The Consequences of Negative Interest Rates
Warren Buffet once told that interest rates are like gravity. If there is no gravitational pull on asset values, then values can be infinite. Little did Warren Buffet know that the world is heading towards a strange phenomenon called negative interest rates.
This strange new world is both confusing and counter-intuitive. The common man is unable to understand what negative interest rates mean. People in many countries of the world are living with negative interest rates. Several small countries have already implemented this policy. In fact, Japan, the third largest economy in the world has also implemented negative interest rates. The idea is also rapidly taking root in Europe which is a group of advanced countries and is likely to be applied there as well.
In this article, we will understand what negative interest rates actually mean and how they affect the lives of common people.
The Zero Lower Bound
Interest rate cuts have been the biggest tool available to central banks to adjust their monetary policy. Hence, whenever a crisis comes up, the immediate reaction of central banks is to cut interest rates. This is what happened in the Eurozone crisis and the 2008 subprime mortgage crisis. In both these cases, the interest rates were brought down to near zero. Now, the interest rates are already at zero, and the economy still isnt functioning as well as it should be. As a result, the traditional policy of taking the interest rates into negative will not really work. Therefore, economists face a problem. This is what they call they zero lower bound problem. To stimulate the economy further, they have been using tools such as quantitative easing. However, those tools also have limited usefulness. Hence the plunge into negative interest rates is all but imperative in most countries of the world.
How Negative Interest Rates Work ?
Negative interest rates are a strange phenomenon. They are counter-intuitive and hence need to be explained. Negative interest rate means the borrower gets paid to borrow money! This means that if a borrower were to take a loan of $100 and then return it one year later, he would have to pay back only $99 (assuming interest rate at negative 1 percent)
In this bizarre scenario, people wouldnt want to collect their receivables as soon as possible because they would incur a loss if they do so. Also, people wouldnt want to save their money in a savings bank account. Doing so would cost them money. Hence they would simply save their money under a mattress rather than going to a bank.
No Benefits for Consumers
Contrary to what one might think, the advantage of negative interest rates will only be available to corporations and big banks. Individuals will not benefit from the negative rates. This is because only the base rate will be negative. Hence borrowers who can borrow at close to the base rate will benefit. On the other hand, individual borrowers are charged a couple of percentage points more than the market. Hence, a base rate of negative 1% would become an effective rate of 1% for the individual borrowers. Hence, for the individual consumers, it would be a double whammy. They would be expected to pay for taking loans from the bank. They would also be expected to keep their savings in the bank.
Negative interest rates would have the opposite effect on the economy. They would force the consumers to keep their money away from banks. People would be better off saving their money at home rather than using a bank. Cash hoarding interrupts the circular flow of economy instead of aiding it. Hence, it is counterproductive.
The governments seem to have a solution to this problem too. Major economies all over the world are going cashless. This means that money will cease to exist in the physical form and will only be available in the digital form. As a result, hoarding the money under your mattress would not be an option! People will be forced to keep their money in the digital form. Then they will be compelled to pay interest on that money if they do not spend it all and keep the consumerist cycle in motion.
No Capital Formation
The worst effect of negative interest rates would be that there would be absolutely no capital formation. All entrepreneurial ventures start with a portion of the entrepreneurs savings. In this strange new world, savings would be a strange concept. Hence, the capital formation would not be a possibility. Also, the competitors of small businesses i.e. big corporations will have an unfair advantage of negative interest rates working in their favor. The possibility of upward social mobility that capitalism provides would be diminished as a result of negative interest rates.
The whole idea of negative interest rates seems bizarre. It reeks of conspiracy since it would create an environment where the playing field would not be level. The rich would already have a huge advantage over the poor and middle class. Individual values of thrift and enterprise will be of no use.
- Fundamental Rules of Corporate Finance
- Present and Future Value of Money
- Net Present Value Calculations
- Opportunity Cost of Capital
- Valuing Cash Flows in Different Periods
Authorship/Referencing - About the Author(s)
The article is Written By Prachi Juneja and Reviewed By Management Study Guide Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts. We are a ISO 2001:2015 Certified Education Provider. To Know more, click on About Us. The use of this material is free for learning and education purpose. Please reference authorship of content used, including link(s) to ManagementStudyGuide.com and the content page url.