Friday, January 22, 2010

Low Interest Rates and Easy Credit Are Catastrophes for Any Economy

The Federal Reserve insists that super-low interest rates and loose lending are the keys to renewed growth. Their analysis is fatally flawed; those are catastrophically destructive policies in any economy.

One of the key analytic tools in the Survival+ critique is very simple to grasp: sort out the incentives and disincentives, and you are halfway to a systemic understanding.

For example, U.S. sickcare (a.k.a. "healthcare") is fundamentally doomed to insolvency and collapse because its incentives for all participants are entirely perverse. (Please see Perverse Incentives and a Government Doomed to Collapse January 14, 2010).

With this is mind, let's examine the incentives built into the Federal Reserve policy of super-low interest rates and loose lending ("easy credit"). The fundamental idea here is straightfoward: consumers have limitless desires, and all we need to do to reinvigorate consumer spending is make borrowing more money both cheap and convenient/easy.

But what about the hidden incentives and disincentives? This policy is incredibly perverse in several profound ways:

1. it provides a powerful disincentive to saving (accumulating capital)

2. it offers a powerful incentive to speculate with "free money" provided by lenders

3. it provides a powerful incentive to leverage a small amount of capital/cash into gigantic bets via "easy money" (3% down payment mortgages, etc.)

4. it rewards risk and destroys moral hazard because the losses incurred by the borrower deploying massive leverage are extremely modest (3% down isn't much to lose, so why not gamble that housing with rise 30% from here?)

5. it incentivizes a feedback loop of ever-expanding bets, leverage and borrowing (i.e. housing speculators buying a second, third and fourth home because they made a killing on their first house) which "rewards" the speculative mania with ever higher assets prices as this specious "demand" grows with expanding leverage and debt.

6. In a financial system which actively suppresses interest rates, then capital earns virtually nothing. Entrepreneurs have no incentive to be prudent in their borrowing, and holders of capital are left with no choice but speculation in risky assets lest their capital melt away in an engineered environment of "benign" (slow steady erosion of capital) inflation. Recall that "low" 2.5% inflation will rob you of a third of your capital every decade.

This is exactly the trap into which pension funds fell: required by actuary models to earn 6%, faced with a Fed-manipulated yield of 2%, they were forced to speculate in real estate, stocks and derivatives to reach the 6% yield they needed.

Is any of this remotely related to capitalism in the sense of encouraging capital formation, prudent risk/return, productivity and enterprise? No. An environment in which savers are punished is not capitalist, for capitalism is in essence a system which rewards the accumulation and productive investment of capital, not the leveraged borrowing and wild speculation engendered by the super-low rates and loose lending policy of the Fed and Japanese central bank.

Young people may be forgiven for not knowing that interest rates of 10-12% for capital and mortgages were the norm in the 1980s--a period of strong "real" growth in the U.S. Reasonably high rates of return did not suppress organic growth--they encouraged it by incentivizing productive use of capital.

Simply put, if your business makes no sense except if you can borrow money at 3% or less, then your business is not viable. If you can't put 20% down, and the house isn't affordable at a rate of 10% interest on the mortgage, then the house is too expensive and you shouldn't attempt to buy it.

If capital formation (savings) is actively punished by manipulated low rates, then a nation soon degrades to a state in which no one bothers saving capital; following the built-in incentives of low yields and easy credit, they borrow and consume beyond their means. (That is, the U.S. in the past decade.)

If leverage, easy credit and speculation are all heavily incentivized, then a nation disintegrates into an economy dominated by and obsessed with asset bubbles. (That is, the U.S. in the past decade.)

Your honor, my first exhibit is the nation of Japan. For cultural reasons, the Japanese stubbornly continued saving after their disastrous pursuit of easy-money, low-interest rate asset bubbles in the late 1980s. The Japanese now hold$16 trillion in cash savings but it earns essentially no return. Now that the populace is aging, they are starting to withdraw that dead capital from their moribund bond/banking capital markets, withdrawing the domestic source of capital which enabled their government's endless deficits and debt accumulation.

This withdrawal of domestic savings will force the Japanese government and other borrowers into the global market, and 0.1% yields will not attract capital flows in the stupendous quantities Japan needs just to float its existing debt. Recall that 45% of Japan's government budget already goes to pay interest on its debt--and that's at super-low rates of interest. Thus the Japanese economy is doomed to implosion once global rates rise.

Frequent contributor U. Doran submitted a story which provides background for this: "Japan is the most asymmetric opportunity I have ever seen".

Super-low rates and easy credit are not panaceas--they are in effect demolition machines which will destroy any economy which is seduced by their siren-song of "easy growth." There is no such thing as "easy growth" based on low rates and easy credit; "growth" based on artificial demand rises to the point that income no longer services the interest costs, and at that point then the collapse of asset prices and government revenues is guaranteed.

I rest my case. The U.S. economy is doomed to implode, just as the Japanese economy will implode, and so too will any economy anchored only by low interest rates and exponential expansion of "easy credit." (There's more on this inSurvival+ but you know that already.)

Lagniappe: U. Doran also sent in this link to Martin Armstrong's latest. If you are unfamiliar with Armstrong's idiosyncratic but deeply informed analysis, check it out:Deep Capture (PDF). is now open for aggregating our collective intelligence.

Order Survival+: Structuring Prosperity for Yourself and the Nation from your local bookseller or from or in ebook and Kindle formats. A 20% discount is available from the publisher.

Of Two Minds is now available via Kindle: Of Two Minds blog-Kindle

Thank you, Edna S. ($20), for your very encouraging, generous contribution to this site. I am greatly honored by your support and readership. Thank you, Cheryl A. ($100), for your stupendously generous contributions of money, resources, ideas and books to this site. I am greatly honored by your support and readership.

Terms of Service

All content on this blog is provided by Trewe LLC for informational purposes only. The owner of this blog makes no representations as to the accuracy or completeness of any information on this site or found by following any link on this site. The owner will not be liable for any errors or omissions in this information nor for the availability of this information. The owner will not be liable for any losses, injuries, or damages from the display or use of this information. These terms and conditions of use are subject to change at anytime and without notice.

Our Privacy Policy:
Correspondents' email is strictly confidential. The third-party advertising placed by Adsense, Investing Channel and/or other ad networks may collect information for ad targeting. Links for commercial sites are paid advertisements. Blog links on the site are posted at my discretion.

Our Commission Policy:
Though I earn a small commission on books and gift certificates purchased via links on my site, I receive no fees or compensation for any other non-advertising links or content posted on my site.

  © Blogger templates Newspaper III by 2008

Back to TOP