Are low interest rates dangerous?

Question

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?

Answer 1

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.

Answer 2

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.

Answer 3

I'll be regarded as an "hawkish guy" but, in my modest opinion, yes. But in order to explain why we should define the variable in which respect are "too low": in this case, the answer is the natural rate of interest, i.e., the rate of interest that would prevail in an economy without money and that is, in equilibrium, equal to the rate of time preference. Now, even in neo-keynesian models (such as the Laubach and Williams' one) the natural rate has certainly declined over time (due to structural factors such as demographics, low productivity and other factors like that) but has never turned zero or negative, since it would make no economic sense. Now, central bank have set up very expansionary monetary policies with policy rates that in some cases are negative, but this - to me - seems too risky. First because by setting the policy rate lower than the natural rate you discourage savings and so enable consumption, and secondly because at the same time you encourage investment and there is the risk to enable a sort of wicksellian "cumulative process", in which the aggregate demand goes up but the aggregate supply (given our low productivity and the consumption of capital) does not adapt at the same time and then can be a risk of inflationary pressures. Pressures that do not necessairly reflect immediately on the CPI but that affect firstly the prices of financial instruments (such as stock and bonds)and only in a second moment the CPI. So, to me, the monetary policy has not the aim to be too much expansionary as it is since a very long time; rather, monetary policy should, in my opinion, follow only structural variables that represents the "true state" of the economy in order to let those structural forces to adjust.There ain't no free lunch and the monetary policy should not forget that.

Answer 4

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.