By Karl Smith
Bill Gross wrote in the FT that zero interest rates could actually contract the economy. That’s wrong but I want to spell out in greater detail than I have seen, exactly why.
Here is Gross:
If a bank can borrow at near 0 per cent, then theoretically it should have no problem making a profit. What is important, however, is the flatness of the yield curve and its effect on lending across all credit markets. Capitalism would not work well if Fed funds and 30-year Treasuries coexisted at the same yield, nor if commercial paper and 30-year corporates did as well. It is not only excessive debt levels, insolvency and liquidity trap considerations that delever both financial and real economic growth; it is the zero-bound nominal yield, the assumption that it will stay there for an "extended period of time" and the resultant flatness of yield curves which are the culprits.
Gross is concerned that flattening the yield curve destroys the traditional business of banking. Part of the confusion is not separating the difference between what I call financing and carrying.
Financing in my terms is generating liquidity from a non-liquid asset. One does this by rolling over or otherwise juggling short-term liabilities in such away that you always have enough net borrowing to fund a long term investment.
If you keep shifting your balance from one credit card to another so as to keep your interest payments low enough to make that deck renovation affordable then you are self-financing the deck. This will work so long as you can always find a new low introductory rate. However, this is risky which is why most people just get a home equity loan from a bank and let the bank juggle its deposits to make sure the money is always there.
Carrying is when you borrow money cheaply and then lend it out more expensively, or otherwise take advantage of a higher return. Carry is generally available to you because you are taking on some risk that the original lender did not want to take on. Indeed, you are carrying that risk for her.
So, if your neighbor needs a deck renovation badly but has awful credit, then you can take out a home equity loan at 5% and the loan the money to him at 7% and earn the 2% spread. You have not created any liquidity nor are you juggling claims. You are just carrying your neighbor for the bank.
Though we think of banks as making money by financing the fact that they have a huge capital stock and lots of detailed information on borrowers means that they can also profit by carry. Lending at least ought to be fundamentally less risky for them because they have more information and a larger buffer. This is why a bank can make money selling you Certificates of Deposit.
Certificates of Deposit, if used to fund a loan of equal duration are purely a carry trade.
Now, Gross is right. If in the extreme the Fed guaranteed a 0% Federal Funds rate for the next 30 years it would eliminate liquidity risk. Remember that the Fed Funds market is unsecured overnight lending.
The Fed would essentially be saying that for the next 30 years banks will always be able to borrow whatever they need to make sure that you have funds on hand and they will be able to do it for free.
Since, liquidity risk has been eliminated the profit from financing has been eliminated – or should be arbitraged away by competing banks – and so there is no money to be made in financing.
Yet, oh heaven is there money to be made in carry.
So much money.
So, so, so, so, so much money.
The chaos and pandemonium in the wake of such a (credible) announcement would be unlike anything you have probably ever imagined. It would dwarf any global financial crisis in history except it would be in reverse. It would be the melt-up to end all melt-ups.
So rather than try to step you through the event chain associated with that stampede of insanity. Let’s think about what would happen if this was offered to just one bank. This institution now has access to unsecured financing at zero percent for 30 years.
Lets start with equities. An equity that has any dividend yield at all is now a good buy at any price less than what you think the nominal price will be 30 years from now. So suppose there is no real growth in stock values. But there is 2% inflation for 30 years. Then right now, today, you’d be willing to pay at least 80% more than the current trading price for any stock with any dividend whatsoever.
The same thing goes for real estate. So, long as a property has any positive rent flow you’d be willing to pay at least more than its current value. Even if you thought real estate prices were going to fall another 30%, you’d still be willing to pay 50% more than the current values for it.
This means an instant and huge rise in stock and real estate values, which in turn means an instant repairing of household net worth.
Yet, we are really understating the case here for simplicity. We can look at rent-ratio on real property. Even if you knew that at the end of 30 years the property you were buying was going to be completely worthless. We are talking ghost town level value collapse. Neither the land nor the building materials are worth a dime.
You would still be willing to pay roughly 30 times the annual rental price, assuming no inflation, 40 times assuming 2% inflation.
Here is a chart of the rent ratios in major cities over the course of the housing bubble.
At two percent inflation San Francisco would be fair priced at the peak, even assuming that in 30 years a massive earthquake would come in and destroy your property and leave you with no insurance settlement whatsoever.
The Northeast Corridor would be a steal even in a zero inflation environment. A guaranteed zero rate for 30 years would allow you to buy up almost every real asset in America at well inflated prices and make a killing.
Of course, the attempt to do that would not only increase the paper wealth of all American but for those who actually sold it would should money in their pockets. If you were able to buy even 10% of the assets that it would be profitable to buy at prices 50% above where they are today then you push roughly $5 Trillion dollars of cash into the hands of households and firms.
That money will need to be spent on something. It can’t be reinvested in existing assets because the very reason it cashed out of the market was because you as the bank drove up prices to the point where these folks wanted out.
Almost certainly most of it would be used to finance new investment. New companies, new housing, new capital. Some of it would be used for consumption. And, much of it would go overseas.
In all cases, however, it raises US aggregate demand and by an enormous amount. At a velocity of 1.5 on MZM it would raise Aggregate Demand by 7.5 Trillion or roughly 50%. This means nominal would rise $22 Trillion. That’s well above the CBO projected potential nominal GDP of $16 Trillion or a straight line 5% extrapolation from 2007 of $19.5 Trillion.
This implies that not only would the economy hit full employment but very rapid inflation would ensue as well.
And, remember that this in turn means that the price you would be willing to pay for real assets rises further still. This means a greater injection of money and even more inflation.
Rather than being contractionary, the credible promise of a zero percent funds rate for 30 years would be hyper-inflationary.
This is precisely why
A) Central Banks are weary of long term promises
B) Such promises are not in fact credible
However, there is nothing about the zero interests that produces the opposite effect from lowering interest rates in general.