Fed Chairman Ben Bernanke’s testimony Tuesday before the Senate Finance Committee, where he reiterated his view that the Fed needed to continue record-low interest rates, reminded me why doctors are required to swear the Hippocratic Oath. Doctors, unlike central bankers, are generally believed to be oath-bound to do “something” to aid their patients, but they are also said to “first, do no harm.” Fed policy the last few years has been “something”. But there is growing evidence that Fed policy may be doing harm.
Five years into the Fed’s decision to set record low interest rates, and its promise last year to continue them into 2014, Fed policy has failed to ignite growth or employment. The United Sates is now in its 54th consecutive month of unemployment over 7.5%. GDP growth is just barely 2% and the negative growth of Q4 2012 – revised up just last week from a decline of “-0.1%” to “growth” of “+0.1%” clearly indicates the the possibility of a recession in Q2 2013.
Beyond failing to re-ignite the economy, though, government manipulation of interest rates to record lows tends to skew sound investment decisions. State budgets, retirement plans, hedge funds, and the fundamental disciplines of the marketplace for the efficient allocation of capital all demand that investments occur within some rubric of some reasonable rate of return – a “hurdle rate”, if you will– that rewards the higher risk of owning part of an enterprise over the relatively less risky option of being its creditor. The hurdle rate compensates for that extra risk; its the“kicker” above the risk-free interest rate that an enterprise would pay a lender that induces him, instead, to share the risks of ownership.
The low hurdle rate induced by the Fed’s manipulation of interest rates justifies investments in the kind of low-growth, low-profit enterprises (“LGPE’s”) that would not clear a hurdle rate set by the marketplace. At nil or even negative real interest rates, a cornucopia of possible investments exceed the artificial hurdle rate. Hedge fund managers and other speculators can make money from LGPE’s simply by cutting expenses and otherwise improving enterprise efficiencies. The managers of such enterprises main investment risk is that interest rates will increase, because then even modest returns will seem poor against the new, higher, hurdle rate. Since the Fed has assured the market that low interest rates will continue through 2014, speculators are virtually assured they can make money at least until 2015 simply by investing in LGPEs and cutting expenses and improving efficiencies.
But these low rates tend to misallocate capital to LGPE’s that ultimately harm the type of organic recovery that occurs with a natural business cycle. Indeed, Federal Reserve monetary policies intended to counteract recession can actually cause an economy to contract that might otherwise be organically expanding.
When a more organic economic recovery of the business cycle occurs, interest rates tend to increase as the demand for funds increases. The higher interest rate raises the hurdle rate for investments across the marketplace. At this point, LGPE investments encouraged by Fed policy prove to be particularly insidious because, in a struggling recovery, investors demand higher investment returns from the capital that was misallocated to the LGPE of the low rates of the recession. To achieve these higher returns, LGPE’s have no choice but to improve efficiencies by layoffs, closings, and outsourcings, all actions that tend to counteract the hiring that occurs in the modest organic recovery of the natural business cycle.
Ultra-low rate interest rates can harm the economy in other ways as well. It can cause a capital strike.
Since low interest rates cause such low hurdle rates, LPGE investments carry with them the risk of loss when a recovery raises the hurdle rate. Investments in small and medium-sized businesses (where most LPGE’s are concentrated) are likely to be withheld. Why invest $1000 in a risky LPGE in 2013 and earn 4% a year until 2023 (i.e., $400) at the end of the term when simply waiting to invest in some other enterprise in 2015 (after the 2014 presumably will increase) might produce a 6% return per year ($480) for the seven years remaining until 2023? Anyone doing the type of “back-of-the-envelope” calculation that decides most investment decisions in small and medium enterprises would recognize he would have more money with less risk in 2023 by simply keeping his money in Treasuries and waiting for the higher 6% rate.
Consider, too, the position in which the Fed’s low rate policy has left state pension funds. Actuarial assumptions for state pension plans generally assume an average four to eight percent year-on-year return on invested assets. Those rates are premised on a “normal” rate of return on bonds of four to six percent. In a low-rate environment, though, pension fund managers are stressed to produce higher returns by shifting a larger portion of their portfolio from fixed-income assets to equities, so that more pension fund principal is at greater investment risk. The alternative – to increase state pension fund contributions — forces already hard-pressed states to either raise taxes in a recession (thus slowing growth) or to reduce expenditures in other areas, such as staff cutbacks or hiring freezes.
In all three instances I’ve described, the Federal Reserve’s low-rate policy tends to continue slow growth or to exacerbate contraction in the economy. Notably, Japan’s low rate policy has mired that country’s economy in over 20 years of slow or no growth, despite fiscal stimulus spending that has doubled the national debt. (Misallocations of capital as a consequence of Japan’s low rates has made the country the leading innovators of flush toilet technology, among other things.)
It may very well be that Japan’s past is America’s prologue. Perhaps its time for Chairman Bernanke and the Federal Reserve to ignore traditional monetary theory (and Japan’s ongoing mistake) about interest rates and follow a more viable, independent, and proven rate setter: the marketplace.
J.G. Collins is the Managing Director of The Stuyvesant Square Consultancy.
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