The Unintended Effects of Bad Policy

There is a reason why credit spreads widen. It is to more adequately compensate savers for taking risk. Adequate compensation for risk forestalls panic by providing an incentive to those with liquidity to supply it. In contrast, extremely loose monetary policy is procyclical and drains liquidity from economies. How can extremely low interest rates and quantitative "easing" create such a counter-intuitive result?

Widening banks' net interest margin by dropping rates to near zero at the low end of the curve will temporarily create accounting profits at banks. However, as inflation takes hold, this seeming "quick fix" will decimate the real economic value of financial institutions' mortgage portfolios and any bonds with a duration of over 10 years. Even with a full suspension of mark-to-market, the real economic book value of many insurance companies and banks may be catastrophically eroded (Buffett observed this years ago with insurance firms during stagflation). This could have the effect of removing liquidity from the system at precisely the point our economy needs it.

Moreover, we cannot afford for the government to be glib about the value of the dollar. Dangerously, given China's recent push for IMF SDRs, the Treasury does not understand that America's profligate borrowing cannot rest on a nebulous concept of our specialness. Our ability to fund our deficit rests squarely on our ability to borrow in our own currency. Once that option is taken away, all bets are off. Policy flexibility will no longer exist. The tipping point will have been reached.

Even if we can continue to borrow in dollars, our policies may have counter-intuitive effects. As a country, we need to understand the dynamics of non-linear effects surrounding interest rates. Just as at some point, higher interest rates no longer compensate the lender for increased risk on the part of the borrower, but actually increase defaults, low interest rates often have the opposite of their intended effect. Extremely low interest rates can vacuum liquidity out of nations. Japan has been referred to as a nation where loose monetary policy was like "pushing on a string." There was no push. It was a pull. Liquidity was sucked out of the country as the Yen became the world's carry trade currency of choice.

Borrowing in a currency is the opposite of investment. It is liquidity-draining to the carry trade currency nation. For all of the talk about about using monetary policy to dampen the business cycle, no result could be more damaging or procyclical.

Policies which create macroeconomic imbalances make it harder for good institutions to chart their own course. The buffeting forces of procyclical policies simply become too great. What institution, no matter how well run, could survive a debt crisis, hyperinflation, the decimation of its bond portfolio, and a sinking economy?

The very credit spreads that the government seeks to narrow may burst at the seams if the Fed and Treasury maintain their current course. Perhaps that is what it will take for lasting liquidity to be restored to our financial system. We may actually need to take our medicine. However, Americans may finally realize that there is a free lunch after all--we will be supplying it as speculators borrow in our low-yielding currency to invest elsewhere.

Comments

[Dave Wrixon:]

Nailed it!

May 18 07:33 AM

[lbsterling:]

But with all central banks racing to zero rates at the same time, where would speculators carry the dollar to?

The future is very hazy.

May 18 08:06 AM

[manya05:]

lbsterling, all the speculator has to do now is borrow at zero interest in dollars, just carry it to a currency that is not being debased as much (even if it pays 0%), and just wait. The carry trade does not even need to be invested in shares, any currency healthier than the dollar will do.

May 18 08:33 AM

[axelrod608:]

Excellent , concise article. The idea that we can borrow and spend our way to prosperity is alive and well in DC and on Wall Street. One unintended result of ZIRP is that every person and company that must survive on dividends or interest is forced into more and more risky investment vehicles.

And your point that when interest rates do finally rise to a sustainable level, banks will be stuck holding low yielding portfolios is so correct. All those new 4 - 5 % mortgages will be a drag on earnings for years to come. WTF are our policymakers thinking ?

May 18 08:58 AM

[Gem Hudson:]

When there is no real wealth in the dollar, there is no prosperity in the economic and print money is still nothing but paper money.

The duch mark that was buying all those big guns before World War One was the same duch mark that was buying all those big guns after World War One but the Weimar Republic in still employing bought out all those big guns but were not selling all those big guns and the Weimar Republic bought all those big guns with nothing else but paper duch mark.

May 18 09:33 AM

[robert.b.fe...:]

Our administration is trying very hard to create a new Weimar Republic here. In oreder to remake America the old America will have to be completely destroyed first. That is us folks. Our wealth and lively hood will be confiscated to make room for the spread the wealth society. With free everything for every one.

May 18 09:44 AM

[lbsterling:]

Manya05,

Yes, that clarifies things. Whereas the carry trade always has an element of currency risk, as interest rates approach zero everywhere, it's pure currency risk.

Why not just cut out the middleman and speculate in currency?

I know that one vision of the future says buy Australian dollars and Rand and watch as everything else implodes, but frankly I'm not planning to bet the farm on that scenario.


On May 18 08:33 AM manya05 wrote:

> lbsterling, all the speculator has to do now is borrow at zero interest
> in dollars, just carry it to a currency that is not being debased
> as much (even if it pays 0%), and just wait. The carry trade does
> not even need to be invested in shares, any currency healthier than
> the dollar will do.

May 18 10:21 AM

[Ferdinand E...:]

Interesting article. The problem is though that it assumes that Ben and Larry are boneheads. I'm not comfortable with that assumption.

May 18 10:33 AM

[Leftfield:]

Stagflation, coming to a nation near you. Well written article, thanks. When we have fiat currency at the behest of the biggest Wall St. and DC interests we have growing lists of maladies and misallocation, not virtues. After about a century of the Fed, their funny money has caused so many bad decisions in our economy as to make us nearly, possibly, toast.

May 18 11:44 AM

[Bruce Vande...:]

The bailouts won't succeed. Eventually the government will just give up and let markets take their course. Many more companies will follow Chrysler and GM. Maybe, we will have a bottom somewhere down the road which we can build prosperity on.

For now, like axelrod608 says, if you have any fixed income stream, you may be at risk, check the underlying assets yourself carefully.

May 18 12:03 PM

[jambo:]

Staggeringly concise Harry. I loved "America's profligate borrowing cannot rest on a nebulous concept of our specialness." Finally, 'smoke and mirrors' has been defined!
This something for nothing supposition that zero interest rate and a modicum of inflation is a good thing, is, has been and always will be B.S. and invoking Japan's history in the great Yen carry trade fiasco is the perfect proof.
Well done, thank you.

May 18 01:47 PM

[jambo:]

Leftfield, I stand here trying to picture what's in the mind of those who mark thumbs down so blatantly on a comment so cogent. I am at a loss to define it.
This isnt agree/ disagree, it's good comment/ poor comment... constructive/ or not. Those who see no value in that with which they disagree, are doomed to a certain mediocrity of mind. While I wish them well personally, should their dreams come true, what is likely is more government.


On May 18 11:44 AM Leftfield wrote:

> Stagflation, coming to a nation near you. Well written article,
> thanks. When we have fiat currency at the behest of the biggest
> Wall St. and DC interests we have growing lists of maladies and misallocation,
> not virtues. After about a century of the Fed, their funny money
> has caused so many bad decisions in our economy as to make us nearly,
> possibly, toast.

May 18 02:00 PM

[TheReaper!:]

What a tangled web we weave , once we practice to deceive .

TheReaper!

May 18 03:03 PM

[Leftfield:]

Thanks, Jambo. I leave thumbs up on well-written opposing views if I've really learned something. I rarely leave negatives except for Cetin. I think we can be grateful if any comment/article either helps us to improve our case or occasionally change our minds.

May 18 06:06 PM

[AssetReset:]

Agreed

Although, if hard assets are being purchased, what better currency to borrow than one at 0% and debasement at some point down the road


On May 18 08:33 AM manya05 wrote:

> lbsterling, all the speculator has to do now is borrow at zero interest
> in dollars, just carry it to a currency that is not being debased
> as much (even if it pays 0%), and just wait. The carry trade does
> not even need to be invested in shares, any currency healthier than
> the dollar will do.

May 18 07:16 PM

[Northstar10000:]

The solution for the Dumbocrats has always been spend spend spend. these are the policies they have been bred on. It ˆs in their blood. They know nothing else. You seem to be saying they have a master plan. They could not ever have a plan. they can only see spending.

May 18 07:53 PM

[Dave Wrixon:]

Currency controls for the World's Reserve Currency perhaps?


On May 18 01:47 PM jambo wrote:

> Staggeringly concise Harry. I loved "America's profligate borrowing
> cannot rest on a nebulous concept of our specialness." Finally,
> 'smoke and mirrors' has been defined!
> This something for nothing supposition that zero interest rate and
> a modicum of inflation is a good thing, is, has been and always will
> be B.S. and invoking Japan's history in the great Yen carry trade
> fiasco is the perfect proof.
> Well done, thank you.

May 19 12:55 AM

[Harry Long:]

Jambo, than you for you comments. While we all shudder to think of the Japanese experience, I think the public's vociferous denials that it could ever happen to us are more a function of a psychology of denial than of objective reasoning.

Ostriches never avoid danger, just get a head full of sand.



On May 18 01:47 PM jambo wrote:

> Staggeringly concise Harry. I loved "America's profligate borrowing
> cannot rest on a nebulous concept of our specialness." Finally, 'smoke
> and mirrors' has been defined!
> This something for nothing supposition that zero interest rate and
> a modicum of inflation is a good thing, is, has been and always will
> be B.S. and invoking Japan's history in the great Yen carry trade
> fiasco is the perfect proof.
> Well done, thank you.

May 20 05:47 PM

[Harry Long:]

Ferdinand, fair point. However, if we agree that economic structures should be robust, their foundations should no more rest upon psychology than should skyscrapers. Their constuction should rest upon sound principles. I am not sure that entrusting the fate of a nation to the individual talents of two men, no matter how intelligent, logical (or not) is a sound bais for societal success.

We should make points of stress as robust to failure as possible. Two men are not a robust structure.


On May 18 10:33 AM Ferdinand E. Banks wrote:

> Interesting article. The problem is though that it assumes that Ben
> and Larry are boneheads. I'm not comfortable with that assumption.

May 20 05:50 PM