Boomergeddon Watch: The Interest Rate Trap

interest_rateby James A. Bacon

In previous blog posts, I’ve explored how the Federal Reserve Board’s near zero-interest rate policy has created drags on economic growth and job creation that have significantly offset its stimulative effects.

First, by reducing yields on bank CDs, money market funds and bonds, super-low interest rates penalize savers. Low yields create an invisible wealth transfer from retirees and those who are saving for retirement to creditors, most particularly the world’s biggest creditor, the United States government. As a result, retirees have less to spend, while wanna-be retirees hang on to their jobs longer, creating less work for younger generations.

Second, in a parallel phenomenon, super-low interest rates reduce the rate of return on pension funds. State and local governments make up the difference through higher contributions, which means they have less money to spend on education, infrastructure and other desiderata — if they can cover the gap at all. The longer we see below-par returns on pension funds, the more Stocktons, San Bernardinos and Detroits will file for municipal bankruptcy.

Now comes Ronald I. McKinnon, a fellow at the Stanford Institute for Economic Policy Research, who explains in an Wall Street Journal op-ed how, counter-intuitively, super-low interest rates depress business lending.

He can explain it better than I:

The traditional spread between deposit and loan rates is about three percentage points. With this spread, banks can lend to small- and medium-sized enterprises, the so-called SMEs — making loans that carry moderate risks and higher administrative costs per dollar lent. To increase the safety of its overall loan portfolio, the bank can also lend greater amounts to larger, more established corporate enterprises.

However, as short-term interest rates are compressed toward zero, larger borrowers find it more advantageous to raise money by selling short-term commercial paper directly to other corporations, pension funds and money-market mutual funds. This leaves smaller banks in particular with a riskier portfolio of loans to SMEs (small- and medium-sized enterprises), and the need to raise more bank capital to support riskier liabilities — so they may instead shrink the size of their loan portfolios.

Thus, while low interest rates stimulate the housing market, auto sales and  credit card spending, they depress lending to businesses, which restricts their ability to expand and create jobs. Add up all the unintended consequences, and the short-term stimulus from Quantitative Easing is less than commonly perceived.

Meanwhile, QE creates a longer-term danger. McKinnon again:

The Federal Reserve, the Bank of England, the Bank of Japan and European Central Bank all have used quantitative easing to force down their long-term interest rates. The result is that major industrial economies have all dramatically increased the market value of government and other long-term bonds held by their banks and other financial institutions. Now each central bank fears long-term rates rising to normal levels because their nation’s commercial banks would suffer big capital losses — in short, they would de-capitalize.

A news article in today’s WSJ quotes a Zions Bankcorp study that says the amount of capital held by the U.S. banking industry would drop by $200 billion to $250 billion if long-term rates were to rise by three percentage points — back to historical norms. In turn, that would result in $2 trillion of reduced lending capacity…. an economic disaster.

It would be tempting to blame President Obama — and I do blame his tax and regulatory policies for making the problem worse on the margins — but the problem is much bigger than Obama. The problem is a $17 trillion national debt and structural budget deficits that add a half-billion dollars to that debt yearly, both of which reflect the unwillingness of the American public and both political parties to pay for all the stuff they want from the federal government. No matter which party is in power, the massive overhang of debt limits federal policy options to an ever-narrowing range of unpalatable choices.

That is how public debt crowds out private-sector borrowing and inhibits job growth. The economy cannot expand fast enough for the United States to grow its way out of its indebtedness. We have entered an age of austerity that will linger for years, even decades, to come — assuming it doesn’t collapse in a financial meltdown.

Here in Virginia, we need to recognize that the old ways will not work anymore. We cannot continue business as usual. We must transform outmoded institutions — transportation, land use, infrastructure, education, health care, economic development and governance. Even in bad times, capital and talent will flow to the best-managed states. There still is time to create an oasis of innovation and prosperity that will help us ride out Boomergeddon when it finally hits.

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14 responses to “Boomergeddon Watch: The Interest Rate Trap”

  1. oh where to start…

    there is no question that quantitative easing is a bad choice, except that the alternative – liquidity trap is worse – not without some disagreement but acknowledged by many mainstream economists – not only in this country but internationally.

    that’s part of the problem now days with biased media (both sides) where from WSJ, you get a one-sided view that neglects to mention the liquidity trap issue.

    how can a balanced view be gained when these OP ED turn into agenda-grinding tomes?

    all the things he says about the adverse impacts of quantitative easing are true.

    but it’s also true – at least from a ton of mainstream economists that a liquidity trap is something else to fear also.

    The problem with the debt is at least in part due to lower tax revenue

    but if you really want to worry about the debt – consider the fact that right now we take in about 1.4T in income taxes and we are spending more than 1.3T on national defense.

    DOD spending alone is more than the next 10 countries combined.

    Every single employee of DOD and National Defense agencies like Homeland Security is not only paid from taxes but their benefits are paid from taxes…

    We can and should cut entitlements.

    Charging seniors $100 a month for health insurance is insane but look at the numbers – about $250 billion is what Medicare costs us right now – out of more than a trillion a year in other spending – well over half of that for National Defense.

    My big problem is the refusal of those who portray the issues to be more honest about where the spending is – entitlements – yes.. but national defense also.. big time….

    we cannot begin to address these problems just by focusing on entitlements.

    you could wipe out the Medicare problem tomorrow just by charging seniors about $400 a month for their insurance – which is still far less than what employers pay for employer-provided insurance.

  2. Larry, you’re missing the larger point, which is that we’re running out of policy latitude. ALL the options suck. There is no way forward but a path of pain.

  3. Jim – we may well be – but what is troubling about these tomes is that they seem to argue against the quantitative easing but then they do not acknowledge the other risks.

    but here’s a question – what happens if QE goes on for several more months or years? it seems to me than QE is supposed to increase employment – albeit at a cost to saving….

    some of this goes to the heart of stimulus (borrowing from the future) vs austerity (pain now even if it goes to a depression).


    austerity is also – not “working” right?

    but here is the really odd part. the stock markets are doing well.. and that means pension plans are doing well… and that investing in stocks/bonds brings better returns than saving money… ..

    As I said before.. I can see there are two sides but you don’t get that from many of these editorials that are essentially agenda-driven advocacy pieces.

    contrary to the opponents, there are 7 folks on the Fed and last vote it was 6-1 to continue QE – although mounting belief that it should end soon.

    I just don’t buy the austerity narrative especially since most who advocate it don’t address the liquidity trap risk…

  4. Who’s talking about an “austerity” agenda here? If all we do is slash government spending at the expense of core programs, we’re losing as much as we’re gaining. But I don’t accept the narrative that our choice is to either raise taxes or cut services. I have devoted this blog to exploring ways to reinvent government, reinvent education, transform transportation, overhaul land use, reinvent health care and rethink economic development. That’s what *I’m* talking about.

  5. Indeed! but “reinventing” in the context of QE vs austerity… is ..

    umm.. not what the pro-austerity folks are talking about.

    witness the GOP in Congress – “cut cut cut”….

    but yes.. I DO give you CREDIT for pursuing “cost-effective” though you’re a bit heavy on the Boomergeddon angle … which seems more “we’re screwed no matter what” sometimes…

  6. I don’t get real caught up in what Congress says or does. I do think they’re a lost cause.

    I’m a lot more interested in what we can do here in Virginia. Unfortunately, I don’t see a whole lot of people, Ds or Rs, articulating the need for the kind of sweeping reform that I’m calling for.

    1. DJRippert Avatar

      Virginia’s politicians are hapless as can be. They can argue for days about abortion vs choice but couldn’t pass an Econ 101 test to save their lives.

      Have you heard anything remotely intelligent from either candidate for governor about improving Virginia’s economy?

      Cuccinelli doesn’t like special interest tax breaks but can’t for the life of himself name one he’d cut or how he’d get the General Assembly to agree.

      McAuliffe wants to focus on education but can’t describe how he’ll pay for his higher cost approach.

      It’s August. When are these guys going to get around to making some clear economic policy statements? I’m guessing never.

  7. Les Schreiber Avatar
    Les Schreiber

    The Federal Reserve in the US has a dual mandate.First priority keeping inflation in check second help reduce unemployment. Unfortunately,retiree incomes are not mentioned. The QE program was adopted by the fed because following the real estate crisis and following economic contraction there was no functioning market for various types of securities,especially those related to housing.
    The commercial paper market is not a substitute for long term capital formation and no corporate treasurer would use it as such. I operated two commercial paper programs for AIG: one was a premium finance operation to smooth out cash flow and payments for clients, the other an arbitrage mechanism to borrow short term very cheaply,they were AAA then, and lend to slightly lesser credits and make a small spread for 30 to 90 days.
    I do not understand how Th
    is guy believes that low rates have a negative effect on lending by destroying bank reserves. The problem now is a lack of borrowing due to a lack of demand and restrictions as to quality of borrower.

    1. re: ” The problem now is a lack of borrowing due to a lack of demand and restrictions as to quality of borrower.”

      that would be aggregate demand… which then drives the producers to borrow to respond…

      with weak aggregate demand.. producers don’t want to borrow and tax revenues to the govt are so weak that the deficit does not improve and threatens to get even worse.

      again – Wall Street itself seems pretty healthy …. is that a result of Fed policies or in spite of them?

  8. No one is questioning the Fed’s right to do what it’s doing (well, maybe Ron Paul is questioning it, but he’s an outlier). That’s not the issue. The issue is the *impact* of what it’s doing. And super-low interest rates do a lot of damage that isn’t commonly acknowledged.

  9. well more than that… is there a better option that does less damage?

    some of this seems to be a feeling that we don’t like our situation and we don’t like any of the options so we talk trash about all the options…

    but we do it in a manner as if making the choices made is irresponsible and reckless….

    the GOP are almost like children whom are offered only options less than wonderful – and they refuse to choose any… and want to blame someone…for causing the bad option “problem”.

    at some point – there has to be some level of leadership… even in choosing options less than wonderful.

  10. Peter Galuszka Avatar
    Peter Galuszka

    Les is right. The real worry is out of control interest rates a la Jimmy Carter in the late 1970s. QE is actually working. Growth is slow but steady. There’s a reason. We are not out of the woods. And Larry is right. You have to start rethinking austerity as the cure-all. It starves the patient. Stop being such a boring deficit nanny.

  11. reading about Harry Byrd… he reminds me so much about modern day GOP.

    when the great depression hit – Roosevelt and the Dems ginned up the New Deal which basically (among other things like rural electrification and SS) was a stimulus plan and Harry Byrd was unalterably opposed to it believing that govt should never go into debt for any reason what-so-ever – even though Byrd himself carried personal debt in his Apple and newspaper business.

    Fundamentally – in a recession – what is the role of govt? Is a debt-producing stimulus acceptable or not?

    Should there be a Central Bank and should that bank have the power to manipulate the money supply to reduce inflation OR to head off a liquidity trap?

    Conservatives today seem to believe like Harry Byrd did – that govt ought not to be borrowing money (from the future) to use as stimulus nor should it be messing with monetary functions.

    but they have the same problem Byrd did in that they have seemingly arbitrary and contradictory positions on what govt should or should not do.

    But the GOP are basically take-no-prisoners warriors when it comes to compromise these days.

    they’d rather shut down govt than try to find some middle ground on the role of govt and the Fed.

    that’s the simple truth.

    1. Larry said: “Conservatives today seem to believe like Harry Byrd did – that govt ought not to be borrowing money (from the future) to use as stimulus nor should it be messing with monetary functions.”

      In 1930, federal debt as a percentage of GDP stood around 20%. Today, it stands around 100%. In 1930, the country had the capacity to borrow a lot without undermining its finances. Today, it does not. Fiscal conservatives today understand the difference. Fiscal liberals do not.

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