Why Zero-Rate Policy Will Fail, by Victor Hong

Here is a simple supply-demand analysis of why the current zero-rate policy will fail.  Draw a supply-demand table in Economics 101, to represent the private credit market.  The highest amount of private credit flows where the supply and demand lines intersect, which also determines market-clearing interest rates.  If rates are artificially set too high or low, private credit disappears, as either users (industries, consumers) or providers (lenders, investors) retreat from unprofitable terms, respectively.

chart from Wikipedia

Currently, as in 1990′s Japan, the US government has pushed benchmark interest rates toward zero, ironically starving the economy of private long-term credit while drowning it in risk-averse short-term liquidity.   If LIBOR hovers at or below 1.00%, few private entities are rationally willing to lend long-term money for productive, legitimate risk-taking activities, especially if the incremental lending spreads over LIBOR (whether 50, 200, or 500 basis points) might still compensate insufficiently for default losses——defaults arising particularly from this credit drought.   Talk about a spiral.

Hence, the US government has become the sole willing major credit source, inadvertently crowding out all private competitors by taking on too much credit risk for too little reward.  Its balance sheet now bulges unwittingly with student loans, unsecured commercial paper, AIG loans, and dealer repo financing.  The real dregs, like municipal loans, GM and Chrysler bridge financing, etc., are coming down the pike.  No wonder that everybody is banging down the doors of the Fed for normal operating funds.

The only way to restore the global economy is for the Fed to stop lending near-free public money to companies, especially failing ones like AIG and GM.   This would allow interest rates to climb back to risk-compensating levels, enticing private credit providers to fund successful businesses again, as before this debacle.

(Thanks to Victor Hong for sharing his thoughts.)

One thought on “Why Zero-Rate Policy Will Fail, by Victor Hong

  1. Pingback: Zero interest rates, and the harm on private economic growth – a Victor Hong lookback

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