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:

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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.


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