Photo: Bloomberg TV
In a complex editorial published in the Financial Times this morning, PIMCO founder and co-CIO argues that the continued depression of interest rates on U.S. Treasury bills might not really be helping the economy.In fact, the indefinite extension of low rates could just be throwing the U.S. into a Japanese-style lost decade.
His argument appears to focus on Operation Twist, a Fed program meant to push down yields on long-term government securities through sales of short-term securities. The Fed’s logic is that the low cost of long-term borrowing will catalyze growth in the housing sector in particular, driving construction and economic recovery.
However, instead of driving economic recovery, Gross argues, the plan is just making loaning out such cash less attractive to banks and investors. If returns are so minimal on such-investments, why hand out money at all?
The modern capitalistic model depends on risk-taking in several forms. Loss of principal – as in default – necessitates the cautious extension of credit to those that presumably can use it most efficiently. But our finance-based Minksy system is dependent as well on maturity extension. No home, commercial building or utility plant could be created if the credit liability matured or was callable overnight. Because this is so, lenders require and are incentivized by a yield premium for longer term loans, historically expressed as a positively sloping yield curve.
A flat yield curve, by contrast, is a disincentive for lenders to extend intermediate or long-term credit unless there is sufficient downside room for yields to fall and bond prices to rise, resulting in capital gain opportunities.
That contrasts past experience, where banks would lend because there was room for yields to fall further—i.e. the possibility that yields could be even lower in the future drives borrowers to give out cash now. But because interest rates are already close to zero—indeed they have never been lower—there’s ample reason for banks to sit tight and wait for a turnaround because the only way yields can turn is up.
Photo: Federal Reserve Bank of St. Louis
But if all banks do this in tandem, then no one will be lending and economic activity won’t improve. Thus there will be no reason for the Fed to raise interest rates and the vicious cycle will continue.
This is a variation on a liquidity trap, a phenomenon we’ve witnessed in Japan over the last 20 years. That Keynesian theory argues that there is a point where an increase in the money supply fails to stimulate the economy, and people continue to hoard cash because they fear downward risks.
Photo: Trading Economics
However, in this case the risk is less of a problem than the opportunity cost that banks’ cash will be better used in the future. This collective expectation just works against the point of accommodative monetary policy:
Maturity extension for Treasuries, and then for corporate and private credit alike, becomes riskier. The Minsky assumption of rejuvenation once the public sector stabilizes the credit system then becomes problematic. Instability may slouch back towards stability, but that stability may resemble more closely the zero-bound world of Japan over the past 10 years than the dynamic developed economy model of the past half century.
This does not appear to be the scenario playing out in the U.S. economy right now, with signs that the housing market is indeed improving and banks are once again extending credit. However, the recovery remains sluggish, and just because economic conditions look more positive right now does not mean that we’ll grow out of slow growth anytime soon.