Schwab Gets It 90% Right

This is an interesting op-ed in the morning edition of the WSJ:

We’re now in the 37th month of central government manipulation of the free-market system through the Federal Reserve’s near-zero interest rate policy. Is it working?

Business and consumer loan demand remains modest in part because there’s no hurry to borrow at today’s super-low rates when the Fed says rates will stay low for years to come. Why take the risk of borrowing today when low-cost money will be there tomorrow?

Why borrow at all, in the main?  Borrowing is the taking of leverage — “gearing.”  It magnifies both gains and losses, and it is the losses that turn into trouble, as often they wind up being borne by someone other than the borrower.

They’re supposed to be borne by the borrower and lender, incidentally.  But the lender rarely actually eats them, especially when things get “really bad” — then the taxpayer gets soaked, directly or indirectly, as we have seen.

Federal Reserve Chairman Ben Bernanke told lawmakers last week that fiscal policy should first “do no harm.” The same can be said of monetary policy. The Fed’s prolonged, “emergency” near-zero interest rate policy is now harming our economy.

It always was Charles.

The Fed policy has resulted in a huge infusion of capital into the system, creating a massive rise in liquidity but negligible movement of that money. It is sitting there, in banks all across America, unused.

No.  Capital and borrowing are not the same thing.  They spend the same, but they’re not the same.  Capital is economic surplus — that which you have after you earn and pay the necessities of life (or to run your business.)  Borrowing is leverage — “mechanical advantage” if you will, but it is always a negative-sum game as not only does it have to be paid back but the interest expense means you must earn even more to pay it with.

The multiplier effect that normally comes with a boost in liquidity remains at rock bottom. Sufficient capital is in the system to spur growth—it simply isn’t being put to work fast enough.

The paradox of debt is that due to the negative sum nature of it there is always less of a multiplier than the liquidity increase would suggest.  That is, mathematically it is a negative game for the borrower in every case.  This does not mean that a borrower cannot turn that disadvantage into advantage, but it does mean that the odds are against him or her in doing so.

The poker player in Vegas is at a similar disadvantage due to the house “rake.”  If six similarly-skilled players sit at a poker table in Vegas and play long enough they will all wind up broke, because the house rake will consume all their money.  It is a certainty if the game goes on for long enough, the skills are evenly-enough matched, and their luck is reasonably even.

The only way for such a player to win is to be better than the other people at the table by a sufficient amount to overcome the house rake.  He must also stop playing when he has amassed enough winnings and depart.  This means that for the player of superior skill he is incented to play at a higher level of wager, becasue he wants the fewest number of hands dealt to make his money to keep the rake’s “rape” of his stack to a reasonable level.

We’ve also seen a destructive run of capital out of Europe and into safe U.S. assets such as Treasury bonds, reflecting a world-wide aversion to risk. New business formation is at record lows, according to Census Bureau data. There is still insufficient confidence among business people and consumers to spark an investment and growth boom.

Business formation comes from capital formation which is the product of economic surplus.  That’s all.  Since capital formation is born of savings, that is, economic surplus, zero interest rates destroy the incentive to do so.  Low interest rates tend to cause people to borrow for uneconomic purpose, just as inflation provides incentive to buy things that aren’t really needed right now “because they’ll go up in price tomorrow.”  This is all malinvestment of one form or another and it’s destructive to the health of the economy.

Just look at SYSCO, which reported results this morning.  They showed that food inflation was 6.8% over the last year, contrary to the government lie that “inflation is non-existent.”  Uh huh.

What Mr. Schwab is missing here is that The Fed is hardly an “independent” central bank.  It is in fact beholden to Congress, which has pumped up $5 trillion in debt over the last three years.  That debt has a servicing cost, and it is the “ultra low” interest rates that make this temporarily affordable.

How is Congress going to service this debt when the rate of interest rises?  More to the point, where are the adults in the room in Washington DC?  We’ve had this on both sides of the aisle — “we must stimulate the economy!” — with borrowed money.

Outright bribery of the electorate both hasn’t and can’t work to lead to a durable recovery.  Instead, it has backed Bernanke and Congress into a corner.  When rates rise to just a blended 4% Congress will be facing a $600 billion annual interest bill.  From where will the money come?

This is the trap into which Japan fell and what we are facing today.  It is an extraordinarily destructive cycle that is very, very difficult to break, because it requires pulling the liquidity support at the same time Congress dramatically raises taxes, cuts spending (real cuts, not the imaginary cuts from “baseline” budgeting) or both.  In short it requires admitting that we took fiscal heroin to avoid pain and accepting the accumulated damage for a period of time, accepting the “deferred depression” that we all tried to hide.

Charles Schwab leaves this unsaid, of course, but then again he’s running a brokerage.  Were people to think this thing through they’d realize that the mathematical conundrum presented by Schwab has no resolution that doesn’t ultimately result in that contraction asserting itself.  There is always the matter of timing, but not outcome — that which is fueled by nothing other than fiscal methamphetamine either leads to a nasty crash when you stop taking or heart failure.  Pick one — both suck but while one is nasty the other is fatal.

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