Mon. Mar 18th, 2024
Source- American Express Archives

The idea of supply and demand is the most fundamental aspect of any modern economy. Due to the disruptions caused by COVID-19, businesses have been affected because of an unbalanced equilibrium in this ratio of supply and demand. Owing to massive job cuts, buyers are not in a position to purchase goods and services. This has resulted in a vicious cycle of joblessness, economic slowdown, and widespread panic and the central banks’ response- Negative Interest Rates.

Debt Based Economy: As Fragile as a House of Cards?

In simple words, interest rate is the price one pays to borrow money. Modern economy is one based on debt, because debt or a controlled inflation amounts to economic growth. We will take the example of a builder. A builder borrows certain amount of money at a fixed positive interest from a bank. The money thus loaned gets used to build apartments, individuals like you and me take out a housing loan to purchase this apartment. The builder pays the loan back to the bank with an interest. This cycle of debt results in overall growth of the economy.

However, one key consideration in this system is the co-existence of demand and supply which is backed by trust in the market’s growth. No one is likely to be interested in buying properties which cannot appreciate in value over a period of time. Thus, when this link breaks, we have a situation called deflation.

Deflationary Spiral: The Eye of The Cyclone

Currently, we are going through deflation. The general sentiment of the market is to hold on to their cash and not invest or spend unless absolutely necessary. This obviously is a problem for the macro-economy. If there is no spending, there will be no production, which in turn will result in greater job losses and economies plunging into depths of a deflationary spiral.

This is where the importance of negative interest rates come in.

Sweden’s central bank was the first to envision this measure where in 2009 it’s slashed the deposit rate to a staggering -0.25%, this behaviour was soon emulated by other banks in the European Union and Japan with over $ 9 trillion worth of government debt carrying negative interests as of the time of writing this article. That amount will only go up as larger and more influential economies such as USA, Brazil, Britain, and India choose to opt for negative interest rates.

Negative Interest Rates: When Push Comes to Shove

As central banks charge negative interest rates to encouraging borrowing, hoarding or saving money in deposits through savings and current accounts will be discouraged by charging fee for parking money in deposits. Now obviously, the assumption here is that people will not withdraw all their money and stuff it under their floor. Although they technically can, it is a highly improbable situation.

It must be noted that such extreme counter intuitive policies are enacted only when the central banks have no other option of stimulating their nation’s economy. Negative interest rates further carry the risk of banks not willing to give out loans due to the fact that banks have numerous assets as securities such as mortgage, which are contractually bound with ongoing interest rates. The risk on such defaults thus become more pronounced as profit margins will be squeezed to the point of non-existence that banks will be less willing to lend money.

The Bottom Line

These are definitely uncharted territories, the modern world has never seen a disaster of this scale and magnitude in it’s establishment’s history. Negative interest rate is definitely one among many desperate measures, as a response to dire situation.
There is no reason to panic or expect a global financial meltdown, our markets are going through a correction phase and will revert to normalcy in due time.

Desperate affairs require desperate measures. – Adm. Horatio Nelson

By Sayon Bhattacharya

A student, Quant Dev, Finance & Capital Market Enthusiast, and now a blogger on The Indian Wire living in the Financial Capital of India, Mumbai. Sayon is a multi faceted individual with limitless enthusiasm to enlighten the uninitiated in the realm of Finance and Business. He enjoys sharing his knowledge and understanding of current and core happenings in these domains with startling simplicity and ease of understanding. Stay tuned to know more about the latest happenings and be up to date with the market.

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