14 August 2019 – There’s been some hand wringing in the mass media recently about negative interest rates and what they mean. Before you can think about that, however, you have to know what negative rates are and how they actually work. Journalists Sam Goldfarb and Daniel Kruger pointed out in a Wall Street Journal article on Monday (8/12) that not so long ago negative interest rates were thought impossible.

Of course, negative interest rates were never really “impossible.” They used to be considered highly unlikely, however, because nobody in their right mind would be willing to pay someone else for taking money off their hands. I mean, would you do it?

But, the world has changed drastically over the past, say, quarter century. Today, so-called “investors” think nothing of buying stock in giant technology companies, such as Tesla, Inc. that have never made a dime of profit and have no prospects of doing so in the near future. Such “investors” are effectively giving away their money at negative interest rates.

Buying stock in an unprofitable enterprise makes sense if you believe that the enterprise will eventually become profitable. Or, and this is a commonly applied strategy, you believe the market value of the stock will rise in the future, when you can sell it to somebody else at a profit. This latter strategy is known as the “bigger fool theory.” This theory holds that doing something that stupid is a good idea as long as you believe you’ll be able to find a “bigger fool” to take your stock in the deadbeat enterprise off your hands before it collapses into bankruptcy.

That all works quite nicely for stocks, but makes less sense for bonds, which is what folks are talking about when they wring their hands over negative-interest-rate policy by central banks. The difference is that in the bond market, there really is no underlying enterprise ownership that might turn a profit in the future. A bond is just an agreement between a lender and a debtor.

This is where the two-fluid model of money I trotted out in this column on 19 June helps paint an understandable picture. Recall from that column that money appears from nowhere when two parties, a lender and a debtor, execute a loan contract. The cash (known as “credit” in the model) goes to the debtor while an equal amount of debt goes to the lender. Those are the two paired “fluids” that make up what we call “money,” as I explain in that column.

Fed Funds Rate

The Federal Reserve Bank is a system of banks run by the U.S. Treasury Department. One of the system’s functions is to ensure the U.S. money supply by holding excess money for other banks who have more than they need at the moment, and loaning it out to banks in need of cash. By setting the interest rate (the so-called Fed Funds Rate) at which these transactions occur, the Fed controls how much money flows through the economy. Lowering the rate allows money to flow faster. Raising it slows things down.

Actual paper money represents only a tiny fraction of U.S. currency. In actual fact, money is created whenever anybody borrows anything from anybody, even your average loan shark. The Federal Reserve System is how the U.S. Federal Government attempts to keep the whole mess under control.

By the way, the problem with cryptocurrencies is that they attempt to usurp that control, but that’s a rant for another day.

Think of money as blood coursing through the country’s economic body, carrying oxygen to the cells (you and me and General Motors) that they use to create wealth. That’s when the problem with negative interest rates shows up. When interest rates are positive, it means wealth is being created. When they’re negative, well you can imagine what that means!

Negative interest rates mean folks are burning up wealth to keep the economic ship sailing along. If you keep burning up wealth instead of creating it, eventually you go broke. Think Venezuela, or, on a smaller scale, Puerto Rico.

Negative Interest

Okay, so how do negative interest rates actually work?

A loan contract, or bond, is an agreement between a lender and a debtor to create some money (the two fluids, again). The idea behind any contract is that everybody gets something out of it that they want. In a conventional positive-interest-rate bond, the debtor gets credit that they can use to create wealth, like, maybe building a house. The lender gets a share in that wealth in the form of interest payments over and above the cash needed to retire the loan (as in pay back the principal).

Bonds are sold in an auction process. That is, the issuer offers to sell the bond for a face value (the principal) and pay it back plus interest at a certain rate in the future. In the real world, however, folks buy such bonds at a market price, which may or may not be equal to the principal.

If the market price is lower than the principal, then the effective rate of interest will be higher than the offered rate because what the actual market value is doesn’t affect the pay-back terms written on the loan agreement. If the market price is higher than the principal, the effective rate will be lower than the offered rate. If the market price is too much higher than the principal, the repayment won’t be enough to cover it, and the effective rate will be negative.

Everyone who’s ever participated in an auction knows that there are always amateurs around (or supposed professionals whose glands get the better of their brains so they act like amateurs) who get caught up in the auction dynamics and agree to pay more than they should for what’s offered. When it’s a bond auction, that’s how you get a negative interest rate by accident. Folks agree to pay up front more than they get back as principal plus interest for the loan.

Negative Interest Rate Policy (NIRP) is when a central bank (such as the U.S. Federal Reserve) runs out of options to control economic activity, and publicly says it’s going to borrow money from its customers at negative rates. The Fed’s customers (the large banks that deposit their excess cash with the Fed) have to put their excess cash somewhere, so they get stuck making the negative-interest-rate loans. That means they’re burning up the wealth their customers share with them when they pay their loans back.

If you’re the richest country in the world, you can get away with burning up wealth faster than you create it for a very long time. If, on the other hand, you’re, say, Puerto Rico, you can’t.