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| Source: Wall Street Journal |
Negative interest rates are a big puzzle. Easy stories miss the point: "flight to quality," "need for collateral," etc. Those stories don't explain why bonds are worth more than money. There's no more quality or better collateral than cash!
So why would anyone suffer a negative rate on government bonds when they can hold cash instead?
For some of us it might make sense. Cash is clunky, dangerous and expensive to put under a mattress. Many banks now charge for the privilege of depositing. So an individual might prefer a very slightly overpriced government bond to cash.
But a bank has a better option. Why not just hold reserves? Reserves are like cash, and as safe and liquid (more so) than government bonds. I might have guessed that only people were buying these bonds. It seems I'm wrong (unconfirmed rumor) -- banks are buying and holding the bonds.
So why would a bank hold a bond at negative interest rate rather than hold reserves? Sometimes there are arcane technical, accounting or regulatory reasons, but so far nobody I've talked to has identified one here.
The best story I've heard so far, suggested by one of the smart students in my MBA class, is this: It's a bet on Germany leaving the Euro. If Germany leaves the Euro, it is likely to redenominate its bonds and so pay off in new DM. The ECB is likely to leave reserves in Euros. So, if you want an asset that will pay off in new DM after Germany leaves the Euro, German government bonds are a good bet.
That story pierces the zero bound. There really is no limit to how low bond yields can go if you think bonds might be paid off in a better currency than the one you can stuff in your mattress.
It sounds a little outlandish, and the chances that Germany leaves the Euro in 6 months seems pretty low to me. Still, it's a nice story. Does anyone have a better one? Remember, you can't answer why bonds look so good -- you have to explain why bonds are a better asset than reserves, for a German bank to hold!
