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.

There Is No Surer Way To Destroy A Banking System Than Giving Depositors A Haircut

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No, not that kind of haircut.

I’m talking about the kind of haircut where depositors lose a portion of their money. This can destroy confidence in a fractional reserve banking system, as depositors in other banks and other countries fear that they too might be forced to take a haircut, leading to mass withdrawals, leading to illiquidity. And — as part of an E.U. bailout of the Cypriot financial system this just happened in Cyprus:

Eurozone finance ministers have agreed a 10bn-euro (£8.7bn) bailout package for Cyprus to save the country from bankruptcy.

The deal was reached after talks in Brussels between the ministers and the International Monetary Fund (IMF).

In return, Cyprus is being asked to trim its deficit, shrink its banking sector and increase taxes.

For the first time in a eurozone bailout, bank depositors are facing a levy on their savings.

This attack on depositors will have clear implications for depositors and banks in other bailout-prone areas of the Eurozone — Spain, Italy, Greece, Portugal. If the EU is prepared to impose haircuts of up to 10% on depositors in Cyprus as part of a bailout package, which countries’ depositors will be forced to take a haircut next? Mattress-stuffing Cypriots will be 10% better-off than their compatriots with confidence in the banking system. Even if only 10% or 20% of bank customers in Spain choose to withdraw their funds, that has the potential to cause serious liquidity problems.

Whether or not this actually happens is another question — although with unemployment running high throughout the Eurozone, those with savings may be particularly wary of losing them. This decision — no matter how many times Draghi and Merkel and Barroso reassure the crowds — makes bank runs throughout the Eurozone much more likely as savers seek to avoid the possibility of a haircut by moving to cash or tangible assets.

And this madness was totally avoidable.

Breaking the Banks

Simon Johnson at the New York Times takes Ron Paul seriously:

Mr. Paul  has a clearly articulated view on the American banking system, laid out forcefully in his 2009 book, “End the Fed.” This book and its bottom-line recommendation that the United States should return to the gold standard – and abolish the Federal Reserve System – tend to be dismissed out of hand by many. That’s a mistake, because Mr. Paul makes many sensible and well-informed points.

But there is a curious disconnect between his diagnosis and his proposed cure, and this disconnect tells us a great deal about why this version of populism from the right is unlikely to make much progress in its current form.

There is much that is thoughtful in Mr. Paul’s book, including statements like this (on Page 18):

“Just so that we are clear: the modern system of money and banking is not a free-market system. It is a system that is half socialized – propped up by the government – and one that could never be sustained as it is in a clean market environment.”

Mr. Paul is also broadly correct that the Federal Reserve has become, in part, a key mechanism through which large banks are rescued from their own folly, so that their management gets the upside when things go well and the realization of any downside risks is shoved onto other people.

But Mr. Paul’s book also acknowledges the imbalance of power within the financial system that prevailed at the end of the 19th century. Wall Street financiers, like J.P. Morgan, were among the most powerful Americans of their day. In the crisis of 1907, it was Morgan who essentially decided which financial institutions would be saved and who must go to the wolves.

Would abolishing the Fed really create a paradise for entrepreneurial banking start-ups, enabling them to challenge and overthrow the megabanks?

Or would it just concentrate even more power in the hands of the largest financial players?

Important questions, no doubt — but also something of a contradiction.

Absolute power — who gets bailed out, who gets access to a lender of last resort, who gets access to money at next-to-zero rates, who gets stimulus funds — is today concentrated in the hands of the largest financial players— the US government, and the Federal Reserve system.

And the US government is susceptible (understatement is an art!) to the activities of lobbyists.

Here’s the NYT on that issue:

The financial industry has spent more than $100 million so far this year [2011] to court regulators and lawmakers, who are finalizing new regulations for lending, trading and debit card fees. During the second quarter, Wall Street spent $50.3 million on lobbying, a small dip from the prior period, according to an analysis by the Center for Responsive Politics.

 Big banks are among the most prolific spenders. JPMorgan Chase‘s team of in-house lobbyists spent $3.3 million, a slight uptick over last year. The biggest war chest among organizations focused primarily on Dodd-Frank belongs to the American Bankers Association, which so far spent $4.6 million on lobbying. The organization wrestled the top spending spot from the Financial Services Roundtable, a fellow trade group that represents 100 of the nation’s largest financial firms.

And the Federal Reserve itself is much worse still. Its stock is owned by private banking interests:

The 12 regional Federal Reserve Banks  issue shares of stock to member banks. The stock may not be sold, traded, or pledged as security for a loan; dividends are, by law, 6 percent per year.

The banking industry effectively writes much of its own regulation, because it is enmeshed into the governmental-bureaucratic superstructure:

Frankly, I don’t think that power could get any more concentrated.

So surely only the naive would be surprised that the banking industry — through their benefactors at the Fed — bailed themselves out of the last crisis to the tune of $29 trillion.

And that is not just unfair; it’s unhealthy.

As I wrote in November:

Bailing out failed and failing financial institutions creates a zombie economy. Why?

In nature, ideas and schemes that work are rewarded — and ideas and schemes that don’t work are punished. Our ancestors who correctly judged the climate, soil and rainfall and planted crops that flourished were rewarded with a bumper harvest. Those who planted the wrong crops did not get a bailout — they got a lean harvest, and were forced to either learn from their mistakes, or perish.

These bailouts have tried to turn nature on its head — bailed out bankers have not been forced by failure to learn from their mistakes, because governments and regulators protected them from failure.

So it should be no surprise that financial institutions have continued making exactly the same mistakes that created the crisis in 2008.

So while it is all very well debate the various schemes to end the problem of too-big-to-fail, it is important to remember that the problem will ultimately solve itself — a system that rewards failures and creates zombies is fundamentally unsustainable.

Ron Paul does not need to end the Fed. By bailing out a system shot with fragility, leverage junkies and counter-party risk — by attempting to sustain a system that is fundamentally unsustainable — the Fed is quietly abolishing itself, or at very least strongly endangering the status quo.

Populism & the Fed

A bizarre piece from Gregory Morris writing for Bloomberg:

Today, as its 100th anniversary approaches, many followers of both the Tea Party and Occupy Wall Street movements are calling to “End the Fed.” The rich irony here isn’t that reactionaries and radicals are in agreement on something; after all, they are both passionately populist. The irony is that it was populist outrage and calls for reform that created the Fed in the first place.

The three decades from the demise of the second central bank to the point where the Lincoln administration began printing greenbacks to finance the Civil War were known as the years in the wilderness for American finance. Banks printed their own notes — and let the buyer beware. Bank runs and panics were a common fact of life.

Even with the terrible economic conditions we’ve seen in the past few years, it’s difficult today to comprehend the precarious state of business and personal finance in those days. Not only was there no central bank to restrain economic swings, there was no deposit insurance and no social safety nets. Banks were chronically undercapitalized and went bust with alarming frequency. There was no recourse for depositors. Farms and shops were foreclosed, families put on the street.

Really? Populist outrage led to the creation of the Fed?

I thought it was a cabal of bankers and financiers meeting in secret.

From Wikipedia:

At the end of November 1910, Senator Nelson W. Aldrich and Assistant Secretary of the U.S. Treasury DepartmentA. Piatt Andrew, and 5 more of the country’s leading financiers, who together represented about one-fourth of the world’s wealth, arrived at the Jekyll Island Club to discuss monetary policy and the banking system, an event led to the creation of the current Federal Reserve. According to the Federal Reserve Bank of Atlanta, the 1910 Jekyll Island meeting resulted in draft legislation for the creation of a U.S. central bank.

Now I know that depositors want their deposits insured. I know that a world of bank runs and panics is not a very reassuring atmosphere for businesses. But let’s be honest — things weren’t that bad. Here’s real GDP-per-capita from the end of the Civil War to the end of World War I:

Does that look like stagnation or weakness to you? No — it looks to me like a consistently rising standard of living powered by significant wealth creation. Sure — bank runs and panics, and bank failures and foreclosures were common. That’s the nature of creative destruction — good ideas can much more easily succeed if bad ideas are free to fail. That meant that society, and the economy, were much more experimental. And that’s the cost of innovation, and endeavour and experimentalism — an atmosphere of volatility.

The real issue is that the Fed’s defenders don’t really like creative destruction, because it is too risky. They cling to the comfort blankets of mild-to-moderate yearly inflation via money printing, significant government intervention to save failed businesses like GM, AIG and Bear Stearns, and an economy and political system swung (if not controlled) by too-big-to-fail megabanks, and their CEOs. Most fiercelythey cling to the risk-free 6% dividend they receive year-in-year out — a risk-free 6% of which most private citizens and investors can only dream.

The reality is that modern economic planning is the art of papering over the cracks. The social safety net, and depositors insurance are there not to create wealth (for they do no such thing) but to keep the febrile masses from rioting. The Fed’s defenders are puzzled that after all those monetary helicopter drops (stimulus, QE, QE2, etc, etc) the masses (Tea Party, Occupy) are still demanding more. The “great moderations”, and free lunches have (as I have explained in detail here and here and here) created a hyper-fragile monolith of delayed crises — America’s huge debt load, youth unemployment, biflation, etc — ready to crash down on society.

Loose monetary policy has created tsunamis of malinvestment, and bubbles (housing, NASDAQ, etc) that ultimately drag the economy back down to earth, resulting in crises that — as Paul Krugman so memorably put it back in 2001 — are reinflated, and reinflated, and reinflated by more and more and more interventionism, and new bubbles to replace the old.

That isn’t sustainable economics, or sustainable growth. Sustainable growth is driven by investment in the things that society wants and needs. It’s driven by people working, saving, and investing in products, services and businesses that they deem to be valuable. That is the nature of a free market, not the government or central bank firing off trillions of dollars to whoever they designate as “systemically important”. Sustainable growth is driven by experimentalism. If an experiment fails, it falls to pieces and a gap in the market is opened for the next experiment. Sustainable growth is not driven by bailouts and moral hazard — ever. That means that investors and financiers will think long and hard before committing capital, instead of throwing it into ponzi schemes and derivatives-black-holes.

There is a sensible middle ground between creative destruction and modernity. If anyone is to be bailed out, it should be the poorest, not billionaire bankers and Wall Street megabanks. Let the government insure the deposits of the masses. Let the government provide a safety net to prevent homelessness and starvation, and sickness — so long as it is funded sustainably from tax revenues, and not borrowing.

But let failed businesses fail. Let bad experiments end. Let bad debtors default on their debts. If the financial system is fundamentally weak then let it crumble — let a new system take its place.

No Capitalism on Wall Street

Herman Cain doesn’t understand the #OccupyWallStreet protests.

From ThinkProgress:

CAIN: I don’t have facts to back this up, but I happen to believe that these demonstrations are planned and orchestrated to distract from the failed policies of the Obama administration. Don’t blame Wall Street, don’t blame the big banks, if you don’t have a job and you’re not rich, blame yourself! It is not someone’s fault if they succeeded, it is someone’s fault if they failed.

Really? Wall Street is succeeding? You could have fooled me. The reality is that Wall Street’s largesse since 2008 has been underwritten by government. That’s why it’s so bizarre that Obama and Bernanke — two “system-saving” bailout architects have acknowledged sympathy for the protestors. Some of the protestors might be angry with the present system, and they may call that system capitalism, but there is no way that that is a fair description. As I wrote last month:

If government doesn’t allow banks that made bad decisions to be punished by the market, then the bailed-out zombie banks can rumble on for years, parasitising the taxpayer in the name of ever-greater bonuses for management, while failing to lend money, create new employment, or help the economy grow.

The global financial system isn’t working because there are fundamental structural problems with the global economy. These include over-leverage, the agency problem, trade deficits, failed economic planning, massive debt acquisition, Western over-reliance on foreign oil and goods, military overspending, systemic corruption, fragility and so forth. Stabilising the global financial system merely perpetuates these problems. The market shows that it needs to fail — preferably in a controlled way so that real people don’t get hurt — so that we can return to experimental capitalism, where good ideas prosper, and bad ideas don’t.

Bernanke’s organisation — the private Federal Reserve — pays a 6% dividend to member banks. That’s a staggering risk-free return on investment. Is it any wonder that banks won’t lend to small businesses or common people when the chosen few can just make easy money through having their funds sit at the Federal Reserve?

So no — Herman Cain is wrong. Protestors shouldn’t be blaming themselves for their “failure”. They should blame a system of government and monetary policy that gives money and favours to its friends. Call it crony capitalism, or corporatism or simply call it corruption.