The ZIRP Trap

The ZIRP Trap

Posted by Karl Denninger

IRA popped up this morning with an article that makes some of the points I’ve been harping on for a year or so now….

Even as bank securities holdings are rising in aggregate, loan portfolios and assets overall are shrinking at an accelerating pace – evidence, we believe, that deflation remains the chief threat to the global economy. As we said two weeks ago, when the Fed embraces a zero rate policy, what they are telling investors is that bonds and other rate-sensitive financial assets have no value. We’ve been talking about the shrinking bank balance sheet for more than 18 months and thankfully this key statistic is starting to get broad attention.


The problem with this premise is that not only does it destroy the asset base (think savings accounts, CDs, etc) that banks require to have a healthy lending environment, it also drives funds in two corrosive and destructive directions:

  1. It encourages carry trades which are inherently destructive because the capital lent leaves the nation where it was borrowed.  That is, it is put to work somewhere else, instead of in the borrowed currency.

  2. It forces people out the risk curve and while at the same time it destroys bank capital bases it exposes the capital that wants a low-risk (or “risk free”) home into risk assets where it can be destroyed.

When you look at credit quality of these “assets” (especially MBS) you see a truly frightening picture.  The Fed’s intentional overpayment has masked an enormous valuation:coupon disconnect; the internal credit quality in these things continue to go to hell, yet the coupon has been stable rather than rising to reflect this deterioration.  That shouldn’t happen in a rational market, but there is nothing rational about The Fed’s interference.

Now consider the lowly retail investor who is in a money market fund with his “must not lose” money.  He is earning zero, and many of these funds are at present absorbing fees.  This is causing them to run at a net loss, as any attempt to post a negative interest rate to investors will result in an instantaneous run on the fund.  Yet ZIRP makes it effectively impossible for these funds to return a positive yield.

Remember, without these funds there is no lending base and thus no credit growth.  The perverse impact of ZIRP is that it destroys bank capital bases, as over time people will simply not sit for a zero yield – effectively or otherwise.

As I have noted for the last three years (and which IRA also notes in their paper) the only solution to a debt-overhang economic dislocation is to force the excessive and unpayable debt to default.  These defaults bankrupt the institutions and borrowers that were imprudent, but in doing so they also clear the market.  This also forces yields to rise to reasonable levels, restoring a yield curve that reflects duration and inflation risk, yet allows the capital base of the sound banks to be rebuilt, as they are able to attract deposits, especially time deposits, with reasonable yields on these instruments.

In other words, it attracts capital to the financial institutions – not debased currency or credit.

Only loaned (and thus borrowed) capital promotes economic growth.

The Fed’s puerile thought process is that “all yield is the same”, “all borrowing cost is the same”, and “all credit source is the same.”  This is a chimera.  The Fed is incapable of producing capital, even by printing.  It can produce credit and it can debase existing money, diluting all existing currency, but it cannot create capital.

Capital is created only by real production in the economy.  No other action creates it.  Yet the loan of capital is what gives rise to the granting of credit without debasement of all existing currency.

The Fed is powerless to do this, but it can destroy the conditions necessary for capital to be lent.

ZIRP does exactly that by ruining the incentives necessary for those with actual capital to be induced to lend that capital.

The Fed should have learned this from Japan, but refused to look at the evidence under their nose.  Instead, Bernanke has continued down a ruinous ivory-tower path born out of his own fertile imagination in relationship to how markets and incentives actually work, conflating the concepts of “money”, “credit” and “capital.”

Addressing this problem and correcting it requires admission that both Paulson and Bernanke, along with Summers and Geithner, were wrong.

In the world of Washington DC where “I screwed the pooch” are four words you will never hear a politician utter, such a sea change will require that either President Obama grow a pair of balls or that he be shackled by a massive shift in power in Washington DC – and those who come in to do so actually understand the difference.

Odds on that event were unavailable at presstime.