Wednesday, September 5, 2012

Bill Gross makes clear zero interest rate policies kill financial sector

In his latest monthly newsletter, Pimco's Bill Gross makes clear that the long-run consequence of the central banks pursuing zero interest rate policies is the elimination of the financial sector, including banks, insurance companies and money management firms.
Our entire finance-based monetary system – led by banks but typified by insurance companies, investment management firms and hedge funds as well – is based on an acceptable level of carry and the expectation of earning it. 
With zero interest rate policies, this is no longer possible as by design the policies artificially depress interest rates below what the market would set as an acceptable level of carry.

Regular readers know that this result is completely predictable.  After all, Walter Bagehot, the individual who wrote the book on modern central banking, Lombard Street, predicted it when he gave his reason for not lowering interest rates below 2%.

And the problem with destroying the financial sector is:
Credit, of course, is what makes the global economy go. We wouldn’t have gotten very far over the past several centuries despite Edison, Bell and Steve Jobs if barter was the accepted form of commerce. Even cash, serving as a medium of exchange and a disreputable store of value could not have promoted 3–4% real GDP growth in this gargantuan economy unless borrowers and savers were willing to exchange future promises – to utilize credit..... 
But in order to promote and indeed foster continuing symbiosis, both borrower and lender need to operate in a nutrient-rich environment, a “credit” petri dish of sorts which fosters strong bones and healthy lenders and borrowers in their adult years. That unfortunately does not seem to be the case....
A lender will not easily lend money to an obese over-indebted borrower – that much is clear – but she will also not extend a check when the yield, carry and return on investment is so low that it cannot compensate for historic business model overheads.... 
When yields are too low, and acceptable risk spreads so narrow that top line interest revenue is increasingly marginalized, then lending is at risk....
And so, what we are witnessing instead is the beginning of a waltz, a dance where financial institutions such as banks, insurance companies and investment management firms fail to reap the economies of scale so reminiscent of the prior era...
If the dancing has slowed down, then the reason is not just an overweight partner. 
It’s that the price of money (be it in the form of a real interest rate, a quality risk spread, or both) is too low. Our entire finance-based monetary system – led by banks but typified by insurance companies, investment management firms and hedge funds as well – is based on an acceptable level of carry and the expectation of earning it. When credit is priced such that carry is no longer as profitable at a customary amount of leverage/risk, then the system will stall, list, or perhaps even tip over.  
For the current shipwreck perhaps we have the Fed and other central banks to blame. 
Please re-read the highlighted text as Mr. Gross makes a critically important point.
Zero bound interest rates according to their historical models should inevitably and inexorably lead to dynamic real economic recovery. Who wouldn’t borrow at near 0% yields – namely the banks – in order to relend at seemingly profitable spreads? Who wouldn’t borrow at 3.5% for a 30-year mortgage – namely homeowners – in order to match or even reduce current rent payments? Well, they haven’t. Not in the amounts they were supposed to in any case. 
Structured impediments such as regulatory risk standards for banks and fear of losing money for households have thrown a monkey wrench into those models. 
Central banks are agog in disbelief that the endless stream of QEs and LTROs have not produced the desired result. Wimpy and Chuck are waltzing, not quickstepping, even with a band playing in up tempo.
Please note, the father of modern central banking, Walter Bagehot, predicted that there were structured impediments.  If these impediments didn't exist, then after 2+ decades of zero interest rate policies Japan should be experiencing the highest growing economy of all time.

Clearly, monetary policy cannot fix the problems that exist in the economy.  Equally clearly, monetary policy can make the situation worse by effectively destroying the financial sector.

2 comments:

jamfletch said...


Japan may not have experienced high economic growth as we normally measure it but they have had stability and experienced real increases in their standard of living.Sustained economic growth is a fallacy and the idea that money can be put to work to make more money is the root problem. Stock markets exist to feed this illusion as do banks.If the dollar value of a house changes it makes no difference to the physical entity that is the house.

Richard Field said...

Japan's society values stability. To the extent that the Japanese are voicing their dissatisfaction with the government's handling of the bank solvency led financial crisis, they have done so by replacing the prime minister. This is now happening more than once per year.

I think a distinction needs to be made between growth in the real economy and making money on money.

I think that growth in the real economy is what it is important. It leads to more food, more health care, more jobs for everyone.

So long as making money on money in ways that support the growth of the real economy occurs, I have no problem with making money on money.

I agree with your observation that we run into trouble when making money on money becomes an end in and of itself.