How do interest rate policies (too low or too high) affect financial stability?

Okay, let's talk about this.

You can think of interest rates as the "price" of money in the entire economic system. Central banks (like the People's Bank of China in our country, or the Federal Reserve in the US) are the ones who regulate this price. Setting this price too high or too low can trigger a series of chain reactions, sometimes even leading to big trouble.

Interest Rates Too Low: When Money is "Too Cheap"

Imagine what would happen if the faucet in the market was constantly open, with water flowing everywhere? Interest rates being too low is a bit like that situation.

1. Asset Bubbles:

   • What happens? The cost of borrowing money is extremely low, making both businesses and individuals feel like "it's a no-brainer to borrow." So, what do they do with the borrowed money? Many will invest it, for example, by buying houses or stocks. When a large amount of money floods into these limited assets, their prices are quickly pushed up, far exceeding their intrinsic value. This is an "asset bubble."
   • For example: Suppose you find that the loan interest is even lower than the rental yield from a property. You're very likely to take out a loan to buy several properties to rent out or wait for appreciation. When everyone thinks this way, housing prices will skyrocket.

2. Excessive Risk-Taking (More "Suicidal" Behavior):

   • What happens? Because the returns on safe investments like normal deposits and government bonds are too low, almost negligible. To make money, financial institutions like banks, as well as ordinary investors, are forced to seek higher-return projects. And high returns often mean high risks. People start investing money in less reliable companies or participating in complex financial derivatives trading.
   • The result? The entire financial system's risk appetite is "nurtured" to grow larger and larger, like a snowball, rolling bigger and bigger, accumulating more and more risks within it.

3. "Zombie Companies" Prolonging Their Lives:

   • What happens? Some companies that should have gone bankrupt and been eliminated by the market manage to "survive" because they can easily borrow new debt to repay old debt. They don't create value; they merely consume social resources, but the low-interest-rate environment allows them to linger.

In summary: Interest rates that are too low are like giving the economy a stimulant. In the short term, everyone can borrow money, asset prices rise, and there's a sense of prosperity. But this prosperity is false, and the bubble could burst at any time. Once, for some reason (such as high inflation forcing the central bank to raise interest rates), this "faucet" is tightened, asset prices will plummet, and highly leveraged individuals and institutions will instantly go bankrupt, triggering a chain reaction that could ultimately lead to a financial crisis. The 2008 US subprime mortgage crisis, at its root, was closely related to the long period of low interest rates preceding it.

Interest Rates Too High: When Money is "Too Expensive"

Now, conversely, imagine the faucet being turned too tight, with hardly a drip.

1. Economic Hard Brake, Even Recession:

   • What happens? The cost of borrowing money is too high. Businesses wanting to expand production look at the loan interest and decide against it, even resorting to layoffs to cut costs. Ordinary people wanting to buy a house or a car hesitate when they see the monthly loan payments.
   • The result? Overall consumption and investment activities in society will be suppressed, and the economy will lose vitality, like a car speeding along suddenly hitting the brakes hard, easily leading to economic recession and rising unemployment.

2. Debt Default Wave:

   • What happens? For companies and individuals who have already accumulated significant debt (especially floating-rate loans), a surge in interest rates is fatal. Their repayment pressure suddenly increases dramatically, making it very easy for them to default.
   • For example: A company that originally needed to pay 10 million in interest annually would see its interest expense double to 20 million if interest rates doubled. This could directly crush the company's cash flow, leading to its bankruptcy.

3. Financial Institutions in Distress:

   • What happens? When a large number of businesses and individuals cannot repay their loans, who suffers first? Of course, it's the banks that lent the money. Banks' non-performing loan rates skyrocket, and their asset quality severely deteriorates. If the situation is serious, depositors, fearing bank collapse, will frantically withdraw their money (this is a "bank run"), which could cause a bank that was merely "sick" to "die."
   • The result? The collapse of one bank could trigger panic about the entire banking system, leading to wider financial instability.

In summary: Interest rates that are too high are like giving the economy a sedative, and an overdose at that. While it can effectively curb inflation (because money is expensive, people stop spending), the cost can be economic stagnation and recession, and it can detonate existing debt problems, similarly threatening financial stability.

Conclusion

So, you see, interest rate policy is like walking a tightrope.

• Too low, it inflates huge asset bubbles, encourages dangerous financial games, and may end with a spectacular "fireworks display" (financial crisis).
• Too high, it "freezes" economic activity, leading to business failures and increased unemployment, and can also detonate debt bombs.

Therefore, the goal of monetary policy is to find that "just right" balance, allowing the price of money to both support healthy economic growth and avoid fostering excessive risks. But this tightrope is truly difficult to walk.