Sowing Inflation, Reaping Deflation

I received several requests to comment on an article written by Antal E. Fekete entitled the Counter-Productive Monetary Policy of the Fed.

The subtitle of his article is "Sowing Inflation, Reaping Deflation". It's 16 pages long and not an easy read.

In general terms, I agree with Fekete. Without a doubt Fed policy is counter-productive, for many reasons, some of which Fekete does not even mention.

• The Fed creates bubbles of increasing amplitude over time.
• The Fed fosters speculation with moral-hazard bailout policies.
• Fed policies benefit those with first access to money, namely the banks, government, and the already wealthy, at the expense of everyone else.
• The Fed is largely responsible for rising income inequality that even the Fed complains about.

Here's a couple of paragraphs from Fekete's article that caught my eye.

My thesis that falling (as distinct from low but stable) interest rates destroy capital across the board is admittedly controversial. I would welcome its examination ‘without fear and favor’ by a competent and unbiased panel that could also examine the superiority of “self-liquidating credit” over credit based on government debt (that could be called, tongue-in-cheek, “self-perpetuating debt”). We shall look at three destructive effects of a rate cut: (a) the increase in the liquidation value of debt, (b) labor's deteriorating terms of trade, (c) the fading of depreciation quotas.

The proposition that the bond price varies inversely with the rate of interest is uncontroversial and universally accepted by friend and foe alike. It describes the effect from the point of view of the credit or. Curiously, people find it hard to comprehend the equivalent proposition describing the very same effect from the point of view of the debtor, namely, that the liquidation value of debt also varies inversely with the rate of interest.

In particular, a rate cut increases the cost of liquidating debt before maturity. Liquidation value is what the debt or must pay if he wants to retire his debt ahead of schedule. As this liquidation value is now higher, falling interest rates make the burden of debt increase. For example, if the rate of interest is cut in half, then according to the rule of thumb the liquidation value of long term debt is doubled (that is, to liquidate the debt will cost twice as much as it did before the cut).

"If the interest rate is cut in half, to liquidate the debt will cost twice as much."

Let's discuss that last sentence.

I asked my friend Keith Weiner if he could explain what Fekete was saying.

He replied ...

Compute the present value of a stream of payments. Suppose you must pay $100 a year for 10 years. The net present value is not simply $100 X 10 = $1,000. Each future payment must be discounted using the prevailing interest rate. If the rate is 10%, then we get the sum of the series: $90 + $81 + $72.90 ... = $586. If the interest rate is cut in half to 5%, then the sum of the series is $762.

"Ahah!" you say. "That's not double." No, a 10-year bond does not double with a halving of the rate. A perpetuity bond does.

Another point Fekete makes is that in irredeemable paper money, debt is never extinguished. The currency itself, the dollar, is just an IOU (it's a slice of the government's debt). When you paid in gold, the debt went out of existence. But when you pay in dollars, you only shift the debt around. All debt should therefore be treated as perpetual.

There is a practical side of this, where the rubber hits the road. Suppose you borrow $1M to build a restaurant, at 10% interest. Then the rate is lowered to 5%. A competitor can build the same level of store and have a lower payment. Or he can build a more opulent place and have the same payment.

Fed Poison

Keith discussed the above points in detail on a Forbes article he wrote The Fed Poisons The Stock Market.

The problem I have with Fekete's model is I'm a practical guy.

While I agree debt is a slice of a government IOU, and that every piece of paper is an IOU, debts between people and corporations can be extinguished. Keith understands this as well; we discussed it on the phone.

So let's return to the statement once more "If the interest rate is cut in half, to liquidate the debt will cost twice as much."

Start with an interest rate of say 1%. It will cost twice as much if the rate drops to 0.5%. Twice as much again to 0.25%. Twice as much again to 0.125%. etc. etc.

There is an infinite number of times one could halve the interest and never get to zero. In the process, the debt would supposedly cost infinitely more to pay off.

Instead of halving the rate, let's suppose the Fed just cut the rate to zero. Then what would happen if the Fed hiked?

A curious thing would happen in Fekete's model. It would not matter whether the Fed hiked the rate to .1%, 1%, or 100% because a zero-divide situation would occur and any move off zero would make it infinitely less costly to pay off.

Let's not confuse a percentage change in a theoretical perpetual bond, with real-world experiences in which one can pay back debt, one can refinance, and one cannot (yet anyway) get a perpetual bond.

In the real world, slashing interest rates in half from 8% to 4% is a big deal. Cutting interest rates from 0.2% to 0.1% is meaningless although both theoretically double the liquidation value.

There is a real world aspect worth mentioning that I believe both Fekete and Weiner would agree with: The lower the Fed pushes interest rates, the more debt ends up in the system. The aggregate debt does become harder and harder to pay off, and it makes it harder and harder for the Fed to hike.

We are rapidly approaching a point where central banks in general will find it impossible to hike, even if they wanted to. Japan is at that point already.

Acting Man Chimes In

I pinged my response to Pater Tenebrarum at the Acting Man blog. He chimed in with similar thoughts. To his reply I added a few of my thoughts, inline, in braces ...

Some bonds are 'callable', which means they can be redeemed at par prior to maturity. But whether bonds trade at a premium due to declining yields-to-maturity or a discount due to rising yields-to-maturity's is largely an accounting artifact from the point of view of a corporation. They will simply let the bond mature, and replace maturing debt with new debt at lower rates.

What I believe is more important and actually does actively destroy capital is the fact that central bank manipulated interest rates no longer properly reflect society-wide time preferences. Instead, they give a wrong signal to entrepreneurs [also households, and corporations] that there are more savings available than there really are.

Investment in long-term projects in the higher stages of the productive structure is encouraged - in spite of the fact that the amount of "free capital" (the economy's pool of real funding) is not sufficient to bring these projects to a successful conclusion. Fracking is a recent example. [The housing bust is a classic example in which, thanks to the Fed, speculation rose so much there appeared to many to be a shortage of housing!]

In essence, however, Fekete is actually saying the same thing, only in a more roundabout or different fashion.

Conclusion

I don't think it's valid to put mathematical formula to this mess as the math gets pretty screwy as one approaches zero.

And as a practical matter, perpetual bonds don't quite exist. Consumer and corporate debt can be extinguished even if the dollar itself is debt. Secondarily, as bubbles get bigger, I propose the damage caused by the Fed isn't even linear.

The important point is that the Fed's monetary policy is extremely counterproductive. Fekete, Weiner, Tenebrarum, and I are all in agreement on that key essential point.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com