Winston Churchill once said, “History is written by the victors.”
This is undoubtedly true, but surely it doesn’t hurt to get started early.
Ben Bernanke, presumably settled in at his new gig at the Brookings Institute after his tenure at the helm of the Federal Reserve, just published his first blog.
The post is entirely dedicated to refuting the idea that the Fed is creating an environment of “artificially low” interest rates, along with a claim that the Fed didn’t throw seniors under the bus, as a senator once stated.
A mere four days earlier, a new report on the cost of financial repression was released by Swiss-based reinsurer Swiss Re.
The conclusion is that artificially low interest rates have cost savers $470 billion between 2008 and the end of 2013.
So on one side we have a man with a legacy to protect and on the other we have a company that has seen its business suffer.
So who is right here, if anyone?
Only time will tell, but if what we’re seeing now is any sign, we might never get an accurate history of what we’re currently living through.
Wicksell vs. Taylor
To figure this one out, we have to take a closer look at the differences between their approaches to the issue.
I know this will be a bit dry, but I’ll make it as quick and painless as possible.
Ben’s argument centers around natural interest rates and the limited ability the Fed has to influence them.
To justify his conclusion, he explains the Fed’s low interest rates by invoking the concept of the equilibrium real interest rate.
This idea was published way back in 1898 by Knut Wicksell, and has influenced both Austrian and Keynesian economics.
In Bernanke’s post, he states that the, “equilibrium interest rate is the real interest rate consistent with full employment of labor and capital resources, perhaps after some period of adjustment.”
That is a bit off, but close. Wicksell’s work focused on a key distinction between the money interest rate and the natural interest rate.
To him, the money interest rate was merely whatever we see in the capital market. All factors weigh in, and what we see is what we get.
The natural rate, the one Bernanke sees as being low, was described by Wicksell as the interest rate at which supply and demand in the real market was at an equilibrium.
On the other side, we have Swiss Re basing its $470 billion loss to savers on retroactive use of the Taylor Rule.
This is a mechanical way to determine central bank nominal interest rates in response to inflation, output, and other economic indicators.
A key part of this rule is that for each 1% increase in inflation, central banks should raise nominal rates by at least 1%.
There we go, not so bad, was it? Now let’s get to the good part.
Ben’s Big Problem
We’ve already hit on the first snag with Bernanke’s post. The way he describes the natural interest rate cannot be reconciled with what we see in the market today.
This all ties directly into supply and demand in the market. In particular, the artificial creation of demand that skews what is perceived as the natural interest rate significantly lower than it should be.
Through the three rounds of quantitative easing in the U.S., a major source of demand for debt was the Fed itself.
The rapid implementation of mortgage-backed securities purchases, and later direct purchases of Treasury bonds, created guaranteed demand that skews the natural interest rate beyond recognition.
Of the over $4 trillion the Fed has on its books, more than half of it is in U.S. Treasury bonds. It held about $500 billion in years prior.
The constant purchases completely destroyed any hope of understanding what supply and demand equilibrium should be in a way that rippled across the globe.
With the Fed putting itself at the front of the line for U.S. sovereign debt, private market buyers had to compete that much harder to meet their institutional needs.
Mutual funds, pension managers, bankers, and everyone else that is required by charter to solely invest in the highest-quality bonds had no choice but to drive up bond prices and thus drive down interest rates.
Other investors without the same requirements were pushed into riskier, higher yield bonds just to recover a yield that topped inflation.
In this sense, the Fed put itself at the front of the line for bonds, blew up the ability to discover the natural rate of interest, and created its own kind of self-fulfilling prophecy.
Swiss Re’s Big Problem
Now let’s look at Swiss Re’s estimate that $470 billion has been effectively lost by savers due to financial repression.
This repression peaked out several years ago, according to the company’s index:
The beauty of the Taylor rule is that it is incredibly devoid of opinion. It simply is what it is, a somewhat complex math problem.
Taylor himself said recently it should be around 1.5%, Swiss Re based its report on 1.7%.
The problem with Swiss Re’s stance is that it is retroactively applying it in an environment where the Fed and other central banks have been so active.
It is not possible to divorce the market from the bond and security buying that has occurred, and the effect low interest rates have had on equities through cheap debt-funded buybacks and other factors.
Even the report’s authors have to concede that the boost to wealth from the stock market was $9 trillion, with another $1 trillion in household wealth.
The discrepancy between the rich with large market exposure and the rest of us would be staggering if the Taylor rule was used and everything remained equal, with interest income being boosted for the richest 1% by an average of $14,000, and a mere $160 for the bottom 90%.
Savers had to accept more risk and equity exposure than they probably wanted to tap into the market gains, but this is more accurately described as obscene intervention, rather than suppression.
From what we’ve seen with market inflow data, the vast majority of people played along, whether they were rich or using defined benefit or other retirement accounts.
Funds in defined benefit and retirement accounts in the U.S.A. have never been higher at $24.7 trillion.
No One Knows
At this point, it is pretty safe to say that neither side of this argument is right here. At the very least, we know neither side has any idea if they are right.
We’re only left with the conclusion that no one knows what interest rates really should be, how we’ve benefited from the unprecedented venture by central banks into economic intervention, and what will happen in the future.
As much as Bernanke and others are fighting to define the legacy of QE and our seven years of zero-interest-rate policies, we’d all be far better off if we just admitted the truth.
David Blanchflower, who was at the Bank of England during the financial crisis, put it best in an interview with Jacob Goldstein from Planet Money two weeks ago.
He was at least willing to admit that central banks were making it up as they went, just as they are now.
I’ll let him put in the final word:
Blanchflower: “They don’t have a nice chapter in a textbook to tell them what they should do. They’ve never done it before. They’re struggling.”
Goldstein: “So the Fed doesn’t know what’s going to happen when they finally wind down QE?”
Blanchflower: “Absolutely not. Sorry. They absolutely don’t know.”
Goldstein: “That sounds terrifying.”
Blanchflower: “It is – it is terrifying.”
