The Fed's purpose, when it comes down to it, is to buy bonds. Under their
various "Quantitative Easing" (QE) programs, they sure have bought a lot of
bonds. This pushes up the price of the bonds. Since the yield is basically
the inverse of the bond price, this means the rate of interest falls.
This month, on rumors that QE will be tapered off and despite continued Fed
bond buying, the yield on the 10-year Treasury bond has spiked from 1.63% to
2.12%. Will this be the end of the bull market in bonds and the start of rising
interest rates in the US in earnest? I rather doubt it, as all of the dynamics
that have created this bull market are still in place. And as the other bond
markets of the world experience greater trouble (such as Japan today),
capital will come pouring into the dollar and the Treasury.
It has been quite a bull market in bonds. Here is a chart of the yield on
the 10-year Treasury.
The recent blip is hardly noticeable on this chart, which shows the fall from
16%.
This is all good, right? It's a bull market, so people are making money. The
cost of borrowing to finance a new business is near its all-time low. The deficit
to GDP ratio is kept in check by low interest payments too, as any Keynesian
will tell you.
Not quite.
In the spirit of the boy who said, "The emperor has no clothes," let's ask
a question. Where do the profits of the bond speculators come from? Who is
on the other side of the trade? Who sold the bond short?
The borrower, who sold the bond, incurs a capital loss as the bond speculator
gets his gain. Changes in the bond price are zero-sum: one side loses and one
side gains. While they can borrow more money at a cheaper rate tomorrow, they
can never make up the loss on the money borrowed at a higher rate yesterday.
Their burden of debt rises as the rate of interest falls.
How does this manifest in the economy? A competitor can enter the business
more easily. If the interest rate is lower, that means he can borrow the same
amount of money and have a lower monthly payment. Or he can borrow more and
have the same payment. Either way, he has a sustainable competitive advantage
over the established business. If the rate falls again, then another new competitor
can enter the market. The established business is pushed into bankruptcy, the
first new competitor is on the ropes, and the newest is doing well. That is,
until the next decline in the rate. The penalty for borrowing at a too-high
rate is harsh.
This is certainly not good for the economy. To the extent that new money goes
into the productive sector at all, it may be used to cannibalize existing businesses.
The old debt is defaulted, and net debt increases slightly as the new loan
is bigger than the old one. Churn is not real activity.
Even more pernicious, our endless non-recovery is not in spite of the Fed's
effort, but because of it. The interest rate is not exclusive to just one business.
It is universal, applying to the whole market. Every business can borrow at
the prevailing rate. When will they borrow? To oversimplify slightly, they
will borrow when they see an opportunity with a net profit greater than the
interest rate. This will push down the rate of profit of their market. The
actions of a myriad of other businesses will push down the rate of profit in
every market.
Let's pause to consider this for a moment. The rate of interest is falling.
This invites businesses to incur more debt. At the same time, their
opportunities to profitably deploy the borrowed money are declining due
to the very reason of falling interest rates.
The falling interest rate not only sucks capital off their balance sheet and
threatens them with death by competitors who wait for a lower rate, but it
encourages more leverage and makes them more fragile by lowering their profit
margin. Who in their right mind would go deeper into debt for a reduced profit
and a longer time to amortize the debt?
The Fed can no more improve the economy by buying bonds than a boss can improve
morale by punishing employees. Their low interest rate forces the economy down
into the mud and keeps it pinned. The Fed purportedly helps stabilize the economy
compared to the gold standard, but it really achieves the exact opposite.
The chief virtue of the gold standard is that it keeps the rate of interest
stable. Look at this long-term chart that goes back to 1790. There are spikes
due to wars and policy blunders, but it is striking how stable it was prior
to 1913 especially in comparison to the era of the Fed.
Today, the saver is disenfranchised. If he does not like the rate of interest,
he can complain, but there is not much he can do, short of speculating on commodities
or stocks. According to many sources I read, pension funds are becoming more
underfunded. Why? It is because the net present value of the payout they must
make to retirees is rising (as a mathematical function of lower interest),
while their ability to earn a yield is falling.
Under gold, if the saver did not like the rate of interest he could sell the
bond and take home the gold coin. His preference sets the floor under the rate
of interest. No yield, no lending. No lending, no bonds can be sold. So the
rate was forced higher. (There was also a ceiling, but the mechanism is only
of academic interest today with falling rates.)
Stable rates preserved the saver's ability to earn a yield, and also protected
the capital of borrowers.
How do savers today expect their money to work for them so they can retire
comfortably? Those with a defined-benefit pension plan don't worry about it;
they have outsourced the problem of finding a yield to third party money managers
behind an opaque structure. As I noted above, most are badly underfunded and
the prognosis is that underfunding will become worse.
Everyone else has a choice of believing in one or another myth. The first
myth is that everyone can become a great trader, who is nimble, quick, and
has superior and timely information. Burt Malkiel wrote a book called A
Random Walk Down Wall Street, which debunks this notion. The average investor
will not beat the market average. Net of costs and fees, he underperforms.
The other myth is that stocks and other assets will go up and up without limit.
So one simply must buy and hold. Then the capital gains will pay for a comfortable
retirement. This plan is no more feasible than the first.
The only thing that can pay for retirement is the return on capital put to
productive use. This is a serious problem in our era of wholesale capital destruction.
Another reason why rising prices cannot pay for everyone's retirement is unique
to gold. A rising gold price is not a gain. It is just an artifact of using
a falling dollar to measure gold's value. If you have an ounce of gold, and
the price doubles to $2800, you have twice as many dollars, but each of those
dollars is worth half as much. You still have one ounce of gold. Only
if you make a profit by earning more gold do you have a gain. While this was
how people made a profit 100 years ago, today few are even thinking about how
to do this.
It is high time they started again.
