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One of my Banking and Finance Master students at the Il Sole 24 Ore business school where I teach made a comment which got me thinking.  What he said was that in times of crisis, high interest rates do not make any sense at all.  You know, I think he has a point.

Normal investment logic dictates that where investments carry a high degree of risk, an investor expects a high degree of return or ROI.

The high risk/high yield theory does seem logical to an extent, until that is, you realise that a strange paradox is at work.  By expecting a greater rate of return on a risky investment, aren’t you making that same investment more risky and therefore increasing the likelihood it will go belly up?  An interesting thought, is it not?

Up, Up and Away!

In times of economic crisis, such as now for example, interest rates on lending tend to sky rocket.  Mortgage rates fly towards the stars.  But this is illogical.  In times of economic unrest, people naturally have less money to spend, or become more cautious about spending sums of money which require finance.

Moreover, by forcing those with finance, such as mortgage holders, to pay more, you are probably forcing them into the situation where they may have to default.  If they stop paying, the return on investment for the lender is at best reduced and at worst becomes a loss.  And displaced homeowners become discontent and will most probably cut their consumption radically.  Not having a home could make it difficult for some people to find jobs too.

Businesses fall into the same boat.  During crisis periods Banks become cautious, all of a sudden, and firms can no longer obtain overdrafts and other credit lifelines, or if they can, the interest rates are high enough to bring tears to the eyes of all but the most hardened of accountants.

What to do?

Basically lenders who want to at least receive their money back should lower interest rates, at least for a time.

Paradoxically, making higher payments is much easier when income levels are higher too, but the upstanding world of high finance does not seem to realise this.

I guess it does go against the laws of supply and demand which dictates that when something is in short supply and demand is high, the cost of the item desired goes up.

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With money, is that really the case though?  The quantity of money available is more or less finite – unless banks print more – so the quantity, or supply, of money stays the same as it was before a crisis erupted.  Demand for money, on the other hand, does not increase during crisis periods.

Theoretically, during a crisis demand for money is lower than supply – people and businesses refrain from investing when they feel that no worthwhile returns can be obtained or that there is a greater risk of losing a part, if not all, of their equity.  Consumption falls too.  Yet the cost of borrowing during times of recession increases.

Low Means Go!

In theory, seeing as demand falls below that of supply, according to the laws of economics, the cost of borrowing should fall, not rise.

If this happened, it would mean people and businesses could still borrow. This, in turn, would keep people in jobs and people in jobs consume more than those who are out of work.  They can save too, or invest!

High Means Bye, Bye Economy

Exorbitantly high interest rates cause businesses and individuals to go bust.  If people go bust, then a zero or worse, rate of return on investment is to be expected.

Lower interest rates mean than businesses people can keep on paying back loans and can keep investing.  OK, so the investor concerned may receive less, but he or she probably stands a much lower chance of losing, if not all, a large chunk of the initial investment.

Ah yes, you will mutter under your breath, but if investors know they won’t receive appetising returns, they will not be so keen on investing in the first place.  True, but if interest rates are lowered for 3 or 4 years and the loan period extended, the investor may well make more in the slightly longer term than if he or she had demanded that payments remained the same and risked causing the borrower to go broke.  The probability of losing money would fall – and a lower risk justifies a lower ROI.

A thought for the day – as Italy’s finance minister tries to come up with a way of resurrecting Italy’s dead in the water economy.

I’m sure someone will point out the error of my reasoning.

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