Greg Ip

Articles by The Economist’s U.S. Economics Editor

Hopped up about zero

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Jul 6th 2010, 16:45 by G.I. | WASHINGTON, DC

[Greg Ip] TWO articles in today’s Wall Street Journal speculate that low interest rates are doing more harm than good. George Melloan argues they are punishing savers and rewarding high-rolling risk-taking hedge funds. David Reilly says they are choking off interbank lending because banks with excess cash don’t feel compensated for lending to other banks.

I think both evidence and theory are against both these arguments. Mr Melloan’s notion that today’s lower interest rates are feeding risky behaviour is directly contradicted by Mr Reilly’s observation that bank lending is shrinking, not growing. The picture is worse if you include the moribund securitisation market. Virtually every measure of risk—the VIX, credit spreads, Libor spreads, the equity risk premium—is wider than its pre-crisis level. But even if the evidence were otherwise, the point of zero interest rates is to boost spending through the wealth effect and encourage investment; that some of that investment is intermediated by hedge and private-equity funds is irrelevant. This may have been an argument against low nominal rates in 2006 or 2007. It is not an argument against them now.

Savers and borrowers should care about the risk-adjusted return, not the nominal return. One reason people and banks seem content to keep a lot of money tied up in deposits earning little or no interest is extreme risk aversion or, in economists’ speak, extreme liquidity preference. What they lose in actual return they make up for in peace of mind. The opposite is true for risk-takers: the pleasure of any actual return they earn is significantly diminished by the sleepless nights their risks entail. Those risks were abstract and underpriced in 2007; the opposite is true today. Maybe some CD investors are feeling hard done by these days. They ought to feel smug for outperforming equities so handily over the past decade and for sleeping so well.

The argument that zero nominal rates are gumming up the interbank market seems to confuse a low risk-free rate with a low spread over the risk-free rate. A bank weighs the return on a loan against the opportunity cost of lending without risk to the government whether that risk-free rate is zero or 5%. It compensates for the additional risk with a spread.

Maybe the interbank market is different: perhaps banks take a minimal spread as a given and then make a binary decision of lend/don’t lend. The elevated Libor spread suggests this isn’t true but even if it were, there’s a better explanation for moribund interbank lending volumes: the Fed has supplied $1 trillion of excess reserves. Far fewer banks actually need the interbank market. The Japanese interbank market also dried up when the Bank of Japan displaced commercial banks as the primary source of overnight funding.

Anyway, if zero interest rates are causing more harm than good, consider the counterfactual: why not hike to 2% right now? Or 10% for that matter? If we’re worried about risky behaviour by hedge funds and pension funds and the like, the right answer is tougher capital and liquidity oversight. If small banks are having trouble borrowing, the answer is recapitalisation, direct liquidity provision. I don’t see how raising interest rates will suddenly do wonders for small banks or, in the long run, savers.

 The original post is here.

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Written by gregip

July 6, 2010 at 10:45 am

Posted in Uncategorized

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