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No Easy Money

The case for raising interest rates

Here’s the recipe for endless prosperity, central planning version: start with a little inflation to plump up asset values, encourage spending and make debt easier to pay off in the future, then add in declining interest rates to encourage expansion and reward buyers of bonds. (As interest rates drop, the value of the bond rises.) Lastly, run some big government deficits to stimulate spending and toss in expanding money supply so there will always be plenty of dollars to borrow and spend.

Our central planners—the Federal Reserve and the U.S. Treasury—have furiously combined these ingredients, and the world watches anxiously to see if the results will be

• A return to cheap-money prosperity;

• A Japan-style no-growth deflation;

• Argentine-style debt repudiation and currency devaluation.

Despite the assurances of Bernanke and associates, the recipe can turn out badly: you can drop interest rates to nearly zero and still get deflation and no growth in the real economy. Alternatively, reckless expansion of cheap money and government deficits undermine the nation’s currency and creditworthiness, triggering debt repudiation and ruinous devaluation.

Some are saying that the U.S. is following the path to doom even as the Fed insists that Japan-style deflation and the devaluation of the dollar are impossible. (What else can central planners say? The five-year plan to eternal prosperity is failing? That would be a quick ticket to Siberia—by which I mean the Commerce Department.)

Forecasting the direction of all these moving parts is like predicting the outcome of a 3-D chess match with multiple players randomly moving pieces. So let’s focus on interest rates, the only force over which the market really has any sway.

If central planners only create money and give it away, the results are predictable: an oversupply of “free money” leads to inflation. Instead, they manage the business cycle by manipulating the supply of and demand for money. If the Goldilocks Economy is getting a tad overheated, the Fed withdraws money and raises short-term interest rates. Businesses and consumers borrow and spend less, and Goldilocks breathes a sigh of relief. If the economy catches a chill, then the Fed “injects liquidity” and lowers interest rates, encouraging more borrowing and spending.

This seems to work pretty well, until it doesn’t. Japan has been borrowing a truly insane 40 percent of its government spending for years and has kept its interest rates so near zero that the prospect of a mighty one-quarter percent increase causes panic. So who’s going to bury money in a bond paying a dime of interest a decade? Well, government, of course, because it can create the money to buy its own bonds. And other investors will, too, if they fear all other investing options will only drop in value. That’s a sad statement about the prospects for real estate and new enterprises in Japan.

But super-low interest rates and massive government borrowing require something special: a huge pool of surplus capital that can be sunk in no-return government bonds. How dumb does money have to be to do that year after year?

The explanation of Japan’s weird stability in going nowhere is partly cultural, which is why drawing parallels between the U.S. and Japan is perilous. In Japan, Big Business, banks, insurance companies, and the government aren’t just in bed with each other: they tuck each other in and put mints on each others’ pillows. Thus super-low interest rates and liquidity are only available on an institutional level. The average small business in Japan can’t borrow unlimited sums at near-zero interest, but global institutional buyers borrowed trillions of yen at low interest and invested the money elsewhere at higher returns: the infamous “yen carry trade.”

The other cultural factor at work is Japan’s prodigious savings rate, which for many years hovered above 20 percent——though it is now dropping as times get tough—compared to a zero or even negative rate in the United States. With opportunities to invest overseas restricted, Japanese savers had limited options: take a gamble on deflating real estate and stocks or buy government bonds. Given that unappealing menu, they chose the bonds.

While Japanese-style government-Wall Street collusion is clearly growing in the U.S., we don’t have the key ingredients of Japan’s balancing act. There is no giant pool of domestic savings, and battered American investors still have options that may be more appealing than a 2 percent yield on a Treasury bond.

Without a domestic cache of surplus capital on the same scale as its borrowing needs, the U.S. Treasury has to borrow stupendous sums from overseas “investors”—Asian central banks, oil exporters, etc. These buyers have tremendous incentives to keep U.S. consumers, their customers, afloat on a sea of low interest and easy money, so the game has been managed thusly: as the ability and/or willingness of these buyers to acquire more of America’s debt wanes, the Federal Reserve steps in and buys Treasuries directly. That’s not just placing a mint on the pillow—that’s fluffing the pillow, too.

Despite all this maneuvering, however, the fundamentals of supply and demand still apply. If there is a huge supply of new debt for sale and little demand, then the Treasury will have to entice buyers with higher interest rates. The U.S. central planners now face a Hobson’s choice: if rates rise, that eventually increases mortgage rates—a bad thing in a recession, according to conventional wisdom. On the other hand, if the Fed creates a few trillion dollars a year to soak up all this new Treasury debt, then the global bond market will start pricing in the risk of inflation or devaluation occurring as a result of this explosion of dollars. The net result is that interest rates rise anyway, regardless of the massive intervention by the Fed.

This is the reason some are muttering darkly about the Argentina Model: when central planners borrow and print money recklessly, outside of outlier Japan, there are only two end-points—hyperinflation or devaluation of the currency, either of which wipes out the income and wealth of the citizenry.

That can’t possibly happen here, or so we are reassured. The dollar is the world’s reserve currency—except now other nations are tiring of our monopoly on printing money and passing it off without consequence. What does all this mean for average Americans? There are two basic results, both pernicious.

Super-low interest rates may be wonderful for borrowers, but they are terrible for savers and those needing healthy long-term returns. Virtually all the pension funds and life insurance companies in the U.S. need annual long-term returns in the 7-8 percent range; 1-2 percent returns doom them to eventual insolvency. Their only choice in a low-rate environment is to demand more cash from their contributors and the insured—a movement that is already visible as public pension plans are notifying cash-strapped cities, school districts, and agencies that their pension contributions are about to skyrocket. That ends up taking huge chunks of money out of consumers’ pockets, the exact opposite of what central planners intend.

Borrowers—especially those institutions in bed with the Fed and Treasury—have a major incentive to borrow money cheap and speculate with it—the U.S. version of the old “yen carry trade” in Japan that reaped billions for institutional players and nothing for the real economy. Indeed, many believe the current global stock-market rally is nothing but hot money borrowed from central bankers gushing into speculative markets for a quick return. Give people vast sums of essentially free money, and, remarkably enough, they tend to play fast and loose with risk. (File next to “subprime mortgage mess.”)

This “free money” phenomenon is also dangerous for homebuyers. Now that the loose lenders Fannie Mae and Freddie Mac have been throttled by insolvency, the central planners are expanding operations at the two remaining state lenders: FHA and Ginnie Mae. Get your guaranteed mortgage with 3.5 percent down right here! While that is marginally better than zero, it sure isn’t 20 percent. In other words, the same old game of low downpayments and easy mortgage money is being played, sweetened by an $8,000 credit for new homebuyers. No wonder housing is “recovering.”

Is risk being properly priced when money is cheap and new loans are practically given away? Of course it isn’t. Eventually, the global bond market will become uneasy about the government game of printing money to buy its own debt and the purposeful injection of nearly free money.

Supply and demand still matter. According to analysts, global governments are borrowing $5 trillion this year to fund their vast stimulus packages. Then there’s private-sector demand for business loans, mortgages, consumer credit, local government bond issues, and so on. Considering that some $35 trillion in global wealth has vanished in the past two years and corporate profitability has plummeted, it’s fair to ask what happens if there’s not enough global surplus capital to fund the explosion of public demand for borrowing.

Economies with immense reserves of cash, opaque central banks, and a citizenry of prodigious savers obviously have the wherewithal to fund massive stimulus spending without worrying too much about global bond markets’ assessments of risk and return. But the U.S. has only one of those “assets”: an opaque central bank. Given the pathetic interest earned on savings accounts, Americans aren’t creating pools of capital, they’re paying down old debt. Much of what the government counts as savings is actually going to reduce costly debt—a rational decision when savings earn 1 percent and credit-card debt costs 18 percent.

At some point the risk of flooding the world with essentially free money will be priced into bond yields, and investors will wake up to the fact that once interest rates are effectively zero, there’s no upside left in bonds’ future appreciation. In fact, the specter of rising rates makes bonds a risky investment because rates and value are on a see-saw: if rates rise, the value of the bond drops. A sharp rise in rates would eviscerate the market value of all existing bonds.

With global demand for surplus capital rising just as global assets and income have dropped precipitously, it’s inevitable that the demand-supply imbalance will be resolved with higher rates. The only alternative open to central planners is to print money, but doing so will not fool anyone: interest rates will still rise because free, easy money will lead to either inflation or devaluation, and the bond market is aware that there is no free lunch—not even for the dollar.

Although higher rates are presumed to spell disaster for the debt-laden U.S. economy, in which total public and private debt is already 350 percent of GDP, the plus side—rational incentives to save and invest—is rarely noted. Perhaps we should be cheering for higher interest rates as a return to sanity rather than fearing them as some sort of unnatural plague.

Just don’t mention that if you’re a Fed apparatchik—you might get shipped to Siberia. 

Charles Hugh Smith writes the Of Two Minds blog (www.oftwominds.com) and a column for AOL’s Daily Finance site. His latest book is Survival+: Structuring Prosperity for Yourself and the Nation.

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