Negative Interest Rates
May 17, 2009
Apparently, the new fashion among the academic economists (including the one at the Fed) is “negative interest rates.” This is actually a very old idea, as we talked about a few weeks ago:
These guys talk a big talk, but their understanding is actually very primitive. It amounts to: whatever happens, just lower the interest rate.
This has always been a justification for currency devaluation and inflation. As we looked at earlier, markets are perfectly capable of “lowering interest rates” all by themselves:
So now we come to an impasse. After the market “lowers interest rates” by itself, if there are still economic problems, then the central bank (according to its justifications) must come up with “negative interest rates.” This is sometimes known as a “liquidity trap” for some reason, although it does not involve either liquidity or traps.
Nowhere do today’s economists consider that, if interest rates are already not the problem (they are already very low), then maybe the problem is something else? One of the main problems today remains capitalization of banks, which has still not been addressed by the means which by now everyone is aware of, namely the conversion of banks’ subordinate debt to equity:
Willem Buiter, of the FT, joins in with his advocacy of “negative interest rates.”
Needless to say, I think Buiter’s three proposals are absolute gaagaa. Read them for yourself and see.
Some of these economist types, citing the Taylor Rule and other such guidelines, are talking about negative interest rates of -5% or so. (John Taylor himself has apparently gotten off this bandwagon and washed his hands of the affair.) There are apparently even internal Fed papers circulating that suggest “negative interest rates” of around -5%.
How would this be accomplished? There would be a flurry of various silly proposals, of the sort Buiter likes to generate. Then, they think about it a bit and conclude that the easiest thing to do would be to use the printing press to generate about 5% CPI inflation, while keeping the short end at 0%. That would produce “real” interest rates that were negative.
This derives in part from various analyses of the Great Depression which concluded that there were very high “real interest rates,” because if you have a nominal interest rate of 4% and a decline in the CPI of 10% in a year, that’s a “real” interest rate of 14%, according to certain justifications. (I think a 4% interest rate, with a currency pegged to gold, is a 4% “real” interest rate.) But, the problem wasn’t that interest rates were high — the problem was that there was a Depression! Businessmen understand this. However, it is fashionable among economists types to blame these “super high real interest rates” on central bank negligence. This means that not only does the central bank have the option, if it so chooses, to try to address economic difficulties via currency manipulation, but it is negligent if it does not do so.
So, we can see that economists’ ardor for interest rate manipulation leads naturally to currency devaluation as a solution. But then, anything and everything that promotes monetary manipulation as an economic solution must inevitably lead to currency devaluation, because that’s really the only thing the central bank can do.
I think this is all a pile of claptrap, and it is normal to assume, at least at some basic level, that serious economists think so too. But, it appears that many in the academic sphere, including Ben Bernanke, actually believe this stuff. Not only do they “believe” it, but it is inherent in their understanding of the universe, in the way that many people knew, beyond all doubt, that the sun revolved around the earth, as anyone could plainly see just by looking at the sky. In other words, they don’t even know that they “believe” it. They cannot think any other way.
At present, we have had a bit of an impasse, because along with Bernanke’s many efforts to jigger the economy with monetary manipulation, there are also elements that would like to have the dollar not decline into oblivion versus either gold or other currencies. I mention gold specifically, because yes, the government types are well aware of the significance of the dollar/gold exchange rate, in their own crabbed and confused way, including and especially Larry Summers.
There was the most intense sort of intervention in the dollar/gold market last autumn, apparently to keep the dollar from continuing its primary trend downward. Evidence of this intervention was quite blatant to anyone who was paying attention. To take one of a great many examples, there was a flood of 90% “coin grade” bars that appeared all over the world during that time. This raised eyebrows everywhere, because there is one and only one known source of 90% “coin grade” gold bars in quantity, and that is the U.S. government. All “investment-grade” gold is 0.999 fine. “Coin grade” gold is 90% gold and 10% copper, to harden the metal for coin use. The U.S. government’s store of “coin grade” gold comes from the gold confiscation of 1933, in which all gold coins were collected by the U.S. government and melted into ingots. There have been rumors for years that certain smelters have been working overtime converting this 90% gold into regular 0.999 investment-grade gold. Also, there has been talk of “quality swaps” and “fineness swaps” between the U.S. government and certain accomodating foreign governments, by which 90% gold was swapped for 0.999 gold owned by others. Apparently, things reached such a point last autumn that such niceties as resmelting and fineness swaps went out the window, and the U.S. government just dumped their 90% gold holdings on the market even though they knew that people would know exactly where it was coming from.
One bullion dealer said that it reminded him of a time around 1991, when all of a sudden there was a flood of gold on the market stamped with the insignia of the Czar of Russia. The Soviet Union collapsed one month later.
It is natural to assume that this kind of gold dumping “depresses the price of gold,” but what it actually does is to push the value of the dollar higher, while gold remains largely unchanged. Did the dollar rise against every conceivable measure during autumn 2008? Obviously, it did.
Quite ironically, this rather dramatic forced rise in the dollar (1/1000th oz. to 1/700th oz. is an increase of 43%, over the space of a few weeks) actually led, in my opinion, to an outbreak of deflationary pressures in the economy. By deflationary I mean those effects related to a rise in a currency’s value. The recent analog would be the 1982 recession, which was caused in no small part because of the dollar’s rise from a nadir of 1/850 oz. in 1980 to 1/300 (almost a tripling of value) in 1982.
What the central bankers would really, really love is to play games with the currency, supposedly “saving the economy” — or just printing money willy-nilly to pay the government’s bills — without suffering any consequences like a decline in currency value. And, if you have enough gold that you can intervene in the markets to support your currency’s value, you can get away with it for a little while. The funny thing is, though, that it is actually the decline in the currency’s value — not “an increase in the money supply” per se — that produces the inflation that gets you to negative interest rates. You don’t get to enjoy any of the effects of devaluation without actually having a devaluation.
The dollar has actually been falling quite a bit since it hit 1/700th oz. of gold last autumn. This accounts in part for the “green shoots” recently, as the prior deflationary effects dissipate — even if the “green shoots” meme is mostly a psy-ops project.
However, the economy is still in rather bad shape, and to get anywhere near the 5% CPI inflation necessary to produce “negative real interest rates” of -5%, the dollar will have to decline further. Ironically, to the extent that this decline is prevented by various forms of gold and forex market intervention, we may find that the Fed busybodies step up their inflationary efforts still further!
Thus, to some degree, I think we gold investors are enjoying a “Fed put” right now.
Here are a few more links to “negative interest rates” papers by mainstream economists. You can see this is something they’ve been jabbering about for a long time.
At this point, I think we are a little beyond “negative interest rates.” The Fed has been buying up Treasury and Agency debt in the open market, not because of “negative interest rates,” but because they are not willing to see a rise in long-end rates, and because the government needs the money. Maybe we have already crossed the line of no return. The “negative real rates” story is turning into a fancy justification for something that’s a lot more basic: printing money to pay the bills.
There are sure to be plenty of bills ahead, too, because the government has by now well established it’s modus operandi: whatever happens, the government will plug the hole with a big wad of cash.
The end game for this is a tendency for the government to migrate towards the shorter end of the curve in its bond issuances. There is apparently great demand for t-bills and other short-maturity issuance. The super-low rates on this paper are very attractive to the interest-payer, namely the government. Already 40% of the U.S. federal government’s entire debt has a maturity of under one year. The long-end, however, has been suffering higher yields. Because the 10 and 30 year rates serve as a benchmark for all kinds of fixed rates, the government and Fed doesn’t want to let those creep higher.
I am absolutely astonished that big bond investors, which used to call themselves “vigilantes” a generation ago, are howling for the Fed to buy up and monetize more long-end paper. Here’s PIMCO’s Paul McCulley, April 2009. You should read the whole thing:
Bloomberg talked to some other big bond investors including Blackrock.
“The Fed needs to consider increasing its purchases of Treasuries,” said Stuart Spodek, co-head of U.S. bonds in New York at BlackRock, which manages $483 billion in debt. Spodek said he resumed buying Treasuries. “We are still in a recession. It’s quite bad. They need to stabilize long-term rates.”
“If all of a sudden this rise in the 10-year yield feeds into higher all-in mortgage rates, that’s when we think the Fed will come in with a vengeance” to increase its Treasury purchases, said Joseph Balestrino, a money manager at Federated Investors in Pittsburgh, which oversees $21 billion in bonds. “We are a buyer.
When I sum it all up, the picture doesn’t look very good. There seems to be no political body — not even bond investors! — who are opposed to what amounts to wholesale currency demolition. This is in part because no “demolition” has happened yet, because of the various interventions to keep it from happening. This has merely emboldened the money-printers. What if you could “print money” in the scale of hundreds of billions and even trillions, and there were no consequences? Wouldn’t you keep on doing it? Could you ever stop?
Note that the Fed has already publicly committed to buying $1.25 trillion in agency securities, another $200 billion in agency debt, and $300 billion in Treasury bonds, before the end of 2009. That’s a total of $1.75 trillion in printing-press finance, before any future add-ons (I bet there will be more Treasury buying), and that’s just what they’re telling you.
I’ve been trying to give a sense in which these ideas are in fact quite old, and actually represent not only today’s failings but also those of the past. The practice of jamming the “domestic” economy with “low interest rates”, QE etc. etc., while trying to maintain a stable “foreign monetary policy” of stable exchange rates or a gold peg, actually dates from the 1940s and indeed from the formation of Bretton Woods itself. The reason why the dollar’s gold peg seemed so hard to maintain in the 1950s and 1960s was that the Fed wasn’t playing its role properly, and was instead engaged in various interest-rate-manipulation schemes. Instead of using a “currency board linked to gold” as I’ve described, the gold link was maintained by rather heavy-handed intervention in exactly the same fashion as the dollar’s value is being supported today. However, the Fed in those days was actually somewhat gold-friendly, and didn’t engage in anything really egregious. It wasn’t until William McChesney Martin was replaced by Arthur Burns in 1970 that things really started to come apart. Burns had his own “quantitative easing” plan, which was to increase the monetary base by X amount to meet a target of nominal GDP growth of 9%. This was of course completely contradictory to a gold standard, but nevertheless the government attempted to maintain the dollar’s gold link by even-heavier-handed intervention for another twelve months or so, until August 1971. Then, of course, it blew up in their face. (You can read the appropriate chapter in my book for more details.)
What’s going on today is far more dramatic than what happened in the early 1970s. It could be very ugly.
I was talking to a friend of mine who was telling me that today’s senior investment types (boomers) have mostly good feelings from the 1970s. It was an economic disaster, but they were young. It was Farrah Fawcett, Corvette Stingrays, Led Zeppelin, and lots of sex and drugs for that cohort. That generation’s conquest of the cultural sphere, which began in the mid-1960s, was completed in the 1970s. Thus, they don’t really feel any visceral fear from “inflation.” Given the existing problems, it seems to them like a minor risk. (It wasn’t actually the present Boomer cohort that were the bond vigilantes of the 1980s. They were junior guys then. The senior guys were the ones who got clobbered in bonds in the 1970s.)
I think we are now in danger of something much more dramatic than the 1970s. Nothing really “came apart” that decade, although it sometimes seemed close. Things could come apart this time. What does “come apart” mean? For one thing, it may mean the Federal Government is no longer there with an extra $500 billion or $2 trillion on demand to make things better. It might not be able to roll over those 40%+ of bonds that come due each year, on top of new issuance which is already pegged at $1 trillion-plus for several years, in Obama’s rather rosy forecasts. It may have trouble meeting its own payroll.
Then we would enter the true money-printing stage, when all the justifications and rationales are exposed as empty rhetoric for something that is much more practical in nature. The government will print money because, in their view, it beats default. Actually, as Adam Smith argued at the very end of The Wealth of Nations, the govermment would be better off just defaulting, rather than setting the whole economy on fire in an act of spite. Apple could sell iPhones, and Exxon could sell oil, even with the government in default. It could even provide a nice chance for a big tax cut. But governments never see things this way.
* * *
American public asks: Why do I have a sore asshole? Apparently, the Fed was rather extra-super-aggressive regarding CDS payouts by AIG, paying waaay more than was required.
And who were they paying? Goldman Sachs and JP Morgan of course.