How Do Negative Interest Rates Work?

Negative interest rates seem to be the new flavour of the month.  A number of countries are experimenting and more will follow no doubt.  It is a fine way to drive away foreign capital and thus to manage your exchange rate to your advantage.

It seems an absolute in these circles that lower exchange values support your local economy.  Exported goods and services are cheaper than they might be for someone outside the country.  All good.

That is of course shortsighted.  You cannot punish people for owning wealth and expect there to be no repercussions.

Interest rates are confusing for many people.  They are pervasive but understood generally at an intuitive level.  The fundamental misunderstanding for most people is that at any time, there are two interest rates in operation.  The natural rate which is the highest rate people estimate they can pay and still profit from borrowing, and the financial rate, which is the rate people actually charge for the use of their money.

In most times the two are tightly connected, but for now they are not.

The need for a negative rate implies that people believe they cannot profit from borrowing even if the price is very low.  What does that mean?  Mostly it means the people do not see how they pay back the principle, (still an absolute requirement) never mind the interest.  A negative interest rate has the effect of lending money with a negative bonus.

For example, suppose people really want to sell houses.  I come to such a vender and they say, “The house sells for $500,000 and that is not negotiable.  However, we will provide $400,000 of mortgage financing at -2.5% for five years.  That means that after five years you must refinance.  You will owe $350,000 then and have made no payments in the meantime.”

That is roughly the same deal after five years as if I had bought the house for $400,000 and paid 3% on the mortgage.

Clearly negative rates preserve the value of assets and that is a good political game.  No deflation to confuse the people and the workings of their programs.

Reality however says that you cannot do it for long.  If you do, what sane person would invest or save?  If banks charge -2.5% on their mortgages, then they must pay depositors something around -4.5%.  The more I save the less I keep.  Spend it all now.

Which, by the way, is very good for the economy and employment.  Another win for the government.

Until it stops.  Then what?

You can find a little more about Knut Wicksell, an economist who made sense of interest rates back in the late 1800s here.

Don Shaughnessy is a retired partner in an international public accounting firm and is now with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario.

Contact: don@moneyfyi.com  705-748-5181

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