I have written about this subject before, purely from an abstract thought, but using fairly rational economic reasoning. The concept is not new, nor my own I’m sure, but it goes something like this.
As long as interest rates are kept artificially low, capital becomes misallocated, and does not end up being used for the greatest societal benefit. Imagine if you had two investment choices to choose from. The first might be able to produce a 20% annual return, but it would take you a year of research and due diligence and some out of pocket expenses if not a large up front investment for R&D. Another opportunity will provide a 3% annual return, with good certainty and without much effort. If you were lazy you might be hard pressed to decide between the two. However most money that moves markets is in the hands of pure capitalists. The difference between them and you is that they can borrow enormous amounts of money at obscenely low interest rates. From their point of view, if they can borrow 8 times the value of the lower yielding investment for say, 1%, then they can leverage the 3% investment eight times and earn a 17% annual return (8*3%=24% but they are going to pay interest of 1% on 7x the original investment so they would net 17%) without the year of due diligence or out of pocket expense. In one sense this is precisely what a great number of credit funds do. They buy low yielding securities, apply leverage and create higher yielding securities (today you can do this through a USD carry trade; you sell 5 year treasuries and buy longer maturity bonds). If that market place had existed in the first half of the 20th century we’d likely never have invented the Integrated Circuit, the World Wide Web, The Personal Computer, vaccines, and a host of other capital intensive initiatives that created enormous returns for the original investors.
While the vast majority of the world is contemplating QE3 and praying that interest rates remain low for extended periods, ought we reconsider what types of industries we will be adversely selecting to succeed with a cost of capital (hurdle rate) as low as it currently is? The best inventions are expensive to develop, take a lot of time, effort and ingenuity. None of that hard work is worthwhile to investors when their cost of capital is as low as it currently is. The obvious outcome to all of this is going to be massive inflation, most likely after a terrible bout of deflation. Must we wait for 1970’s type inflation again to begin to raise rates? Sure it will be painful to do this now, no doubt. But our only choices are to do it now or do it later. In my experience its best to get shitty things done as soon as possible so you can move on and then begin to enjoy life again.
If you want a little extra encouragement, take the chart below to heart. Its a comparison of US Unemployment (seasonally adjusted) all the way back to 1970 side by side with the 10 Year Treasury Yield. Notice first that the two lines have moved mostly together up until recently. Notice that the gap between the two is currently at the widest over the entire period. The old relationship of lowering interest rates to lower unemployment has broken down. Now see how the “pain” endured from 1980-1983 also saw interest rates jump from 8% to 11% and unemployment from 6% to nearly 11%. However, the speed with which unemployment then began to decline was much faster than we have experienced from our most recent recession. Loosening capital by lowering interest rates is not currently creating new industries nor new jobs. Instead most of this liquidity is being stored in cash, in anticipation of the next crisis and with apprehension towards Washington who remains anti business. Note that the pain felt in the early 1980’s paved the way for two decades of job creation.
Besides when rates are too low, we’ve all now learned that people who really can’t afford debt seem to get it, and those least equipped at managing debt end up with a whole shit ton of it. (Greece, sub-prime borrowers, small over-leveraged poorly run companies, etc…)
We are at the precipice of another stagflationary environment, likely to be far worse than what happened in that period since our government finances are not in order. The stimulus and policy responses undertaken from 2008 to now have been appropriate, but they will no longer work. I don’t want to see the government creating jobs and industries, I want to see inventors and entrepreneurs do it. In driving to Washington DC last month I saw first hand what happens when the President funds “shovel ready” projects. Every schmo with a shovel gets a check to build a bridge to nowhere. I literally saw multiple bridges crossing I-95 that seemed to literally be going to no where. There were no roads to meet the new bridges on other side, and in most cases they were cutting through fields and farmland.
There may be intelligent places the government can invest in rebuilding our economy (i.e. energy security), but I have lost all confidence that the current staffers have any bit of a clue of how to do that appropriately. If we take away the free money, capital providers will need to do more work to make good risk adjusted returns. And governments will be forced to reign in deficits and not just borrow more at lower rates to finance old debt that supported wasteful spending. Paul Volker was the right man at the right time during that period. He was also the right man at the right time when Obama took office. Unfortunately Obama let him go at precisely the time he needed him most.