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.