Two More Recent Articles on the ZIRP Trap

The world is finally catching up to understanding what is going on with monetary policy. This latest bit is from Ronald McKinnon of Stanford writing in the Tuesday WSJ (" The Near-Zero Interest Rate Trap"):

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The conventional critique of the Federal Reserve's policies of near-zero interest rates and massive monetary expansion is that they risk kindling excess aggregate demand and high inflation. Yet inflation world-wide remains low, and some major trading partners of the United States, such as Japan and now China, are worried about deflation. China's Producer Price Index fell 2.7% in June, the 16th consecutive monthly decline.

Nevertheless, artificially low short- and long-term interest rates can still distort the financial system and hold the economy back. And modest increases in interest rates to more "normal" levels could lead to more investment without an inflation risk.

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The problem here is that as banks and other financial institutions get used to near-zero interest rates and accumulate low-interest bonds for some years, they end up in a trap from which escape is difficult. And this trap has negative implications even for corporations that seek direct, long-term financing.

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By trying to stimulate aggregate demand and reduce unemployment, central banks have pushed interest rates down too much and inadvertently distorted the financial system in a way that constrains both short- and long-term business investment. The misnamed monetary stimuli are actually holding the economy back.

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The Fed will not seriously try to exit the ZIRP trap though. I predict that there will be many years of yo-yo policy of making initial moves to exit ZIRP, and then returning almost immediately to it when it upsets markets.

And this will likely be followed by decades of unsustainable federal debt that everyone knows won't be paid back, but the game will keep going on anyway as the government will refuse to repudiate its debt like it should, and will instead keep milking paltry investment returns in the name of wealth stability for the old, while the young get screwed by the older generation's entitlement bullshite.



There was also a decent article from July 17, " Central Banking Needs Rethinking," by Amar Bhidé & Edmund Phelps, that focused more on the traditional bank regulation aspect of it.

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Moreover, the Fed's quantitative easing appears not to have increased confidence and may have reduced it. No one—the Fed included—knows how much more it will buy or how much of its mountain of Treasurys will be sold back to the market. The Fed said it would end easing at serious signs of faster inflation. But as the housing bubble that preceded the financial crisis showed, imprudent speculation can be destructive without high inflation. Today we have banks, insurance companies and pension funds leveraging their assets and loading up on credit risks because prudence cannot provide acceptable returns.

The cost of this uncertainty can be considerable. An attendant foreboding may lie behind some of the depression in business investment—even if myopic traders in bonds and currencies are impervious to it and too-big-to-fail banks go on making one-way bets. Also, the time and money that businesses give to innovation and efficiency gains are squeezed if the businesses are distracted by the uncertainties surrounding monetary policy.

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What we do need from the Fed is reform of the ways banks are regulated and supervised. Tough, on-the-ground examination of individual banks not only helps keep them solvent, such scrutiny can also prevent out-of-control money growth without suppressing productive lending. Similarly, rules that discourage banks from relying on yield-chasing hot money will limit the runs and panics the Fed has to fight.

Unfortunately, over the past couple of decades, bank regulation, like the Fed's macro-interventions, has become more top-down and formulaic.

Until the 1980s, for instance, bank examiners would assess how large a capital buffer each bank should have, taking into account its specific risks instead of relying on internationally standardized ratios.

Dysfunctional rules have also sustained the growth of monolithic megabanks that have little interest in traditional productive lending.

Unsurprisingly, the Fed's aggressive monetary easing has helped large companies already flush with cash issue bonds at low rates, while small businesses have struggled to secure working-capital loans.

In a modern economy some areas of top-down control are likely to be unavoidable. But that does not mean we should settle for institutions that are less participatory or accountable. It is not desirable that seven people on the Federal Open Market Committee have the power to intervene on a massive scale based on theories that may or may not be right and do not reflect a popular consensus.

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