Regular readers know that I brought up Walter Bagehot's 1870s observation that the effective lower bound for monetary policy was 2% over a year ago. At the time, I asked readers to explain what if anything had changed so that this was no longer true.
For anyone who does not know, Mr. Bagehot is the individual who, while the editor in chief of the Economist Magazine, literally wrote the book on modern central banking.
Mr. Gross is now explaining to everyone why Mr. Bagehot got it right.
[The] deceased economic maestro of the 21st century – Hyman Minsky – probably couldn’t have conceived how his monetary theories could be altered by zero-based money.
.... who could have conceived 30 or 40 years ago that interest rates could ever approach zero per cent for an extended period of time? Probably no one.Actually, this is why we have to go back to Mr. Bagehot in the 1870s because zero percent for an extended period of time was not inconceivable then.
Nor, more importantly I suppose, can Ben Bernanke, Mario Draghi or Mervyn King. In their historical models, credit is as credit does, expanding perpetually after brief periods of recessionary contraction, showering economic activity with liquid fertiliser for productive investment and inevitable growth.Mr. Bagehot did not focus on credit, rather he focused on the impact of low rates on savers.
If they were to adopt Minsky’s framework, they would visualise a credit system expanding from “hedge” to “securitised” to “Ponzi” finance...
In modern central bank theory, liquidity traps are a function of fear and unwillingness to extend credit based upon the increasing probabilities of default. This world is the second half of Will Rogers’ famous maxim uttered in the Depression: “I’m not so much concerned about the return on my money, but the return of my money.”
But what if the return on Will’s money could come into play as well? What if liquidity could be trapped by zero-based policy rates and the absence of yield across much of the triple-A yield curve? What if money could be stashed in a figurative mattress because it didn’t earn anything? What if there was a liquidity trap duality of too much risk and too little return?...Mr. Bagehot was explicitly concerned with what would happen to savers behavior if there was too little return.
The modern capitalistic model depends on risk-taking in several forms. Loss of principal – as in default – necessitates the cautious extension of credit to those that presumably can use it most efficiently.
But our finance-based Minsky system is dependent as well on maturity extension. No home, commercial building or utility plant could be created if the credit liability matured or was callable overnight. Because this is so, lenders require and are incentivised by a yield premium for longer term loans, historically expressed as a positively sloping yield curve.
A flat yield curve, by contrast, is a disincentive for lenders to extend intermediate or long-term credit unless there is sufficient downside room for yields to fall and bond prices to rise, resulting in capital gain opportunities....
When all yields approach the zero-bound, however, as in Japan for the past decade and in many developed economies today, then the dynamics may change.
What incentive does a US bank have to extend maturity to a two- or three-year term when Treasury rates at that level of the curve are below the 25 basis points available to them overnight from the Fed? What incentive does Pimco or banks have to buy five-year Treasuries at 75bp when the maximum upside capital gain is two per cent of par and the downside substantially more?Do capital markets actually work and efficiently allocate capital to its highest and best use when zero interest rate policies distort the yield curve so that risk is systematically mis-priced?
Alternatively, is Mr. Bagehot's 2% the minimum level for interest rates where capital markets function and efficiently allocate capital to its highest and best use?