ShmoopTube

00:02

principles of finance a la shmoop a semi interesting history of interest

00:09

rates well some of this has already review for you people but it's so [Man discussing interest rates]

00:14

important to have an anchored understanding and risk and return that [Anchor falls from ship into ocean]

00:18

well we're gonna repeat ourselves like a bad episode of How I Met Your Mother

00:23

all right well here's the starting point yep the US Treasury bond you have an [The Fed building appears]

00:27

essentially risk list investment in bonds backed by the US government's

00:32

ability to tax its hard-working citizens ie if those bonds go bust while the

00:38

world has likely been nuked so we have bigger things to worry about [Woman appears from drain hole]

00:42

alright well those bonds in this example yield a whopping 10 percent yeah

00:47

different part of history you know that historically the stock market over

00:50

decade-long periods with dividends reinvested and maybe stupidly ignoring

00:55

taxes in the above calculations because of all they just cloud things for now [Taxes float by projector screen]

00:59

but historically the stock market's returned about 10 percent a year over a

01:03

long period of time but you also know the stock market's risky the US [Car drives off fiscal cliff]

01:09

government bond market is not so why on earth would you ever invest in the stock

01:15

market if you could get 10 percent return on government bonds way less [Car reverses from cliff edge]

01:20

risks same reward mm-hmm well if you were smart and had taken this course you

01:24

wouldn't invest in the stock market you would risk lessly

01:28

happily collect your 10 percent interest from government bonds paid twice a year

01:33

like all bonds and while you go golfing or surfing or skiing or basically [People golfing and surfing]

01:37

whatever hakuna is your Matata and interest rates have done some crazy

01:42

things in modern US history so take a look here's a chart yeah post-world War

01:48

two well here's what interest rates did and went up a whole lot and then then [Post World War 2 interest rate graph appears]

01:54

they came to down a whole lot that's what they did so what's happening with

01:58

that giant spike there well after World War two the world had incurred a ton of [Man stood by Bob's Plane Sales appear with Uncle Sam]

02:02

debt you know buying stuff to beat back the Nazis and to a lesser extent feed

02:07

back to Japanese it was a crushing amount of debt so if we didn't figure

02:12

out something clever the debtor nations were never gonna pay off their debts and

02:17

well then they'd feel bad but let's say that dad carried a five percent interest

02:21

and let's say inflation at the time was two percent well then the real interest

02:26

rate you were paying was three percent because the dollar got cheaper by a [Interest and inflation rates appear]

02:31

couple percent year after year and you had the same interest payment got it it

02:35

got two percent easier in a year to pay that five percent because while a carton

02:41

of milk went from being a dollar to being a dollar in two cents and a week's [Cartons of milk appear]

02:45

wages went from a hundred bucks to one hundred and two bucks that's a inflation

02:51

101-102 but what happens if inflation suddenly takes off and becomes eight

02:56

percent and well then the real rate of interest on those bonds five percent

03:01

debts is what well it's five minus eight and yeah that's negative three percent

03:07

that means the debt gets cheaper to pay off each year so if you're an in

03:13

detonation well your first ask of your government and their finance people is [Man ringing bell in Venezuela]

03:18

gonna be go get me some more of that inflation please

03:22

well the swing makes the debts dramatically easier to pay off for the [Girl on a swing]

03:27

Debt in nations and the load can be made very easy or at least easier for those

03:33

nations you know to handle so who does it screw over when we have high

03:36

inflation and fixed rate debt well the people who loaned the money in the first

03:40

place if a dollar used to buy a carton of milk and now with inflation it takes [Cartons of milk appear]

03:45

a dollar eight and week wages have gone from a hundred bucks to

03:48

a hundred eight while that debt gets a whole lot cheaper to pay off

03:54

and note there's a curveball in here we've denominated everything in dollars [Baseball thrown to boy with bat]

03:59

thus far but let's just imagine that the US loaned Britain a billion dollars to [The Queen and Uncle Sam sitting either side of cash]

04:05

buy weapons to go fight Hitler in his buddies

04:07

well they'd owe us their 5% interest in loans to them payable in dollars but what if we

04:14

wanted to be you know stupid nice strategic depending on how you view it

04:20

because the Brits did lose well half their strong young men and trying to [Boot tramples on Das Boot]

04:24

stamp out the Nazis so like come on give me a break

04:27

so what if we made our loans to them payable back to us in either dollars or

04:33

spot rate pounds you know the British currency that's the British Pound and [Muscley man walks to cash register]

04:39

spot rate this means that well on the spot if you stopped at a street vendor

04:43

or major commercial bank and asked for the ratio of dollars to pounds and they [Man at a desk of world currency]

04:48

quoted you a number like two dollars for every pound well that would be the spot

04:52

rate to convert your pounds into dollars so if we gave Britain the right to pay

04:56

us back in either pounds or dollars well then the Brits could in fact create [The Queen takes basket of GBP]

05:01

their own inflation sort of but how well think of the consortium of banks as

05:07

being the caretaker of the smores fire of love in the world they need to keep [Money thrown onto marshmallow over fire]

05:12

the flames burning just enough to singe the marshmallows which are fragile by

05:16

Nature anyway and not too hot to nuke them into charcoal raising borrowing [Marshmallow explodes and burns]

05:21

costs has in essence a multiplier effect and makes the cost of renting money

05:26

higher which in turn makes people buy less and certainly less things on credit

05:31

like homes and cars and stuff at the mall it's a cooling function when you [Man stood by Swarovski store]

05:35

raise interest rates got it lowering the cost of money does the opposite when the

05:40

cost of borrowing is almost free like it is today like with 2% government paper

05:45

people will be incentivized to borrow freely and they usually do if they did

05:51

borrow and buy a bunch of stuff and cars and homes well then the economy would [Man sitting in living room watching sports]

05:56

presumably heat up the vehicle that the US government uses to try and control

06:00

inflation is called the FOMC or Federal Open

06:04

Market Committee funk the easiest way to affect interest rates is to play with

06:09

the supply of money in the system more money equals lower interest rates and [Uncle Sam using laptop]

06:14

the reverse also applies just like jiggling the toilet handle the Fed [Toilet handle jiggled]

06:19

jiggles the money supply until it gets it to the desired rate or cost that it

06:24

wants for people to rent that money the Fed does this by buying and selling

06:28

Treasuries of which it owns a lot Grok this, yes if it's selling Treasuries

06:35

that means it's draining money from the system and pushing up interest rates got [Money goes down the toilet drain]

06:41

it it's collecting cash or liquidity out there so making money more precious if

06:45

it's buying well then it's using its cash and sprinkling it all over the

06:49

place and injecting cash or money or liquidity [Money waterfall appears down the stairs]

06:52

into the system well then interest rates will fall there's a lot more supply of

06:57

cash hole out there got it well most of the rest of the developed

07:00

world has more or less the same system so governments try to find middle [Dog on a toilet seat]

07:04

grounds and this is where history is a useful guide after World War 2 the world

07:09

was swimming in debt and there was an odd confluence of an overheated economy [Water in pan boiling]

07:14

driven by the manufacture of weapons and planes and well you know war babies lots

07:20

of inflation but the surviving Western government sort of shook hands and let

07:25

the inflation ride for a while to let debts get paid down more easily of most [Inflation walks into car]

07:31

dramatic interest was the inflation hitting in the middle of the Cold War

07:35

where Vietnam was the playground of new weaponry toys from both them and us well

07:42

Jimmy Carter was elected president in 1976 and the newspapers which were [Jimmy Carter appears]

07:46

actually on paper back then and not bankrupt decried stories of little old

07:51

ladies living in their cars because they had put all their savings and safe [Old lady in car with cats]

07:56

low-interest government bonds yielding 3% and inflation was prancing along at 7

08:02

or 8% a year well those little old ladies were forced to eat dog food

08:06

bathed in dirt and washed their clothes in the river according to the

08:09

journalists in the paper yeah well Jimmy wanted to stamp out this inflation [Inflation balloons and Jimmy Carter pops them]

08:14

nemesis lots of old people had voted for him

08:17

and so he leaned on the Fed to raise interest rates and it did and it did and

08:22

it did and it continued to do so for half a decade it was bad news for all

08:26

the dumb

Full Transcript