Matt Yglesias is having a problem with a column by Larry Summers:
“He’s saying that in a low interest rate environment we dare not leave investment decisions up to the private sector, which is going to just blow the money on boondoggles and white elephants—the state needs to step in and plan the economy. Socialism, in other words. But does Summers really think that? It sure doesn’t sound like something he thinks.”
Here is the problem paragraph by Summers:
“However, one has to wonder how much investment businesses are unwilling to undertake at extraordinarily low interest rates that they would be willing to undertake with rates reduced by yet another 25 or 50 basis points. It is also worth querying the quality of projects that businesses judge unprofitable at a -60 basis point real interest rate but choose to undertake at a still more negative real interest rate. There is also the question of whether extremely low safe real interest rates promote bubbles of various kinds.”
I don’t see much of a problem here. This is an entirely reasonable statement.
It’s worth stating clearly: negative interest rates involve paying the borrower to borrow money. In a negative interest rate environment, the lender is paying money to the borrower so they will borrow money.
Usually, people and companies have to pay to borrow money. You go to the bank, get a loan, and pay the entire amount of the loan back, with extra money in addition to the money you borrowed.
This extra money is a way to compensate the lender for the risk of possible default, non-payment, or delayed payments. Negative interest rates turn this relationship on its head, so that the borrower is being paid for the trouble of actually borrowing money.
You can think of negative interest rates as borrowing money, and then paying back less than you borrowed, keeping some of the money you borrowed as your own.
What types of investments have such poor future returns someone would have to pay you to make the investment? Well, risky investments with poor certainty of returns. Or possibly, investments which don’t entirely cover lending costs.
The first – poor certainty of returns – seems like a bad investment anyway, and probably not ones we should choose for our economy.
The second reason – investments which do not cover lending costs – is the definition of ponzi finance for Minsky. Ponzi finance is where the investment does not generate enough cash flows to cover lending costs, so the investment asset must go up in value to create a profitable investment opportunity. It’s the final stage before a credit bubble breaks and causes disaster.
If you are talking about the Financial Instability Hypothesis as a possible reason of what happened to cause the crisis, then you don’t want to spur anyone to make investments which are almost certainly going to cause another credit crisis.
It’s entirely reasonable for anyone – even a jackass like Larry Summers – to question what types of investments are so terrible someone needs to shove cash money into your hands so you will do the investment. It’s also reasonable to think forcing companies to take loans could lead to another bubble.
There is a case to be made that we should be giving private businesses and people money to promote investment. I’ve made this argument before. And, paying people to take out loans is a way to give people money, so let’s force them to take out loans, right?
However, if we have a choice between giving people money in the form of loans, or simply giving people cash money, I strongly prefer cash money. We do have this choice, so we should probably prefer just giving people money over incenting them to take out loans.
Making people take out loans exposes them to another problem. James Monitor hints at the problem in his latest:
However, today we see something very different. As Exhibit 2 shows, today’s opportunity set is characterized by almost everything being expensive. As I noted in “The 13th Labour of Hercules,”2 this is a direct effect of the quantitative easing policies being pursued by the Federal Reserve and their ilk around the world.
“The Fed has been unusually transparent in explaining its thoughts on the impact of quantitative easing. Brian Sack of the New York Fed wrote in December of 2009 (bold emphasis added):
A primary channel through which this effect takes place is by narrowing the risk premiums on the assets being purchased. By purchasing a particular asset, the Fed reduces the amount of the security that the private sector holds, displacing some investors and reducing the holdings of others. In order for investors to be willing to make those adjustments, the expected return on the security has to fall. Put differently, the purchases bid up the price of the asset and hence lower its yield. These effects would be expected to spill over into other assets that are similar in nature, to the extent that investors are willing to substitute between the assets. These patterns describe what researchers often refer to as the portfolio balance channel.
Market participants have (at least until the last month) reacted to this situation by “reaching for yield” as witnessed by the more detailed fixed income forecasts in Exhibit 3. This could be described as a “near rational” bubble (inasmuch as investors are reacting to the very low cash returns, which they expect to last for a long time). I’ve described it as a “foie gras” bubble as investors are being force-fed higher risk assets at low prices.
A “foie gras” bubble! That’s a good one. I wish I had thought of it.
Still, he gets close to a problem of high asset prices. His concern in the paper is about investing – it’s hard to make money in a market where the expected future returns are very low. The problem with low expected future returns is this means there is a higher possibility of losses in the asset class, and those losses are potentially larger.
We are concerned with something other than returns – we are concerned with the stability of our economy.
You may have heard the phrase “priced for perfection”. In the investing world, this means the asset price is using the best possible scenario as the base case, and any possible negative scenarios are ignored.
I think Yglesias whiffed on this one. I am not a huge Larry Summers fan for lots of reasons, but his column from 2012 is actually pretty good.