In today’s Financial Times, the famed investor Bill Gross tries to explain why low interest rates are harming the economy (“The ugly side of ultra-cheap money”). The interesting thing about his piece is that much, if not most, of what he says is totally correct. But he just can’t quite seem to put all the pieces together and make sense out of them. What seems to be Mr. Gross’s problem?
Well, first let’s see what Mr. Gross gets right. The first thing that he gets right is that banks and other financial intermediaries make their profits off of the spread between their cost of funds, their borrowing rates, and their lending rates. When the interest rates at which banks and financial intermediaries can lend have been depressed by monetary policy — supposedly in the interest of spurring investment — banks and financial intermediaries can’t function profitably. Money dries up, because banks can’t earn a profit unless their lending rates exceed their borrowing rates by more than, say, 100 basis points, while current spreads are between 20 and 90 basis points. “It is no coincidence” Mr. Gross observes, “that tens of thousands of layoffs are occurring in the banking industry, and that branch expansion is reversing industry wide.”
This is one of many troubling features of the Little Depression in which we now find ourselves. But Mr. Gross mistakenly blames it on a monetary policy that is trying to stimulate the economy by keeping interest rates low.
Historically, central banks have comfortably relied on a model which dictates that lower and lower yields will stimulate aggregate demand and, in the case of financial markets, drive asset purchases outward on the risk spectrum as investors seek to maintain higher returns. Near zero policy rates and a series of “quantitative easings” have temporarily succeeded in keeping asset markets and real economies afloat in the US, Europe and even Japan. Now, with policy rates at or approaching zero yields and QE facing political limits in almost all developed economics, it is appropriate not only to question the effectiveness of historical conceptual models but to entertain the possibility that they may, counterintuitively, be hazardous to an economy’s health.
But Mr. Gross needs to ask himself why it is that banks, which would certainly like to lend at profitable rates, can’t seem to do so. It is no answer to say that the Fed has forced banks’ lending rates down; the Fed has done no such thing. The Fed’s policy rate is the rate at which banks can borrow reserves; it is not the rate at which banks can lend to customers. One might say that the Fed, through quantitative easing, has forced down the interest rates on government debt to very low levels as well. Yes, but banks are not lending to the government, they are lending to businesses. And if banks can’t lend to businesses at interest rates high enough to earn a profit, it is because businesses just aren’t willing to borrow at interest rates that high, not because the central bank policy rate is so low. Why won’t businesses pay a higher interest rate on bank loans? What businesses are willing to pay for bank loans simply reflects their depressed demand for financing, which in turn reflects their rather pessimistic expectations about the profitability of future investment and the sizable quantity of cash they have on hand, not the effect of quantitative easing. If central banks raised interest rates, i.e., the interest banks must pay for reserves, it would not make banks more profitable; it would just reduce further the amount of funds businesses wanted to borrow from banks. Current low interest rates reflect the depressed state of the economy, not a ceiling on bank lending rates imposed by the Fed.
So Mr. Gross has it backwards, current low interest rates are not being imposed on the economy by the central bank, low interest rates are a symptom of an economy in a state of severe and chronic depression. Now it is true that banks and financial intermediaries are unable to operate normally when the spread between their borrowing and lending rates is as narrow as it is now. But there is a solution to that problem: raise inflation expectations, thereby raising lending rates and the spread between bank borrowing and lending rates. The Fed knows how to do that; it just needs to make up its mind that that is what it wants to do. That’s just what Market Monetarists have been pleading for the Fed to do. Mr. Gross, isn’t it time for you to get with the program?
Update: I see that Paul Krugman also wrote about Bill Gross today on his blog. As the recipient of four shout-outs from Krugman since this blog started, I guess that it’s only fair that I return the favor. I’m sure that he will appreciate the added traffic on his blog.
Uneasy Money 
There is a strange paradox here. You have in other posts noted that stock investors (who form the monolithic stock market) like inflation, and a cursory review of business news shows that investors’ reaction to announcements by the Fed indicate a clear understanding of which policies are expansionary, with stock prices responding accordingly. Nonetheless, individual investors’ voices have been mostly absent from the call for NGDP targeting (or some similarly aggressive measure), while individual investors have been found to make the case for this or that contractionary policy. I’m not sure how to explain this.
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Woe is me, my interest income is too low!
This very Gross piece is a subset of the above sentiment that has created a cottage industry on Wall St. These include:
1. low interest rates hurt credit intermediation through banks (Gross’ argument)
2. low interest rates reduce national income and hurt the economy
3. low interest rates are unfair to Grandma and her fixed income (but don’t forget to cut social security!)
4. low interest rates are financial *REPRESSION*, i.e., the gov’t is brutally subjugating my economic rents (Gross, El-Erian, Rogoff, & other CNBC guests use this regularly).
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The Fed’s goal should be to raise nominal expenditure on output, not to create inflation.
Additional nominal expenditure on output creates two opportunitites for firms–they can sell the same amount at higher prices or they can sell a larger quantity of products at the same price. And, of course, there are many combinations of both higher prices and higher products.
If firms find it beneficial to produce more, they will need more capital goods. Under current conditions they would likely fund those by selling off securities they are holding. I see this as a reduction in the supply of credit, which will raise interest rates. Still, some businesses might use bank loans for this purpose, and so the result would be an increase in the demand bank loans.
The increase in production would tend to increase employment as well. Since people who lose jobs, which happens all the time, must find new jobs, and new jobs have been very difficult to find, these worries cause restraint on consumption spending. To some degree, those willing to consume more will borrow from banks, though they might also reduce their lending to banks. So an increase in demand and increase in supply of bank credit is a likely result. Still, some people might sell off T-bills and buy consumer goods. This would be a decrease in the supply of credit.
I characterize all the above as increases in the natural interest rate.
And so, a Fed policy aimed at raising nominal GDP can raise the natural interest rate and market interest rates.
It is true, of course, that to the degree firms respond to increases in nominal expenditure on their products by raising prices, this is higher inflation. To avoid real losses on bank deposits and short term securities, there is a motivation to spend them on consumer goods and capital goods. Of course, there may be a bias to storable commodities which is better than nothing. Anyway, as above, this reduces the supply of credit and so raises nominal interest rates.
Realistically, both pathways will occur, and so the nominal interest rate will rise because of a higher real natural rate and a higher expected inflation rate.
In my view, the second effect is a necessary evil. The first effect is a positive good.
However, it is very important that the monetary authority commit to raising nominal expenditure on output to a target growth path and it should make no commitment as to what will happen to interest rates or inflation. If the process results in higher inflation and interest rates, then that is what will happen.
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I think some people cannot adjust to the new reality–inflation and interest rates are dead, just like Japan. Real estate is down and dead, meaning property loans are crappy. It is a self-reinforcing cycle, if Japan is any indication.
The Fed should print money until Ben Franklins are coming out of Bernanke’s rear end in huge torrents.
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I think Gross’s major point is that financial repression is flattening the curve and reducing financial intermediation. QE, in other words, has negatively impacted velocity. I would think MM’s would have some sympathy for this view, as they argue that QE without a higher NGDP/inflation target is likely to be ineffective.
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BTW, I also think you might misunderstand the function of shadow banks. The vast bulk of shadow bank activity — the dominant form of financial intermediation — is to fund long term “safe” securities with s.t. liabilities. It is not to lend money at higher rates to private borrowers. The misunderstanding comes from the structure of debt securities. Some 70-80% of securitized credit is actually rated AAA through the process of tranching and subordination, or through government guarantees (RMBS). Thus, for shadow banks, the spread that matters is the AAA-rated yield curve, which is in turn a function of Treasury yields. This is why he refers to money market funds — a shadow bank component — in his piece.
Because most TBTF traditional banks have large shadow bank components, they will continue to de-lever alongside the shadow banking system. This is one reason that banks are not responding to relatively high spreads on traditional lending activity.
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Mr. Gross always talks his book. He made a big miscalculation on interest rates, he was betting on inflation. …”This week saw something stunning: The world’s most famous bond manager, Bill Gross, was forced to send out an apology to investors over his dismal performance this year.”…
Read more: http://www.businessinsider.com/the-costly-misplaced-worry-about-the-deficit-2011-10#ixzz1hCTmVgGS
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David,
you may find this Federal Reserve Bank of San Francisco paper interesting about the signaling effects of large-scale asset purchases announcements.
Click to access wp11-30bk.pdf
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What Bill Gross is essentially saying is that commercial banking – the banks that make their profits off of the spread on interest rates are being hosed at the expense of investment banking – the guys that throw money at the investment wall and sees what sticks.
What Bill Gross fails to mention is that this was all made possible by the repeal of the Glass Stegal Act (Summers, Greenspan, and Rubin please take a bow).
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Will, Interesting observation. Maybe the investors complaining about monetary expansion are trying to give bad advice in the hopes people will act on the bad advice increasing the returns to the rest of the market. But maybe I am being too cynical.
Steve, I think that are legitimate concerns about low nominal interest rates (disintermediation being one of them), but they mistakenly attribute the low interest rate to an arbitrary choice by the Fed, when the low interest rates reflect a more general economic dysfunction. But I agree that there is something really annoying about the presumption of some people that they have a natural right to a risk free real interest rate of at least 2%. It is even more annoying that these same people would never concede that there is a natural right to a “living wage.”
Bill, I think that we agree pretty much on how monetary expansion aimed at increasing NGDP would work, and I think I agree with just about everything you say in your comment. However, I still prefer to speak in terms of inflation or price level expectations and the importance of affecting those expectations. I think that there is more microeconomic foundation for speaking about individual expectations of future prices including expectations about the future value of cash than there is about expectations of NGDP. So I find it more natural to couch my arguments in terms of expectations of future prices than in terms of NGDP expectations. But to be honest, I should admit that I get a little guilty satisfaction from epater les bourgeois by openly advocating inflation.
Benjamin, I recommend you find a different metaphor with which to describe your very wise policy recommendation.
David, I actually considered your first point as a possible way of understanding what Gross was saying, but if that is what he was getting at, he very effectively submerged it beneath a lot of irrelevant rhetoric and missed the essential policy recommendation, setting a target for increased NGDP and price level. On you point about money market funds, thanks for the elucidation which I didn’t pay enough attention to. However, if the real interest rate is negative, it is not clear to me why the central bank should set a floor under its nominal interest rate just so that MMFs can operate profitably. MMFs need to adapt to the current market situation just as others are doing. But the real solution is still to raise nominal interest rates by raising inflation/NGDP.
GeorgeK, You are right, Gross is not exactly an infallible predictor of where the markets are headed.
Richard, Thanks for the link.
Frank, I have serious reservations about allowing commercial banks to engage in investment banking activity, and especially when their deposits are ensured by the government. But to be fair to those you mentioned, the Glass-Steagal wall between commercial and investment banking was already breached and not much of a barrier by the time that Glass-Steagal was reapealed.
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“And if banks can’t lend to businesses at interest rates high enough to earn a profit, it is because businesses just aren’t willing to borrow at interest rates that high, not because the central bank policy rate is so low. Why won’t businesses pay a higher interest rate on bank loans? What businesses are willing to pay for bank loans simply reflects their depressed demand for financing, which in turn reflects their rather pessimistic expectations about the profitability of future investment and the sizable quantity of cash they have on hand, not the effect of quantitative easing.”
What Bill fails to mention is how effective tax policy works. If banks want to make high interest loans, then it is up to the federal government to assist the repayment of these loans through tax policy. The federal government does this by selling tax breaks to any business (and individual) that wants to buy them, rather than giving them away through lobbyist efforts.
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Frank, I think that you are quoting me not Bill. At any rate, I still don’t understand the mechanism by which tax breaks would be sold and how that transaction would affect a company’s assessment of its cost of capital.
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I explained it here:
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