Ilargi: QE Breeds Instability

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Yves here. While Ilargi discusses how a follower of Minsky would predict that QE would end badly, Keynes, a successful speculator, gave more detailed explanation of why low interest rates were a trap in his General Theory. As Nathan Tankus wrote in a 2013 post:

Since Bernanke started talking about “tapering off” Quantitative Easing, the bond markets have freaked out. This is a very logical reaction.

Before last month, it seemed like QE would go on indefinitely. Once that belief was shaken – even in the slightest fashion – everyone ran to the exits. Bernanke and other Federal Reserve economists appear bewildered by this phenomenon. The impression one gets from their follow-up comments is that they wished they could ask bond speculators “did you read the damn speech?” The answer, of course, is no and for good reason.

All investors need to know is the conditions under which QE (and for that matter, the Zero Interest Rate Policy) will be pursued has changed. Now the substantive change may actually be relatively minor, but that’s irrelevant to speculators. The reason is very simple: those holding assets with longer maturities will take huge capital losses with relatively small changes in interest rates (As a reminder: it is basic “bond math” that a change in interest rates send bond prices in the reverse direction. A rise in interest rates makes bond prices fall and a fall in interest rates make bond prices rise). It is better to exit now when those future changes are uncertain then take even more massive losses.

This is the logic behind the actual “liquidity trap” presented by Keynes in his general theory. Specifically, Chapter 15 entitled “The Psychological and Business Incentives To Liquidity.” Here he argues that every fall in the interest rate relative to what is commonly believed to be a “safe” rate increases the “risk of illiquidity”. The the “risk of illiquidity” is the risk of holding an asset not easily convertible into money at “book” value (this also means an asset is more or less “liquid” based on the relative easiness to convert into money “book” value). Further, rather then seeing interest as a return to “waiting”, Keynes argues that it is “a sort of insurance premium to offset the risk of loss on capital account”.

How can one evaluate the uncertainties relative to the “insurance”? By what has been subsequently known as “Keynes’s square rule”.

The square rule was defined by Keynes in this chapter as “an amount equal to the difference between the squares of the old rate of interest and the new” (mathematically represented as Δi = i2 ). If interest rates (at that maturity) are expected to rise faster then a squaring of itself, it means your capital losses (market price of the bond or investment) will fall faster then the increase in the rate of return (and vice versa).

Based on this understanding, a liquidity trap is not a short term rate of interest at zero but a uniform expectation that interest rates will rise to such an extent that the rate of return on a bond or equity won’t preserve your principal and thus a refusal by anyone but the central bank to buy bonds at such a high price (i.e., low interest rate).

Keynes says explicitly in chapter 15 that “what matters is not the absolute level of r but the degree of its divergence from what is considered a fairly safe level of r, having regard to those calculations of probability which are being relied on” (r being the rate of interest). Why this confusion has resulted has many complex historical reasons, not least of which is economists disinterest in actually reading and comprehending what was written more then five years before them…

….if the interest rate rises too fast those “middle-class people” will take much larger losses on the value of many of their assets than they will get back in interest….That is without even taking into account the higher borrowing costs that many would most likely face. Remember also that at such low interests rates “too fast” is actually a very small increase. To go back to Keynes:

If, however, the rate of interest is already as low as 2 per cent., the running yield will only offset a rise in it of as little as 0.04 per cent. per annum. This, indeed, is perhaps the chief obstacle to a fall in the rate of interest to a very low level. Unless reasons are believed to exist why future experience will be very different from past experience, a long-term rate of interest of (say) 2 per cent. leaves more to fear than to hope, and offers, at the same time, a running yield which is only sufficient to offset a very small measure of fear.

The “reason” in our current situation, whether justified or not, was Quantitative Easing. It is quite reasonable for participants to panic once the hope is removed and all that is left is fear. QE was bad policy but once it was done, it could only be ended very gradually. Tapering may prove to be as ad-hoc and inadvisable as QE itself.

By Raúl Ilargi Meijer, editor-in-chief of The Automatic Earth. Originally published at Automatic Earth

Central bankers have promised ad nauseum to keep rates low for long periods of time. And they have delivered. Their claim is that this helps the economy recover, but that is just a silly idea.

What it does do is help create the illusion of a recovering economy. But that is mostly achieved by making price discovery impossible, not by increasing productivity or wages or innovation or anything like that. What we have is the financial system posing as the economy. And a vast majority of people falling for that sleight of hand.

Now the central bankers come face to face with Hyman Minsky’s credo that ‘Stability Breeds Instability’. Ultra low rates (ZIRP) are not a natural phenomenon, and that must of necessity mean that they distort economies in ways that are inherently unpredictable. For central bankers, investors, politicians, everyone.

That is the essence of what is being consistently denied, all the time. That is why QE policies, certainly in the theater they’re presently being executed in, will always fail. That is why they should never have been considered to begin with. The entire premise is false.

Ultra low rates are today starting to bite central bankers in the ass. The illusion of control is not the same as control. But Mario and Janet and Haruhiko, like their predecessors before them, are way past even contemplating the limits of their powers. They think pulling levers and and turning switches is enough to make economies do what they want.

Nobody talks anymore about how guys like Bernanke stated when the crisis truly hit that they were entering ‘uncharted territory’. That’s intriguing, if only because they’re way deeper into that territory now than they were back then. Presumably, that may have something to do with the perception that there actually is a recovery ongoing.

But the lack of scrutiny should still puzzle. How central bankers managed to pull off the move from admitting they had no idea what they were doing, to being seen as virtually unquestioned maestros, rulers of, if not the world, then surely the economy. Is that all that hard, though, if and when you can push trillions of dollars into an economy?

Isn’t that something your aunt Edna could do just as well? The main difference between your aunt and Janet Yellen may well be that Yellen knows who to hand all that money to: Wall Street. Aunt Edna might have some reservations about that. Other than that, how could we possibly tell them apart, other than from the language they use?

The entire thing is a charade based on perception and propaganda. Politicians, bankers, media, the lot of them have a vested interest in making you think things are improving, and will continue to do so. And they are the only ones who actually get through to you, other than a bunch of websites such as The Automatic Earth.

But for every single person who reads our point of view, there are at least 1000 who read or view or hear Maro Draghi or Janet Yellen’s. That in itself doesn’t make any of the two more true, but it does lend one more credibility.

Draghi this week warned of increasing volatility in the markets. He didn’t mention that he himself created this volatility with his latest QE scheme. Nor did anyone else.

And sure enough, bond markets all over the world started a sequence of violent moves. Many blame this on illiquidity. We would say, instead, that it’s a natural consequence of the infusion of fake zombie liquidity and ZIRP rates.

The longer you fake it, the more the perception will grow that you can’t keep up the illusion, that you’re going to be found out. Ultra low rates may be useful for a short period of time, but if they last for many years (fake stability) they will themselves create the instability Minsky talked about.

And since we’re very much still in uncharted territory even if no-one talks about it, that instability will take on forms that are uncharted too. And leave Draghi and Yellen caught like deer in the headlights with their pants down their ankles.

The best definition perhaps came from Jim Bianco, president of Bianco Research in Chicago, who told Bloomberg: “You want to shove rates down to zero, people are going to make big bets because they don’t think it can last; Every move becomes a massive short squeeze or an epic collapse – which is what we seem to be in the middle of right now.”

With long term ultra low rates, investors sense less volatility, which means they want to increase their holdings. As Tyler Durden put it: ‘investors who target a stable Value-at-Risk, which is the size of their positions times volatility, tend to take larger positions as volatility collapses. The same investors are forced to cut their positions when hit by a shock, triggering self- reinforcing volatility-induced selling. This is how QE increases the likelihood of VaR shocks.’

QE+ZIRP have many perverse consequences. That is inevitable, because they are all fake from beginning to end. They create a huge increase in inequality, which hampers a recovery instead of aiding it. They are deflationary.

They distort asset values, blowing up prices for stocks and bonds and houses, while crushing the disposable incomes in the real economy that are the no. 1 dead certain indispensable element of a recovery.

You would think that the central bankers look at global bond markets today, see the swings and think ‘I better tone this down before it explodes in my face’. But don’t count on it.

They see themselves as masters of the universe, and besides, their paymasters are still making off like bandits. They will first have to be hit by the full brunt of Minsky’s insight, and then it’ll be too late.

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  1. Ben Johannson

    They distort asset values, blowing up prices for stocks and bonds and houses, while crushing the disposable incomes in the real economy that are the no. 1 dead certain indispensable element of a recovery.

    Distort as opposed to what? Let me guess: Market Man always gets the correct valuation, in league with Natural Interest Rate Man.

    It’s like this guy has some weird mish-mash of Ron Paul, vulgar internet austrianism and classical economics rolling around in his head to write this stuff. It’s entirely polemical and hyperbolic, unhinged dare I say. By his own logic the GFC must have resulted from low interest rates creating “volatility” (apparently volatility is some horrible thing which must be avoided at all costs.)

    Also, gotta love that “Aunt Edna” reference. Always on about Yellen’s age these guys.

    1. craazyman

      “Distort as opposed to what?”


      haven’t you heard? That’s when the economy revolves around and around in a perfect circle, organized by timeless and eternal natural laws that a man in a study by a fire with a glass of sherry and classical music on a stereo with a garden blooming out the window can intuit simply from erudite contemplation and application of advanced mathematics — while wearing Edward Green shoes and an ascot.

      Get with the program already.

      Only an asteroid can impart the dreaded VAR Shock but QE is a bank of photon torepdoes aimed at space ready to blast any pebble that gets withing 500,000 miles of earth. It’s not economics anymore, it’s science fiction and you’ve gotta have your own flying saucer to survive when the torpedo banks dry up and the asteroid cometh like Jesus in the Rapture.

      1. craazyboy

        Demonic Possession is what really creates instability. It’s what they do. Once you realize this, and also realize demons have possessed almost everyone with wealth and/or power in the entire world, then you finally can see what the problem is.

        Unfortunately, understanding this doesn’t really help with figuring out what to do about it. Sure, you can hide under your bed and keep all your closet doors tightly shut. This may give you some peace of mind for a period of time, but then you realize you are just fooling yourself. The demons are still everywhere.

        Exorcism can fix this problem, if you do lots and lots and lots of them at this point. But you need lots of exorcists to do it. I read the Vatican has a large division of exorcists that I had hoped they would deploy and help us combat Demonic Possession. Much to my dismay, I then read of problems at the Vatican Bank, which were symptomatic of Demonic Possession! A sinking feeling overcame me as I realized our only defense against demons had been infiltrated itself.

        Now I’m concerned the Vatican exorcism division is just a bureaucratic façade – the exorcists being all frauds. They are performing exorcisms, for public consumptions, but the demons remain, fully in control of their mortal vessels.

        I feel helpless and don’t know what to do.


        typing from under his bed.

    2. diptherio

      By his own logic the GFC must have resulted from low interest rates creating “volatility” (apparently volatility is some horrible thing which must be avoided at all costs.)

      Uh…no. Just because he points out that near-zero interest rates are leading to instability now, it doesn’t follow that all instability is created by low interest rates and I don’t see that argument being made here.

      The argument is that “stability creates instability”: not interest rate policy. The Fed has been an active and willing participant in creating “unnatural” stability (can’t think of a better word off hand) in multiple ways, only one of which is ZIRP. As Bill Black has often pointed out, low interest rates are not a requirement for these types of fake-stability scams that inevitably end in massive instability–like the S&L crisis, when interest rates were plenty high.

      Other ways the Fed has created fake-stability include (but are not limited to):

      1) Bailing out institutions that should have been bankrupted/dismembered, allowing dysfunctional organizations to not only survive, but metastasize (see JP Morgan, Gold-in-Sacks, etc).

      2) Allowing the persistence of a monetary system that literally gives the power to create new currency to banks.

      The stability these measures provide is illusory because they simply delay disruptive events and difficult decisions that will have to be dealt with eventually, no matter what. It’s like a doctor giving someone morphine for an arterial laceration. Bystanders look on, aghast: Aren’t you going to do something about that huge gushing wound on their leg?

      The doctor replies, “You do not understand modern medicine. I do. Do you have a medical degree? I didn’t think so. I do and I know that morphine is damn near a panacea. Look, let’s ask the patient how I’m doing. How do you feel, Patient?”

      And the poor morphine-addled schmuck looks up all bleary-eyed and mumbles “I…I feel great!”

      “See,” says the doctor, “I told you this was going to work.”

      A little while later the patient starts to complain of light-headedness…maybe the treatment isn’t working after all. But our intrepid doctor administers more morphine and proclaims loudly…”There will be growth in the Spring!”

      1. Ben Johannson

        This post is not about Minsky’s work, which is treated as a throwaway sentence near the top.

        Ultra low rates (ZIRP) are not a natural phenomenon. . .

        Assumption of a natural rate of interest.

        . . . and that must of necessity mean. . .

        Ideological assumption standard for vulgar austrians.

        . . . that they distort economies in ways that are inherently unpredictable.

        “Ultra low rates”, not stability, are creating instability. His words.

        Ultra low rates are today starting to bite central bankers in the ass.

        Again he tells us ultra low rates, not stability are creating instability.

        I could continue in this vein for some time, posting quote after quote. This guy does not know Minsky.

        1. Alejandro

          You didn’t mention this quote-“What we have is the financial system posing as the economy. And a vast majority of people falling for that sleight of hand.” Which from my POV, summarizes what the post is about. I would be very interested in your POV about this.

          Also, Craazyman makes an excellent point about “Equilibrium”, where the range of POV’s can seem overwhelming.

          1. Ben Johannson

            What we have is the financial system posing as the economy. And a vast majority of people falling for that sleight of hand.

            My POV is financial growth and economic growth are the same thing. There’s no separation between financial sector and “real” economy, that’s why we have to take finance very, very seriously.

            1. Alejandro

              Thanks for the response…in the first sentence you claim they’re synonymous and in the first part of the second, you imply that they’re connected…which seems to make the point of Illargis quote.

              I’m not sure what you mean by “that’s why we have to take finance very, very seriously” but if you’re implying my reference to Craazymans point, let me emphasize that I was “very, very serious”. If you opened the link, you’d at least see what I was inferring. I firmly believe that no one can possibly have all the answers…but through earnest engagement with giving and receiving honest feedback we can certainly all learn from each other.

                1. Alejandro

                  Thanks for the feedback, Ben. According to Merriam-Webster, separate is a synonym of disconnect and disconnect is an antonym of connect. Some might find this clever but the circuitousness just seems like semantic sleight of hand that just serves to confuse and distract from the shenanigans that, as you state below, destroyed lives. Which seems to be Ilargis point.

                  1. Ben Johannson

                    Huh? I wrote that they aren’t separate. What part of that don’t you understand?

                    1. Alejandro

                      “What part of that don’t you understand?”

                      Help me out…You initially claimed “are the same thing” followed by “no separation”. Are you suggesting that there are no bubbles?

                      Parasite and host may indeed have no separation, but they certainly are not the same thing…“What part of that don’t you understand?”

                    2. Ben Johannson

                      You’ve now changed the subject yet again, this time from your multi-comment fixation on the meaning of a word while missing its grammatical context, to something about bubbles.


                  2. Ben Johannson

                    Ilargi’s point is “ultra low” rates ruin everything, an argument he inaccurately attempts to connect with Minsky’s Financial Instability Hypothesis. I get enough of the “what he really meant to say” nonsense from McArdle.

                    1. Alejandro

                      What’s nonsense is castigating an honest attempt to scrutinize the logic of QE, with no substantive refutation other than he might have interpreted Minsky differently than you. As far as the “what he really meant to say” meme, that seems more like projection with Minsky.

                    2. Ben Johannson

                      Yes, we should not read what he wrote, we should imagine what you would say about what he wrote, ignoring the two don’t have much relationship at all. How damage control of you.

                    3. Ben Johannson

                      I have an idea. Because I don’t like cats, I’ll write a post about them claiming their dander, which contains feline allergen-1, creates instability. Then I’ll write “Minsky” and call it a day. Like Ilargi I don’t have to follow anything like logic because I’m behaving as a polemicist. My goal therefore is to “win” regardless of any false ideas I’m spreading or who I’m misinforming.

                      He interpret Monsky differently, he got Minsky completely wrong, probsbly because he doesn’t know anything about the subject.

                    4. Alejandro

                      More blabber yet no refutation and I see you’ve attracted a cheerleader. As a self-proclaimed “expert” on Minsky would you have the courtesy of providing some clarity as to how Minsky would view QE in todays context?

            2. Henry

              “There’s no separation between financial sector and “real” economy…”

              Well golly gosh, the financial sector is doing really well, so that must mean the “real” economy is doing really well. The FED is on the right track and all is well. NOT!

              1. Ben Johannson

                The financial sector is not doing really well, that’s the point. Too many miss that trading financial assets is a zero sum game: for every winner there is a loser. We only get to see the financial winners, creating the notion everything there is peachy. We don’t see the destroyed lives and damaged institutions that result unless we read blogs like NC. Showing us the losers is a big part of what Yves does here.

                1. AQ

                  Too many miss that trading financial assets is a zero sum game: for every winner there is a loser.

                  By that measure the financial sector can never do well because there will always be losers.

                  Are we saying that now is different? If so, why as there have always been losers?

          2. Fool

            You seem to argue a lot, but don’t seem very informed about how the economic/financial system works. Now you’re referencing Craazyman, a guy who may or may not be “all there”.

            1. Alejandro

              You seem to have the timing of a vulture…this party was mostly Saturday, with some hangover Sunday. Where were you then?

                  1. Fool


                    but listen, i wasn’t trying disparage you. argue to your hearts content — i’m all for the dialectical process of knowledge. that being said, Ben Johansson seems like an informed guy on this stuff, and from my vantage point you were debating him without nearly as strong of a factual foundation and thus making frivolous points.

    3. casino implosion

      He has always been a bit weird and unhinged. I used to follow Automatic Earth…think I even found my way here from there in about 2008… but the constant hysterical doomsaying got a bit much.

      1. John k

        He got me to look at the right things in 3q07, made my first ever (bank) short early October, exited all stocks end of that year.
        Many, including me, thought gd2 was nigh, not realizing saving banks plus stabilizers would stop the fall. I remained short a little too long in 09, then went to long bonds… Ok but missed the bull, like Ilargi too pessimistic… Well, not as pessimistic as that, stopped reading him in 2010.
        Hussman also does not see that stabilizares did, and always will, prevent gd2 (saving banks goes without saying.). But great graphs.

    4. nothing but the truth

      “Distort as opposed to what?”

      this is what i say to my kids is a “good question”.

      Basically money is an illusion. It represents something real. You can think it is absolute, but that is your illusion. So finance, eventually is about ratios in the real economy, because we are trying to get to the real here. If most modern rich people are financiers, this just means the wealth has been pilfered away from the real workers to the govt backed financiers. Because as we well know, the illusion of finance can only be sustained by the state.

      So distortion must mean a distortion in the relative pricing of the factors of production (ie, relentless increase in purchasing power of assets owners ie, primarily natural resources an the expense of labor -> read Henry George) . Is finance even a factor of production? No, finance is a psychological necessity from our requirement of trust. And it became solidified in an unholy alliance between govt and financiers. As such finance is a part of the government.

      1. Fool

        What about Finance’s “illusory” nature in particular is sustained by the state?

  2. Steve H.

    It seems to me that this is more like the bowstring being drawn back before the arrow is released. There is a cui bono for a sudden increase in bond rates that selectively strikes at foreign owners of dollars, as a reversal strategy in financial warfare. (I reserve the right to be wrong.)

    Many economic formulas are presented as being conservation laws. But there are some non-conserved (entropic) factors which run ahead of equilibrium mechanics. Fiat money for one. Bond and stock issuance, compounded with derivatives, is another.

    The issuance is meaningless without a buyer, and if the rate goes over a certain level (I’ve read 7% is a rule of thumb), it’s considered unlikely that the return will be paid. This uncertainty of Reward leads to hyperbolic discounting, i.e. ‘git it now.’ “It is better to exit now when those future changes are uncertain then take even more massive losses.”

    But if you can issue a bond that covers the return that needs to be paid, you can just kick the can down the road. So if the FedGov, or GoldBucks, needs to cover an 8% bond payout, they just issue a bond for the cash. As long as the Fed buys it, there is no upper limit. The value of the dollar drops, but as long as the number of dollars that you have increases at a rate greater than the relative loss, you’re swimming in gravy.

    But what to do with the extra dollars? There are diminishing returns on yachts and islands. However, at root those dollars are uniquely suited to pay taxes, and if the price of say, real estate, explodes, so does the gross tax needed to maintain ownership. If the current owners of distributed capital cannot pay the tax, then those with access to entropic dollars can get ownership at a discounted rate. It doesn’t matter if it’s local owners or the Chinese, if they can’t match your dollar catchment, you end up with the real property.

    This happened during the Dustbowl/Depression and led to megafarms, when the banks consolidated land ownership as the Okies fled to California when the prices for their product cratered. It creates an active incentive to dump QE without a taper.

    I’m just sayin’…

    1. Steve H.

      As I read I realize that QE is the purchase of securities, so what I’m talking about is the selection of which securities to purchase.

      Thank you.

  3. Jim A.

    What it does do is help create the illusion of a recovering economy. But that is mostly achieved by making price discovery impossible, not by increasing productivity or wages or innovation or anything like that. What we have is the financial system posing as the economy. And a vast majority of people falling for that sleight of hand.

    Sounds right to me.

  4. Steve H.

    As I read I realize that QE is the purchase of securities, so what I’m talking about is the selection of which securities to purchase.

    Thank you.

  5. Abram

    Ultra low rates (ZIRP) are not a natural phenomenon

    I understand that Keynes and Minsky advised keeping rates from falling too low for policy reasons, but I have take issue with the “natural rate” argument made in this post. As Warren Mosler has pointed out many times, the “natural rate” of interest without intervention by a central bank is pretty close to zero.

    1. Abram

      I have fallen afoul of confusing terms. I read “natural” as market. The market rate without the Fed propping it up would be close to zero, as Mosler argues.

      The “natural” rate referred to in this article is the the magical rate that the market has predetermined to be the optimal rate for it to function. The job of the Fed then is to use their rate-divining wands to figure out what Mr market wants and give it to him. A quite ridiculous concept.

      1. susan the other

        When the taper ended QE (or so we were told then, in fact the Fed has since admitted it continued to buy MBS from the banksters) the Fed called a meeting with the big banks and asked them to come to some agreement on what the overnight rate should be in a world flush with liquidity. QE had officially ended when they asked this question. So the liquidity referenced must have had a different source. Lately we hear nothing but complaints about there being no liquidity at all. And arguments that QE in fact caused a drought of liquidity because it dried up the bond puddle and the buyers. So just where will the required liquidity come from when they raise interest rates? The reason we never get a coherent explanation is because?

        1. susan the other

          Because they were probably planning to suck all the money out of the EM countries? Can’t we just have something like a steady-state plan? A goal? What the hell. Let’s ask Ilargi to trace his theory as far back as he can. Maybe all the way to 1776 to determine which came first, financial crises or easings? It’s like asking, well what came before the Big Bang?

    2. nothing but the truth

      as money as such is a purely artificial construct, the idea of any naturalness about its time value cannot be true.

  6. dcb

    The easiest way to understand central banker thing is via a Quote by Upton Sinclair, Jr.:
    “It is difficult to get a man to understand something, when his salary depends upon his not understanding it!”

  7. dan

    Wasn’t there some law passed, a year or so after QE started, that all the losses on the Fed’s bond portfolio would be passed on the the federal government?

  8. Dan Lynch

    I am skeptical of ZIRP — it seems to encourage risk taking and speculation — but for the record Keynes’ stance on interest rates evolved and toward the end of his life he favored very low rates.

    Perhaps some of the speculative problems associated with ZIRP could and should be addressed with regulation, but the US government does not have a good track record at regulating finance.

    1. Andrew Watts

      Keynes favored low interest rates at a time when capital gains taxes were skewing towards a higher spectrum. Theoretically the government could utilize low interest rates and high taxes on the unearned income of the rich to re-distribute wealth and unlock economic resources that were being accumulated/hoarded that had all the utility of dead money in the economy.

      Low interest rates with low capital gains taxes puts us in a situation where more productive assets flow into the hands of the already affluent which only further chokes economic activity and growth. Nor does this change the fact that the Fed is an engine of inequality and guardian angel of Wall Street.

      1. Chauncey Gardiner

        Agree with your observations, Andrew. Thanks. Besides the FED’s ongoing MBS and Treasury bond purchases at reduced levels (ostensibly to replace maturing securities under QE), it appears to me that the Fed’s reverse repo facility is being used both to provide liquidity to specific institutions and intermediaries on an ad hoc basis, and to continue to suppress interest rates on the short end of the yield curve while allowing interest rates on Treasury notes and bonds with maturities beyond 1-year to rise. Among other outcomes, this policy has the practical effect of steepening the yield curve and increasing the banks’ and other creditors’ net interest margins.

        Whether this will further suppress bond prices to begin to allow for a positive real return after inflation is unclear, as well as whether it will begin to more significantly affect margin debt rates and stock prices.

        I try to be cautious in my assumptions about the real purposes behind the Fed’s policies and programs. I certainly don’t think they’re fools, although their true policy objectives may not be aligned with what we assume or believe to be sound public policy.

        1. financial matters

          I’m not sure how a reverse repo increases liquidity. It seems more to stabilize interest rates.

          I understand it as the Fed offering treasuries to money market funds in exchange for cash and then buying them back at a premium thus allowing money market funds to post positive interest rates without engaging in tri party repo.

          1. Chauncey Gardiner

            Thanks, financial matters. Knowing the Fed’s legendary care with specific language, I am viewing it as possibility from reading the FRBNY’s website. No first-hand experience with these instruments, so I welcome your input, particularly on objectives, structure and mechanics. This is just how it appears to me as an interested citizen.

            My question is whether the NY Fed’s “Temporary Open Market Operations”, which according to the Fed include both repurchase agreements and reverse repurchase agreements, are not just being used to manage overnight interest rates in the financial system, but are also being used as an assured source of funds (Liquidity) at near-zero cost on an ongoing basis?

            This is the related language from the FRBNY website:

            “Temporary Open Market Operations

            To implement monetary policy, short-term repurchase and reverse repurchase agreements are used to temporarily affect the size of the Federal Reserve System’s portfolio and influence day-to-day trading in the federal funds market.” (my bold)

            A recent speech by Fed Vice Chairman Stanley Fischer is consistent with your view that it is primarily a rate management tool, although he stated the Fed is targeting a much broader set of financial institutions than just money market funds:

            “The reverse repo counterparties include 106 money market funds, 22 broker‐dealers, 24 depository institutions, and 12 government‐sponsored enterprises, including several Federal Home Loan Banks, Fannie Mae, Freddie Mac, and Farmer Mac.” (fifth paragraph from bottom)


            1. craazyboy

              This looks like the “reverse repo” plan the Fed talked about shortly after announcing QE1. At the time they wanted to assure the market they had an exit plan for QE1. Back then bond traders had nightmares about the Fed dumping half a trillion of long term treasuries and MBS on the market as soon as the Fed deemed it necessary to raise rates.

              So reverse repo was the way to ease those fears. Plus Ben did the “pay interest on banking reserves” thing as a tool to raise rates, but it was thought that had too much of a bottleneck in it to be completely effective, so they wanted to hit a broader footprint by dealing direct with money market funds.

            2. financial matters

              It seems that the hole that needs to be plugged is to keep the Fed from bailing out triparty repo via these counterparties. They (tri party repo transactions) could face very large liquidity problems that hopefully won’t be transferred to the public purse.

    2. cnchal

      I see no reason to be in the slightest degree doubtful about the initiating causes of the slump….The leading characteristic was an extraordinary willingness to borrow money for the purposes of new real investment at very high rates of interest – rates of interest which were extravagantly high on pre-war standards, rates of interest which have never in the history of the world been earned.

      Notice Keynes was talking about real investment. Today, the Fortune 500 is borrowing vast sums to buy their own shares back, which is the exact opposite of real investment. It wouldn’t be possible if interest rates were high.

      Here is Keynes take on primitive accumulation.

      The modern age opened, I think, with the accumulation of capital which began in the sixteenth century. I believe – for reasons with which I must not encumber the present argument – that this was initially due to the rise of prices, and the profits to which that led, which resulted from the treasure of gold and silver which Spain brought from the New World into the Old. From that time until today the power of accumulation by compound interest, which seems to have been sleeping for many generations, was reborn and renewed its strength. And the power of compound interest over two hundred years is such as to stagger the imagination.

      Let me give in illustration of this a sum which I have worked out. The value of Great Britain’s foreign investments today is estimated at about £4,000 million. This yields us an income at the rate of about 6 1/2 per cent. Half of this we bring home and enjoy; the other half, namely, 3 1/2 per cent, we leave to accumulate abroad at compound interest. Something of this sort has now been going on for about 250 years.

      For I trace the beginnings of British foreign investment to the treasure which Drake stole from Spain in 1580. In that year he returned to England bringing with him the prodigious spoils of the Golden Hind. Queen Elizabeth was a considerable shareholder in the syndicate which had financed the expedition. Out of her share she paid off the whole of England’s foreign debt, balanced her budget, and found herself with about £40,000 in hand. This she invested in the Levant Company – which prospered. Out of the profits of the Levant Company, the East India Company was founded; and the profits of this great enterprise were the foundation of England’s subsequent foreign investment. Now it happens that £40,000 accumulating at 3 1/2 per cent compound interest approximately corresponds to the actual volume of England’s foreign investments at various dates, and would actually amount today to the total of £4,000 million which I have already quoted as being what our foreign investments now are. Thus, every £1 which Drake brought home in 1580 has now become £100,000. Such is the power of compound interest !

      Pirates, all the way down.

    3. Rosario

      There cannot be stable economy without regulation and law governing the works. Markets are politics. Economic tools will get tossed around all day to more-or-less the same effect until politics are engaged in concurrence.

  9. Steven Greenberg

    Since the Fed is an arm of the government, I wouldn’t think there would need to be a law that “all the losses on the Fed’s bond portfolio would be passed on to the federal government”. That passing on would be a natural consequence of the structure of the Fed.

    Of course, when an entity that creates money out of nothing suffers losses, I don’t know what this passing on means.

  10. P Fitzsimon

    The proof for QE/ZIRP failure is bank lending or the lack of bank lending. Banks, until recently, have for the last six years simply added to their excess reserves instead of lending. The low interest rates and cheap credit, for those who can borrow, have kept the stock and bond markets rising.

  11. JEHR

    I have been waiting for the next big crisis and maybe this portends it. I really think that only the banksters should suffer though–not anyone else!

  12. tegnost

    Things are much clearer for me now thank you, i can see from the example of “keynes square rule”, how if it’s true things seem practically unmanageable, i’ve always thought the primary impact of unwinding qe to be suffered in emerging economies, so “interesting times” ahead…regarding aunt edna sorry but the fed is open about its attempts to affect the psychological perception of any number of things so we can’t discount the possibility that yellen was chosen for her aunt edna qualities. There is a weird wizard of oz like thing going on up there where they say we’ve put this show on for you so so why don’t you just believe and click your heels three times and its all fine

    1. JurisV

      Now for a spot of levity — or did the author actually mean to cast a sly allusion by referring to Aunt Edna? “Edna” kept stirring in my brain until I remembered why. Of course ! I almost spewed tea onto my monitor when Dame Edna Everage came to mind — especially when Janet Yellen is part of the conversation.

      1. HotFlash

        Why yes, yes, I *do* live under a rock, and that is why I had never heard of Dame Edna. But I have now. If you have not, the wikipedia article is of course, Dame Edna 101, but this performance from 1979 (the Proms) is, um, unforgettable. Or perhaps unforgivable.

  13. Synoia


    an amount equal to the difference between the squares of the old rate of interest and the new” (mathematically represented as Δi = i2 )

    The equation quoted cannot be correct because it is a equiv lance, not a difference (is is a – b, not c – a – b), second you then continue to quate scalar values (the square of the interest rate), which is also suspect,.

    An interest rate is a velocity, $/year, the square of the interest rate is $ (squared)/ year (squared), where I believe the intention was to express the rate of change of the interest ate as an acceleration ($ squared . y year, or a the differential of the interest rate (d$/dt)

    A picky point is YOU SHOULD NOT USE I (or i) as variable. It is an irrational number, the square root of -1.

    This now raises more question in my mind. Interest rate is a velocity, where it is a number applied over the direction over time, and essentially one dimensional, which I believe simplistic.

    Let us introduce another factor, fear (F) into the equation, or greed (g). f remains it define form, an abstract function. Capital I, is defined as the interest rate.

    Then we’d get I(later) = I(now) + k(the central bank change) + f(F, g)

    where (F, g) = f(I(later)), and the equation becomes:

    I(later) = I(now) + k + f( f(I(later))

    and, assuming fear and greed are non-linear (insert hollow laugh here), we have a non linear equation with feedback, as the basis for future interest rates, and such non linear feedback equations are the basis of chaos theory.

    1. Synoia

      Sorry about the typos…

      the basic (equations should be a = b, and c = a – b)

      And one has to be careful because if interest rate and the change of interest rate are vectors, which I suspect), simple addition is not the correct mechanism to sum vectors…in two dimensions one has to sum the x and y components separately and then compute the hypotenuse…

      However, I also suspect the economy is not a one or two dimensional system, as I can conceive of three dimensions, time, fear and greed, which would make a model of the economy potentially a chaotic surface….

      1. susan the other

        I like your variables. Because time can be counted on to do its thing. So we need to turn fear and greed into a new way of doing the other things – by anticipation and even-handedness. Somehow.

        1. Synoia

          Fear = the fear of loss
          Greed = Opportunity for gain

          Fear and Greed need limits (governance) so the fear is minimized and Greed (gain) controlled within these limits.

          But, limits themselves change the behavior of the underlying system, limiting loss is basically insurance, and limiting greed, is basically the tax system.

          You’ll notice this is in complete antipathy to “Markets know best.”

          As for changing human behavior – the Scandinavians do it best. But, they are small homogeneous countries, with what appears as years of “a caring tradition, aka: We Are All In This Together” whereas the US appears to have a history of “F… you, I’ve got mine”.

        2. Synoia

          Time is not as invariant as you think, because the time we are discussing is the future period over which Interest rates, fear and greed change.

          As you note, the past is the past and invariant (we hope).

        3. Steve H.

          Hmm. One problem is that in non-manmade systems, greed is a function of deprivation and has practical limits. One is satiation (getting full). Another is time, as when an elephant seal has a harem so big he spends most of his time trying to protect it from intruders. Human greed, however, seems to be a positive feedback system, and institutionalization breaks down the normal time constraints by allowing behaviors to occur independent of the organism.

          Fear (as measured by rats in shock-boxes) is considered a negative reinforcer and decreases the likelihood of a behavior manifesting. However, I’ve been told by someone who ran such experiments that nearly a third of their rats would run into the shock box when the little light went on, instead of manifesting avoidance. (These outliers were tossed from the data set.) Whatever the explanation for this (and there are many), it does tend to muck up the predictive validity of the equations unless the subjects are pre-selected. I believe Barnum referred to certain preselected entities as ‘suckers.’

          1. Synoia

            Man’s greed is not as limited as food greed, if limited at all.

            I don’t believe the food greed and man’s “riches” greed compatible.

            So I’ve not well defined “greed”. My bad. For this discussion purposes it is the ever increase accumulation of “riches”.

    2. craazyman

      Even if Keynes was theoretically right, people can’t do math well enough to even know they’re in a liquidity trap. So it’s not really real in reality. What people do is, they act as if they’re up on a cliff thousands of feet above any liquidity trap, and they buy the damn bonds anyway, thinking they’ll get lucky. That makes the liquidity trap disappear completely. I think Keynes has the causality inverted. The liquidity trap doesn’t make bond buyers disappear. The bond buyers make the liquidity trap disappear. Ecce Homo and QED.

      1. Synoia

        and they buy the damn bonds anyway, thinking they’ll get lucky = Greed.

        I believe.

        And I believe we agree. What I’m asserting is the markets and the economy are chaotic systems, and will always descend into chaos (aka: Crash).

        Then it follows that relying on Mr Market to perform governance is nonsense – because it becomes provable that the market cannot govern itself.

        However, I also do not discount another component of fear – Denial, especially Denial(R).

      2. craazyboy

        One thing to remember is both Keynes and Marriner Eccles(the “pushing on a string” dude) spent some time thinking and talking about the real economy, rather than just blathering all the time about these made up Wall Street markets. Hard I know, but they were talking about the effect of interest rates on business investment, and back then it was thought business investment lead to employment. (quaint world back then, huh?)

        1. Synoia

          Yes, and back then people believed the stock market existed to provide growing companies with capital.

          They would have frowned upon it as a Casino.

          My sister, who worked as a Stockbroker the City (of London) recently remarked to me that “the City has changed, it is not what it was.” Then we had the discussion on self-enrichment vs client focus.

          However, her fellow stockbrokers at that time did not recommend investing in any manufacturing companies because of the “Union Problem.”

          Upon graduating from University, I discovered the hidden side of “The Union Problem.” Management.

          Then I emigrated from the UK for the first time, and went to paradise. There was a growing and looming black cloud on the horizon, so after a few years I departed.

          The second time I emigrated from the UK, I believed I was going to a better paradise. However, upon reflection, the “Paradise” part of the second destination is missing.

    3. larry

      Synoia, you are right about i. It is considered a universal constant that should be interpreted in the preferred way in any proof. That is the convention. It is also the convention, which the commenter didn’t use, which is to indicate exponentiation, in this case the square of a number, with a particular circumflex, namely ^, as in x^2.

  14. Jesper

    QE increases lending, or in other words: QE increases leverage. Highly leveraged systems are inherently unstable.

    Some thought that the lower interest rates would make it easier to pay back borrowing while maintaining consumption. The outcome was instead increasing leverage in one part of the economy and in other parts of the economy there was falling consumption due to falling incomes. I suppose that in one part of the economy the expected outcome actually became real. Economists only care about the average so they are quite unable to grasp why their predictions were and are wrong…

    1. Synoia

      while maintaining consumption.

      While unemployment was climbing? Where did “Some” in “Some though” come from?

      Consumption is demand. Cut employment cut demand. Give money to Banks -> More casino playing because no one will invest is there when there are less paying customers.

      I was told that by a OC republican businessman.

  15. Calgacus

    To add to Ben & others’ comments and explanations:

    The natural rate of interest is zero. This is obvious.

    Take a dollar bill out of your wallet or purse. Plant it somewhere. No matter how you water it or speak to it, it will still be a dollar bill, worth one dollar, no more, no less. To have a non-zero rate of interest on its currency, the currency issuer has to DO SOMETHING ELSE, in addition to the usual, important but invisible operations of exchanging old dollars for new ones, allowing old dollars to satisfy new debts etc all such transactions at the attractive rate of 1 dollar to 1 dollar!

    To have a negative interest rate a la Silvio Gesell, the issuer has to accept, redeem dollar bills with old dates on them only at a discount. To have a positive interest rate, the issuer has to issue bills with dates in the future printed on them – they are called “bonds”. In any case a lot more usually pointless bother than just printing dollars and not caring about dates.

    Ilargi says ultra-low interest rates are not “natural”. In simpler and better terms this means: The demand for low interest, long term bonds is “naturally” small. If you are an insurance company or somebody with a very predictable long-term future obligation, they are better than nothing, of course. Keynes square rule helps explain the risks involved. BTW Keynes always favored low interest rates, was famous as the greatest apostle of low rates of all time.

    1. craazyboy

      Um, it’s when you take a dollar bill out of your wallet and put it in someone else’s wallet and say “Do what you want with it, just catch me sometime and give it back.”

      Just about everyone would say you are a poor negotiator if you do that without specifying when you want the dollar back, and that you expect no interest.

      Even Jesus was ok with 3%-5% real interest rates.

      To do it for nothing means you would have to be nicer than Jesus. Or that you have a bank account.

      1. Calgacus

        What is “it” in “it’s when”? The phrase “natural rate of interest” & my post above refers to rates on government securities, where the rate is zero according to sane people, something else according to “mainstream” “economics”. There are a host of other (private) interest rates, of course. Keynesian/MMT/QE/ZIRP forever just means that to get a dollar (from the government) you have to do something real (for the government). Unfashionable, but it’s been done.

  16. Rosario

    Economic policy does not occur in a political vacuum. Who says the Federal Reserve is operating with the best interests of every American in mind? Doesn’t it inherently engage politics however much appearances force an aura of mechanical indifference? QE and low interest rates have little to no benefit to society when our politics (via laws/regulation or lack thereof) orients the capital to ever inflating assets for a narrow class. If, however, our politics framed this economic policy toward more equitable, materially productive ends it would be a different story. Like a mechanic with a set of tools. If they are idiots or malevolent they will do more harm than good.

  17. financial matters

    I think Illargi has this all right relative to creating a fake stability and a real inequality.

    Minsksy stability though means people feel comfortable and so reach out for riskier investments. The only people feeling comfortable are the 1 percenters who feel secure they will be bailed out.

    Employment beats interest rates for addressing inequality.

    I think it would be useful if more people felt comfortable and then could diffuse out the Minsky instability.

  18. jonf

    So I have a question or two. Who gains from high interest rates? We have had ZIRP for around six years now. How come we have not all turned to pumpkins? Long term treasury rates may fluctuate to some extent but they are anchored by ZIRP. Increase the FFR and you increase long term rates. Who wins?

  19. Fool

    Can this blog get back to matters like financial chicanery and inequality? If I had an appetite for sky-is-falling nonsense — or people who cite a pseudonym named after the imaginary character of a bong-smoke-philosophy movie for 16 years olds — I would go to zero hedge.

        1. Sanctuary

          How is it not? The article shows how it is. The onus is on you to show how it is not.

          1. Fool

            wtf are you talking about? The article was ZH-style apocalyptic nonsense. How can “chicanery” be ascribed to the Fed’s manipulation of interest rates when that is literally its job.

  20. john c. halasz

    QE is the logical end consequence of monetarism, which Kaldor confuted even before it began.

  21. Steven

    Somehow this whole discussion has to be brought back to earth. Money is supposed to facilitate the production and distribution of wealth in economies characterized by centralized production and an ever-increasing division of labor. But instead of being a medium of circulation and store of value, the means, the tool, has become the end. After 2008 it should be pretty clear that creating money is not the same thing as creating wealth. Capitalism ‘worked’ when the wealth taken out of the health of its ‘laboring cattle’ and / or the value of their money by fractional reserve banking and other forms of financial engineering was used to create the ‘use values’ required to sustain life ‘faster, better cheaper’. That may be of little consolation to its immediate victims but we as beneficiaries should at least acknowledge the benefits for which they paid so dearly.

    However, at some point we have to come back to that ‘sustain life and make it worth living’ thing. Since money is THE means of subsistence in a modern economy, access to it – more precisely, to the goods and services for which it is required – is the sine qua non for judging the success or failure of not just monetary systems but the legitimacy of the whole underlying social order. But because capitalism was in the past so successful at (ultimately) creating wealth and because money was the byproduct accompanying that success, economic life is being turned into a game in which the sole object is to rack up the biggest score.

    The West – it’s 0.01% and the CEOs of its hollowed out economy – can go on ‘keeping score’ with their money and playing Great Games of world hegemony. But when the music stops this time all the chairs will be on the other side of the world.

  22. ewmayer

    Since today’s “official background coloration” for Links appears to be horse racing: I find the economics here quite interesting. It’s been said that the owners of American Pharoah (pronounced Fuh-RO-Ah just like it’s misspelled, despite what its owners may claim ;) stand to make as much as $100 million in stud fees over their horse’s remaining lifetime. In one sense that is reflective of simple biology — a stallion can impregnate many mares in the time it takes a mare to gestate a foal. It also explains the marked preference for male racehorses over female ones (only 3 Kentucky Derby winners have been fillies, by way of a sample) – even if your filly wins the triple crown, she can only impart her genes to a much more limited number of offspring

    But consider — modern IVF technology makes it relatively easy to harvest eggs from a female, combine with sperm in vitro, and reimplant the fertilized eggs, not necessarily into the egg donor. So I would expect to see a thriving market for IVF and surrogate foaling for race-champion mares’ eggs.

    In fact at the genetic level there is a good scientific reason to *prefer* “champion quality” female DNA in terms of paying big $$$ for it — namely that the mother passes along more of “herself” to her offspring. Before you write a “You moron — it’s 50/50!” flamepost, the reason is that the mother passes on an equal share as the father of her chromosomal DNA, but the crucial mitochondrial DNA (mtDNA) gets passed on via the cytoplasm of the egg, thus comes only from the mother. As mitochondria are cells’ powerhouses, that DNA would seem rather important in what makes a champion racehorse.

    Of course well-known mutations such as the “x-factor” linked to Secretariat’s oversized “huge engine” of a heart are also big business in equine pedigrees. (Note in this particular case the mutation gets its name from the fact that it occurs on the X chromosome, i.e. Secretariat only passes it on to his daughters, though he did so with 100% reliability, since being a male he had just that single X to pass on.) But proven-quality mtDNA would seem to be a more reliable and less potential-downside-prone basis for a champion runner.

    Would love to hear from more horse-knowledgeable NCers on this “equine economic dimorphism”. Discuss!

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