I repeat: The Fed’s Permanent Zero rate policy is toxic

Here’s my position on Bernanke’s rate easing: in conjunction with Obama’s attempts to revive mortgage lending for underwater homeowners, it can definitely give a good kick to the economy. rates will be lower and that actually drains interest income out of the economy. But if those lower rates translate into huge refi activity, then they turn from a drain to a huge stimulus fill-up.

Here’s what I said about rate easing and permanent zero last August:

What the Fed has done is told us it would keep the Fed Funds rate at effectively zero percent through mid-2013, two years from now. This is one step short of ‘rate easing’, the term I am using to describe a Central Bank’s targeting a specific non-policy rate, a form of quantitative easing where the Fed targets price instead of quantity.

While rate easing and its cousin permanent zero might have some salutary effect in the short term, these policies are toxic to the financial sector and consumption demand. Likely, they will not spur the economy but lead to a deepening malaise.

Why Permanent Zero is toxic and leads to depression

Basically, low rates steal interest income from savers and fixed-income investors and give it to borrowers. It’s as if the Fed reached into your pocket and stole money from you and gave it to the over-leveraged guy down the street drowning in a mountain of debt. Clearly, that’s what moral hazard is all about (and so I don’t advocate the Fed’s zero interest rate policy).

Here’s the thing though. If more borrowing doesn’t occur, it is a net drag on the economy. Since we know that loans create deposits, which end up increasing reserve balances – not the other way aroundlow rates are entirely dependent on the demand for credit not on the supply of credit.

If President Obama is socialising mortgage losses ahead of the November election via what are effectively cramdowns at Fannie Mae and Freddie Mac then you are going to see some serious refi activity from underwater borrowers. That’s bullish. And that’s what my weekly post was all about.

More at Credit Writedowns Pro. But remember, households are still over-levered and interest rates cannot be stimulative since they are zero percent. When the next recession hits and the yield curve is still flat as a pancake, bad things are going to happen. That’s why I have to remind you how toxic this policy is.

Permanent zero can work over the medium-term if you get refis but longer-term, the economy is dependent on wage and employment growth and monetary policy doesn’t drive that.

  1. Deschain says

    Given that you say this

    > low rates are entirely dependent on the demand for credit not on the supply of credit.

    Shouldn’t your title be

    “The Fed’s Zero Rate Policy Reflects a Toxic Economy”

    1. Edward Harrison says

      No, low rates subsidize debt accumulation which creates systemic risk and leads to financial crises. If the Fed promotes anything, it should be savings.

      1. Deschain says

        But isn’t one person’s savings just another person’s debt?In other words, low interest rates keep the cost of our expanding national debt down. But somebody owns that debt – in other words, they saved to accumulate it.I view debt accumulation as a symptom of some other imbalance. Like:trade imbalances
        income inequality
        aging population (declining labor force as percent of population)Basically you have some part of the population that is subsidizing some other part of the population. That subsidization can come in one of three ways: (1) taxes (2) outright inflation (3) debt accumulation + financial repression. (1) is (usually) a tax on income while (2) and (3) are taxes on wealth.

        To put it another way – do we really want the Fed to be promoting savings right now? Isn’t the problem that we actually have massive overcapacity relative to our ability to consume, because we’ve suppressed wage growth among the portion of the population with a high marginal propensity to consume (all the income growth has been among the high marginal propensity to save crowd)?

        1. Edward Harrison says

          We should not encourage debt accumulation now. It will lead to a bigger bust down the line. The Fed should ALWAYS promote household savings. Moreover, it’s simply not true that private sector debt accumulation has anything to do with imbalances. It has everything to do with credit growth and easy money.

          1. Deschain says

            If debt is piling up somewhere, assets are piling up somewhere else. Right? They have to be. There is a big difference between a society where everyone is saving 6%, vs. one where the top 1% of the distribution is saving 30% and the bottom 99% is saving zero. The total net savings rate is the same but one society likely has much higher total gross private debt out than the other.

            Money is only easy when there’s a lot of it lying around looking for a home (because it’s not being spent).

          2. Edward Harrison says

            That’s an incomplete understanding of the situation. If the assets supporting the debt do not have the anticipated cash flow required to support the debt, it is irrelevant whether the assets exist. This is how all financial crises happen and the key elixir making it happen are unusually low nominal rates of interest and the allure of easy capital gains both by borrower and lender.

            Bottom line: excess credit growth creates what Minsky calls Ponzi finance and that leads to crisis. You have to write down the debt to a sustainable level that is dictated by the cash flow of the assets to which that debt is secured or the crisis will never end.

          3. Jesse_Fan says

            “You have to write down the debt to a sustainable level that is dictated
            by the cash flow of the assets to which that debt is secured or the
            crisis will never end.”

            Or you could increase the cashflow of households that are debt ridden, so that they can pay down the debt with devalued dollars.

            This would mean broad wage inflation through progressive fiscal policies. Yes this would mean savers would get hurt, but losses will be acknowledged slowly over time.

            I don’t see why “writing down the debt” is the ONLY solution Ed.

          4. gaius marius says

            correct me where i’m wrong, fellas. this comes down to the fact that sovereign “debt” in a fiat-floating-exchange-rate currency setup is not actually debt as commonly understood. if the government spent into existence the sum needed to retire excessive private sector debt, the bust would be over with the private sector debt overhang removed. that would be tantamount to a systemic jubilee, and is an inevitable thing — whether it’s done over a week or twenty years (a la japan), public deficits will by definition be the only vehicle for creating the private surpluses that are required to retire excess private sector leverage.

            even if we engage a deflationary writedown/bankruptcy cycle to destroy assets and capital, rapidly shrinking the national balance sheet as in the early 1930s, the rebuilding of capital is still going to require private surpluses and therefore public deficits — indeed moreso, as viable businesses are sure to be flushed along with the overlevered in such a scenario. the writedowns in aggregate only reallocate the losses and exactly who must run the surpluses.

          5. Edward Harrison says

            Just to add to what you and Jesse are getting at, we are looking at debt/income, debt/cash flow and debt/GDP ratios and making determinations of individual and aggregate creditworthiness. Sometimes these determinations are wrong. In a Ponzi phase of the secular credit cycle, they are wrong on a systemic level that causes a financial crisis and depression. the question is how to get out of the crisis.

            I see four ways to get there that either increase the denominator (income, cash flow, GDP) or decrease the denominator:

            1. by paying down debts via accumulated savings.
            2. by inflating away the value of money
            3. by reneging in part or full on the promise to repay by defaulting
            4. by reneging in part on the promise to repay through debt forgiveness

            What we want to see is the first way to debt reduction. But the debt overhang after a Ponzi phase is too large for that to be effected ina quick and politically sustainable way. The other three ways will have to come into play to varying degrees. In this crisis, we have a ways to go.

          6. Anon123 says

            But your whole premise is flawed at the very first step: that accumulated savings “pay down debt”.

            They don’t, they increase debt elsewhere in the current economy. So your “solution” achieves the exact opposite of your intent.

          7. Anonymous says

            If an individual pays down their debts then eventually they become debt free and then any excess income is available to save or spend. The problem is that if everyone does it the paradox of thrift is invoked. Overall spending falls, and the economy suffers. That is why either corporations or the government offset this fall in overall spending until the economy rebalances and debts are at a level that can be supported. This is why Japanese sovereign debt has increased over the last twenty years. The only long term solution is to ensure that savings do not fall too far and that debts do not grow to large. Both Keynes, Minsky and Hayek realised this. The problem is that governments actually encourage such bad economic behaviour because in the short term it benefits them and the downsides are in the future. Banks lobby for it because it means a boost to short term profits and their bonuses. So while individual savings can lead to increased debt elsewhere that depends on if the government are willing to borrow to fill that gap. If not the economy shrinks to cover for that increased savings. That is the impact of austerity by governments failing to offset the savings of the private sector.

            So paying down debt only increases banks funds. If they are not borrowed again then the overall level of debt falls. Though it also reduces the total spending of the economy, that is why a zero interest rate policy is toxic. It only creates more debt when the problem is excessive levels of debt. Debt levels are so high that they are unsustainable. So debt repayments are in the short term transferred from one sector to another. That is why government deficits are increasing.   

          8. Edward Harrison says


          9. gaius marius says

            exactly. private sector leveraging is an instrument of recovery, as borrowed money becomes someone’s income. but accumulated debt is inherently destabilizing when new loans are predicated on cash flows which are themselves predicated on new loans (ie, minsky’s ponzi finance). and so, post-bubble, we are returning to asset values (and corresponding underlying debt levels on the national balance sheet) discounted to sustainable cash flows.

          10. Mailart says

            Do you call food stamps and welfare an asset?  This is just thowing money down a rathole but the debt still remains.

          11. Deschain says

            Exactly the point – it’s not an asset (though, the recipients would argue with your characterization as well).

            The loss has already happened. Right now it’s about fighting over who has to take it. And yet as long as wage growth remains compressed through policy choices, consumption will continue to have to be funded by taxation, be it through regular taxation, inflation, or financial repression. Or we go full on Great Depression II.

            The jubilee comment above is dead on – that is the process of forcing debt owners to recognize the loss. The way you’ve proposed is just the government creating a lot of extra money to give to debtors, which dilutes current wealth holders in favor of current debtors. However, that just corrects the stock problem; we also have to correct the flow problem, which is a function of depressed wage growth, or we will just round trip the process.

          12. Anonymous says

            The Fed abandoned worrying about domestic savings because it could get cheaper Chinese savings. As a result the US economy will have to undergo the paradox of thrift until domestic savings are at a level that individuals feel safe with. Only then will consumption grow. If savings had not being decimated by previous low interest policies then there may have been no bubble and there would not be a delay in rebuilding the economy as savings are rebuilt and debts paid off. 

  2. Deschain says

    I would summarize it this way: panics happen when savers realize the loans that they thought had been invested, were in fact consumed, and thus can not be paid back. The loss has already occured; the panic is just about realizing it.

    When you look at our increasing sovereign debt – or Japan’s for that matter – obviously the significant majority of those dollars are going directly into consumption (SS, Medicare, unemployment, etc.). The debt is being funded by savers – people whose consumption has been sated (relatively).

    Low interest rates are all about making that feasible (so that interest costs do not rise and swamp the government). The Fed may not even realize that’s what they’re doing, but that is what they’re doing. Taxing savers to enable consumption. (That’s if you assume it’s actually the Fed setting interest rates, vs. the Fed marginally influencing the market which is really set by supply and demand.)

    I tell my wealthy conservative friends, if they don’t like deficits, stop buying the 10 year at 2%. (And stop investing in institutions that do that.) Stop voluntarily accepting financial repression. That would force the government to either (a) tax, (b) outright inflate, or (c) practice austerity (with predictable depressionary results.)

    The only way out of the trap is to rebalance incomes (via a combination of tax, labor, trade, and regulatory policies). That will (a) allow growth in consumption that is not debt financed, and (b) reduce the amount of savings available from the wealthy (ie savers), which will naturally cause interest rates to rise.

  3. Anonymous says

    Edward, your statement “low rates steal interest income from savers and fixed-income investors and give it to borrowers” indicates that these rates are “artificially low”..another statement you made.  What is it about interest rates that should be guaranteed?  Why are higher rates more natural than low rates?  Why shouldn’t savers be required to actually invest and recycle those savings into the real economy rather than receive a guaranteed high rate of risk free return? 

    Dollar savings, IMO, by definition, earn 0 return.  It’s the act of investing them that earns return.  

    What is your take on this?

    1. Edward Harrison says

      Your part at the end is MMT’s position and it has some merit. Basically the return from bonds is like the return from a savings account while currency returns are like the returns from traditional checking accounts, which are zero. MMT’ers argue that rentiers don’ have to have a “guarantee on their dollar-based risk-free return; that is a gift from government.

      I don’t agree with this 100% because my main problem is that interest rates are controlled by the Fed through and this affects the allocation of capital and the demand for credit. I don’t think any central planner can make these kinds of decisions without distorting the economy – and the bias will always be toward excessive credit creation. So I can’t really say that rates are artificially low although I suspect they are.

      1. Anonymous says

        Right.  The problem is in determining the “market rate” of interest.  In times like these, I rather think the interest rate would move hyperbolic in the other direction:  up, because banks don’t trust each other, so the price would skyrocket.  This is, in my opinion, a flaw in the Austrian ideology.  If you know any literature on the subject, I’d be interested in reading it. I’m not sure how they overcome this objection. 

        But anyway, if you can’t trust the market price, the 2nd best option is to allow the monopoly issuer of reserves to set the price. The other way to look at it is that this IS the market rate, because the system has so many reserves –not necessarily from FED QE (although that helps), or because the Fed set the rate there, but because banks are necessarily hoarding, so that they eventually reach the point where they don’t need any more and won’t lend them out.   

        1. Edward Harrison says

          Good post. That’s the problem in any crisis, determining how to prevent panic from taking over and causing the market rate of interest to skyrocket. Ultimately, the lender of last resort role is to step in and provide liquidity at a penalty rate i.e. at a rate in excess of the prevailing rate before crisis began but low enough for solvent entities to remain solvent. That is very much art and not science.

          1. Anonymous says

            But that is why Congress created the FDIC. If a bank failed it would seize the banks assets and make depositors whole again up to a limit. That moral hazard is being subverted by the zero interest policy especially when they can park that money at the Fed for 3%. So why is the FDIC only closing small banks and not the big 19 who at the start of the crisis were all deemed insolvent by Nouriel Roubini? Political clout is probably the main reason. 

        2. ChrisBern says

          Why are high (or even hyperbolic) interest rates a flaw in the Austrian ideology?  Keep in mind Austrians have no problem suffering short-term pain in the form of recessions–it’s (ostensibly) all of the more prevalent and mainstream ideologies that try to avoid recession at all cost, which simply adds more and more stress to the system until it blows up one day in a big way. 

          So back to the initial point, if banks don’t trust each other and extending further credit is viewed as risky, interest rates SHOULD be high!  If that means a few months or even a few years of credit and economic contraction before things settle back down again, so be it.  Avoiding these natural cycles as the Fed has done since at least the late 80s is playing with fire in a serious and unpredictable way IMO.

          I’m not Edward but as for further reading on how to achieve robustness in an economy, I would highly recommend the Black Swan Of Cairo (https://fooledbyrandomness.com/ForeignAffairs.pdf).

          1. Anonymous says

            ChrisBern.  I might agree if I saw any evidence that the market “would” return to normal.  What if it doesn’t?  What if the unimpeded market never reaches an equilibrium or the equilibrium it does reach is to cut off nearly all investment?  Furthermore, why is it that “a few months” or “a few years” of “short term pain” is necessarily superior to what we have now?  The reason I say it’s a flaw is because there’s no way of knowing, IMO, what the end result will be other than blind faith.   That’s all for now, will look into your link…

          2. ChrisBern says

            Has a market ever not eventually returned to normal?  High interest rates will begin to attract investors (and/or new lenders) at some point, which will begin to drive the interest rate back down.

            I see your point on short-term pain versus what we have now (muddle-through), and which is preferable.  That one we’ll have to wait and see on I think, for any evidence at least.  It’s my belief that we are adding more and more instability to the system with each passing year.  Hardly anyone is asking how  central banks are going to unwind their balance sheets, but that’s a critical question and there isn’t an obvious answer.  The private sector has practically no options to save (ZIRP) or invest safely, which is especially punitive on retirees or near-retirees.  Governments have very little, if any, room to deal with the next downturn, much less crisis.  Assets in developed nations are generally valued too highly because they have too much associated debt and too few cash flows underlying them, and this will continue to be a clog in the system (retarding new lending among other things) until assets are allowed to reach their natural price. 

            Nothing has changed systemically from 2008 other than a lot of private debt got moved to the public balance sheet.  Moral hazard and TBTF are more real than ever.  Market imbalances were never allowed to correct.  To me it’s difficult to say what will cause the next big bust–Europe’s certainly a contender!–but I’d be surprised if it’s more than a a year or two away.  And that bust will be a nasty one compared to 2008.  Just my opinion and I hope I’m wrong.

          3. Anonymous says

            I regard myself as a Keynesian but do not see issue with Minsky or Hayek’s views. Small recessions clear out dead wood in the economy. We need them so intervention to eliminate their effects is misguided. The Fed lowering interest rates to keep employment up meant that it sustained mal-investments. These investments should have been allowed to fail as capitalism would normally have done. Economists and governments have serious problems. Monetary policy can only go so far. Fiscal policy is also required, and that is why the growth in the US is in spite of policy not because of it. Low interest rates are stopping the housing market reaching its floor. Without a floor first time buyers will be reluctant to buy with a serious risk of further falls. The world needs higher interest rates to enable investors to be more selective of where they invest. Any idiot can borrow at 0.25% and make easy profits from any investment. Higher interest rates mean that companies will have to offer returns higher than interest rates to maintain share price, that or offer higher dividends. What higher rates will do is make sure that investments generate higher returns than the cost of capital which can be the internal rate of return. That reduces mal-investment. Higher rates will slow asset bubbles and reduce systemic risk, as low capital gains will mean banks will seek bigger deposits and better repayment plans. This will reduce risks for banks, customers, governments, central banks and society. All this has been lost since Monetarism took hold over economics. 

  4. Anonymous says

    Nice discussion and ideas.  I note “themightgin” point of why should anyone get interest for “risk free” parking of money -its a thought I have often had. Despite nil interest, I am not “investing” it anywhere else.

    But I read a comment from a Richard Kline at Naked Capitalism about the zero rates really being nothing more than a prop to banks – keeping the banks from failing.  If the whole idea of “loans” or “investment” is to allocate resources usefully, than what metric could we use to determine that an investment is “useful” other than “interest”???  Are loans to “stimulate” or to “invest” or both?
    For instance, I have put forward the notion that billions should be “lent” to me so I can “stimulate” the economy by consuming blow, visiting strip clubs, and drinking excessively – a proposal that would be extremely stimulative to me, and stimulative in general to the economy.  Despite my altruism to make this sacrifice for you people, the US refuses to loan me billions – I’ll get that money circulating!!!  Other than the fact that I won’t pay interest (and hopefully will drop dead before any principal must be returned), why is Citi anymore deserving of billions of interest free money than I am?

    1. Anonymous says

      fresnodanathome:  low rates appear to be a sop to banks, but I would recommend going back and reading Edward’s article that preceeded this one which he linked to above:  Why Permanent Zero is toxic and leads to depression.  Basically what he said was that PZ leads to margin compression at banks; I’m not sure this necessarily has to be the case, but it’s certainly happening and is sowing the seeds of the next banking crisis.  

      I don’t really have a problem with the low borrowing rates for banks; banks are a public/private partnership whose role in the economy is to judge investment risk, they determine and lend to credit-worthy borrowers.  That’s the way its supposed to work anyway. 

      Your final example is a great one.  During the credit boom you certainly could have gotten a large 2nd mortgage on your home and used that line to do lines.  I’m quite sure lots of people did.  You just missed the party.

      It’s exactly what banks aren’t supposed to do with their lending capacity because your failure to pay it back is supposed to hit their capital investors.  Now everyone is angry because the Government stepped in to protect the capital investors who should’ve lost their dough.      

      1. Anonymous says

        I was responding (tongue in cheek) to your first comment about how bank interest is set.  When I learned economics, one had to continually run to keep from being eaten by dinosaurs, and interest rates were supposedly some equilibrium between demand for loans and the number of savers and the amount of savings.
        From what I have read from Keen and other sources, this “dinosaur” theory is all bunk – loans come first and than the reserves – The FED creates all the money that is needed if a bank has made a loan.  When loans made sense, this seemed to work pretty well.  As well as the fact that the FED can just set interest rates by command (by commanding that all the money be printed or keystroked into existence), I think your point about people earning interest, the rate of interest, and  risk free return is a good one, and it makes me think about capitalism and markets in general.  (by the way, One could suppose the amount of interest just ends up being equal to inflation, but I digress).  And this applies to government paid interest as well.  One has to ask about market interest rates, where are the bond vigilantes? 

        Just as the idea that savers should get a risk free rate of return for doing nothing, at some point I would say the question has to be asked of stock holders as well.  I guess companies do go bankrupt, but the idea that stockholders are “owners” strikes me kind of like the idea that bank interest rates are actually set by a free market.  I own stocks through my mutual fund, a system designed, advertized, and JUSTIFIED on the basis that no thinking goes into the investment decision, which is supposedly superior to out thinking the market.  So why should there be any reward?  Oh yeah, the risk…..but the risk I always hear about is not keeping up with inflation.     

        Would society actually be better off if there was an option for protecting your savings from inflation, but no “windfall” for the cautious and conservative?  If we can buy “forever” stamps, why can’t we put all our savings into “forever” bonds (bonds that pay the cpi rate of inflation as interest???)

  5. Anonymous says

    “Where are the bond vigilantes?”  They don’t exist for monetarily sovereign nations.  Bill Mitchell, Scott Fullwiler and other MMT’ers have a lot of posts on this topic, as does Rodger Mitchell.  

    “Why can’t we put all our savings into “forever” bonds?  you can.  Just stop investing in your pension fund and buy TIPS.  Keep in mind the CPI doesn’t have a housing component, so if housing bounces back you’ll still be behind the curve.  

    I know Keen has some ideas about preventing secondary market stock purchases, or limiting them significantly.  If you really want to invest in people, not paper, just go to a local REIA, find a smart Real Estate Investor who can find undervalued Real Estate in your area and let them invest your money.  No doubt they are looking for capital.  

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