Wednesday, December 21, 2011

Bill Gross and Walter Bagehot agree that ZIRP doesn't work

In a Financial Times column, Bill Gross presents the idea that ultra cheap money causes the financial system to breakdown.

Regular readers are familiar with this idea.  This blog presented it over the last several months by
  • Noting that Walter Bagehot, the father of modern central banking, observed over 125 years ago that 2% was the lower bound; 
  • Documenting a number of economic headwinds that occur under zero interest rate policies; and
  • Suggesting that ultra cheap money gives market participants an incentive to pay down their debts as paying off the debt provides a much higher risk free rate of return than can be achieved in the market.
Returning to Mr. Gross,
Gresham’s law needs a corollary. Not only does “bad money drive out good,” but “cheap” money may as well. Ultra low, zero-bounded central bank policy rates might in fact de-lever instead of relever the financial system, creating contraction instead of expansion in the real economy. 
Just as Newtonian physics breaks down and Einsteinian concepts prevail at the speed of light, so too might easy money policies fail to stimulate at the zero bound.
Historically, central banks have comfortably relied on a model which dictates that lower and lower yields will stimulate aggregate demand and, in the case of financial markets, drive asset purchases outward on the risk spectrum as investors seek to maintain higher returns. 
Near zero policy rates and a series of “quantitative easings” have temporarily succeeded in keeping asset markets and real economies afloat in the US, Europe, and even Japan. Now, with policy rates at or approaching zero yields and QE facing political limits in almost all developed economies, it is appropriate to question not only the effectiveness of historical conceptual models but entertain the possibility that they may, counterintuitively, be hazardous to an economy’s health....
Rates at the zero bound do something more. Zero-bound money – credit quality aside – creates no incentive to expand it....
In the case of low yielding Treasuries the Gresham’s corollary at first blush seems illogical. If a bank can borrow at near 0 per cent then theoretically it should have no problem making a profit. 
What is important, however, is the flatness of the yield curve and its effect on lending across all credit markets. Capitalism would not work well if Fed funds and 30-year Treasuries co-existed at the same yield, nor if commercial paper and 30-year corporates did as well. 
It is not only excessive debt levels, insolvency and liquidity trap considerations that delever both financial and real economic growth; it is the zero-bound nominal yield, the assumption that it will stay there for an “extended period of time” and the resultant flatness of yield curves which are the culprits. 
Conceptually, when the financial system can no longer find outlets for the credit it creates, then it de-levers. The point should be understood from a yield as well as a credit risk point of view. When both yield and credit are at risk from the standpoint of “Gresham’s law,” the mix can be toxic. 
The recent example of MF Global emphasises the concept, as does the behaviour of depositors in some struggling European economies. 
If an investor has money on deposit with an investment bank/broker that not only appears to be at risk but returns nothing, then why maintain the deposit? 
Perhaps an investor would be more comfortable with a $100 bill at home in a mattress than a $100 bill on deposit with a broker – Securities Investor Protection Corporation notwithstanding.... 
This was precisely the issue that FDR addressed in his fireside chat at the end of the US bank holiday in March 1933.  The fireside chat was aimed at restoring confidence in the banking system and succeeded because of the implied government guarantee of 100% of bank deposits.
Historical examples and central bank staff models will likely not validate this new Gresham’s corollary. Fed chairman Ben Bernanke blames policy rate increases in the midst of the 1930s for an economic relapse, and a lack of credit expansion for Japan’s lost decades 60 years later. 
But all central banks should commonsensically question whether ultra-cheap money continually creates expansions as opposed to destroying liquidity, delevering and obstructing recovery. Gresham as opposed to Keynes may become the applicable economist of this new day.
Actually, Walter Bagehot is the applicable economist of this new day.  He observed the 2% lower bound and advised banks not to breach it.

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