The Problem with Easy Money

Markets rallied hard yesterday after the G-20 "agreed to maintain support for the recovery until it is assured." This news was a fitting sequel to last week's move by the Federal Reserve to continue their policy of keeping interest rates "exceptionally low" for "an extended period."

 One way or another, it's clear we're going to have so-called easy money for many quarters to come. The conventional thinking is that this will stimulate the economy and produce inflation. But this understanding is woefully simplistic and will likely prove to be completely untrue. Without a rapid change of course, our once great economy will slip into the same kind of liquidity-rich atrophy and monetary coma as Japan has endured since its major banking crisis.

The common thinking is that low rates make it easy to borrow and increase the amount of money available. But usually in economic history, countries with high interest rates have attracted foreign capital, which then promotes economic growth. This happened as recently as 2008 when "hot money" dashed into Chinese banks to take advantage of high yields and a strong currency on the mainland.

It also works in reverse: In 1837 and 1907, higher interest rates in London drew capital away from the U.S. and produced sharp financial panics. And, as I argued in this column, Fed rate cuts may have had a similarly disastrous impact on the U.S. credit market in 2007.

Of course there are times when low rates do promote lending, like in the U.S. during the 1980s through 2008, when household debt grew twice as much as GDP as borrowing got cheaper and cheaper. And there was the famous case of the Great Depression, when the Fed's tight-money policies prolonged the crisis.

So, when do low rates help and when do they hurt?

This chart compares 1-month Eurodollar rates with non-seasonally adjusted y-o-y CPI.
Source: BLS, Fed H.15

It seems low rates can provide a boost when an economic system is already well established. But they also create a toxic environment for real growth and innovation because no one wants to invest in a country where the currency could keep losing value. The key moment when low rates become a problem is when they go negative, which I will discuss further below.

Secondly, I believe markets and economies are forward looking. If rates can't go any lower, the perception that there is no improvement or growth on the horizon will get priced in. That significantly reduces the attractiveness of investing and raises the bar in terms of necessary return. For instance, consider what happens to a company when it goes from being a growth story to an established large stock: The multiples go down, pushing its earnings and dividend yields higher.

That means investments and assets in the U.S. need to yield more to compensate investors for the underlying lack of growth. By forcing rates lower, you prevent this natural economic response from happening.

So if low rates are so bad, why did America prosper in the 1980s when Paul Volcker cut interest rates? The country and its economy were already in place, with industries, markets and consumers well established. Millions of baby-boomers needed and wanted homes and cars. Low rates didn't create demand for those items. It only made them more accessible.

Foreign exchange was also much less important an issue than it is today. Sky-high rates only a couple of years earlier had reestablished the dollar as the global currency, and the collapse of commodity prices reduced the appeal of diversifying into hard assets. Furthermore, Asian governments in Taiwan, South Korea and China were willing to build export economies around the dollar, creating an unnatural demand for U.S. currency that other countries didn't have.

Looking back at that era now, it shines as a "Golden Age" for the dollar as a fiat currency. Supported by the U.S.'s huge market, economic and military power, institutional transparency, educational leadership, the legacy of Breton Woods and unchallenged by gold, the greenback reigned supreme.

And, most importantly, Paul Volcker only cut rates after destroying inflation, so real interest rates were still positive. The same couldn't be said for Latin American countries, whose behavior in the 1980s we are now imitating. Consider the case of Venezuela, whose currency had been highly esteemed for decades and enjoyed reserve status sporadically after WWII.

When Volcker was busy hiking rates in the U.S. to slay inflation, central bankers in Caracas were busy holding rates low to keep business interests and politicians happy. Venezuelan money streamed into U.S. banks and the bolivar broke its long established peg to the dollar. The central bank didn't lift a finger and the currency went into a death spiral that continues to this day.

By the late 1990s when I worked as a reporter in Venezuela, this sick paradigm had become well entrenched. Interest rates were below the rate of inflation, making it impossible to save money in bolivares. So every month people bought travelers checks in dollars or wired funds to Miami. Local banks still made money, but mostly by purchasing government bonds and playing the yield curve. Meanwhile, credit for businesses and consumers was extremely tight.

Substitute gold and foreign equities for travelers checks, and it sounds a lot like the U.S. right now.

Source: Fed H.8

The only difference between that case and the U.S. is that Venezuela had a serious inflation problem. It started in the late 1970s after the country was flooded with petro-dollars, and then exploded after the currency was devalued.

But inflation in and of itself is irrelevant. Countries such as Italy, Turkey, Brazil or Spain all had strong banking systems and healthy lending despite high rates of inflation.

The common theme in all the cases of monetary and financial dysfunction, such as Venezuela, the U.S. and Japan, was negative real interest rates. If people know their money isn't safe in "cash" (or local currency), their money will leave the financial system, either by exiting the country or by getting converted into a hard asset such as gold. (This also happened in the U.S during the 1970s when real interest rates approached zero.)

It all has same result: less financial intermediation. That means less investment capital, less employment growth and fewer companies getting formed.

Even with all the printing presses in the world, Ben Bernanke is impotent to change this basic law of economics. In my next column, I'll explore why.

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