Imagine…after months of searching, you finally find the house you are looking for, make an offer, and have it accepted. Now, all that remains is figuring out how to pay for it. The agreed-upon price is $250,000. Being a good saver, you have $50,000 for the down payment and plan to finance the $200,000 balance. You have good credit and since you also have a substantial income, you go to the bank and apply for a 10-year fixed rate mortgage.
After a short wait, the loan officer informs you that your loan has been approved and your monthly payment will be $1,624.66. Wanting to know what the loan will REALLY cost, you whip out your smart phone, open the calculator app. and enter $1,624.66 X 120 (12 payments per year for 10 years). The result – $194,959.20. What? That must be a mistake. You’re borrowing $200,000 and the total of all your future payments will be $5,041 LESS than that? Actually, it’s no mistake. This scenario is the current reality in Denmark where a bank called the Jyske Bank is offering a 10-year mortgage with an interest rate of MINUS 0.5%!! Sound good? Absolutely…if you are a borrower.
But what if you are a lender or an investor? If you go to that same bank and want to buy a certificate of deposit, you will be told that for a deposit of $103,000, the bank will give you back $100,000 in two years. Now, those low rates don’t seem so attractive.
Through the looking glass we go to the bizarre new world of negative interest rates.
Actually, negative rates are not (yet) widespread in the consumer market, but they have been around for a decade or more in the commercial realm, and they are becoming more common, especially in Europe and Japan. In fact, roughly a quarter of the $15 trillion debt issued by governments and companies around the world is trading with negative yields. That means that bond prices are so high that investors are guaranteed to get back less than they paid via interest and principal if they hold the bond to maturity. They are, in effect, paying someone to look after their money.
In the United States, the Federal Reserve (“the Fed”) has the power to set the interest rate that it charges the banks that borrow from it. If the Fed wants to stimulate the economy, it lowers the rate, which (theoretically at least) allows banks to charge a lower rate to its customers, encouraging borrowing and, ultimately, economic activity. Conversely, if the Fed worries that inflation is becoming a problem, it can put on the brakes and raise rates. The end result is that the economy slows. At least that’s how it’s supposed to work in a perfect world.
The central banks of Europe and Japan have taken this stimulus mandate to such an extreme that they are now actually charging banks to park their money, hoping that the banks will get the message and start making loans, even at ridiculously low or even negative rates.
In an ideal world, there exists lenders with money, who would like to lend it for a reasonable return to borrowers who can make a productive use of that money and are willing and able to pay it back with interest. Ultimately, the amount of interest lenders can charge borrowers depends on the relative pools of each. Historically, the pool of qualified borrowers has exceeded the pool of potential lenders, meaning lenders have been able to call the shots.
But, in this wacky new world, that power balance has fundamentally shifted where now there are more potential lenders than qualified borrowers. There is a host of reasons for this, but they are primarily demographic. Aging baby boomers are sitting on a lifetime of savings and suddenly having difficulty finding somewhere fruitfully to park it.
Can we expect all this strange new monetary policy medicine to breathe life into ailing and aging economies? Frankly, it’s too early to say. The experiments overseas have yet to come full circle. At the end of the day, it comes down to a question of faith. Do you believe human beings are still capable of engaging in activities that create value over time? History and common sense suggest we can. If so, it doesn’t make sense in the long run for money owners to simply sit and watch their money burn. They should seek out, and invest in, wealth-generating opportunities. Maybe negative interest rates are what it takes to move them off the dime?