Praying to the Porcelain God, by Robert Gore

Imagine you’re running a business and you get a call from your bank. It is no longer going to charge interest on its loans, and you can borrow as much you want. You pull a list of capital expenditures and projects from your desk drawer. Zero percent interest makes much of the list feasible—expansion, better offices, new products and markets, more hiring, and so on. It’s just the shot in the arm your business needs.

Eighty-one months—almost seven years—later and you’ve crossed off every item on your original list plus ones you added after the bank’s phone call. Your first projects were solid successes, the next ones not quite as profitable, and the last few only marginally so or outright money losers. You’re worried. Turns out that you weren’t the only businessperson getting zero-interest-rate loans; everyone else was, too. Competition has become more fierce, because some of your fly-by-night competitors, who should have gone out of business long ago, have been kept alive. Although the bank isn’t charging interest, it’s time to repay the loan. You’re not sure you can do so without closing something and laying people off.

There is no more important price in an economy than the price of money. Understand how it functions at the individual agent level of the economy—businesspeople, savers, investors, and consumers—and it’s a straightforward transition to understanding its macroeconomic importance. Interest rates, like all prices in a free economy, fluctuate constantly, reflecting the ever-shifting demand for money from producers, investors, and consumers, and the ever-shifting supply of money from savers seeking a return on their money. If interest rates are free to fluctuate, the interest rate will equilibrate that demand and supply.

Suppress the interest rate exogenously and the analysis becomes an application of the law of supply and demand. Borrowers, like our hypothetical businessperson, seeing a lower price of money use more of it, as do investors and consumers. Suppliers of funds, savers, faced with a lower price for their funds, supply less. Now there’s a gap between the increased demand for money and the decreased supply, just as rent control laws create housing shortages. What fills that gap? Let’s put a name on that exogenous agent that suppressed the interest rate: the central bank. It can manufacture as much of its own debt as is necessary to bring the supply of loanable funds in line with the increased demand at the suppressed, below-market interest rate.

At first, the lower interest rate and increased lending appear to be just the shot in the arm the economy needs. Investment, production, and consumption increase. Savers may grumble, but nobody pays attention to that beleaguered minority group. Eventually, the economy resets to the lower rate. The expected return on new production and investment drops to where it is equal to that rate, and for any further stimulation, more suppression of interest rates is required. This can go on until the rate is set at zero (and some have argued that rates can even go negative). However, the important point is that no matter where rates end up, it is the lowering that leads to the increases in investment, production, and consumption, not the absolute level. The economy will adjust to the new price of money.

After almost sevem years of the Fed’s zero interest rate policy, similar policies from the Bank of Japan and the European Central Bank, and a huge increase in government-promoted, interest-rate-suppressed Chinese debt in response to the last financial crisis, whatever stimulus that could plausibly be attributed to lowering rates and increasing debt is long gone. The global economy has completely adjusted to the ultra-low rate regime. The more accurate term is maladjusted, because these rates are artificial, rather than the product of market forces. They have led to investment, production, consumption, and debt in excess of what would have prevailed with market-determined rates, and savings less than what they would have been with such rates.

Excess investment and production lead to gluts of mined and manufactured goods. The effect is qualitative as well as quantitative. Mis-priced interest prompts entrepreneurs and executives to undertake dodgy projects they would have rejected if they had to borrow at market-determined rates to fund them. As the economy-wide marginal return on investment settles in at the suppressed interest rate, one dodgy, zero-sum set of “investments” increases: speculation. The growth of speculative activity and ever more complicated financial derivatives markets has been fueled by preternaturally cheap debt.

At the corporate level, the exhaustion of productive investment opportunities prompts executives to either return funds to shareholders through dividends or to use that cash flow (sometimes augmented by cheap debt), to speculate on the company’s share price. Hillary Clinton has made political hay about corporations buying their own shares instead of making productive investments. The world is glutted with raw materials, intermediate goods, finished goods, and consumer goods, the visible manifestation of return on investment equilibrating to the artificially low cost of funds. Glutted markets and falling asset prices are screaming, “No more!” In what would Ms. Clinton have corporations invest? Undoubtedly there are elements of self-enrichment and bull market crowd psychology at play when executives authorize share buybacks. However, returning capital to shareholders is also an admission that they don’t have any better ideas of what to do with the money. Ms. Clinton doesn’t either.

A loopy idea to “reinvigorate” a global economy that hasn’t been invigorated since the financial crisis is central-bank promoted negative interest rates. After a night of drinking, there comes a point where an additional drink does nothing for the drinker but make his toilet session later that evening and his hangover the next morning that much worse. The economic effect of negative interest rates would be similar to that deleterious drink. They will destroy what’s left of saving; the foundation of honest capitalism. Theoretically, if producers and investors can borrow at negative rates, it may be economically rational to undertake projects that lose money. Speculation will increase and end in its inevitable tears. Already over-indebted governments and consumers (in modern welfare states, most government spending funds consumption) will go deeper in debt.

Negative interest rate proposals are really just last call at the central bankers’ Castaway Lounge. The patrons guzzling their final-finals then staggering into the night may or may not realize that it’s all downhill from there, but they’ll find out soon enough. The bigger the binge the bigger the purge, and this has been history’s biggest credit binge. After decades of below market interest rates that have reached their logical floor, the purge looms. The global economy has found its way to the bathroom, where it needs some quality time with the porcelain god. The worst thing the bartenders can do is offer hair of the dog. The best thing they can do is let the drunk suffer his punishment. Who knows, there’s an outside chance he may emerge from it resolved that it never happens again. Of course, we know how those resolutions go.

 1912 (PRE-CENTRAL BANK): GOLD, $20.67 AN OUNCE; WHISKEY, A NICKEL A SHOT. VALUE WAS VALUE DURING AMERICA’S GOLDEN PINNACLE.

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