Zero rates have created a dangerous risk seeking return mentality
You saw the posts by Sober Look on the excess risk investors are taking on in the high yield market and the consequences of low yields on US households. Let’s make it a trilogy of posts then. There are plenty of other posts today that highlight this problem. And it is a problem. One thing Austrians harp on is the misallocation of resources caused by heavy handed and persistent interest rate market intervention. They are right that the industrial organization and the structure of investment capital priorities is critical to longer-term growth. What we are seeing now is a skew into high risk activities. As I wrote 4 years ago:
1. Inflationary monetary policy leads to an expansion of credit throughout the economy, the basic building block for a boom-bust business cycle.
2. In a credit boom, less credit is available for productive assets because credit and resources are diverted to marginal debtors and high-growth/high-risk activities. Low interest rates and expansionary credit environment gives the illusion of profitability to unproductive investments and high-risk activities in the economy, that would appear foolish in an appropriate monetary environment.
3. Companies, flush with cash, invest heavily to prepare for expected future growth. An investment and capital-spending boom ensues.
4. Higher asset prices lower the cost of capital, fuelling a further boom in investment and capital spending, creating overcapacity in goods and services industries.
5. The increase in asset prices produces the so-called ‘wealth effect’ for consumers: a decrease in savings and an increase in consumption.
6. As the whole episode rests on an excess creation of credit, debt levels increase greatly.
7. The inflationary monetary policy is extremely distortionary as it redistributes capital to economic actors whose costs rise after their income from those whose costs rise before their income. Those who live from a fixed and interest income like pensioners find their costs rising with higher inflation while their income decreases in real terms.
8. Runaway asset price/consumer price inflation ultimately demands higher interest rates and a contractionary monetary policy, whereupon the whole house of cards collapses.
9. When the asset price bubbles pop, revulsion steps in, credit contracts and the bubble currency depreciates, as hot money flees the depreciating assets.
10. Eventually, the inflationary monetary policy debases the fiat currency, leading to a relative appreciation of the prices of ‘hard’ assets (like gold and silver and commodities like oil and natural gas) relative to the home currency.
11. The result is a wealth effect in reverse, leading to a collapse in consumption, a secular bear market and recession.
12. An expansionary monetary policy in a post-bubble environment can cushion a hard landing but does only lengthen the period before full economic recovery.
This will end badly.
This is a big theme and I think enough threads here show that QE and zero rates have distorted things in a very negative way. these things have unintended consequences. It’s not a free lunch for the Fed, manipulating rates down and expecting that all will be well. It creates excess risk taking and then renewed crisis. When the business cycle turns down entirely, this will be evident to all.
This is a clear sign of risk seeking return as investors hungry for yield move out the risk curve because of financial repression. When the Fed talks about why they have engaged in QE or zero interest rate policy they talk about shifting private portfolio preferences. this is a sign that they have shifted and ultimately this is a distortion that will harm the US economy later down the line.
More signs of risk seeking return. A very bad sign.
Switzerland has 2.7% unemployment/ It shows you that you can achieve full employment in today’s Europe even with a very strong currency. The Swiss model is not easily replicable but it is worthy of emulation.
The Italian economy is getting hit hard by the European crisis response. This is where the rubber hits the road more than in Spain because Italy has (had) a primary government budget surplus. The crisis in Italy is a tragedy that didn’t have to be.
Good news at least on the margin
More evidence that German intransigence and Spain’s debt woes mean double dip as I said two years ago.
Good piece. It highlights three myths that are indeed widespread and false. One in the Anglo-Saxon world is that unregulated markets with TBTF banks are a good thing. We see now this is false. The second myth is a German one, that austerity works when in fact it has led and will always lead to lower growth in the near term and debt deflation for indebted economies. The last myth is that the system as structured actually works. it doesn’t and it won’t.
Interesting thought piece on the nature of money from late last month. I am agnostic here except to say that it rhymes a bit with MMT and it is thought-provoking. Worth a read
The title here is a bit exaggerated in typical telegraph style but the point is valid, that Italy and Germany are finding greater discord in the euro debate both at the policy and populist level.