Defying the Laws of Financial Physics

March 16, 2015

Most of us can vaguely recall from our high school or undergraduate days something about the laws of physics. Sir Isaac Newton, for example, gave the world three laws of motion (yes, it is still true that force equals mass times acceleration).

Matters are not so neat and tidy in the world of finance. Once upon a time, wise minds said that interest rates can never go below zero. Savers, so the argument went, would never part with their money only to have a borrower return with a lesser amount. The option of savers being able to hold on to that money—e.g., to simply bury it in the backyard in Mason jars—would ensure that market interest rates would stay above zero.

So much for that law of financial physics. Today banks placing excess reserves at the European Central Bank are being charged—i.e., are not being paid—a negative interest rate of -0.20 percent. Similarly negative interest rates are being charged on bank excess deposits by the Danish and Swiss central banks (-0.75 percent) and the Swedish central bank (-0.85 percent). A rising number of world governments are able to sell bonds that pay negative interest rates. For example, two weeks ago when Germany sold new five-year bonds, “investors paid €100.39 per €100 worth of paper with no income payments, accepting a yield of minus 8 basis points on their money.” Today nearly a third of all European sovereign debt is trading at negative yields.

So why are world savers not grabbing their shovels? Any nominal interest rate can be understood as the sum of two parts: a real interest rate plus expected inflation. The real rate is struck between savers and borrowers in terms of consumption today versus consumption tomorrow. Expected inflation accounts for the chance in money-based economic systems that the value of that consumption tomorrow may change because of price inflation. Negative nominal interest rates reflect both real interest rates and inflation rates being so low or negative. All of this reflects, unfortunately, the continued fragility in the world economy.

Start with the inflation part. Expected inflation is often closely linked to actual inflation, and in so many countries today both these measures are at or even less than zero. Last week the Organization for Economic Cooperation and Development reported that among its 34 members the annualized rate of inflation fell in January to just 0.5 percent. January factory-gate prices in the eurozone were 3.4 percent lower than they were a year earlier. As we have discussed earlier, falling prices in many countries has much to do with stagnant demand among households and businesses alike.

What about real interest rates? The supply of and demand for loanable funds together determine these real rates. In boom times, companies seek lots of loanable funds to finance all the new opportunities they are keen to develop—and thus are willing to pay a lot to the savers. In too many parts of the world today, the Keynesian “animal spirits” that animate much of business investment remain too muted amidst political dysfunction and policy uncertainty.

It was six years ago last week that the plunge in many asset prices amidst the world financial crisis hit bottom: remember the Dow closing at 6,547 on March 9, 2009? In many ways, capital markets today are healthier than they were back then. But negative nominal interest rates underscore that all is not well in today’s global economy.

Articles © 2015 Matthew Slaughter and Matthew Rees. All rights reserved.
Publication © 2015 Trustees of Dartmouth College. All rights reserved.