It is difficult to argue for sound money and price discovery these days. Even occasional Fed critics like myself have defended the use of aggressive monetary accommodation to deal with the realities of a COVID economy. The “no atheists in foxholes” principle is alive and well, and I do not envy what the Fed is fighting against: the unemployment realities, the GDP contraction, or any of the other transitory ramifications of this extraordinary time. I am a critic of aggressive interventionism on the part of our central bankers, but that has never pushed me to impugn their motives.
The Fed’s belief that macroeconomic weakness should be countered with low interest rates is one thing. Indeed, as Ramesh Ponnuru and others have pointed out, inflation expectations are as low as they are for reasons that go beyond the Fed’s interventions, and that does indeed afford it the extra leeway to take aggressive action (for now). The problem, however, is the growing belief that low (or in this case, no) interest rates are not a temporary necessary evil, but an eternal good. This mentality has little or no intellectual foundation, and it has dangerous economic and moral consequences.
The cost of capital is an important component of macroeconomic reality. When the cost of capital exceeds the return on invested capital, recessions result, businesses retreat, and jobs are lost. Ideally, given that there will be recessions from time to time, I would rather see volatility in the ROIC (which is market driven) than in the cost of capital. That said, interest rates (the price of money) are subject to market forces, too, like any other price. Unlike many other prices, the price of money is what enables price discovery of everything else. But the cost of capital is not determined by market conditions alone. In a society with a central bank it is hugely influenced (although not fully controlled) by the interventions of that bank. Different central banks have taken on different levels of intervention throughout history, but their ability to change the cost of money is not up for debate.
The problems with distorting the cost of capital above and beyond those periods of emergency intervention are many. They begin with the way that emergency interventions never seem to stay “emergency interventions.” Temporary government programs become long-term government solutions, as Milton Friedman taught us, and central banks have not been immune to this in Japan, the U.K., the European Union, or the United States, at least in the last quarter century or so. During “normal” periods, emergency provisions are at best not accelerated further — only very rarely are emergency provisions actually removed or reversed.
And it’s all the more dangerous when the emergency provision is one that strikes many as benign: low interest rates. Who wouldn’t want a lower cost of funds to finance both consumption and production? It is one thing if we are talking about Fed facilities to buy corporate bonds — surely, we all see that as an outlier of aggressive accommodation; but low interest rates? Who could possibly find fault with such a thing?
Certainly not President Trump, no stranger to the cost of money, who has frequently tweeted his desire for lower and lower rates still (on five occasions since I last counted actually calling for negative interest rates). Some have pointed out that in 2018 the president was right and Powell wrong about the predicament the Fed thought it was fighting against (when the Fed began tightening monetary policy even without the presence of inflation). But the president is not calling for the preservation of low rates as a result of, say, careful consideration of the Phillips Curve (however irrelevant that may be). He simply prefers accommodative monetary policy, regardless of the macroeconomic outlook. In 2018, the Fed’s error was trying to unwind two Fed post-crisis policies at once: ZIRP (zero interest policy) and QE (quantitative easing). Instead of taking the patient off one medicine at a time, the Fed tried to do both at once, and quickly reversed course, leaving us, once again, with very low rates.
In 2020, COVID realities have once again switched the focus entirely, and for good reason. But we are left with a conversation that I believe is wholly inadequate for tackling the long-term realities of our economy, and, we hope, a post-COVID economy.
Artificially low interest rates punish savers. They distort price discovery and lead to malinvestment. And worst of all, they suppress the expected return on new investment, thereby stifling productivity and growth.
To begin with savers, everyone knows that money-market rates and CD rates head to zero when the Fed sets the fed funds rate at zero, and that this disproportionately hurts senior citizens, retirees, savers, and those who prefer less risk. This is not just an effect of the policy; it is the point of the policy. The Fed is consciously trying to push people out along the risk curve. Even if the primary target is not senior citizens buying more stocks, it certainly is the inevitable consequence. Now, many seniors may avoid taking the bait and turning to some over-priced investment property just because their 3 percent CD now yields 1 percent. But in taking the lower yield, those savers are forced into a lower income, a lower ability to consume, and a lower quality of life. This is hard to square with a Fed whose long-term mandate is sound money, and is, I’d argue, also immoral. Accepting the victimization of savers (a generational victim, I might add) as the necessary collateral damage of a centrally planned view of the greater macroeconomic good is an egregious excess of the Fed’s mandate — a consequence that the borrowers who so love low rates have no moral right to ignore in their celebration of “cheap money.”
But it doesn’t stop with the reality of one party winning (borrowers) and one party losing (savers). For borrowers ultimately suffer, too, as money is borrowed and allocated into capital projects that simply would not happen without the enticing allure of the artificially suppressed cost of capital. Finding the balance between risk and reward is a fundamental element in any business and, by extension, is the lifeblood of free markets. Artificial distortion of the risk/reward calculation leads to faulty decision-making. Money is lent that otherwise would not be lent (the debt-service level becomes reasonable when the cost of that debt is artificially suppressed). Thus, money is most certainly borrowed that otherwise would not be borrowed. The result is an excess of leverage, greater systemic risk, and a constantly reduced return environment.
Some might argue that low rates simply hurt those who lack the brio to spend freely or invest like a cowboy instead of a grandmother. And they could argue too that other people’s misallocation of capital in a period of low rates is not their problem, and that they themselves have the good sense to avoid less attractive investments. Aside from the arrogance of believing that they are immune to the aforementioned malinvestment risk, or the moral ambiguity of favoring a monetary policy that consciously seeks to punish one party and reward another (versus holding that inherent tension in equilibrium), such attitudes reveal a tremendous naïveté about how well-functioning capital markets should operate.
The expected rate of return on any given project, innovation or risk-taking endeavor, is inevitably influenced by the prevailing discount rate. An ultra-low risk-free rate changes the culture of industry. Its titans become financial managers, and not creative operators. When overall expected rates of return are pushed down in concert with the low cost of funds, the end result is a higher bid in the price of legacy assets, and a lack of investment into new assets. Low rates motivate a company to buy its competitor; natural rates motivate a company to beat its competitor. We all suffer in a society stuck in a period of financialization, where companies can survive and even thrive with sub-optimal productivity.
Those who believe free enterprise to be a process for maximizing human ingenuity, for optimizing human capabilities towards a greater prosperity, should be striving for maximum productivity out of our economy every day. An economy spoiled by low interest rates gets fat, lazy, and mediocre — because it can. It lacks motivation, hustle, and dynamism, deprives itself of its best use and capability. This is the real sin and the real danger of permanently low interest rates: They suppress growth, and in suppressing growth, suppress human flourishing.
But even if we look beyond our current COVID economy, there is little our central bank or other central banks can do in a world characterized by excessive sovereign indebtedness. Low rates are necessary (but not sufficient) to finance the deficits of countries who lack basic budgetary discipline. And the conclusion to be drawn from this is not only that low rates are not all they are cracked up to be, but that they are also a symptom of the underlying problem of excessive indebtedness. And if excessive indebtedness is the consequence of the excessive size of government, then the excessive size of government is standing in the way of our prosperity.