Interest rates are at historical lows and Mr. Bernanke has promised to keep them there for however long it takes to restore the health in the economy. This however, is precisely the opposite of what needs be done to restore the economy’s balance, and ultimately its health. Extremely low interest rates only encourage misallocation of capital and serve as an incentive to create debt. This policy is at the expense of thrift and savings. The way to solve a crisis of excess leverage is to reduce leverage. Seems pretty simple. In order to encourage a reduction of leverage, interest rates must go up, providing incentive to save.
Neither a borrower nor a lender be,
For loan oft loses both itself and friend,
And borrowing dulls the edge of husbandry.
Hamlet Act 1, scene 3, 75–77
Unemployment remains stubbornly high, at 9.6%. GDP growth appears to be tailing off after the effects of the various fiscal stimulus packages have run their course. Consequently, debate rages amongst policy makers and economists as to what can and/or should be done to help the economy. On one hand, we have the Keynesians led by the administration who suggest that more fiscal spending need be done to stimulate spending and overall economic growth. On the other side, we have the austerity folks, citing Rogoff and Reinhart, who suggest that the amount of debt now on the Federal balance sheet will permanently hamper growth.
Neither of these arguments is complete in and of themselves. This is because they look at traditional relationships between fiscal and monetary policy and economic behavior of consumers and business. However, in the wake of a massive credit crisis, which has not gone away rather merely stopped bleeding, consumers and businesses are not responding to fiscal and monetary policies in traditional ways. Current policies are punishing lenders through low returns on savings, and are not helping borrowers due to a lack of available credit despite the low rate environment.
Aggressive actions on the part of the Federal Reserve were critical in staving off what might have been a complete meltdown in the economy due to the credit crisis. Since, the initial crisis was averted we have seen very limited impact of Fed policies. Money supply is there, but demand is not. This can be seen from the chart above which shows money supply continuing to grow significantly. Unfortunately as the dashed line shows, the growth in money supply has been matched by a decline in velocity. In essence, the Fed has pumped over $2 trillion into the system, but it has largely sat on the books of the banks. To be sure, taking the Fed’s money at zero and lending it out either in the interbank market or in similarly short term money market vehicles is easy profit for banks that desperately need earnings, but the effect on the broader economy is minimal. Consumers who have seen the values of their homes drop 30% or more and who are concerned about their jobs are in no position to borrow, even if banks were willing to lend. Similarly, businesses who serve those consumers don’t see reason for expansion in an environment where there is already excess capacity in pretty much everything.
Mr. Bernanke has stated that the Fed stands ready to do whatever it takes to insure economic recovery. In fact, a recent study by the San Francisco Fed indicates that if there were no constraints on interest rate levels, the Fed would be justified in pushing rates significantly negative. Part of that means that Fed Funds are expected to remain at near zero for the next year at least. While flooding the market with liquidity was necessary for averting the crisis, it may have run its course as an effective policy. In fact, one might argue exceedingly accommodative monetary policy has done nothing to solve the underlying problems that created the crisis, and may be perpetuating the aftermath of the crisis.
Source: SF Federal Reserve
Another major problem with this excess of liquidity is that is penalizes thrift, and creates an environment whereby risk taking is inadequately compensated. Looking at the first point, with money fund rates at zero, where is the incentive to save? Currently, savings rates are at their lowest levels in 50 years. That is a great thing for borrowers, assuming they are in a position to qualify for loans. Currently 30 year mortgages are averaging 4.35% (per Bankrate.com). This means that a borrower with a $250,000 mortgage at a preexisting rate of 6% could refinance at a monthly savings of $254, which amounts to lifetime savings on interest payments of almost $90,000. The problem is, of course, to qualify for this loan one needs a 20% down payment or equity in their house. Given what has happened in the housing market, those borrowers are less prevalent than they used to be, and they aren’t the distressed consumers that we are trying to help anyway. Here as with many things that have been attempted on the policy front, we are using the wrong tool to address the problem. Low rates don’t help those who can’t get them.
Additionally, the low rates are creating another type of crisis. That of inadequate return on savings. This is especially true for retirees, and those who rely on interest income for their livelihood. The average return on a 6 month CD is 0.81% (per Bankrate.com). This means that the interest generated on a $1 million savings account is a mere $8100 per year, hardly enough to live on. The administration has talked about its concern for the decimation that took place in the 401k retirement savings of Americans due to the stock market declines. But how about the damage being done, but virtue of inadequate returns on fixed income savings.
Low returns are creating a conundrum for investors. Clearly as can be seen from fund flows out of equity funds and into bond funds, individual investors don’t trust stocks and are concerned about return of capital. Equity mutual funds continue to see outflows while bond funds surge. Money market funds pay nothing, so investors are forced to either go out the yield curve or invest in higher yielding more credit sensitive types of securities in order to achieve any type of return. In essence, we are once again punishing thrift and rewarding borrowers. This transfer of wealth is a long term burden that prevents a return to a balanced healthy economy.
St. Louis Fed President Bullard has proposed a return to at least somewhat higher interest rates. His logic has to do with economic equilibrium between inflation and growth, which at zero rates creates a deflationary cycle. I would add an additional benefit to this logic, and that would be an incentive for savers to invest and borrowers to spend efficiently. Curing the ills of the housing market can better be achieved through a combination of time and prudent fiscal policies. Mortgage restructuring, while not the be all and end all, addresses the problems of those who are in the most distress. Low rates don’t help those folks. This process takes time, however. As Mr. Bernanke pointed out recently, central bankers can’t control everything. Put rates back to non crisis levels, and leave the economy to its natural pace of restoring health. We spent ten years digging the hole the economy now finds itself in, it will take a while to fill that hole back in. Providing incentives for saving/deleveraging, while assisting those in need through directly targeted fiscal policies is a much more efficient recipe for long term health.
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