Interest rates keep dropping. In my country in northern Europe we now have negative interest rate - banks have to pay the central bank for lending it their money.

I have two questions:

  1. Why are interest rates lower than any time ever before?

  2. Are low interest rates dangerous? The low interest rates will make it easier to borrow money for projects that would otherwise not have been possible. Irresponsible lending has proven dangerous in the past.

Are the low interest rates a way that the central banks are "artificially resuscitating" a poor economy which may finally lead to a crash?

Adding that we have never seen this situation before I ask if this situation with extremely low interest rates is dangerous?

One aspect of the question is: Are these low interest rates expected to stay low or are they considered an extreme value in a cyclic variation?

  • 1
    $\begingroup$ also, I suggest asking the related question as a separate question. $\endgroup$ – serakfalcon Mar 8 '15 at 8:03
  • $\begingroup$ I agree. Could OP remove the first part of the question (since there was a first attempt to answer 2.) into a new question? $\endgroup$ – FooBar Mar 8 '15 at 13:39
  • $\begingroup$ I think the question is significantly different from the question quoted in the comments. The answer that has come is related to the question as a whole. I therefore wish to keep the question as it is. / With "dangerous" I naturally mean (as said) that some kind of economic crash (e.g. stock market) may occur. $\endgroup$ – cvr Mar 8 '15 at 13:51
  • $\begingroup$ @ycc_swe you still have 2 separate questions: i) historical evidence ii) is this dangerous. There is no need to have both together. It's the other way around, the stack exchange system is optimized at having every question deal with a separate issue. $\endgroup$ – FooBar Mar 8 '15 at 14:55

If by dangerous it is meant they add possible downwards volatility of assets, that could easily be argued for as:

$ PV = D / (1+r)^t$

Where D denotes any future income. This is especially the case if the reason for the low rates is very easy monetary policy, as such policy cannot be maintained and thus the rate is not equilibrium rate and must rise, causing a crash in asset values when that happens.

Central banks determinate the interest rates in the short run, their policies are targeted to lower rates, thus a low rate. The other reason is that of supply and demand. There is not much demand for credit (no profitable ideas, no more room for consumer credit) and on the other hand the supply of credit is significant due to central bank action. High supply and low demand equals a low rate.

  • $\begingroup$ But that formula for discounting future $D$ only holds for $t$ in the future if $r$ is expected to be the interest rate until $t$. If $t$ is far in the future, then it is unlikely that this can come about due to the central bank, whose control of real interest rates is inherently a short-to-medium term thing (as you mention). This puts a limit on the extent to which a central bank can affect asset prices, at least through this channel. $\endgroup$ – nominally rigid May 9 '15 at 16:49
  • $\begingroup$ @nominallyrigid That's not the correct interpretation of the equation. But I think this is easier to interpret through supply and demand, if the central bank stops demanding, prices crash. After all the interest rate just signals about the drop in demand. However, to arrive at the correct interpretation, think you bought a govt bond yielding 5 %, with bond interest rates obviously at 5%. Now interest rates rise to 10%. Your bond just lost half its value as you can get bond yielding 10 % for same price as you bought the 5% yielding with. Thus future rates have no bearing, r is the current rate. $\endgroup$ – Dole May 11 '15 at 22:55

A central bank sets the interest rates for banks (i.e. not us mere mortals) to borrow from it.

Low interest rates are a central bank's tool to try and encourage banks to lend, thereby encouraging all sorts of helpful behaviours like investment and home-buying. (If rates are low, that should mean borrowing for mortals is cheap, because you'd hope the banks pass on those low central bank rates to their customers!)

But if there's something fundamentally "wrong" with the economy, banks won't lend and/or people won't want to invest/borrow however low the interest rates get. After all, the idea of being in debt might be worrying to people per se, not just because of the interest repayments.

So the central banks have been lowering and lowering rates, desperate to kickstart the economy, but it's not been working, because there's something just "wrong" with the economy, and it's got nothing to do with interest rates.

That could be to do with banks being scared to lend (not enough money in their safety cushions perhaps?) or people/firms being too scared to borrow/invest (worries that things will get worse in the near future maybe?)

So rates get ever lower, and still the economy doesn't get moving.

  • $\begingroup$ What does "kickstart the economy" actually mean? $\endgroup$ – user253751 Dec 20 '19 at 12:59
  • $\begingroup$ That's a great question @user253751. Worthy of it's own question on this site in fact! Put a link to this answer in your new question. $\endgroup$ – LondonRob Jan 6 '20 at 15:00

Zero rates don't seem to have helped resuscitate Japan's economy to the point where they can be raised again and negative rates are a big unknown.

We're only going to see what its effects are in the years going forward, but it is fair to say that market valuations have been greatly distorted by this sort of free money.

Perhaps a better form of stimulus than going negative rates would be a guaranteed universal basic income. They benefit everybody rather than just those who are in a position to borrow for free and/or to get paid to borrow.


Your Answer

By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy

Not the answer you're looking for? Browse other questions tagged or ask your own question.