Click here to read this article in pdf format: September 2 2012

Over the past months (and particularly in the last weeks), we have increasingly read negative comments on the ongoing zero-interest rate policy (ZIRP) and in some instances, negative-interest rate policy (NIRP). We find these comments were anecdotal. Not superfluous but anecdotal. They touch on the influence of ZIRP on savings, on the profitability of banks, on fiscal policies, on debt, etc. Perhaps, the anecdotal format is explained by an inclination towards induction rather than deduction and perhaps our discomfort with this is driven by our familiarity with the Austrian method.

Today, we want to examine the origins of the idea that ultra-low rates of interest can exist, how this idea came about, why it was flawed and how it leads to an informal economic system. It was a fallacy based on misunderstanding of the rate of interest and human action.

Origins of the idea that ultra-low rates of interest can exist

From our very limited knowledge in the history of economic thought, we are inclined to believe that the topic of zero interest rates was first introduced by John M. Keynes, when he contemplated the possibility of the existence of a liquidity trap (chapter 13), in his so-called “General Theory of Employment, Interest and Money”. Keynes did not see this as the result of explicit policy but as an aberration of market participants, driven by their animal spirits, which define their liquidity preferences.

Keynes’ concepts were popularized in visual format by Sir John Hicks , when he came up with the famous IS-LM model. In the graph below, following this model, we can see that the equilibrium rate of interest is negative. The “S” line is an indifference curve for the aggregate supply of loanable funds. In the axes, we see a benchmark rate of interest (r, vertical ax) and income (horizontal). The “I” line is the indifference curve for investment demand. As the rate of interest falls or income rises, the demand for investment goods increases. If the rate of interest falls too, the aggregate supply of loanable funds decreases.

The chart also shows that there is an income level that would get us to a desired level of employment (Yp). Logically, it would seem that either a higher level of investment or a lower level of savings is required, to “bridge the income gap”.

In our view, the whole approach of thinking in terms of indifference curves is ridiculous. Nobody is ever indifferent. Everybody is always making a decision. Having said that, let’s remember that Keynes challenged the notion that both investments and savings were sensitive to the rate of interest. For Keynes, investment demand was mainly a function of income and secondarily

of the rate of interest. In the same fashion, savings were also driven by income. To Keynesians, savings are by-product of consumption, that part of the income we did not consume at the end of a period:

Investment = f (Y)

Savings = Income – Consumption, but as consumption is a function of income: Savings = Y – C (Y)

 

Why the idea was flawed

It should now be clear that there is an inconsistency in simultaneously believing that investment demand and savings are mainly driven by income but that it is necessary to lower the interest rate to boost investment, as the Fed does…and the Fed is Keynesian! Keynes also thought that fiscal policy was necessary to boost investment demand, so that the intersection between the I curve and the S curve takes place at a positive rate of interest. By the same token, Keynes must have not considered increasing savings to bridge the gap (i.e. an increase in the supply of loanable funds), because that would have meant a reduction in income! In his own words (from Chapter 13): “and whilst an increase in the volume of investment may be expected, ceteris paribus, to increase employment, this may not happen if the propensity to consume is falling off…(= savings increase)”

According to Professor Jesús Huerta de Soto, Keynes lacked a theory of capital, which cornered him into an horrible circularity:

On one hand, Keynes thought that the rate of interest was determined by the liquidity preference of the public (as in the chart above, because the liquidity preference determines the supply of loanable funds). In his own words: “…whilst an increase in the quantity of money may be expected, ceteris paribus, to reduce the rate of interest, this will not happen if the liquidity-preferences of the public are increasing more than the quantity of money…”

On the other hand, Prof. Huerta de Soto rightly notes, if you asked Keynes what determines the liquidity preference of the public…he will answer: The rate of interest does! We  think (we are not PhDs in Economics or historians of economic thought)  the evidence of what Prof. Huerta de Soto points is found on Chapter 15:

“…In normal circumstances the amount of money required to satisfy the transactions-motive and the precautionary-motive is mainly a resultant of the general activity of the economic system and of the level of money-income(…); whereas experience indicates that the aggregate demand for money to satisfy the speculative-motive usually shows a continuous response to gradual changes in the rate of interest, i.e. there is a continuous curve relating changes in the demand for money to satisfy the speculative motive and changes in the rate of interest (…).. Indeed, if this were not so, “open market operations” would be impracticable…”

In summary, Keynes thought that the liquidity preference of the public determined the rate of interest, and that the rate of interest was determined by the liquidity preference of the public (i.e. the aggregate demand for money to satisfy the speculative-motive). Keynes oversaw that the rate of interest is nothing else but an inter-temporal rate of exchange, between present and future consumption.

 

Misunderstanding of the rate of interest and human action

This inter-temporal exchange rate is very relevant and we dare to say, instinctive. The fact that we understand it at its most basic level, which is the awareness of our mortality, is precisely what made us evolve into human beings. When time has a price, when the inter-temporal rate of exchange is relevant, when the rate of interest is positive and important, men tend to be more desperate than otherwise and they create, they take risks, they look for more efficient ways to produce what they need, they become more productive…they grow!

This basic instinct is so strong that even if a central bank determines that the rate of interest should be zero, humans, aware of their life cycle, will refrain from consuming today in exchange for consuming more tomorrow. Before you disagree with us on this, think about the following: The curve “S” above is for loanable funds, not for savings! If the interest earned from these funds is not “enough”, that will not prevent people from saving. People will just not invest their savings in loanable funds, in securitizable assets (which is in line with Hernando De Soto’s works on informal economies) . They will save in non-financial assets and if the public markets, manipulated by central banks don’t acknowledge that inter-temporal exchange rate, the public assets will be privatized.

Thus, we should not be surprised if, under zero-interest-rate policies in the developed world, we witness a growing trend in corporate leverage, with vertical integration, share buybacks and private equity funds taking public companies private. It would be only natural. We warned of this back on May 7th.

Another way of examining this is the following: The zero interest rate indicates that time is free. And as anything that is free is wasted, time will also be wasted. Therefore, the equity of a firm, which is the equivalent of a call option on the assets of a firm, will become very cheap in terms of the debt of the company, as the debt does not grow with time because no interest is due on it (this only holds true, if the company is profitable, as a friend pointed to us). Arbitraging for this distortion in relative value, lifts the price of stocks, and to make this process sustainable in time, central banks need to keep throwing liquidity to the system, until they no longer can….

Now, if savings leave the matrix “system”, we will see in the long run an important de-leveraging, as the credit multiplier becomes less and less powerful. With more assets outside the system, the pricing mechanism becomes less efficient, since there are fewer signals to market participants. Capital markets disappear, specialization decreases, economies of scale are threatened. With more assets outside the system, productivity plunges and with it, unemployment skyrockets in rigid (unionized) labour markets (characteristic of developed economies). As developed economies, with high stock of capital, rely on economies of scale, this fundamental transformation has enormous damaging potential.

The flight from the system brings more financial repression as a logic reaction. In those nations with established coercive savings plans pension plans , politicians set their eyes on these virgin pools of capital, to force a bid to their liabilities (i.e. sovereign debt). This process eventually spirals, since the financial repression aimed to prevent market participants from protecting their inter-temporal exchange decisions, grows exponentially and brings about precisely the opposite outcome: A complete defence of savings, now fully thrown into an informal economy.

At this point, something has to be said about wealth transfer, because not every market participant is able to re-allocate his/her  investments and re-direct his/her savings from the system to the informal world. Those who cannot save enough, those employed in firms and trapped in pension plans, will see their assets evaporate. If the harm is too significant, it may even be a cause for them to leave their condition as employees and become self-employed. This is the landmark of underdeveloped economies: A huge mass of self-employed, undercapitalized citizens in an informal system. The informality prevents them from accessing credit, which enhances their undercapitalization.

Finally, we ask that you note one last thing: As productivity, employment and production decrease, even a steady and low rate of inflation has the potential to morph into hyperinflation. It’s only a matter of time, and it occurs once the capital markets (including the futures markets) vanish, when the only reason to demand currency is for transactional purposes, when the demand of currency to settle debts is only marginal.

Martin Sibileau

Click here to read this article in pdf format: June 25 2012

We are as deceived as you are with the policy decisions undertaken by the European Union (EU) and the US. As we muddle through their consequences, today we take a moment to offer a few thoughts…

-On the EU: Banking Union, bailout funds and other tricks

After the second LTRO (i.e. long-term refinancing operation) and the Greek debt swap exchange (in March), the likelihood of the break-up of the European Monetary Union has risen exponentially, and continues to rise. Along with this trend, cross border lending by banks continues to fall and flight of capital from the periphery remains in place. The fear of a final collapse is there and rumours of a pending banking union were thrown at the markets.

A banking union, if true and under whatever form it takes, requires a final omni guarantor, backed by an omni pool of resources, funded by an omni tax. This means that the required step of a EU fiscal union is still the only solution to the (only) problem. As we repeated since 2010: This is an institutional crisis! The same analogy is applicable to any bailout fund that “they” may want to throw at us. EFSF? ESM? You name it, they are all useless. They all need an omni guarantee. To think otherwise is simply delusional and a waste of time. Fiscal union, on the other hand, is not possible overnight. It demands constitutional changes. Any strength in the Euro upon these rumors should be faded.

-The European Central Bank (ECB), its collateral and Argentina:

On Friday, the ECB announced that it will reduce the rating threshold and amend the eligibility requirements for certain collateral. In other words, the ECB is accepting lower rated assets to back its liabilities, i.e. the Euro. This brings the European Monetary Union closer to an “Argentina 2001” moment. Why? Argentina suffered from a fast deterioration because its banks, after years of hyperinflation and the confiscation of the 1989 Bonex Plan could only fund themselves via deposits. The European Union banks are getting dangerously close to that stage: Raising equity is no longer an option, unsecured funding has been subordinated by past bailouts, available assets to encumber are almost non-existent at this point (which is precisely why the ECB had to accept lower rated assets on Friday). Therefore, the only fools still funding the banks, at least  the banks in core Europe (because banks in the periphery live on liquidity lines from the ECB) are the depositors. We want to believe that majority of these deposits come from corporations, whose treasurers deposit other peoples’ (i.e. the corporations’ shareholders’) monies. Otherwise, we would be underestimating the intelligence of the people of the European Union, and we don’t.

Given the circularity in the solution proposed by the leaders of the EU (i.e. banks buy  debt from bankrupt nations; the banks go insolvent and are “saved” by the bankrupt nations, which in turn, are now even more insolvent), it is only a matter of time until the very deposits of EU banks are challenged, after every last asset owned by the banks is downgraded to junk and pledged to the central bank.  This brings us to the next point…

-Who leaves first?

With the outlook of former austerity programs (which never got to be implemented, by the way) being relaxed, to “promote growth”, we now believe that it is likely that Germany be the first to leave the European Monetary. The latest action in bunds (i.e. Germany’s sovereign debt) seems to indicate that we are not alone with this thought. Here is why: If a peripheral country is seen as likely to leave the monetary union, the flight of deposits from that country to Germany’s banks appreciates Germany’s sovereign debt and its yields drop, as it has, to negative territory. But if those countries are perceived to stay, as it was after the Greek’s election during the past weekend, then Germany will have to foot the bill. Therefore, the value of its sovereign debt will fall and its yield rise. This is precisely what occurred in the past days. The question is: When will Germany leave? To which we answer in these simple terms: Germany will leave only when the cost of staying surpasses that of leaving. Under both scenarios (staying or leaving) there is a cost. The cost of staying, is a higher yield on Germany’s debt. How high? Potentially, to the magical 7% that Spain has touched and Italy is on its way to touch. Germany would leave before then, as the unthinkable (i.e.Germanyout of the capital markets) takes place. The cost of leaving would be represented by the defaults of the countries that stay, on their obligations to the Bundesbank (for the liquidity lines they enjoyed under Target 2). We think (and explained in our last letter) that this cost can be mitigated, if no capital controls are imposed and bi-monetarism is embraced. This would allow banks –both in Germany and the periphery- to take deposits in Euros and in the new local currencies. Under this scenario, the European Central Bank would not be dissolved. However, if Germany left first, we doubt there would be any incentive from the rest of the countries to allow the existence of Euro-denominated deposits.

-Operation Twist, Part Two

We are not going to add noise to the decision by the Federal Open Market Committee (FOMC) to extend its purchases of long-term US Treasuries and selling, in equal amount, short-term US Treasuries. We are only surprised (very much) by the fact that every analyst, fund manager or media anchor judges the decisions of the FOMC –past, present and future ones- by their impact on the private sector: On activity, on the labour market, on asset prices, etc. Why is nobody openly saying that in a country where fiscal deficits are higher than $100BN per month, the central bank has no alternative but to buy and monetize fiscal debt? Why is nobody linking the deficit and the purchases? Who can really believe that the US are not kicking the can? Who can really think that there will not be, eventually, straight debt purchases?

-The unintended consequences of zero-rate policies, from a micro perspective.

From our lessons in corporate finance, as students, we remember that equity is the riskiest part of a company’s capital structure. Equity is a call option on the assets of the company, with the value of its debt being the strike price. If the value of the assets increases over that of the debt, the spread goes to the shareholders. Hence, for that to occur, the company must “grow”. Companies that have a high likelihood of growing can be financed via equity. Companies that are not likely to grow, that are established in a mature industry and generate steady cash flows, are better candidates to be financed with debt.

With this in mind, we now turn to the fact that zero rate policies sought after globally by central banks have destroyed any possibility of obtaining a decent yield in corporate debt. This forces those who cannot afford to eat off their savings, to “gamble” them in the stock markets, with the hope that the same central banks will boost equity valuations. However, the zero-rate policies kill growth and those poor peoples who were forced to leave the comfort of corporate debt and transfer their savings to stocks will find themselves invested, contrary to common sense, in the riskiest part of the capital structure, in a call option, exactly at the time when no growth will come. How unfair is this?

-Why this agony can last longer than you or we can think

Unlike financial crises in underdeveloped countries, the one affecting the developed world takes place in sophisticated capital markets. There are futures/derivatives markets, forced savings via pension plans, and legalized Ponzi schemes whereby collateral can be pledged multiple times to support liquidity. These factors can cause a significant delay in reaching the “final outcome” and are subject to manipulation:

To break the futures markets, one needs to see a failed delivery by one of the players. But politicians can always capitalize or inject liquidity to that counterpart and avoid the break-up of that market.

A significant portion of the workforce is coerced to save through collective pension plans. The coerced savings act as a cushion between reality and illusion. Those forced to save believe in the illusion that somehow, their pension plans will provide them with an income in the future. If reality set in and the magic was lost, politicians could (and have done so) simply postpone the retirement age or even hike the savings rates enforced upon them. Even in the case where people realized that the cost of staying in the pension plans was higher than leaving them under penalties, politicians can simply “temporarily” prohibit withdrawals and effectively confiscate the monies.

It will take dramatic events to be confronted with these situations, but we think that this crisis will last long enough to face them.

-Murray Rothbard and his book “America’s Great Depression”

The question is therefore: When is this crisis going to crystallize and what will it take for it to do so? Don’t ask us why but we re-read Murray Rothbard’s “America’s Great Depression”. In its Chapter 12, under the section titled: “The attack on property rights: The final currency failure”, Rothbard tells us that: “…despite the gigantic efforts of the Fed, during early 1933, to inflate the money supply, the people took matters into their own hands, and insisted upon a rigorous deflation (gauged by the increase of money in circulation)— and a rigorous testing of the country’s banking system in which they had placed their trust…”

From this, we take two conclusions: (a) The crisis ends with a rigorous deflation or liquidation of liabilities,  (b) That deflation has to be expressed in terms of a new standard (gold?).

In the ‘30s, the US dollar was still backed by gold. Gold was the Fed’s asset, the US dollar its liability. Today, the US dollar is backed by US Treasuries. Therefore, “to insist upon a rigorous deflation” is to repudiate the US Treasury notes. We can now see the implications of such repudiation, but we have written enough for today. We will elaborate more on this topic, in our next letter.

Martin Sibileau