Zirp and the double dip

By Felix Salmon
July 8, 2010
Greg Ip has an interesting argument: if we were really headed for recession, he says, the yield curve would be inverted. But you can't have an inverted yield curve when the Fed sets short rates at zero. Therefore, we won't have a double dip.

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Greg Ip has an interesting argument: if we were really headed for a recession, he says, the yield curve would be inverted. But you can’t have an inverted yield curve when the Fed sets short rates at zero. Therefore, we won’t have a double dip.

Ip concedes that Japan provides an obvious counterexample of a country which had a recession and Zirp at the same time. But he’s convinced that in the US, loose monetary policy will suffice to keep us growing:

Our entire financial system relies on borrowing short and lending long and profiting from the spread. When that spread disappears, sooner or later, so does liquidity. In 2007, that happened in dramatic fashion, partly because we didn’t realise how precarious liquidity was in the vast shadow banking system. Indeed, the more I study the events of the last few years, the more I’m convinced that illiquidity contributed more to the crisis than insolvency.

What all this tells me is that as long as the yield curve remains relatively steep, it is a powerful inducement to credit creation. Credit is currently contracting, but with time the positive lending spread will recapitalise banks and awaken interest in lending. Right now is an excellent time to start a bank: just check out the enthusiasm among private equity funds for buying failed banks from the FDIC.

This is not very convincing: if zero interest rates are so good at fostering new lending, how come credit is currently contracting? After all, we’ve had zero interest rates for a good 18 months now, how long is this supposed to take?

My feeling is that we had a boom and bust in credit, and that most companies — the ones not owned by private equity shops — were sensible enough to avoid levering up during the boom. That’s how they survived the bust so easily, in contrast to banks and homeowners. They’re now sitting on large amounts of cash, and the likelihood that they’re going to start borrowing again in any serious quantity is low. Meanwhile, individuals have embarked upon a long and slow process of saving more and paying down their debts, rather than levering up. In other words, if you’re looking forward to a credit-fueled recovery, you might well be in for disappointment.

At the same time, zero interest rates are still too high: the Taylor Rule would set interest rates in the US at -1.3%. So even a Zirp is restrictive, absent quantitative easing.

None of which means we’re going to enter another recession, of course. And indeed for most people it doesn’t really matter: the key issue facing Americans today is that they can’t find jobs, and it’s increasingly obvious that positive GDP growth isn’t much better when it comes to job creation than negative GDP growth. But it does help a lot on the fiscal side of things. And if you’re worried about government finances, you should be worried sick about the possibility of a double dip. Which is real, zero interest rates notwithstanding.

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