The Contrafactual Case Against ZIRP

Reposted From EconMatters

The ZIRP Debate

The long held debate is what would the US economy being doing without ZIRP by the Federal Reserve, would we be doing worse, about the same, or better? The other delineation in the argument is whether there is a cutoff point where ZIRP stopped being effective, if it was effective at some point, and where this line of demarcation should be in terms of one, two, three, four and subsequent years of zero percent interest rates.

2012-2014 Period

I will focus on the last three years as I will give the benefit of doubt that in some small way ZIRP served some initial benefit to the economy by helping heal banks’ balance sheets and filling the void from the massive deleveraging that manifested from the busting of the credit bubble and the subprime crisis that help fuel the housing and financial crash of 2007/ 2008.

But even there the case can be made that the aforementioned collapse was the direct result of a poorly designed and shortsighted abnormally low interest rate policy in the Greenspan Era of the Federal Reserve.

The argument can also be made that ZIRP in any form is just bad monetary policy, and that in the long run a complete flushing and cleansing of the financial system was necessary and beneficial to incentivize the right kind of investment strategies going forward. This system cleansing would pave the way to much more sustainable, solidly founded business principles which would serve as a better foundation for the next era of productive growth in the economy for decades to come in this country.

But for the sake of argument let us give in that to some degree ZIRP was beneficial to stabilizing the patient to use a medical analogy for at least for the first couple of years. But regarding the last three years I will argue that the economy would actually be more productive and be prepped for more robust genuinely sustainable growth if we had foregone the ZIRP strategy and normalized interest rates to be more in line with proper functioning financial principles which respect the value of money, and promote healthy financial transactions between parties.

A Healthy Respect for the Value of Money

The ability to borrow at Zero Percent distorts and promotes unhealthy choices with regard to capital allocation. If capital was privatized no lender in their right mind would undervalue the importance of their function as a lender and just give their money away. In fact, the principal of individuals is to over value whatever resources they have in deals between parties, and having an abundance of capital wealth is no small resource, it is probably the most valuable resource in the world in a healthy functioning modern financial system.

One just doesn`t give it out with a return below the rate of inflation that would be irrational, illogical and a complete distortion of the principle of what constitutes value. Yet the Federal Reserve does just this fact with their ZIRP methodology, they distort the value of money, not just in the traditional money printing sense, but in creating an unhealthy value of what money represents, and how capital is allocated in the economic system.

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The Yield Carry Trade & Unproductive Capital Allocation

The biggest example of this is the abundance of capital that is currently being addressed to unproductive investment strategies like Yield Arbitrage Strategies in largely paper markets which in the end just become ones and zeroes in the electronic banking system, amongst a relatively small sector of participants and has no add on economic benefits to the greater economy.

Big banks and investment funds and anybody who has access to ZIRP funds just borrows at 15 to 25 basis points and invests in assets which provide a positive yield carry, they earn an electronic profit that gets reinvested in the same yield carry trade, and none of this capital ever reaches the broader economy, let alone create productive growth that is sustainable once ZIRP ends.

As there is no long term fundamental business creation that has been fostered with this form of investments strategy which will grow for decades and lead to future business prospects it should be dis-incentivized by the Fed. When ZIRP ends investors just sell their bonds and pay back the portion of the money they borrowed, and depending upon how messy the exit take small to large losses on the positions as some of these positions are so levered up that not everybody cannot profitably exit with limited downside risk consequences at the same time with regards to exit price expectations.

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So I would say one shouldn`t just look at the period of the money made before the ZIRP unwind, but the entire period in aggregate and three-five years in the unwind phase. Moreover, what sustainable economic activity is left after the Yield Trade unwinds, has this led to any sustainable long-term business activity, new innovation, or actual job creation?

I would think on any fair analysis the answer is a resounding no on all accounts! The economy would actually benefit considerably more from a different form of capital allocation like small and medium size business loans. The traditional banking role in the economy to fund entrepreneurs and small business ideas with solid business plans! You know the old lending adage of borrowing short-term and lending long-term to foster business and job creation.

Stock Buybacks & Unproductive Capital Allocation

The other obvious area where ZIRP leads to a lower grade of capital allocation is that it incentivizes companies to borrow money to buy back stock because interest rates are so low that they don`t need a healthy return on their money. This is another example of not having respect for the value of money, these are just paper gains in stock prices that will reverse themselves once ZIRP ends, the markets crash, and shares are reissued to financial markets at much lower prices. This serves as a vicious, negative reinforcing cycle of lower future earnings growth all things being equal because these additional losses are reflected on the companies` balance sheets for buying their own shares at higher prices and selling them back to the market at lower prices. This is the antithesis of a rational stock buyback strategy!

The only valid reason for buying back stock is if the company can make money on the transaction, i.e., the shares are woefully undervalued relative to their future business prospects. This isn`t the case right now with companies, they are buying back stock to make their earning`s look better even at market highs, taking advantage of low interest rates, and cashing out the executive team with fat option bonuses. The old pump and dump strategy of the corporate elite who are fortunate enough to receive options in their compensation packages.

With a more healthy respect for the value of money, borrowing money actually has consequences; the companies need a sustainable, healthy long-term recurring revenue stream for their investment not a sugary high. They require higher long run returns in organic growth business opportunities that lead to positive after effects of additional job creation and broader support for the overall economy.

In short companies use the money for capital allocation strategies that create real value in the economy, and not paper gains in a stock price that are transitory once the unwind of ZIRP begins and the stock price reflects the actual company prospects of which suffer because no capital investment went into research and development during this period. Capital investment in research and development results in long-term sustainable organic growth prospects for the company.

Think about all this money being used for stock buybacks being reallocated to more productive means, and a healthy borrowing rate incentivizes companies to invest in projects that have real long-term recurring revenue streams and much higher returns when taken over the aggregate period of the investment cycle. So this is another area where the economy would actually being doing better right now without ZIRP, less stock buybacks, and more investment in longer term business development projects.

In Summary

These are two major areas where it can be argued that not only are we getting less bang for our buck with ZIRP, but that we are actually hurting the economy by fostering lesser productive means of capital investment in our economy.

The interesting point is that I am analyzing ZIRP effects with basically the best that ZIRP is adding to the economy, and we haven`t even gotten to the nasty part of the effects of ZIRP which is the Unwind Phase. I feel the takeaway will be even more negatively revealing once the aggregate effects of ZIRP are taken into account with the additional information of the unwind of this strategy.

Like any trader knows you haven`t made a dime until the position is actually closed out, how many of these bond holders are going to make money over the aggregate, it isn`t like these bonds are going to be held on their books once ZIRP ends! There is an entrance fee, and unlike a night club, there is an exit fee; so the ZIRP party may seem like fun for many of these participants, but wait until they have to sell these same bonds that nobody wants on their books!

These are two areas where the Federal Reserve might want to consider in their overall evaluation of the effectiveness of the ZIRP Experiment. I think the counterfactual case in these two examples is quite compelling, and I would assert that the US Economy would be doing better with a healthy respect for the value of money that a normalized rate policy instills in the financial system between parties looking to make capital allocation investment decisions.

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