Interest rates in the US, Europe and the UK were reduced to close to zero
in the wake of the Lehman crisis nearly seven years ago.
Initially zero interest rate policy (ZIRP) was a temporary measure to
counter the price deflation that immediately followed the crisis, but since
then interest rates have been kept suppressed at the zero bound. It had been
hoped that the stimulus of close-to-zero interest rates would also guarantee
economic recovery. It has failed in this respect and the low bond yields that
result have only encouraged the rapid expansion of government debt.
It is clear that monetary policies of central banks are the problem.
Instead of boosting recovery they have simply destroyed the mechanism which
recycles savings into capital for production. They have brought about
Keynes's wish, expressed in his General Theory that he "looked
forward to the euthanasia of the rentier", whose function in providing
finance for entrepreneurs is to be replaced by the state: entrepreneurs
"who are so fond of their craft that their labour could be obtained much
cheaper than at present."[1]
Instead of storing the fruits of his labour in the form of bank deposits
to be made available to the investing entrepreneur, the saver is discouraged
from saving, instead being forced to speculate for capital gain. In that
sense, ZIRP is the logical end-point of Keynes's ideal.
The mistake is to subscribe to the ancient view that interest is usury and
that it only benefits the idle rich, a stance that appeared to be taken by
Keynes. What Keynes missed is that interest rates are an expression of time
preference, or the compensation for making money available today in return
for a reward tomorrow. If you try to ban interest rates by imposing ZIRP,
then the vital function of distributing savings in the interests of progress
simply ceases. An economy with ZIRP joins the ranks of the living dead.
Von Mises recognised this in 1909 when he wrote that "...a falling
value of money goes hand in hand with a rising rate of interest and a rising
value of money with a falling rate of interest. This lasts as long as the
movement of the objective exchange-value continues. When this ceases, then
the rate of interest is re-established at the level dictated by the general
economic situation."[2]
Besides noting that Von Mises's analysis was independently confirmed by Gibson's paradox, it may be helpful to restate it in
easier to understand terms. History has shown that a borrower of good
standing in a sound-money economy that is stable would pay about 3% interest.
If prices are rising, his margins will improve, and he will be prepared to
pay more to seize the opportunity to profit. If on the other hand prices are
falling, he can only afford to pay less and he will most likely restrict his
future activities to those he can finance from his own resources. It is this
free market demand that sets interest rates, not the usurious lenders reviled
by Keynes.
On the face of it a suppressed interest rate should make it profitable to
borrow, but that is not the way a producer looks at it. The marginal benefits
of extra borrowing have to exceed the costs of investing in production in
order to be profitable. A business with a good balance sheet will normally
improve its existing products by reinvesting its own reserves without
recourse to external funds under almost all conditions. Recourse to external
funds implies a materially different product being planned or that a
significant expansion of productive capacity is being considered, a more
risky step requiring greater capital expenditure, only to be undertaken when
economic prospects are set fair.
It is this capital commitment that is missing, despite prolonged monetary
stimulus. Central bankers are becoming acutely aware of the failure, which
has only lured their governments into a deepening debt trap. That is why the
Bank for International Settlements has publicly expressed concerns for some
time and why both the Fed and the Bank of England have expressed the wish to
get back to some sort of interest rate normality. It will be extremely
difficult, but let us assume for a moment that interest rates are raised:
what happens then?
An increase in interest rates to more than one or two per cent will be
accompanied by rising commodity prices: this much is evident from Gibson's
paradox. It would likely come about as speculative money flees financial
assets, closes short positions in commodities, and then seeks protection from
a fall in the purchasing power of currencies.
Businesses will see two things. Obviously, with bonds, stocks and
residential property prices falling as interest rates rise, the business
outlook would be deteriorating. However, with commodities and wholesale
prices rising, reflecting a fall in money's purchasing power, businesses
would be prepared to pay more interest to Keynes's rentiers. This is the
basis behind Gibson's paradox.
Not that this is properly understood: macroeconomists have found that
their theories have failed, and they don't know why. They want to back-track
to safer ground, but are frightened of the consequences. Normalising interest
rates could generate a stock market collapse, risk setting off an avalanche
of bankruptcies from overleveraged businesses and make government finances
wholly untenable. Higher interest rates risk triggering a second financial
crisis that could also undermine currencies, pushing up price inflation.
While macroeconomic theories can be faulted on the basis of outcomes, there
is little doubt the systemic threat from a trend of rising interest rates is
very real.
On balance, it is a situation that calls for inaction justified by hope.
After all, with the Fed funds rate at 0.25% and $2.6 trillion of commercial
bank funds already on deposit at the Fed, could it be that even a small
increase in the rate will just suck more deposit money out of the US banking
system, leading to a contraction of bank lending?
Central bankers are beginning to see what it has been like for their
colleagues in Japan, where for twenty-five years with zero interest rates
nothing tried seems to work. Welcome to Keynes's world of euthanized savers
and state-sponsored funding. Welcome to the world of ZIRP zombies.
[1] Keynes: General Theory of Employment Interest and Money, Chapter 24
section 2.
[2] See Von Mises, The Theory of Money and Credit, p. 349. (English
translation, 1953 Yale University Press.)
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