Reader Henrique from Brazil asks “Can you please explain in simple layman terms why zero or negative interest rates are bad? What should the interest rate be?”

Hello Henrique.

I am sure that I have covered this before numerous times but here is a list that I have not itemized before.

  1. Low interest rates spawn asset bubbles. As bubbles expand, banks make loans on asset prices that rise higher and higher. When bubbles burst, they leave behind a pool of debt that cannot be paid back. It was unusually low interest rates that created the housing bubble and the junk bond/equity bubbles we are in now.
  2. Low interest rates spur all kinds of economic development that is not productive. That development sends a signal that things are OK and that shortages exist. In 2005, people actually believed there was a shortage of Florida condos. A couple years back it seemed like going into massive debt to drill oil wells was a good idea. Today we know it was not such a great idea.
  3. The Fed, central bankers in general, want 2% inflation. However, there is no reason to believe 2% is a magic number.
  4. Inflation benefits those with first access to money: the banks and the already wealthy. Rising income and wealth inequality is a direct result of interest rates set too low. Think back to the housing bubble. By the time money was available for liar loans, the party was nearly over.  Those who bought late in the game got crushed.
  5. In foolish attempts to hit 2% inflation, desperate central banks have now tried negative rates. Outside of central bank intervention, negative rates are impossible. Negative rates imply one would rather have 90 cents ten years from now than a dollar today. Clearly that is absurd. While we do not yet know precisely what problems may arise from such economic silliness, we can say for sure there will be more economic distortions.
  6. What should the interest rate be? I don’t know, nor does anyone else, especially central banks. Rates are best left to the free market. In an environment with no fractional reserve lending and a stable money supply, interest rates would likely be low, and prices stable.

Mike “Mish” Shedlock