What’s So Bad About Zero Interest Rates?

There is hardly a Federal Reserve policy more derided by all sophisticated people than the “zero interest rate” regime enforced after the 2008 financial crisis and again in the wake of the Pandemic.

Over and over, we were told that zero rates were “inflationary,” that they distorted incentives and capital allocation, and were generally the equivalent of giving a toddler too much candy before bedtime. The treats might be relished but we’d pay the price in a long-run crisis of obesity and sloth.

Bond guru Bill Gross went so far as to proclaim, “Zero bound interest rates destroy the savings function of capitalism… zero destroys existing business models such as life insurance company balance sheets and pension funds.” He also warned that savers were being “slowly cooked alive” by vanishing returns on safe assets.

Howard Marks, of Oak Tree Capital, warned that low rates on safe assets push investors to “take additional risks… because they believe it’s the only way to achieve the returns they seek.” And those risks will eventually lead to losses.

All these warnings adhered closely to the great rule of prediction: if you say “what,” never say “when,” and you can’t be wrong. Predictions of disaster in the long run will always come true because in the long run there will always be disasters.

While near-zero rates were in force, however, disasters were conspicuously rare.

Graph 1 shows “inflation,” as represented by the consumer price index (CPI) vs. the Federal Funds Rate targeted by the Federal Reserve. Far from correlating with “inflation,” the zero-rate regime was nearly the only time in the past 35 years that government measured inflation stayed at or under the Fed’s target rate of 2%.

Graph 1

How about poor capital allocation? Or excessive risk? As Graph 2 illustrates, neither showed up in economic results. GDP (gross domestic product) growth was roughly typical during the near-zero rate era.

Graph 2

Nor, as Graph 3 shows, did returns on low-risk assets disappear. They fell, continuing the 40-year downward trend triggered by Reagan era tax policies. But 2% is not a conspicuously inadequate return on assets as safe as 10-year treasuries, especially in a low-inflation environment. Nor is 4% unreasonable for AAA corporates. How much do the zero rate critics want American corporations to pay for safe money?

Graph 3

The truth is closer to the other way around. With savers spooked by inflation ever since President Nixon took the dollar off the gold standard, we suffered through decades of punishingly high rates, never knowing if they were justified because the dollar had been unhinged from reality. Why go back?

The too-much candy theme is little more than economic puritanism. If we are doing well and making money, we too quickly forget we are but sinners in the hands of an angry God.

Thank heaven Fed Chairman Powell is there to remind us!

However, all these projections assume that government inflation numbers have something to do with reality. As our readers know, we have believed that government data on so-called “real prices” is deeply misleading. It assumes that government spending–all those windmills and ethanol subsidies–are worth what they cost, while private innovation–teleputers in our pockets–is sluggish at best. It implicitly denies the venerable “learning curve” that shows real prices dropping by 20%-30% with every doubling of total output.

At least since “Knowledge and Power” (2013), George has been expounding the evidence from “time prices.” Registering the hours and minutes of work required to earn goods and services, time prices replace notional judgements of government with the inexorable and objective reality of time.

Time prices were introduced by Nobel laureate economist William Nordhaus with regard to lighting technology through the ages. In the titular words of his 1993 paper for the National Bureau of Economic Research, “Do Real-Output and Real-Wage Measures Capture Reality? The History of Lighting Suggests Not.” From Neanderthal cave fires to whale oil lamps to Edison’s lightbulb to fluorescent lighting and on to light-emitting diodes, Nordhaus calculated that the drop in the time price of lighting was 6,000 times faster than estimated by economists and their CPIs. Then in 2022, Marian Tupy and Gale Pooley in the prize-winning Superabundance demonstrated exhaustively that economic progress has been massively faster than economists estimate.

If real progress is drastically faster than the CPI captures, real interest rates and yields are similarly higher than nominal rates. Far from plunging into negative realms, as if time could move backwards, real interest rates–gauging real average returns to expenditures of time–remain around 4%.

Judged by time prices, there is nothing low about interest rates except the understanding of them by economists.