Clearly, this may be the most unusual MR post that you will ever read. It concerns some, to me, strange actions by the Federal Reserve in the U.S. that appear to have been ignored by the major media for years.
A quick word of warning. This is a bit wonky. It is very unlikely that any of you discussed this over a drink with cronies or with your fellow professionals regardless of your discipline.
Here goes:
In late 2008, we had a financial crisis that ushered in what is now known as The Great Recession. There was panic in the financial markets across the globe. To help stem the fears, the US central bank, better known as the Federal Reserve, stepped in with boatloads of cash to quiet the markets somewhat. They also cut interest rates very quickly to the point where they approached zero. This new policy, often referred to as ZIRP (Zero Interest Rate Policy) helped to calm things down by acting as something of an economic stimulant.
Some weird things began to happen that really got my attention. I began getting solicitations to borrow $1-2 million at absurdly low interest rates of about 1.5%. For someone who considers himself to be modestly affluent, this was a bit shocking. I worked some math and saw that if I purchased a few stocks with high yields, I could easily cover the interest payments (and deduct them) as well as pay off much of the principal with dividends alone. If the securities raised their dividends each year, I could knock my loan down even faster.
I then began to see TV commercials on CNBC and Bloomberg for these types of loans. There was still much fear in the air, and I did not try to take out such a loan. I did, however, buy a car a few years later with ZIRP still rolling along. The interest rate and monthly was absurdly low. Being a child of rural New England, I have always hated debt and made extra payments for several months and paid off the vehicle quickly.
Okay, why did this concern me? As a media professional, demographics have been my beat for entire career. And being trained in economics academically, I realized that a ZIRP policy would have some winners and losers. Around 50% of American credit card holders carry a balance each month and pay annualized interest rates of 12-21% per year depending on their card selected and credit worthiness. With ZIRP, credit card balances were not slashed. They stayed largely intact.
To those with a substantial asset base, ZIRP was a windfall. To those struggling, it was business as usual except for mortgage rates which fell dramatically. Companies benefited mightily by borrowing money to buy back their stock at very low interest rates and thus pumping up their share prices as earnings rose due to a smaller float (share base).
By keeping ZIRP in place, there was an “Allocative effect” where certain parts of the economy benefited. It shifted money to wealthy people and larger corporations. I thought about this a great deal but could find nothing to confirm my suspicions. Finally, after some digging, I found an interview in the Wall Street Journal in May 2010 with Thomas Hoenig, a Federal Reserve regional president who articulated the “Allocation effect.” Hoenig was often the lone dissenter on policy matters during the Ben Bernanke era at the Federal Reserve. He was a “hawk” who did not think rates needed to drop as quickly as the Fed chairman did.
Finally, last year, Christopher Leonard, a financial writer wrote a book entitled The Lords of Easy Money (Simon & Schuster, 2022). He interviewed Hoenig extensively and covered the Fed’s handling of ZIRP in great detail.
My question is simple: How did I spot this back in 2009-10 and the media did not give it much attention? I am business news junkie but the Allocation effect did not surface clearly to me except from Leonard’s book.
I am not trashing the Fed. They are smart folks but also human. We did have a crisis in 2009 and things had to move fast. My personal feeling is that rates came down too fast and were kept too low for too long. We needed see how the initial rate cuts worked before going to zero. Younger people complain to me about high interest rates today. For much of my life, 5% on a passbook savings account was the norm. The 3.5% mortgages that many received in recent years struck me as artificially low. I vividly remember telling people close to me that bankers would have to be crazy to give a fixed 30-year mortgage at 3.5%. Who knows what things will be like in 10 years, let along 30? The response was the usual, “Don, you just do not understand.”
At least we did not go the European route of negative interest rates. When I first read about them, I felt they were insane. How can you have a market economy with negative interest rates? The idea appears to have been to get people to spend so they made sitting on cash in savings accounts unattractive. A few Danish banks even wrote mortgages for a time with a negative rate handle. Don’t believe me? Read--https://www.theguardian.com/money/2019/aug/13/danish-bank-launches-worlds-first-negative-interest-rate-mortgage
I love the financial press and devour their offerings daily. Why was the “Allocation effect” not covered adequately? It gives left wingers more ammo to claim that the rich always get richer. Actions have consequences and many had to see this coming.
If you would like to contact Don Cole directly, you may reach him at doncolemedia@gmail.com or leave a message on the blog.
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