How do negative interest rates work anyway?
Paul Solman: But how are negative interest rates supposed to work?
Mohamed El-Erian: Let me tell you the theory, and let me tell you what happened in reality. The theory is that if you take interest rates negative, people like you and me are going to say, “That’s a silly game! I’m not going to lend my money to governments who want me to pay them. I am going to go into the stock market where I can get positive returns!”
Paul Solman: Or if I’m a company, “I’m going to invest in some new technology or factory or something.”
Mohamed El-Erian: Correct. The idea is to push households and push companies to take on more risk. In one case, financial risk — the stock market — in the other case, economic risk. Economic risk is investing in, say, plants and equipment. So let’s look at the first one. You take financial risk, you push up the price of stocks.
Paul Solman: Of which has certainly happened.
Mohamed El-Erian: Which has happened. You and I then open a 401(k), and we say, “Wow, we’re richer!” In theory, we trigger what economics call the wealth effect. Because we feel we’re wealthier, we go out and spend more.
As we spend more, and as companies are pushed to invest, they say, “Hey wait a minute! There’s more demand in the system. Let’s invest more.”
And then the third element is that if you happen to be the only one with negative interest rates, you also weaken your currency, which means you make your exports more competitive.