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.

You should need a license to take out a mortgage

In The Atlantic, Moisés Naím points to a recent study that poses three simple questions on personal finance:

1. Suppose you had $100 in a savings account and the interest rate was 2 percent per year. After five years, how much do you think you would have in the account if you left the money to grow? A) more than $102; B) exactly $102; C) less than $102; D) do not know; refuse to answer.

2. Imagine that the interest rate on your savings account is 1 percent per year and inflation is 2 percent per year. After one year, would you be able to buy A) more than, B) exactly the same as, or C) less than today with the money in this account?; D) do not know; refuse to answer.

3. Do you think that the following statement is true or false? “Buying a single company stock usually provides a safer return than a stock mutual fund.” A) true; B) false; C) do not know; refuse to answer. [The Atlantic]

These questions were asked to people around the world, and the correct answers are A, C, and B. Did you get them all right? If you did — congratulations, you understand the basics of how interest ratesinflation, and portfolio diversification work. Most people surveyed around the world didn’t.

In Russia, 96 percent of those surveyed failed to answer the three questions correctly. In the U.S., 70 percent failed. The highest performing countries were Germany where 47 percent failed and Switzerland, where 50 percent did. But this isn’t rocket science. The questions reflected basic financial concepts that are essential for saving for the future, using credit cards, taking on a student loan, purchasing a home, investing, and building up a pension.

Worse than this, Americans also showed overconfidence in their abilities. Asked to rank their financial knowledge on a scale of 1 (very low) to 7 (very high), 70 percent of Americans surveyed ranked themselves at level 4 or higher. Yet only 30 percent answered the questions correctly.

These surveys provide some pretty scary food for thought, because uninformed, overconfident people are more prone to make bad decisions that endanger their own financial health and the wider economy. As this paper from the World Bank shows, individuals who are financially literate have better financial situations.


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).


Why America’s new love affair with saving is not great economic news

This data from Gallup shows that the 2008 recession transformed America’s relationship with money. In 2006, before the recession, 55 percent of Americans saw themselves are savers, and 45 percent saw themselves as spenders. By 2010, 62 percent saw themselves as savers, and only 35 percent saw themselves as spenders, a pattern which holds up today:

This tallies with data showing that the total level of money Americans are sitting on has soared since the recession. This is not great news.


Why so many Americans are missing out on the stock market boom

The stock market has been on a major tear for the last four years, with both the Dow Jones Industrial Average and S&P 500 climbing to all-time highs:

But the gains aren’t trickling down to the majority of Americans.


Hey, Pope Francis: Markets are the solution, not the problem

Pope Francis continues to make waves as the new head of the Catholic Church, offering a blistering critique this week of free markets and capitalism in his first apostolic exhortation:

[S]ome people continue to defend trickle-down theories which assume that economic growth, encouraged by a free market, will inevitably succeed in bringing about greater justice and inclusiveness in the world. This opinion, which has never been confirmed by the facts, expresses a crude and naïve trust in the goodness of those wielding economic power and in the sacralized workings of the prevailing economic system. Meanwhile, the excluded are still waiting. []


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.


The London Real Estate Bubble


In October, London real estate asking prices jumped 10%. In my view is kind of parabolic-looking jump has developed out of quite a silly situation, and one I think is a good exhibit of just how irrational and weird markets can sometimes be.  London real estate prices have been rising strongly for a long while, and a large quantity — over half for houses above £1 million — of the demand for London real estate is coming from overseas buyers most of whom are buying for investment purposes. It is comprehensible that London is a desirable place to live, and that demand for housing in London might be higher than elsewhere in the UK. It is a diverse and rich place culturally and socially, boasting a huge variety of shopping, parks, art galleries, creative communities, restaurants, monuments and landmarks, theatres and venues, financial service providers, lawyers, think tanks, technology startups, universities, scientific institutions, sports clubs and infrastructure. Britain’s legal framework and its straightforward tax structure for wealthy foreign residents has proven highly attractive to the global super rich. With London real estate proving perennially popular, and with the global low-interest rate environment that has made borrowing for speculation cheap and easy, it is highly unsurprising that prices and rents have pushed upward and upward as the global super rich — alongside pension funds and hedge funds — sitting on large piles of cash have sought to achieve higher yields than cash or bonds by speculating in real estate. In some senses, London real estate (and real estate in other globally-desirable cities) has become a new reserve currency. And while this has occurred, price rises have proven increasingly cyclical as both London residents and speculators have sought to buy. The higher prices go, the more London residents become desperate to get their feet on the property ladder in fear they won’t ever be able to do so, and the more speculators are drawn in, seeing London real estate as an asset that just keeps going up and up.

Yet the bigger the bubble, the bigger the bust. And I think what we are seeing in London is a large psychological bubble, a mass delusion built on other delusions. Chief among these delusions is that real estate should be seen as a productive investment, as an implicit pension fund, or as a guaranteed source of real yield. While investors can look at real estate however they like, there is no getting away from the fact that real estate is a deteriorating asset. Sitting on a deteriorating asset and hoping for a real price gain — or even to preserve your purchasing power — is a speculation, not a productive investment. For commercial enterprises buying as a premises for business, or for residents buying as a place to live this is not in itself problematic. But as an investment this can be hugely problematic. It is just gambling on a deteriorating asset under the guise of buying a “safe” asset.

Of course, in the UK where housing has been treated by many successive governments as an investment, and as a haven for savings and pensions, real estate owners have done particularly well. Governments have been willing to prop up the market with liquidity via schemes like Help To Buy and via restrictive planning laws to rig the market to restrict supply. This may make investors feel particularly secure, but governments can be forced — not least by demographics — to swing in another direction. An important side-effect of continually rising prices and a restricted supply of housing is that many people will not be able to afford to buy a home. With the house prices-to-wages ratio sitting far above the long-term average, the next UK government will come under severe pressure within the next few years to allow — and probably subsidise — much more housebuilding to bring down housing costs for the population. The past-trend of government-protected gains may have inspired a false sense of security in investors.

But such a reversal of policy would not in itself crash the London real estate market. After all, London is a unique place in Britain, and the majority of the new housebuilding may take place away from London. More likely, the bubble will simply collapse under the weight of its own growth. Sooner or later, even with liquidity cheap and plentiful, the number of speculators seeking to cash out will exceed the number of speculators seeking to cash in, and confidence will dip. Sometimes, this simply equates to a small correction in the context of a large upward trend, but sometimes — especially when it can be negatively rationalised — it manifests into a deeper malaise.

When this occurs, one probable rationalisation is as follows.  Domestically, many of the relatively low-income artists, designers, technologists, musicians, students, artisans, academics, service workers and professionals (etc) who make London London are priced out, then they will go and contribute to communities elsewhere where rents and housing costs are lower — Birmingham, Manchester, Glasgow, Paris, Berlin, out into the sprawl of the home counties, and deeper into the English countryside, to places where a four bedroom house costs the same as a studio apartment in central London. Where once this would have been culturally, professionally and socially prohibitive, fast, ubiquitous internet allows for people to live a culturally and socially connected life without necessarily living in a big city like London. Internationally, other cheaper cities and jurisdictions will simply catch up with London in terms of amenities and desirability to the global super class. Competition for global capital  is huge, and while London as an Old World metropolis has done well since 2008, it may suffer in the wake of renewed competition from newer, cheaper, faster-growing Eastern metropolises.

When the bubble begins to burst — something that I think could occur endogenously within the next five years, especially if the fast increases continue — speculators, and especially speculators who are heavily leveraged may face severe problems, resulting in a worsened liquidation and contraction, and possibly threatening the liquidity of heavily-invested lenders. As many people at the table are sitting on big gains, they may prove desperate to cash out. Just as many presently feel pressured to get in to avoid being priced out of London forever, a downward turn could be severely worsened as many who are heavily invested in the bubble and scared of losing gains on which they hoped to fund retirements (etc) feel pressured to get out. Such an accelerated liquidation could easily lead to another recession. While I doubt that London prices will fall below the UK average, prices may see a very sharp correction. The psychological bubble is composed of multiple fallacies — that housing is a safe place to put savings and not a speculation, that deteriorating real estate should yield higher returns than productive business investments, that the UK government will continue to protect real estate speculators, that large flows of capital from overseas speculators will continue into London. A bursting of any of these fallacies could begin to bring the whole thing into question, even in the context of continued provision of liquidity from the Bank of England.

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.