.7 billion. If you assume that in the future, spending in cryptocurrency is possible and that it’s not just a store of value, and if negative interest rates disrupt, or as many argue, weaken the foundation of the banking and financial systems, the world of cryptocurrency will get a big push.
The idea that mainstream banking options, such as savings accounts at banks, could in a rare scenario become ROI negative (especially, if you take into account inflation) means people, much like big fund managers, begin looking for other places to park their money.
This has lead to an interest in companies that allow retail consumers to deposit their digital assets like cryptocurrency against them and accrue a fixed interest rate. Cred (not to be confused with CRED) is one such company.
However, much of what happens to the world of crypto is dependent on how much policymakers allow this crypto para-economy to evolve or say, what Donald Trump tweets.
So, is it good or bad?
So, are negative interest rates good or bad? There are no clear answers yet. In 2016, the International Monetary Fund said in a paper that negative interest rates “have so far supported easier financial conditions and contributed to a modest expansion in credit, demonstrating that the zero lower bound is less binding than previously thought.” That said, cutting interest rates also affects the profitability of banks and may outweigh benefits, the paper warned.
Four years have passed since this paper was published, and many argue that negative interest rates have not had the intended impact. If anything, it is impossible to measure accurately if the situation would have been any better had those governments not adopted negative interest rates. But for now, we need to wait and watch what economists and policymakers choose to try.
Although this brings to mind the old jab biologists like to take at economists:
Biologists at least have the decency to test their experiments on mice and fruit flies before human beings.