Gordon C. Boronow on How Do Negative Interest Rates Work?

Over $17 trillion dollars’ worth of global debt is now “earning” an interest rate below 0%. Negative interest rates are infecting developed countries such as Germany, Switzerland and Japan. I read an article recently that said there are negative interest rate mortgages available in Denmark. Just trying to think about negative interest rates makes one’s head explode.

From a practical perspective, the mechanics of negative interest rates are clear enough. The borrower guarantees to pay, say, $1000 in a year. The lender then agrees to give the borrower $1020 (for a negative 2% yield) for the guaranteed payment. Voila, negative interest! You might point out that the lender would be better off just holding onto the cash, but that’s another story. A negative interest rate mortgage is even more cool. Each payment the borrower makes on the mortgage reduces the principal balance by more than the amount of the mortgage payment. How cool is that?

What has happened to interest rates that they are so low for so long? What does it mean for the economy in the United States and elsewhere? I certainly do not know, nor does anyone else. Interest rates are a price signal in the economy; the price of postponing consumption to a later period. Persistently low interest rates are a puzzle to economists and policymakers. Standard economic theory would expect that interest rates should be high enough to convince consumers to save something and not spend it all today and low enough that businesses can borrow and invest and still make a profit. In any case, economic theory does not expect negative interest rates.

Who determines what the level of interest rates should be? In a reasonably free economy with properly functioning financial markets, we do. That is, the interest rate is determined by the interaction of borrowers and lenders trying to do business together. If there are more borrowers seeking funds than lenders (i.e., savers) willing to lend them funds, then interest rates will increase. Borrowers compete for the scarce funds by offering to pay higher interest on the loans. This attracts more lenders and discourages some potential borrowers until the interest rate finally “clears the market” (i.e., demand for funds from borrowers is equal to the supply of funds from lenders). The reverse situation occurs when there are more lenders than there are borrowers. In that case, lenders compete to attract the scarce borrowers by lowering the rate they require to make the loan. Falling rates attract more borrowers and deter potential lenders, until the interest rate “clears the market” (demand equals supply). Simple, right?

Well, not so much. You see, since the end of the gold-is-money era in 1971, central banks have played an increasingly active role in the manipulation of money and interest rates. The central bank for the United States is the Federal Reserve Bank. There are similar central banks in other countries. Here is how it works in central-bank-controlled financial markets:

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SOURCE: Christian Post, Gordon C. Boronow