[fsk]

Finance is complex because:

1. If a transaction is complex, it's easy to sucker people into buying. Why would anyone buy a structured product?

2. If a transaction is complex, both sides can claim an immediate profit based on their idea of how it should be valued.

3. A lot of complexity in finance is driven by the fact that big banks can borrow at 0% while true inflation is higher. Via various derivatives, this government interest rate subsidy is packaged and sold. For example, I can't borrow at 0% to buy stock, but if I buy a call option, the bank can borrow at 0% to finance their hedge.

4. Because different people have different interest rates (banks borrow at 0%, large corporations borrow at 5%), banks can price a derivative at 3%, and both sides can LEGITIMATELY claim an immediate profit on the trade. (Bank borrows at 0% and lends at 3% to finance the derivative hedge. The corporation is borrowing at 3% instead of the 5% they normally would pay.)

[britknight]

Banks don't necessarily borrow at 0%. Granted, they are able to borrow at a much lower rate than you or me (closer to the Federal Funds Rate managed by the U.S. Federal Reserve), but they still pay interest on their loans.

Of course, real interest rates have gotten close to zero, but in general real interest rates of 0% are nonsensical in stable, developed economies. Economically speaking, if rates were 0%, it would in the long run make sense to bulldoze the rocky mountains to save money on gas, because there is no marginal cost to consider.

[jameshart]

"if rates were 0%, it would in the long run make sense to bulldoze the rocky mountains to save money on gas, because there is no marginal cost to consider"

Wait, run that by me again more slowly.

In general, it does make sense to make large infrastructure investments in order to increase long term productivity, especially when interest rates are low, but in general, it's always the case. Hell, bits of the Rockies WERE bulldozed (And dynamited) to save money on railroad or freeway construction that would pay off on a fifty to a hundred year timescale. What does zero percent interest have to do with that? Presumably there are even some positive interest rate values for which the eventual gas savings outweigh the cost of hiring the guys with the bulldozers, if those are the only costs you care about.

If there's a quadrillion dollars worth of hydrocarbons on Titan, and it'll cost me a trillion dollars and fifty years to bring them to earth, it makes economic sense for me to do it, even if interest rates are 5%. I don't think it's the interest rate that makes these projects make sense or not make sense.

What's the magic that happens at zero that causes otherwise nonsensical projects to make economic sense?

[civilian]

Exactly. I think he's assuming he'll never have to pay back the principle.

[britknight]

(In response to above as well as parent)

> What's the magic that happens at zero that causes otherwise nonsensical projects to make economic sense?

The bulldozing-mountains example is purposefully over-the-top (I believe I first heard it in an article by Bernanke[0]). The point that I am trying to illustrate is that at a 0% interest rate, the traditional marginal cost/marginal utility analysis breaks down, since as long as the marginal utility of the last investment dollar spent outweighs the marginal cost of spending that dollar (the interest rate), traditional economic thinking would have you spend that dollar.

> Exactly. I think he's assuming he'll never have to pay back the principle.

The rocky-mountain example does assume this, but it doesn't make a 0% interest rate any more ludicrous. Imagine that you could take out a loan for $x at 0%. Simply because of the fact that time gives assets the opportunity to grow, the future value of that loan when it is to be repaid is greater than the value when you received the loan [1]. Of course, the 0% rate would remove some traditional investment options (savings account, Treasury bonds, etc.), I think it is reasonable to assume that investments will still be able to appreciate to some degree.

However, this appreciation would be constrained in reality by inflation if the real interest rate is 0%. If, on the other hand, the nominal interest rate is 0%, then the loan effectively counteracts the headwind of inflation, and any return, no matter how small, winds up in your pocket.

[0 (7th paragraph)] http://www.brookings.edu/blogs/ben-bernanke/posts/2015/03/31... [1] https://en.wikipedia.org/wiki/Time_value_of_money

[hderms]

I guess that assumes infinite access to credit? Otherwise there would be an opportunity cost associated with bulldozing the rocky mountains in favor of some other activity with higher marginal utility, right?

[dllthomas]

Time gives the money a chance to grow if there is anywhere that offers a safe return. Lending at a negative interest rate is paying someone to keep your money safe. Borrowing at a real negative interest rate may not make sense if you aren't sure you can do that.

[fsk]

Actually, it was a bad example.

Suppose you spend $1M to produce something worth $100k. You lost $900k.

But suppose you borrowed at 0% while inflation was (to use round numbers) 10%. After about 50 years of borrowing at 0%, your $100k is now worth more than $1M. (I'm too lazy to use logs to figure out the exact breakeven point right now.) You made a profit.

With 0% interest rates, your investment that destroyed $900k of value was (eventually) profitable. If you can avoid mark-to-market accounting, you can just borrow, wait for inflation, and eventually sell for a profit.

When interest rates are less than inflation, a capital-destroying investment can seem profitable.

[stretchwithme]

Its possible to borrow money, blow through the cash on some unproductive investment and then be unable to repay the principle on the agreed-upon schedule.