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CNN Admits There Are Serious Problems with Central Banks' Low-Interest-Rate Policy

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5 COMMENTS

TAGS Money and Banks

06/27/2019 Ryan McMaken

On Monday, CNN reported on how, in spite of all the talk about job growth in recent years, wealth accumulation and incomes have been significantly and negatively impacted for many groups in the United States.

Much of what the article explored has been emphasized ever since the Great Recession started. The impact on younger earners, for example, has long been noted: "people entering the labor market during recessions have lower lifetime earnings."

What was most interesting about the CNN article, however, was its admission that a persistent low-interest rate policy — one pursued by the central bank since the 2008 financial crisis — brings with it a serious downside. In a section titled "The mixed blessing of low interest rates" author Lydia DePillis discusses how low-interest rates have reduced the standard of living for those on mixed incomes, and has destabilized pension funds. Low rates have also made big firms even bigger at the expense of smaller firms:

But just like taking painkillers for too long can have side effects, the Fed's monetary policy remedy gave rise to some unintended consequences. For example, low bond yields led the big funds that control trillions in investment to put their money into private equity and hedge funds that paid high rates. As a result, initial public offerings, which allow a wider group of people to benefit from the creation of new businesses, virtually dried up.

Meanwhile, low interest rates have been bad news for pension funds, which mostly depend on bond yields in order to remain solvent. Public pensions' assets amounted to just 66% of their liabilities in 2016, down from 86% in 2007,according to the Pew Charitable Trusts . For the 100 largest private pensions, that ratio was 87.1% in 2018, according to the actuarial firm Milliman, compared to 105.7% in 2007.

For retirees counting on fixed-income securities like government bonds, low interest rates can also mean a lower standard of living.

"Low interest rates, while they have a lot of benefits, have a lot of costs for society as well," said Kevin Kliesen, an economist at the Federal Reserve Bank of St. Louis.

And that's just short-term rates, which the Fed controls directly. Long-term interest rates were in decline before the financial crisis, and the ensuing recession depressed them even further; Fed officials are now struggling to nudge inflation up to their 2% target.

Those low interest rates may be sapping the economy of its vitality. One study published this year found that they give larger firms a greater incentive to invest than smaller ones. That fuels market concentration and reduces business dynamism — that is, the ability of startups to disrupt incumbents.

"As interest rates go down, they disproportionately favor market leaders as opposed to market followers," said Atif Mian, a finance professor at Princeton University who coauthored the study. That effect, he found, "is large enough for low interest rates to not have any expansionary effect on the economy any more."

There are three big takeaways here, and it's surprising CNN has mentioned them.

• Low interest rates have produced a quest for yield that favors the wealthy over the middle class.
• Low interest-rate policy hurts regular people who depend on fixed incomes and low-risk sources of interest income.
• Low interest rates favor large established firms over startups.

In other words, low interest rates favor the rich over the middle class, while widening income gaps.

This won't be terribly surprising to those who follow the Austrian-school critique of ultra-low-interest and easy money policies.

Although critics of markets and so-called "neoliberalism" insist on ignoring the destructive power of central banks, the fact remains expansionary monetary policy serves to increase income inequality while favoring the already-wealthy. In other words, central banks are the cause of so much that capitalism is blamed for.

How Central Banks Destroy Wealth

Central-bank policy is problematic in a variety of ways. One of them — not mentioned by the CNN report — is the Cantillon effects brought about through the creation of money which is used first by financial institutions closer to the central bank and the easy-money spigots.

A scond problem results when a "yield famine" results from low-interest-rate policy, but regular people can't afford fancy yield-chasing investment products that are available to the wealthy.

Thus, ordinary people are left trying to gain interest income from government bonds, savings accounts, and CDs. In many cases, this strategy may not even allow the investor to keep up with price inflation.

A third problem stems from issues on the production side of the economy.

The CNN story notes a recent report suggesting large firms benefit more from low rates than small firms. The report, titled "Low Interest Rates, Market Power, and Productivity Growth" (by Ernest Liu, Atif Mian, and Amir Sufi) found that "the gap between the leader and follower increases as interest rates decline, making an industry less competitive and more concentrated." In other words, low interest rates reduce competition and increase monopoly power of a small number of firms.

Moreover, the authors conclude their report

introduces the possibility of low interest rates as the common global “factor” that drives the slowdown in productivity growth. The mechanism that the theory postulates delivers  a number of important predictions that are supported by empirical evidence. A reduction in  long term interest rates increases market concentration and market power in the model. A fall  in the interest rate also makes industry leadership and monopoly power more persistent.

The rise of low-interest-rate-induced monopoly power then stifles innovation, leading to lower productivity, and slower global economic growth. According to Liu, et al, this is not limited to the United States. It can be observed as a result of central-bank policy worldwide.

Last year, analyst Karen Petrou described how low rates have favored large

As our research shows, QE exacerbates inequality because it takes safe assets out of the U.S. financial market, driving investors into equity markets and other financial assets not only to place their funds, but also in search of yields higher than those possible with ultra-low rates. The Fed hoped that soaking up $4.5 trillion in safe assets would stoke lending, and to a limited degree it did. However, new credit largely goes to large companies and other borrowers who have used it for purposes such as margin loans and stock buy-backs, not investment that would support strong employment growth. Growing household indebtedness in the U.S. is principally consumption or high-price housing driven and thus also a cause – not cure – of inequality.

Far from propelling middle class consumers to ever-higher levels of prosperity, low-interest rate policy is leading either to stagnation of losses in wealth.

But these revelations should not be shocking.

After all, Edward Wolff's 2014 article "Household Wealth Trends in the United States, 1962-2013" suggests that our low-interest-rate world has done little to increase economic well being or counteract the effects of recessions:

From 2007 to 2010, house prices fell by 24 percent in real terms, stock prices by 26 percent, and median wealth by a staggering 44 percent. Median income also dropped but by a more modest 6.7 percent and median non-home wealth plummeted by 49 percent. The share of households with zero or negative net worth rose sharply from 18.6 to 21.8 percent.

However, from 2010 to 2013, asset prices recovered with stock prices up by 39 percent and house prices by 8 percent. Despite this, both median and mean wealth stagnated, while median income was down by 1.3 percent but mean income rose by 0.9 percent. The percent of households with zero or negative net worth remained unchanged.

According to wolf in this 2017 follow-up, as of 2016, "median wealth was still down by 34 percent."

The evidence is mounting against the usual narrative which states that low-interest rate policy has been a clear good because it has stimulated demand and consumption.

On the contrary, there is reason to believe low-interest rate policy has lowered productivity, lessened economic growth, and favored large firms at the expense of small firms and innovation.

Median incomes have also suffered.

But central banks are clearly afraid to do anything but kick the low-interest can down the road. The Fed's multi-trillion-dollar balance sheet isn't going anywhere, and the Fed has no appetite for raising rates. But when the next recession hits, it's likely the Fed and the world's central banks will dish up more of the same: near-zero rates in the name of recovery and wealth creation. But this strategy's record of delivering has been questionable at best.

Ryan McMaken (@ryanmcmaken) is a senior editor at the Mises Institute. Send him your article submissions for Mises Wire and The Austrian, but read article guidelines first. Ryan has degrees in economics and political science from the University of Colorado, and was the economist for the Colorado Division of Housing from 2009 to 2014. He is the author of Commie Cowboys: The Bourgeoisie and the Nation-State in the Western Genre.

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Fundamental economics - read this and make your assumptions more robust

Why It's Important to Understand "Economic Costs"

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4 COMMENTS

TAGS Austrian Economics Overview SubjectivismValue and Exchange

06/20/2019 Per Bylund

The concept of economic cost seems to confuse people. It is not the price you pay for a good, but the reason you pay it.

The cost of one action is the value you could otherwise have gained from taking another action. In other words, if you have $100 and you have the choice to buy two goods, each at a price of $100, you'll naturally choose whichever is more important (valuable) to you. The cost of it is not the $100, which you give up to purchase it, but the value of the other good, which you can no longer purchase. That other good is the opportunity foregone by your action, the true cost of your action — the economic cost.

Why does this matter? Because our actions are intended to create value, and we always aim to maximize that (subjectively understood) value. The economic cost concept brings to our attention what we actually give up to get a value, and thus why we choose a certain course of action.

An economy, which is a system of economizing on scarce resources, is the systematic allocation of resources to maximize value. It is not about minimizing the price paid, which is something different. It is about value. While this may seem like an academic point, the implications are enormous.

Those who are ignorant of this concept focus on the outcome of action only — the "net gain" — rather than the cost. Doing so means we end up wasting enormous resources while not getting the value that was well within reach.

Examples of this include arguing that there were massive gains from, for example, World War II or the US space program in the 1960s. Both were enormously wasteful, but also generated tangible benefits. WWII led to the discovery of artificial rubber, freeing us from costly and time-consuming rubber production. Yes, that's a benefit. And there were plenty of technologies developed as part of the space program. Those were also benefits. But at what economic cost? That's the real issue: what other benefits did we never see because we instead pumped in enormous resources into war and the space race? What other discoveries and innovations were within reach had those resources been used differently?

The WWII example should be obvious, since the war itself was hardly productive. But the space program is exactly the same issue: what opportunities did we, as a society, forego because the government preferred to invest billions of dollars into the prestige program of beating the Russians to the moon? We don't know what we didn't get, of course.

But this doesn't mean we cannot say whether it was the right thing to do. The fact is that in a market system entrepreneurs compete with each other not to minimize cost, but to produce value. Naturally, this means net value: what actual benefit is provided in the eyes of the consumer. The entrepreneurs don't know what consumers will value, but they bet their livelihoods on what they think will benefit consumers most. The result is a variety of goods and services from which consumers can choose, and they will choose what is the best option from their point of view. What is not produced cannot be chosen. But what is not produced also does not seem to be worth it to the numerous entrepreneurs engaging in value facilitation for consumers.

Note that this is not a matter of whether entrepreneurs can "afford" the capital investment needed. It is about the rate of return: whether the value is high enough above the outlays necessary to produce the good/service (the production cost). With a sufficiently high ROI (return on investment), relative to other possible and attempted projects, entrepreneurs can always find the funds needed: investors are looking for a return on their funds, after all.

So the argument that "only the government can" invest in something because it requires capital is bogus. It asserts problems that don't exist, and often fails to properly apply the concept of economic cost (as in the examples above). Economic cost tells us what is expectedly most important to people, regardless of the capital investment magnitude. Higher ROI means greater value, which means a higher price can be charged — and more profit earned.

This is where economic cost is essential to understand the workings of the economy. Because if a project envisioned by an entrepreneur appears to be highly profitable, regardless of initial investment needed, she/he will pursue it. This means, at the same time, that other entrepreneurial projects, which are expected to provide a lesser return on investment, will not be pursued. What matters for society and the economy is that the greater value is pursued, because it makes all of us better off. This is why, through competition, the swift weeding out of entrepreneurs with projects that do not actually produce much value is important: they literally waste our resources because the value foregone — the projects that were not undertaken because the resources were bound up in these lesser projects — is higher than the value produced. It is an economic loss regardless of what benefits came out of it.

Consequently, we can conclude that the space program, just like war, was a wasteful act. The government stepped in because no entrepreneur was willing to undertake it, which is because its expected ROI (if any) was much lower than other projects entrepreneurs could pursue. We don't know what we lost, but it could have been cures for nasty diseases, doing away with poverty, or whatever. The fact that consumers were not expected to spend their own money on the space program, and the fact that no entrepreneurs expected that they would, at least not to the extent necessary, means it was not considered valuable enough. Its economic cost was expected to be higher than the economic value!

Now, does this mean that nothing good came out of the space program? Of course not.

There were innovations and technologies discovered that have served us well. But they were, at the time of investment, either not expected (at all) or not expected to sufficiently serve people. There are certainly examples of flukes that ended up creating beautiful things (like Arpanet becoming the Internet), but who in their right mind would argue that we should waste resources on grand government projects because there might be unintended consequences that we'd benefit from?

Considering the economic cost, what we could have gained from that investment was expected (by everyone!) to be higher than the project pursued by the government.

That's the reason the government did it. Government is in the business of wasting scarce resources at high economic cost, i.e., without sufficient expected value. No matter how one looks at it, this is wasteful. Unless, of course, one ignores the concept of economic cost: the higher-value opportunities that are foregone — lost — because we're instead pursuing the lower-valued ones.

To simplify, it is a matter of picking the low-hanging fruits first, because there is much higher return — greater "bang" for the buck — from doing so. It makes no sense climbing to the top branches "in case" there is some other and unexpected benefit from putting in the extra effort.

Formatted from Twitter, follow @PerBylund.