Why ZIRP doesn’t work

By Felix Salmon
December 21, 2011
Bill Gross has a wonky column in the FT, saying that setting interest rates at zero doesn't boost economic growth:

" data-share-img="" data-share="twitter,facebook,linkedin,reddit,google" data-share-count="true">

Bill Gross has a wonky column in the FT, saying that setting interest rates at zero doesn’t boost economic growth:

With policy rates at or approaching zero yields and QE facing political limits in almost all developed economies, it is appropriate to question not only the effectiveness of historical conceptual models but entertain the possibility that they may, counterintuitively, be hazardous to an economy’s health.

Certainly the record will show that countries with persistently low interest rates tend to have sluggish growth, and although the obvious causality there runs the other way — central banks cut rates in response to slow growth — it’s never been clearer than it is now that such policies don’t always work.

Gross’s point is that zero rates, far from encouraging people to borrow more, actually encourage deleveraging instead, at both the short and the long end of the curve.

Why wouldn’t people want to borrow at ultra-low interest rates? In part, because no one wants to lend at ultra-low interest rates:

A good example would be the reversal of the money market fund business model where operating expenses make it perpetually unprofitable at current yields. As money market assets then decline, system wide leverage is reduced even if clients transfer holdings to banks, which themselves reinvest proceeds in Fed reserves as opposed to private market commercial paper.

On top of that, if central banks commit to keeping rates at zero for an extended period, then interest rates don’t just come down at the short end — they come down all across the curve. And if you have a flat yield curve, like we do now, then banks and shadow banks can’t make money the old-fashioned way, through maturity transformation. Taking in money overnight and lending it out for five years doesn’t look particularly attractive when five-year interest rates are themselves under 1%.

“When the financial system can no longer find outlets for the credit it creates,” says Gross, “then it de-levers”. And deleveraging tends to cause economic contraction.

On the other hand, “outlets for credit” are also known as “borrowers”. It seems to me that the real problem here is on the demand side: if there were lots of companies and people wanting to borrow money, then there wouldn’t be a problem. And as Paul Krugman says, “there’s nothing stopping banks from making loans at profitable rates to firms that want more credit”.

The question is whether reducing interest rates actually boosts demand for credit, at the margin. Certainly it does in normal times, when central banks cut rates from, say, 6% to 5.25%. But borrower calculus is different when rates get cut from 1% to 0.25%. If a semi-permanent ZIRP is a sign of a country in a prolonged economic slump, then one can see how it could act to discourage potential borrowers rather than get them flocking to their banks to demand credit.

In any case, Gross doesn’t actually have any solutions to the problems of zero interest rates. He simply writes that “all central banks should commonsensically question whether ultra-cheap money continually creates expansions as opposed to destroying liquidity, delevering and obstructing recovery”. Well, fine — they can disappear off into their ivory towers and do all the commonsense questioning they like. But say they come to the conclusion that he’s right, and that they’re obstructing the recovery. Then what? Should they raise interest rates?

This is where Gross suddenly goes very quiet: it’s pretty hard to see how demand for loans would go up just because the Fed was raising rates. The problem isn’t that Bernanke is doing the wrong thing: the problem is that Bernanke is powerless. ZIRP might well not be working. But higher Fed funds rates wouldn’t help in the slightest — except perhaps to give Bill Gross and his short-Treasuries position, a boost in the bond-fund league tables.

Update: I forgot to mention Gross’s timing: right on the eve of the ECB discovering €489 billion of demand for three-year money at 1%. Which doesn’t sound like deleveraging to me.

Update 2: And as Joe Weisenthal points out, if Gross is worried about a flat yield curve, higher short-term interest rates are hardly going to help: they’re just going to bring short-term rates even closer to long-term rates.


We welcome comments that advance the story through relevant opinion, anecdotes, links and data. If you see a comment that you believe is irrelevant or inappropriate, you can flag it to our editors by using the report abuse links. Views expressed in the comments do not represent those of Reuters. For more information on our comment policy, see http://blogs.reuters.com/fulldisclosure/2010/09/27/toward-a-more-thoughtful-conversation-on-stories/

In the beginning ZIRP benefited banks in a large way, enabling them to borrow from their customers or the Fed , take small duration risk and lock in a nice profit, but the long end has come down reducing the spread and some banks actually try to make money lending to other banks and are seeing their business model come under tons of pressure(one example is Bank Of New York Mellon). Lastly on the consumer side when the short term money earns zero, and going out on the yield curve generates little extra yield but exposes one to huge duration risk, the only reaction to have is to go for return of capital and shun any risk.

Posted by Sechel | Report as abusive

Gross has company in the name of Thomas Hoenig, who actually thinks we’d be better off if the Fed raised short term rates to 1%. Hoenig is the only guy at the Fed who actually got it.

Posted by Sechel | Report as abusive

There is this book by this obscure fellow called Krugman, “Return of Depression Economics.” Perhaps Gross should read it. The reason ZIRP lasts so long (in Japan’s case two decades), is that when enter the Minsky moment and create a huge balance sheet recession, the demand for safe assets and cash, exceeds the supply.

Brad Delong quotes J.S. Mills describing the Panic of 1828 and the resulting “general glut” “…In 1829, John Stuart Mill made the key intellectual leap in figuring out how to fight what he called “general gluts.” Mill saw that excess demand for some particular set of assets in financial markets was mirrored by excess supply of goods and services in product markets, which in turn generated excess supply of workers in labor markets.

The implication of this was clear. If you relieved the excess demand for financial assets, you also cured the excess supply of goods and services (the shortfall of aggregate demand) and the excess supply of labor (mass unemployment)…”

As for the existence of a “general glut,” at least in labor there is currently 8.6% U3, and 15.5% U6 unemployment in the U.S. and the Eurozone periphery is all in double digit unemployment. Debtors are saving, paying down debt, or defaulting and surrendering assets worth pennies on each dollar originally lent. Creditors are sucking it in and looking for the safest assets they can find. Velocity of money is becoming as slow as molasses in January. This Mr. Gross, is why ZIRP does not spark growth, because interest rates need to become negative.. From the master: “…Gross seems to have joined the group of people who view current low rates as somehow unnatural, the result of policies that distort the market. But actually it’s quite clear that the “natural” rate of interest in the economist’s sense — the rate of interest that would match desired savings with desired investment at full employment — is negative. The zero bound is in fact a price floor rather than a price ceiling, enforced not by law but by the fact that people can always just hold cash…” http://krugman.blogs.nytimes.com/2011/12  /20/gross-confusion/

Posted by sherparick | Report as abusive

” I forgot to mention Gross’s timing: right on the eve of the ECB discovering €489 billion of demand for three-year money at 1%. Which doesn’t sound like deleveraging to me.”

Lets see, Governments lending to banks, lending to governments, lending to governments, lending to banks ad infinitum… Your update seems to miss the point.

Are banks lending to retail or business…or have they set the bar so high that isn’t happening since it wouldn’t be profitable at artificially low rates due to the disconnect of rates from risks?

And isn’t retail already caught over borrowed against currently devalued assets previously intentionally and erroneously overpriced by lenders to fuel product flow of mortgage backed securities etc. which were the only place for banks ‘to go’ for yield in the surrounding already artificially low rate environments?

Raising rates would be interesting but it won’t happen until after the house of cards collapses on its own, since if rates were raised before then that would cause the collapse.

Posted by Irving13 | Report as abusive

“The question is whether reducing interest rates actually boosts demand for credit, at the margin. Certainly it does in normal times, when central banks cut rates from, say, 6% to 5.25%. But borrower calculus is different when rates get cut from 1% to 0.25%. If a semi-permanent ZIRP is a sign of a country in a prolonged economic slump, then one can see how it could act to discourage potential borrowers rather than get them flocking to their banks to demand credit.”

I would add to this thought, that particularly on the business side, there’s a sort of lower bound return to the investment return that one will accept, no matter how cheap one can borrow. I think of it as either psychology developed in a “normal” interest rate environment or a minimum expected return based on the thought that a project also has downside risk of generating losses. My view, based on experience with middle-market companies, is that this return is well above current interest rates, so whether the Fed Funds rate is at current levels or 1% or 2% doesn’t matter a lot for capital equipment purchase decisions. Someone’s not expanding a factory to earn a 5% or 6% return on capital no matter how low interest rates are.

I will concede that real estate development might be a bit more sensitive ultra-low rates, though even there low rates drive up prices on existing buildings more than spurring new activity. A developer still wants to earn some minimum nominal return to account for development and the risk of selling or leasing the project, as the case may be.

Posted by realist50 | Report as abusive

Great post but you could have done without the update. I suspect that that surge in demand for loans has a lot more to do with the need to replace vanishing funding sources and maybe store up a bit of extra cash for maturing debt that could be a bit dicey to roll over than it does with an urge to grab cheap money to relend. Not much real releveraging here – nothing to see …

Posted by TomLindmark | Report as abusive

It’s the demand, stupid. Gross doesn’t seem to understand that it’s the spread between private borrowing and Fed/government borrowing that determines where people lend their money. And low rates on the government side make private borrowing *more* attractive to lenders.

Unless he’s talking his book, his column makes no sense.

Posted by AngryInCali | Report as abusive

I would like to see more analysis of the effect of low rates on income. Like many Americans, my salary has been flat for a long time so the only way to increase my income is through interest on savings. But with ZIRP that can’t happen. What are the long term consequences of an economy with a zero return on savings?

Posted by RogerNegotiator | Report as abusive

I’m sure this is a drastically uniformed comment, but I’d like to know exactly what people are talking about when they talk about 1% interest rates. As is quite obvious (Felix mentioned it in the previous post) the actual interest rates paid by mortgages are 4%. The interest rates paid by businesses are even higher. The interest rates paid on credit cards remain at their 18%+.

I raise this issue not to mock Felix, but to ask what the REAL issue here is. Because it looks to me like the real issue is not that the lending rates as seen by the real world have hit zero; it is that the financial sector is unable to extract the rents it has extracted for the past thirty years. That may be a tragedy to some, but it is a different sort of tragedy, with a different sort of solution, from what people seem to be discussing here. (And among other things, one of the lessons to take away from this whole sorry episode, not that anyone in power is interested in such a lesson, is that finance should NEVER get to be rentiers on so large a scale because once that starts up it’s impossible to roll back without massive pain that goes beyond the financial sector.)

Posted by handleym99 | Report as abusive

As the last two commenters noted (RogerNegotiator and handleym99) the lack of income to savers is not EVEN considered. Kind of lick people who advocate inflation and have completely forgotten stagflation – sometimes oil prices rise, wages don’t, and everybody is worse off (ask Jimmy Carter).
I have a mortgage at an effective interest rate of 5.5% – I want to sell my house in the near future (with fees, I doubt refinancing would be a net gain, and I also doubt I ever get TRUE information from the bank or the people selling re-financing).
So with the bank giving me less than 1% how do I “invest” my spare money….what a conundrum…..gee, what could I do???? Less than 1% interest.
Oh, what don’t I pay down my 6% loan? How about people with 15% credit card debt????
I wonder if most investors think the same thing?
I think Orwell said “there are some things only an intellectual could believe, for no common man could be so stupid.”

Posted by fresnodan | Report as abusive

I’m with fresnodan and handleym99 but would stress that banks make money by making debt, and the longer the debt remains on the books the more money they make.

We got an over the top acceleration of debt production by the financial sector into the private sector, and a lot of it went to consumables and housing asset inflation instead of productive assets.

Ka-Boom. Short of a massive dose of debt forgiveness, or whatever you want to call it, we’re stuck in a recession that will always flirt with real deflation. If housing is almost 40% of household assets, and household incwages are losing ground too we’ve got to be real close to a deflation cycle. ZIRP isn’t going to produce inflation outside of re-inflating equity prices, and we’ve already seen how quickly that type of inflation can be unwound–a couple days.

Posted by Beezer | Report as abusive

AngryCali hit the nail on the head in that its the spread between private/public borrowers that Gross ingores. Therefore its a demand for loanable funds that are limiting the amount that is lent. If demand were gigantic then banks could supercharge their ‘credit’ spread even if the yield curve is overall flat.

Fact is even at low rates and modest credit spreads the private sector is not demanding to borrow enough to cause credit spreads to expand. Watch credit spreads to figure out private demand for money.

Posted by sditulli | Report as abusive

+AngriCali, +sditulli. It’s the interest rate spread, not the interest rate, that matters.

The one point Gross has is that ZIRP can suppress long term lending through the channel of interest rate risk. You can’t hold a thirty year mortgage, even at a 3-4% net interest margin, when the federal funds rate is near zero. You might be safe for ten or fifteen years, but at some point interest rates will rise and your cost-of-deposits will kill you.

But in the short- and medium-term? Please. It’s not a low fed rate that’s killing banks. It’s borrower demand that’s so weak you can’t demand a spread.

Posted by strawman | Report as abusive

I was insulted by Gross’ piece because every person who has ever dealt with a bank knows they charge a spread over their cost of funds. That’s how they make money. If there’s demand, they make money. Bank profits always go up when there’s higher loan demand because that means more borrowers, that risky borrowers aren’t as risky (because of the up cycle), and a larger interest rate spread.

The Boston Fed just published a paper that deals with lending to small companies. It reports bank spreads have shrunk and the reason is they’re lending with less risk. It’s simplistic to say it’s just demand; it’s demand and supply working together. The spread is down because demand is down and demand being down means more borrowers are risks so only the less risky borrowers get funds and they get a better deal. That crushes bank activity from both ends, as they make less on the loans they are making.

The very long term interest rate is different but that mostly affects lend and hold and, bluntly, those are not commercial loans. The standard commercial loan has been under 10 years for a long time. It may be 7 years or whatever using a 20 year amortization but commercial lending is not long-term lending. That’s for individual home owners.

Posted by jomiku | Report as abusive

Raising short term interest rates wouldn’t do much, but raising long term interest rates would increase pensioner incomes and spending. Of course, there is no way for an economist to realize this, though it is intensely obvious to the tens of millions of people living on pensions and variable annuities.

Posted by Kaleberg | Report as abusive

ZIRP doesn’t work because it involves lending money to bankers. If they tried lending money at zero percent to non-bankers it would work quite well. Basically, the entire banking sector is technologically and societally obsolete, but has the political power to continue as a subsidized museum piece.

Posted by Kaleberg | Report as abusive

The point of ZIRP is to allow banks to recapitalize in the face of declining(I should say already wiped out) asset values on their balance sheets. The alternative to ZIRP is to mark assets to market immediately, close the banks which are bankrupt, move the marked down assets to other institutions and let the market set rates for interest thereafter.

Posted by Jardinero1 | Report as abusive