Courtesy of Mish.
I received several requests to comment on an article written by Antal E. Fekete entitled the Counter-Productive Monetary Policy of the Fed.
The subtitle of his article is "Sowing Inflation, Reaping Deflation". It's 16 pages long and not an easy read.
In general terms, I agree with Fekete. Without a doubt Fed policy is counter-productive, for many reasons, some which Fekete does not even mention.
- The Fed creates bubbles of increasing amplitude over time.
- The Fed fosters speculation with moral-hazard bailout policies.
- Fed policies benefit those with first access to money, namely the banks, government, and the already wealthy, at the expense of everyone else.
- The Fed is largely responsible for rising income inequality that even the Fed complains about.
Here's a couple of paragraphs from Fekete's article that caught my eye.
My thesis that falling (as distinct from low but stable) interest rates destroy capital across the board is admittedly controversial. I would welcome its examination ‘without fear and favor’ by a competent and unbiased panel that could also examine the superiority of “self-liquidating credit” over credit based on government debt (that could be called, tongue-in-cheek, “self-perpetuating debt”). We shall look at three destructive effects of a rate cut: (a) the increase in the liquidation value of debt, (b) labor's deteriorating terms of trade, (c) the fading of depreciation quotas.
The proposition that the bond price varies inversely with the rate of interest is uncontroversial and universally accepted by friend and foe alike. It describes the effect from the point of view of the credit or. Curiously, people find it hard to comprehend the equivalent proposition describing the very same effect from the point of view of the debtor, namely, that the liquidation value of debt also varies inversely with the rate of interest.
In particular, a rate cut increases the cost of liquidating debt before maturity. Liquidation value is what the debt or must pay if he wants to retire his debt ahead of schedule. As this liquidation value is now higher, falling interest rates make the burden of debt increase. For example, if the rate of interest is cut in half, then according to the rule of thumb the liquidation value of long term debt is doubled (that is, to liquidate the debt will cost twice as much as it did before the cut).
"If the interest rates is cut in half, to liquidate the debt will cost twice as much."
Let's discuss that last sentence.
I asked my friend Keith Weiner if he could explain what Fekete was saying.
He replied …
Compute the present value of a stream of payments. Suppose you must pay $100 a year for 10 years. The net present value is not simply $100 X 10 = $1,000. Each future payment must be discounted using the prevailing interest rate. If the rate is 10%, then we get the sum of the series: $90 + $81 + $72.90 … = $586. If the interest rate is cut in half to 5%, then the sum of the series is $762.
"Ahah!" you say. "That's not double." No, a 10-year bond does not double with a halving of the rate. A perpetuity bond does.
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