Recently some commentators (Blu Putnam at CME and Mike Shedlock at Mish) have started using a couple of words I have been thinking for a long time with respect to our economic overlords at the Fed. Those two words are linear thinking. I am surprised that for such supposedly smart people – I mean they have all the right credentials – their thinking seems to lack any depth. With masses of PhDs at their disposal they must be aware of what they are doing right?
In normal times, when credit availability and its price can act as a constraint on economic behavior, the classical Central Bank thinking is that lowering rates can spur economic activity. It works in a couple of ways. Business people who are evaluating potential returns on business investment use a discount rate to deflate future cash flows to a value today. When that rate is lower, future cash flows are worth more in today’s dollars. If the discount rate is 0% then future dollars are worth the same as dollars today. And if rates were negative, then future dollars would be worth MORE than dollars today. That is of course the core of the concept of the time value of money, something we will have more to discuss later. Secondly, rates serve as a benchmark against which to measure that return. For example, if an investment is expected to return only 5%, then why go to the hassle of building a business if you can obtain 5% by simply buying a 5 or 10 year treasury note, whatever the case may be.
From this logic, our well educated monetary mandarins have smartly deduced a rule – lowering rates increases business activity. But central banking is an inexact science. No one can know at any given time what the right rate is to spur activity in a dynamic and large economy with lots of international trade links such as ours. So if lowering rates some does not work to increase activity, as the case now seems to be, then perhaps lowering them more will. But therein lies the rub. At some point (which was mostly theoretical prior to the dawn of this century), you approach 0%. Free money. The so called Zero Lower Bound. Why is it a lower bound? Because in every book, tract, treatise and bedtime story from the dawn of man until now, the concept of the time value of money was presumed to mean that a unit of value now is obviously and always worth more than one at some future time. This flows from the fact that the future is uncertain and also that the moral fabric of western civilization (and probably most others) is woven with the thread of the concept of delayed gratification and the idea of saving. It also flows from the last century’s increasingly frequent experience with inflation, especially after we went to a fiat monetary system.
But what if there were persistent deflation? Well then money in the future would be worth more than money now. It flies in the face of all that is holy. It also creates an incentive to hoard money, to put it in the so-called mattress, which of course only makes the situation worse; the old deflationary spiral ensues. So now some bold economists, dark robed academicians all, are starting to try on the idea that maybe the zero lower bound is not a barrier after all. That is what the academy is good for after all, trying on outrageous ideas that fly in the face of conventional thought. Like the argument about the existence of the number zero, there is a fight brewing. Hopefully it will not result in the death, dismemberment or excommunication of anyone from the economic priesthood.
Several European countries and the ECB as well as the Bank of Japan have put negative rates in place. They have also bought so many of the sovereign and now corporate bonds in the secondary market (wink, wink) that more than $13 Trillion worth of bonds trade at negative rates (or did until last week). Of course, by buying up so much debt the Central Banks have apparently unwittingly reduced liquidity in the system because all that debt acts as collateral in the money dealing systems of the world. (Try Googling Repo Fails or just go here.) Nevertheless, in remarks after the Jackson Hole Fed Confab recently the Vice Chair of the Fed suggested that the negative rate experience was fruitful and positive for them. I wonder. (Fischer said “…Well, clearly there are different responses to negative rates. If you’re a saver, they’re very difficult to deal with and to accept, although typically they go along with quite decent equity prices. But we consider all that, and we have to make trade-offs in economics all the time, and the idea is, the lower the interest rate the better it is for investors.” Umm yeah, except trade-offs in economic outcome are supposed to be made by ELECTED officials Mr. Fischer. Were you elected?)
If I could have a friendly argument with Stan Fisher, I would argue that the zero bound and negative rates are qualitatively different from an ordinary positive rate regime and that the movement down from some positive rate to a lower rate is not the same as a move to zero or below. And the cloistered econometricians at the Fed and elsewhere must be aware of the ramifications or we are not getting our taxpayer’s money worth.
As Bill Gross has said, negative rates turn assets into liabilities. Except that is not strictly true. First, again, if inflation is negative then if negative rates on a debt instrument are less negative than inflation a person still comes out ahead in terms of future purchasing power. Real rates (nominal rate minus the rate of inflation, which means if inflation is negative you ADD the second number to the first, moving to the right on the number line) are still positive. And this is what the economists at the Fed are getting at. In order to provide the amount of monetary accommodation they have in past crises, they would need to be able to drop rates 300-500 basis points. Well if they did that from the current level of 35-50 basis points where fed funds and IOER are now, that would mean rates in the neighborhood of -3 or -4%. Now like Y2K, nobody knows what that would do to the world. At which point in the conversation it is appropriate to just make a list of who gains and who loses from such an outcome.
First off to lose are savers and retirees. Having saved money for retirement, getting no interest to live on means they will be living on their capital. Unless there is actual deflation, they risk running out of money before they die or at the very least seeing their standard of living be lower than anticipated. Savers in such a system of financial repression (Like in Monty Python’s autonomous collective scene in The Holy Grail “Help, help I’m being repressed. Come and see the repression inherent in the system!”) will have less income to spend and this will reduce their aggregate demand for goods and services. Surely the Fed is aware of this but has concluded that the spur lower rates give to business investment more than offsets the loss? Which might be true if the availability of cheap credit were truly a constraint. But in the current crisis, it is likely that the elevated levels of debt already in existence at all levels (corporate, government and household) as well as poor demographics are more important. Also likely more important is the smothering presence of governance in all spheres of economic activity.
Neal Kashkari talked about the demographic challenge recently and Yellen has briefly nodded to it in post meeting questioning or congressional testimony briefly on a couple of occasions. It may be that they are unwilling to feature these issues in public discussion as they are intractable, do not lend themselves to monetary solutions and might inspire panic or at the least spoil the narrative of their political masters. It is always better to face problems than pretend they do not exist and kick the can down the road, but in our political systems kicking the can is what you get.
Another dynamic with respect to savers, as featured in comments by people like Jeff Gundlach and others, is that by depriving savers of interest income, you actually make the job of saving harder, so rather than going without, prudent savers must conclude they must save MORE, further depressing consumption and aggregate demand. But again the Fed must have figured this into their swollen antiquated econometric models right?
Second in the list of losers are pension funds and insurance companies. These entities have baked certain assumptions about returns into their business models regarding the returns necessary to meet their future liabilities. If those assumptions are too high, that means that pension funds will need much higher present contributions to meet future payouts or they will have to reduce payouts. Recently Bruce Rauner , the governor of Illinois, practically went ballistic when one of the state funds proposed reducing their assumption by a mere 50 basis points from 7.5% I believe to 7%, for it meant the state would have to come up with hundreds of millions more dollars to plug the gap. Of course in the real world they would have reduced their assumption by much more because they will be lucky to get anywhere close to 7% in coming years. Insurance companies will simply go out of business when they fail to be able to pay insurance claims and annuities. The whole retirement industry will stop at some point and an entire way of life will have ended.
Banks are probable losers. The bread and butter model of banking is to make more on loans than you pay in order to have money to lend. Being able to lend many times your deposit base helps, but a flat yield curve hurts bank earnings. Nobody can say what happens if banks pay people to take loans. If they get paid to raise money through deposits by charging people to hold their money in savings accounts instead of paying them interest, or they get paid even more to borrow in wholesale markets than they pay to make loans then maybe the system can continue. Seems pretty farfetched though. In a deflationary world, people may come to accept that getting less back than they deposited is ok. Then again, maybe not. As Gross also said, a world of negative rates is not a world in which capitalism can operate.
In general, debtors gain from negative real rates and lenders suffer.
Who are the biggest gainers? Governments of course, which is why there will probably be a push to go negative in the future. The US, Europe and Japan all have liabilities that they will never be able to repay. They must undertake some method of default. Straight default is onerous and unseemly with negative consequences for funding ongoing operations like wars and entitlements to buy votes. Inflating debt away is the tried and true method historically. Hence Keynes dictum observing Lenin: “There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency [inflation]. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million can diagnose”. This is of course why Gold, which as this century dawned (only 15 years ago or so) was selling for under $300 an ounce has ramped to $1900, and after a few years of consolidation is still well above $1300 and rising.
Corporations are the other major beneficiary. Those who can borrow for free or nearly so (some better than free now as they perversely get paid to borrow) have been able to keep their executive stock option treadmill running nicely by borrowing to buy back stock which has the effect of increasing earnings per share and enriching themselves while those not on the option treadmill get nothing in the way of wage increases. This has the effect of widening the gap between the rich and the poor and stoking dangerous populism.
On the positive side zero or negative rates makes corporate dividends look good by comparison and fosters movement from the lower left to the upper right in stock markets. This keeps Wall Street and its denizens happy, while helping Main Street but a little because it has a salutary signalling effect to businesses and helps pension plans holding equities as well. It also means that once fully priced, the future returns to equities are baked in the cake and low. And as all that corporate borrowing has gone to repurchase their stock (there are only 3600 stocks or so in the Wilshire 5000 now) and not into productive investment, it is likely that future earnings per share will have a hard time increasing sufficiently to support extended valuations. That sets up a future potential disaster if rates ever do rise for any reason, in which case stocks would simply crumble. Hence the idea that the Fed has painted itself into a corner. Rising rates hurt stocks and also bankrupt governments. That is one of the more pernicious effects of Central Bank rate suppression, that governments have not had to exercise any spending discipline or risk credit retribution. That may be fine after fighting a world war against fascism but what have we bought for it today?
Of course one important unanswered question is whether rates are lower than they otherwise would be in the absence of all this central bank activity? What would the natural levels of rates be under current economic circumstances? No one knows. But one can hypothesize about effects. Having the Fed or other Central Banks affect rates is a form of price fixing, where the price is the price of money. It is the most basic economic truth about price fixing, demonstrated over and over again in the real world everywhere from Nixon’s wage and price controls in the 1970s to Venezuela’s utter mismanagement of their economy currently, that where a price of something is fixed below where the market clearing price would be, the result is a shortage. This implies that if the price of credit is held lower than its market clearing price, there will be a dearth of credit. Certain measures of lending in the US imply that this is not the case, as lending is through the roof. I do not pretend to know the answer.
Of course the reverse is also true. A price fixed above its market clearing price would result in a surplus. Were this the case it implies that there is too much credit available. This fits with the argument about misallocation of capital more congruently, but again I do not know the truth. What I do know is that our experience with price fixing boards has resulted in stamping them out for the distortions they introduce. Why we have not done this with the most important price fixing board that still exists (the Fed) is a mystery, as the economy would almost certainly work more efficiently at producing the optimal level of aggregate wealth in the economy without their interference.
After all there is simply no way they can have any idea what the right price for credit is, as they have amply and repeatedly demonstrated. Which means that at ALL times the economy is working under a distortion that means the quantity of credit is either in surplus of deficit. In the long run that cannot be the optimal configuration. Hence we must conclude that the right course of action, as it has been with all other price fixing boards, is to wrap up their business and wind them down. Misallocation of capital is the result of fixing the price of credit incorrectly. Such misallocation lowers the long run aggregate wealth of the economy.
The simple truth is that the behavior of markets and businesses and the economy does not respond to manipulation of rates in a linear fashion as one drops them toward and through zero. Zero and lower is wildly different. If we cannot do away with the Fed altogether, and that seems unlikely, given the inertia the idea of having a Fed has, at the very least it would be nice if the members of the Fed had enough humility not to impose a negative rate regime on the US economy. I am not holding my breath.
If they do usher in a negative rate regime upon commencement of the next crisis, there is one predictable effect. If rates are significantly negative, more negative than the benefit of having ones money held for them in an institution, people will simply store cash at home. To avoid this problem, people like Kenneth Rogoff, who had previously done a great service by writing “This Time is Different”, before going insane in pursuit of aggressive Statism, would have the government do away with cash altogether. Such an arrangement, mandated by law, would represent a dangerous limitation on the liberty of the individual. If all money were required to be recorded digitally and subject to oversight and manipulation (mandated negative rates for holding cash in the bank ledger) by the authorities, in order to encourage spending and penalize thrift, individual sovereignty would be the biggest loser of all. That is a result that would represent a Rubicon-type watershed and would be grounds for revolutionary pushback by the afflicted, meaning everyone. Tragedy indeed.