The global economy is entering an absurd situation that the majority of people do not fully understand or have experienced in the past. Over the past year, central banks around the world have set negative interest rates for money deposited with them. Let's take a deeper look at the consequences this may have.
Negative interest rates
Suppose you have cash and you want to earn some “safe” interest (I call it safe because the probability of losing money when depositing cash in the bank is supposed to be extremely low), you loan the cash to the bank and in return, the bank will pay you some interest. Afterward, the bank will use your money to give loans to operating businesses, in order to earn more interest. The bank’s profit will be the gap between the interest it earns from giving the loan and the interest it gives to you. So, in normal times, when you (the lender) lend the bank (the borrower) the money, the lender will receive money.
Currently, we are in the contrasting environment with some currencies. If you have Swiss franc (CHF), euro or Swedish krona now and you want to deposit into the bank, you would not receive any interest, and instead will have to pay interest. The lenders will have to pay the borrowers to borrow their money. Yesterday, Japan also adopted a similar negative interest rate policy. While Switzerland and Sweden set the interest at -0.75% and -1.1% respectively, Japan’s interest rate is now at -0.1%.
Although a long series of quantitative easing with low interest rates has been adopted for several years, it seems that the deflationary forces are even stronger with commodity prices falling significantly. Thus, central banks have to use negative interest to deal with the economy.
Charlie Munger (Trades, Portfolio) has a say
Charlie Munger (Trades, Portfolio) has commented that this situation had never happened in his whole life. He recalled 1.5% interest rates, which surprised economists at the time. The 1.5% interest rate had basically destroyed all insurance companies in Japan, because they guaranteed 3% interest rate.
“I was flabbergasted when they went low, when they went negative in Europe – I’m really flabbergasted. How many in this room would have predicted negative interest rates in Europe? Raise your hands. [No hands go up]. That’s exactly the way I feel. How can I be an expert in something I never even thought about that seems so unlikely. It’s new territory…”
Munger said that anyone who confidently thinks they know the consequences are “witch doctors.” He considered this situation to be very weird.
“If interest rates go to zero and all the governments in the world print money like crazy and prices go down – of course I’m confused. Anybody who is intelligent who is not confused doesn’t understand the situation very well. If you find it puzzling, your brain is working correctly.”
Going back to basic finance fundamentals, what is interest? The interest rate is used to price risk. High interest rate is considered high risk. Thus, most of the high interest rate loans go along with the low probability to repay. However, when the interest rate is in the negative territory, it seems that the risk-pricing mechanism does not work anymore. What are the consequences? Personally I do not know, but I don’t think it’s a positive macro picture.
