The Subtle Tyranny of Interest Rates

Interest rates are the price of credit. They are the price of access to capital.

Now, it is obvious that pricing credit is not tyrannical in and of itself. Interest compensates a lender for default risk and the risk of inflation eroding the purchasing power of the money that they lend.

The tyranny I am getting at is subtle. It is the tyranny that Keynes pointed to when he proposed a euthanasia of the rentier. Keynes proposed that low interest rates would:

mean the euthanasia of the rentier, and, consequently, the euthanasia of the cumulative oppressive power of the capitalist to exploit the scarcity-value of capital.

Keynes pointed to an important feature of interest rates: the fact that capital has a cost is not just the result of default risk and the risk of inflation. It is also a result of the scarcity of capital.

Now, that is inevitable in a world where financial capital consists of metal that you dig up out of the ground.

But in our brave new state-backed fiat monetary system, why should capital be so scarce that those who have it can profit from its scarcity?

Obviously, central banks should not print money to the extent that it becomes worthless. But capital availability is absolutely critical to the advancement of society: the investment of capital is how societies become productive. It is how technology improves, and it is the key to wealth accumulation.

What Keynes didn’t specify was what exactly in the interest rate paid was the part that represented the “scarcity value” of capital.

Obviously, it doesn’t include the part that compensates for inflation, which is why we need to look at inflation-adjusted interest rates. And it isn’t the part that compensates for default risk. This is easily calculable too: it is the excess paid over lending to the monetary sovereign.

In the U.S. and Britain, that would be the American and British governments. In the eurozone — for complicated political reasons — there is no monetary sovereign exactly, but we might measure it by looking at it in terms of the spread against German government borrowing, because Germany seems to be the nation calling the lion’s share of the shots.

Here’s the real interest rate on U.S. 10-year government borrowing (I chose the 10-year because it is a benchmark, although I would have preferred to use a harmonized rate from across the yield curve.):


So what are we really seeing? The general trend is that real interest rates on U.S. government borrowing are overwhelmingly positive, with a few periodical exceptions where real rates on borrowing went a bit negative. This bias toward positive real interest rates on lending to the monetary sovereign, I would argue, is the rentier’s profit resulting from the scarcity of financial capital.

Year over year, that is going to compound heavily. It is these rentiers, I would argue, who should be euthanized. Not because they should be resented for doing well out of the system.  No. They should be euthanized because of the opportunity cost of devoting resources to enriching rentiers, resources that could be deployed productively elsewhere.

And how to euthanize the rentiers? Because we have identified what the rentier’s share is, the answer is very simple: making a real interest rate of zero on lending to the monetary sovereign an objective of monetary policy.

Update: After much debate, I have decided that euthanizing rentiers is not a matter for monetary policy, but a matter for fiscal policy. I have written another post discussing this.

The taper is finally here: What the Fed’s move means for the economy

Ben Bernanke, in his final press conference as chairman of the Federal Reserve, announced today that the central bank would be tapering asset purchases to $75 billion a month, down from $85 billion, which has been widely seen as a modest first step toward reducing the Fed’s outsized role in financial markets and the economy.

The move caught many economists by surprise — USA Today survey found that most economists polled said the Fed would maintain its current levels of quantitative easing, as the policy is known, before trimming down in January.

After the financial crisis in 2008, spooked investors started piling into low-risk assets like Treasuries, driving prices dramatically higher. The Fed’s aim in buying these assets was to take safe investments like Treasuries off the market, in order to encourage investors to take more risk and invest in higher-yielding and more productive ventures like stocks, equipment, and new employees.

The ultimate objective was more jobs, and more economic activity.


Who should the SEC punish next for the Madoff scandal? Itself.

J.P. Morgan Chase is nearing a settlement with federal regulators over the bank’s ties to convicted fraudster Bernie Madoff, reports The New York Times. The deal would involve penalties of up to $2 billion dollars and a rare criminal action. The government intends to use the money to compensate Madoff’s victims.

For two decades before his arrest, Madoff had banked with J.P. Morgan — and apparently laundered up to $76 billion through the bank. Employees at the bank had raised concerns about Madoff’s business. In 2006, a J.P. Morgan employee wrote after studying some of Mr. Madoff’s trading records that “I do have a few concerns and questions,” and expressed worry that Madoff would not disclose exactly which trades he had made. Madoff’s company turned out to be an elaborate ponzi scheme that stole an estimated $18 billion from clients; it collapsed in 2008.

Is it fair to blame J.P. Morgan for the activities of Madoff? Do banks have a responsibility to know if their clients are involved in criminal activities? I think so — banks should have strong checks and balances to prevent fraud and money laundering, because if they don’t then criminals like Madoff can get away with it for years and years. According to Robert Lenzner of Forbes, “J.P. Morgan never reported to the Treasury or the Federal Reserve a huge cache of checks going back and forth for seven years between Madoff’s Investment Account 703 and Bank Customer Number One, belonging to real estate developer Norman Levy, who died in 2005.”

By agreeing to pay the fine and the government’s rebuke, J.P. Morgan is admitting a failure of oversight. But it’s not as if J.P. Morgan is the only one to blame. Others on Wall Street had expressed concern about Madoff’s business much earlier.


Why the Volcker Rule won’t solve the problem of Too Big To Fail

The Volcker Rule was originally proposed to end the problem of banks needing taxpayer bailouts. Paul Volcker, the former chairman of the Federal Reserve, proposed that commercial banks using customer deposits to trade — a practice known as proprietary trading — played a key role in the financial crisis that began in 2007.

Five former Secretaries of the Treasury — W. Michael Blumenthal, Nicholas Brady, Paul O’Neill, George Shultz, and John Snow — endorsed the Volcker Rule in an open letter to the Wall Street Journal, writing that banks “should not engage in essentially speculative activity unrelated to essential bank services.”

The Volcker Rule was signed into law as part of the Dodd–Frank Wall Street Reform and Consumer Protection Act in July of 2010, but its implementation has been delayed until yesterday when it finally received approval from the five (!) regulatory agencies that will enforce it — the Federal Reserve, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, the Securities and Exchange Commission (SEC), and the Commodity Futures Trading Commission (CFTC).


What The Federal Reserve Could Learn From Strike Debt


One year ago, a campaign group affiliated with Occupy Wall Street called Strike Debt announced a campaign called the Rolling Jubilee, which sought to buy up distressed debt for pennies-on-the-dollar — for the purpose of abolishing it.

Historically, a debt jubilee was a feature of ancient Jewish law, under which all debts were written off every seven years. So why is Strike Debt trying to do something similar?

Strike Debt describes the program as a “bailout of the people, by the people.” The group targeted people struggling to service necessary debt, such as those without medical insurance who ended up needing expensive medical care.

So far, the Rolling Jubilee campaign has bought up and written off almost $14 million in debt.


Can The Fed Taper?

The Taper Tapir

Back in June, I correctly noted that it was severely unlikely that the Federal Reserve would taper its asset buying programs in September. I based this projection on the macroeconomic indicators on which the Federal Reserve bases its decisions — unemployment, and inflation. The Federal Reserve has a mandate from Congress to delivery a monetary policy that results in full employment, and low and stable inflation. With consumer price inflation significantly below the Fed’s self-imposed 2% goal, and with the rate of unemployment relatively high — currently well over 7% — I saw very little chance of the Fed effectively tightening by reducing his asset purchases.

There exists another school of thought that also correctly noted that the Fed would not taper. This other school, however, believes that the Fed cannot ever taper and that the Fed will destroy the dollar before it ceases its monetary activism. This view is summarised by the Misesian economist Pater Tanebrarum:

While it is true that the liquidation of malinvested capital would resume if the monetary heroin doses were to be reduced, the only alternative is to try to engender an ‘eternal boom’ by printing ever more money. This can only lead to an even worse ultimate outcome, in the very worst case a crack-up boom that destroys the entire monetary system.

So the Misesian view appears to be that the Fed won’t stop buying because doing so would result in a mass liquidation, and so the Fed will print all the way to hyperinflation.

Since talk of a taper began, rates certainly spiked as the market began to price in a taper. How far would an actual taper have pushed rates up? Well, it’s hard to say. But given that banks now have massive capital buffers in the form of excess reserves — as well as a guaranteed lender-of-last-resort resource at the Fed — it is hard to believe that an end to quantitative easing now would push us back into the depths of post-Lehman liquidation. Certainly, in the year preceding the announcement of QE Infinity — when unemployment was higher, and bank balance sheets frailer — there was no such fall back into liquidation. What a taper certainly would have amounted to is a relative tightening in monetary policy at a time when inflation is relatively low (sorry Shadowstats) and when unemployment is still relatively and stickily high. Whether or not we believe that monetary policy is effective in bringing down unemployment or igniting inflation, it is very clear that doing such a thing would be completely inconsistent with the Federal Reserve’s mandate and stated goals.

Generally, I find monetary policy as a means to control unemployment as rather Rube Goldberg-ish. Unemployment is much easier reduced through direct spending rather than trusting in the animal spirits of a depressed market to deliver such a thing, especially in the context of widespread deleveraging. But that does not mean that the Fed can never tighten again. While the depression ploughs on, the Fed will continue with or expand its current monetary policy measures. Whether or not these are effective, as Keynes noted, in the long run when the storm is over the ocean is flat. If by some luck — a technology shock, perhaps — there was an ignition of stronger growth, and unemployment began to fall significantly, the Fed would not just be able to tighten, it would have to to quell incipient inflationary pressure. Without luck and while the recovery remains feeble, it is true that it is hard to see the Fed tightening any time soon. Janet Yellen certainly believes that the Fed can do more to fight unemployment. This could certainly mean an increase in monetary activism. If she succeeds and the recovery strengthens and unemployment moves significantly downward, then Yellen will come under pressure to tighten sooner. 

In the current depressionary environment, the hyperinflation that the Misesians yearn for and see the Fed pushing toward is incredibly unlikely. The deflationary forces in the economy are stunningly huge. Huge quantities of pseudo-money were created in the shadow banking system before 2008, which are now being extinguished. The Fed would have had to double its monetary stimulus simply to push the money supply up to its long-term trend line. Wage growth throughout the economy is very stagnant, and the flow of cheap consumer goods from the East continues. So Yellen has the scope to expand without fearing inflationary pressure. The main concerns for inflation in my view are entirely non-monetary — geopolitical shocks, and energy shocks. Yet with ongoing deleveraging, any such inflationary shocks may actually prove helpful by decreasing the real burden of the nominal debt. Tightening or tapering in response to such shocks would be quite futile.

Sooner or later, the Fed will feel that the unemployment picture has significantly improved. That could be at 5% or even 6% so long as the job creation rate is strongly growing. At that point — perhaps by 2015  — tapering can begin. Tapering may slow the recovery to some extent not least through expectations. And that may be a good thing, guarding against the outgrowth of bubbles.

Yet if another shock pushes unemployment up much further, then tapering will be off the table for a long time. Although Yellen will surely try, with the Fed already highly extended under such circumstances, the only effective option left for job creation will be fiscal policy.

On the Breakdown in the Correlation Between Gold Price And The Federal Reserve’s Balance Sheet

Once upon a time there was a strong correlation. Then it broke:

20130921_gold1_0 (1)

Of course, we know that correlation is not and does not imply causation. But I think there was an underlying causation to the relationship that we saw, but it was not a superficial relationship of more asset purchases, higher gold prices. I think the causation arose out of self-confirmation; people noticed that the Fed was printing money, and believed that expansion of the Fed’s balance sheet would lead to price inflation (in ignorance of the fact that the broadest measure of the money supply was still shrinking in spite of all the new money the Fed was injecting into the economy, and the fact that elevated unemployment, weak demand, and plentiful cheap goods make it very hard for strong inflation to emerge). Many others believed that in the wake of 2008 and the shadow banking collapse, the financial system was fundamentally broken, and that the world might have to return to the gold standard. I myself believed that at the very least the West was in a prolonged Japanese style deflationary depression that in the absence of a return to strong growth might only be broken by very high inflation or a liquidationary crash.

Neither of these predictions — of imminent elevated inflation (or hyperinflation), and of imminent catastrophic financial system breakdown — have come to pass. Core inflation is close to its lowest year-on-year rate in history, and further financial system failures have mostly been prevented. So expectations have been shaken and are adjusting. Gold doesn’t produce any yield other than speculative price gains, but when gold is going up in price by around 20% a year it is still an attractive thing to hold to many, especially in an environment where its year-on-year speculative yield vastly outstrips bond yields and rates on savings. Once gold stopped going up by such a margin, investors had to sell their gold to lock in any speculative gain they might be holding onto, resulting in selling. And once gold started to fall, investors faced negative yields on gold, further spurring selling. This has meant gold has faced strong headwinds, and that is why its price has dropped by over 30% since its all-time high in September 2011, even while the Federal Reserve balance sheet continued to soar. Correlation broken. And in a market where the only yields are speculative gains, lost momentum can spell long-term depression as we saw for almost 20 years between 1980 and 2000.

Where gold goes from here is an interesting question. The main spur that pushes gold as an asset is goldbug ideology — the notions that it is the only real money, that it has intrinsic value, that fiat financial systems — and even modern civilisation in general — are fundamentally unmanageable and unsustainable and prone to collapse. As the technologies of capitalism, energy and production improve and advance, these goldbug views have been allayed and pushed to the margins as occurred in the 1980s and 1990s. In my view, their resurgence in the early 21st century stems almost entirely from the fact that real energy prices were rising, and real incomes falling. These two phenomena and their causes are complex and interconnective but essentially the energy infrastructure that brought the world spectacular growth and pushed all boats higher on a rising tide from the early 20th century to the 1990s began to come under strain — cutting into firms’ incomes, and individuals’ living expenses — and it has taken a long while for the market to even begin to equilibriate away from the increasingly-expensive old energy infrastructure and toward new infrastructures (initially increased U.S. production of shale, but going forward renewables especially solar). And while through financialisation and utilising insider-advantage much of the economic and financial elite managed to keep growing their incomes strongly, the vast majority came under stronger financial pressures and were only capable of sustaining their standard of living through debt-acquisition, which itself became a strain due to debt service costs.

As energy prices begin to fall (in what future economists may call a series of technology shocks), as private deleveraging proceeds strongly (with or without higher inflation) and as new cost-cutting technologies such as 3-D printing become more widespread real incomes will probably begin to rise again for the masses indicating a new supercycle of growth and pushing goldbug and other scarcity-concerned views to the fringes once more. We are, I think, moving inexorably to a world of superabundance, whether we like it or not. (Of course, in such a world assets like gold may still have a popular following to some degree, but that is another story for another day).

So even while the Federal Reserve continues to expand its balance sheet into the future in an effort to keep the US financial system liquid and further lubricate private deleveraging (and simultaneously chasing the elusive unemployment-reducing properties of Okun’s Law), the broken gold-Fed correlation is likely to break down even more.