Note: This article was originally published on Zonotho, a financial education start-up, in July 2020. I was asked to explain “negative” interest rates, a truly bizarre concept even for finance people, to a general audience.
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The other day my mum asked me to explain negative interest rates. I realized I had no easy way to do this. It’s such a wacky concept: why would interests ever be negative? Under normal conditions, they wouldn’t. Which is why it’s easier to start with understanding positive interest rates.
Why do we charge Interest?
Picture a scene. One day over lunch, Laurent asks his colleague Nikhil for a loan of R20 000 for one year. This is a risky proposition for Nikhil. In the worst case, Laurent might never pay him back (risk). And if Nikhil does get his money back in a year, he’s lost money because prices have gone up (inflation). Or what if his car breaks down and he doesn’t have the money because he loaned it to Laurent (opportunity cost)?
Given that Nikhil will be facing risk, inflation, and opportunity cost, the only way the loan makes sense is if Nikhil can get some upside out of the deal. This upside is his interest.
But how much interest should he get?
How Interest Rates are determined
For Nikhil, it’s going to depend on a number of things:
Other Debts – If Laurent already owes someone else R20 000, then Nikhil will have to stand in line to get his money back. If Laurent has no other debts, it’s less risky for Nikhil.
Debtor’s Assets – Does Laurent have a car or investments he can sell if needed to pay back the loan? Laurent having assets make it less risky for Nikhil.
Debtor’s Income – If Laurent earns R20 000, then the loan is one month of his salary. But if he earns R2 000 then how does he expect to pay Nikhil back in one year?
Purpose of the Loan – Why does Laurent need the money? If he’s loaning the R20 000 to pay off gambling debts it’s a very different situation than if needs it to pay the deposit for an apartment
Credit History – How has Laurent managed with his previous loans? If he’s got a reputation for not paying, it makes it riskier for Nikhil
The more red flags that show up, the higher the interest Nikhil will want to charge. At some point, he may decide the loan is too risky and walk away. But assuming Laurent checks out, Nikhil will come up with a rate that makes sense for him to take this risk.
This, in a nutshell, is how interest rate markets work.
What are “Negative” Interest Rates?
So you must be thinking: if Nikhil is always facing risk, inflation, and opportunity cost, then interest should always be positive. Imagine if Laurent asked for a R20 000 loan and Nikhil told him he only needs to pay R18 000 back i.e. negative R2 000 interest. Laurent would think it’s a scam. It isn’t business, it’s charity. Even if Laurent loans the money and leaves it under a mattress he walks away with a R2 000 profit. So yes, negative interest rates would normally never occur in a free market.
So where do they occur then?
Mostly from central banks. As I write this in 2020, the European Central Bank (ECB) has an interest rate of negative 0.5% and has had negative rates since 2014. The Bank of Japan (BOJ) has had an interest rate of negative 0.1% since 2016.
Central banks don’t follow the same rules as you or I. If Nikhil started making negative interest rate loans, he would very soon go bankrupt. Central banks, however, can print money out of thin air and loan it to banks at a loss. So why would they do this?
Why offer Negative Interest Rates?
By creating these abnormal conditions, central banks are trying to influence how markets operate. Among other things, their hope is that by offering bad returns for saving, people and businesses will save less and spend more. This is why negative interest rates are seen as last-ditch efforts to “stimulate” the economy when everything else has failed.
Negative interest rates come with many side effects and problems. As Warren Buffet puts it: when interest rates are negative, he loses money by keeping it in the bank. He would rather put it all under a mattress and would prefer not to collect on his debts.
Another issue is that the money printing required to fund negative interest rates causes inflation, which hurts the poor more than it does the rich. It also allows banks to profit while taking no risk. Perhaps the worst side effect is that people and businesses will save less, and so more will have nothing to fall back on when a crisis hits (like say, a global pandemic), and may find themselves trapped in debt. You can read more about preparing for financial emergencies here.
Lastly, there is simply the fact that negative interest rates have never been tried before for a sustained period. When they were first introduced in Europe, the ECB called them a “temporary measure” to boost the economy. However, six years into negative rates the European economy hasn’t shown much growth. And where do they go from here?