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Winners and Losers of Negative Interest Rates

We analyze the Winners and Losers of Negative Interest Rates, one of the strangest things that were implemented as a result of the 2008 financial crisis.


What are Interest Rates?

Interest rates reflect the price of money. The price of money is defined by how expensive it is to borrow it or, if are on the other side of the equation, how much we get paid to own money.

If we put money in a savings account, we will most likely be paid interest. The higher the interest rate, the more money we will receive. As savers, we are interested in higher interest rates. In other words, we want a higher price for that which we offer to the financial system.

When someone wants to borrow money, regardless of whether it is a household, a corporation, or a government, they will have to pay interest. That interest will be the luxury of using someone else’s money.

While money can be borrowed in various forms, including a loan from a bank or by selling a bond, it ultimately leads to having to pay an interest rate. Therefore, the lower interest rates are, the better it is for borrowers, since they will have to pay a lower price to use other people’s money.

Note that the price of money represents a flow of purchasing power flowing from one party to another, generally from the borrower to the lender. This is the compensate the lender, or saver, for foregoing consumption today and potentially facing higher prices in the future in the form of inflation.

How Negative Interest Rates appeared

A negative interest rate would indicate that the lender is paying the borrower for borrowing money. While this may seem unintuitive, it is because negative interest rates go against all logic. It is about giving someone €1,000 today and expecting to be paid €900 back in a few years.

Under normal market conditions, more creditworthy borrowers have to pay lower interest rates. That makes sense as they pose lower risk of default. This applies to countries as well. Therefore, better managed economies are able to finance themselves at lower rates of interest.

Conversely, if a country pursues poor economic policies, increased spending levels, and higher deficits and debt, investors will only lend money if they are sufficiently rewarded for the additional risk they were taking. This additional reward is in the form of a higher interest rate.

The market acts as a mechanism to incentivize solid budgetary practices. That should motivate government officials to manage their country’s finances responsibly. If they want to borrow too much money, the debt markets will penalize that by charging higher interest rates.

However, most Western governments decided to go on a spending spree after the 2008 financial crisis. Instead of trying to balance their budgets, they opted for sustained large fiscal deficits, to the point where government borrowing was making it difficult for the private sector to get financing.

Additionally, interest rates on government debt started to soar as investors had little trust that these governments would be able to get back to a path of solid fiscal policy. Consequently, interest spend increased dramatically.

Given this could eventually lead to the bankruptcy of multiple countries, as it happened with Greece, central banks decided to implement negative interest rates and buy the government bonds themselves. It was no longer necessary for private investors to buy that debt, as the central bank would do it with newly created money.

Effectively, a bond can end up yielding a negative rate of interest if we the price we pay today for it is higher than all the cash flows it will generate for us.

For example, if a bond pays no interest but only €100 at maturity, and we pay €105 for it today, there will be negative interest rate. If we hold it to maturity, we are guaranteed of experiencing a €5 loss. After accounting for inflation, the loss will be much larger.

Winners of Negative Interest Rates

Governments are the big winners of negative interest rates. Instead of implementing reformsor making their budgets sustainable, they simply increased public spending. Income from taxes or debt financing were no longer a limitation.

At the same time, it is always possible to think of more things we can spend money on. Human desires and wishes are unlimited, especially if we do not have to pay or work for them. This is the positions in which politicians found themselves.

Other groups in the private sector also benefited from negative interest rates. Those were the people able to borrow money cheaply, including some large corporations, as well as owners of assets whose prices go up when interest rates go down.

Consequently, asset owners saw their nominal wealth increase. Owners of large real estate holdings also benefitted as real estate prices are correlated with interest rates. The lower interest rates are, the higher home prices tend to go. This exacerbated wealth inequality.

Losers of Negative Interest Rates

One of the biggest losers of negative interest rates are the future generations of those countries that took advantage of these monetary and fiscal policies to go further into debt. While debt may be cheap, money waster still has to be paid back. Future generations will have to face ever increasing tax burdens.

Savers are also heavily punished by negative interest rates. At best they can hope to make 0% on their money while inflation eats away at the purchasing power of their savings.

That led many savers and investors to buy bonds yielding close to nothing, sometimes even taking considerable interest rate or credit risk. Negative yielding bonds were also bought by private investors as a means to escape the yet more negative interest rates applied by the central bank on cash balances.

That created a very weak financial system in which players were not encouraged to save and have their finances in order, but instead go further into debt. The consequences of the negative interest rate policy (NIRP) will be long felt.

Young people also struggled as they saw real estate prices soar due to ever lower interest rates. That made it very difficult for young generations to get on the housing ladder, delaying many of their life plans and reducing their wealth accumulation capacity.

Ultimately, one of the silent losers of negative interest rates was the free market. In a world where governments have almost unlimited spending power and with central banks fixing the price of money like never before, free market incentives become distorted.

As a result, economic growth becomes weaker, the job market stifles, and social mobility declines. This is all to the benefit of politicians and bureaucrats who see their power go up. If you like this analysis about the winners and losers of negative interest rates, I encourage you to subscribe to my newsletter:
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Published in Bonds Economy

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