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Understanding Negative Interest Rates

The next big theme I want to talk about is a pretty interesting one called, “Understanding Negative Interest Rates.” If you go to a bank and take out a loan, the bank charges an interest rate to give you that money. And if you have a credit card and use a $100 and the interest rate is 20%, that means if you don’t pay it off, you have to pay the $100 plus the 20% per year.

Now, the idea here is that if an economy is doing very well and there’s a lot of inflation, the central bank will raise the interest rate. So, the amount of money you pay for the amount of money you borrow is going to be higher. But if the economy isn’t doing well, nobody wants to borrow, inflation is low and prices aren’t rising, the central bank will say, “One of the biggest reasons nobody wants to borrow is because money is too expensive, so we’re going to lower the interest rate.”

If you know a little bit about economics, you know that for a long time, it was assumed that zero was the lowest interest rate you could go to. People assumed that once you cut the interest rate to zero, you couldn’t make it negative because it would have no impact. When you go to zero, you’re saying that if people leave their money in the bank, they’re not going to earn interest. But also, banks would charge you less money for the money you borrowed from them. So, there are two sides here. One is the amount of money you are charged for interest when you borrow it. The other side, which most people are worried about now, is that if you’re a consumer and leave money in your bank, you’re not going to earn interest from the bank because interest rates are zero.

Let’s focus on the second one because this is where it gets interesting. If the interest rate goes to minus one, that means you have to pay the bank money to leave your money there. Previously, when the interest rate was plus one, the bank would pay you money. The idea was that if you made the interest rate negative, the consensus was mostly that people would pull their money out and do things with it. Very few central banks went negative. In fact, I think it was only Denmark, Sweden, Switzerland, Eurozone and Japan.

There are two interesting insights here. First, due to the way banking has changed, the impact of a slight negative interest rate hasn’t modified people’s behavior in the way central banks expected. At least that’s what we think. Let’s say you have $5,000 in a rural branch of a bank, and you have to drive 45 miles to get there. If interest rates are negative, and you get scared and want to take your money out of the bank because you think the bank is robbing you, they are not giving you any interest, to take the money out you have to drive 45 miles, bring your money home, put it under a mattress or do something with it, and then if you want to change your mind, you have to go back to the bank. That’s a very big inconvenience factor.

Here’s the insight. Now, with the rise of digital banking, it’s possible that people will see the .1% or .2% negative interest rate as a convenience charge. Let’s unpack the insight. When we look at how policy or products are rolled out, it’s very important that we don’t just look at it from a rational perspective. The rational thing would be to say that if interest rates went from plus 0.5%—which means the bank is going to give you 0.5% for your money—to minus 0.5%—which means you have to pay the bank 0.5% to keep your money at the bank—we shouldn’t assume that people’s behavior will be the opposite because all other things are not equal.

It’s still to be seen whether this convenience factor is true, but we know that because banking and shopping is run differently versus how it used to be, people’s behavior will be different, and we need to think carefully about how changes in any policy, like privacy protection, will modify behavior if people are interacting with the world differently. The fact that central banks in Denmark and Japan have done this, their economies haven’t collapsed, and people haven’t taken their money out of the banks, tells us that people are not going to behave in the opposite way once you switch the interest rate from plus 0.5% to minus 0.5%.

It will be different in different countries. Japan is not very digitized but Denmark is. The question we have to ask is why hasn’t behavior changed? Think about what that means for the decisions we’re making in the world. More importantly, we have to think about what it means as more of the world becomes digital.

The final example is the rise of Airbnb. People assumed that nobody would want to stay in a private home versus a hotel, for a number of reasons: a hotel is well-managed, safety issues, etc. But if you look at the numbers today, Airbnb is worth far more than the largest hotel chain in the world. They don’t own any rooms. But what changed? Technology. It’s not just that technology allowed them to do this. That’s fairly obvious. It’s that the behavior modification people expected was different when consumers transacted using this technology platform, and that’s what we need to think about.

This is an excerpt from Monday Morning 8 a.m. newsletter, issue #25. Many of you have found Monday Morning 8 a.m. so useful that you’ve asked us to release a book version of these newsletters. We’ve obliged and released a Kindle version, which you can find on Amazon under “Strategy Insights.” It contains the insights from previous Monday Morning 8 a.m. issues, edited into a bite-sized format that’s very easy to use. And you can learn about other FIRMSconsulting books here

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