Lower the Cap Rate, Not

Sometimes I think regulators are in over their heads.  They aren’t talented enough to run a company, but they think they can control the excesses of financial companies.  Then there’s the Fed.  They think they can control an entire economy through the weak policy lever of affecting the views of people have for calculating what interest rates they should use to capitalize the values of assets.

Think of assets as a stream of future cash flows.  But what are those cash flows worth today, to buy or sell them?  The interest rate that makes the price and the cash flows equal is the capitalization rate, or, “cap rate.”

For years, at least in the Greenspan era, lowering the cap rate via Fed funds was the rule when times were weak.  He was the anti-Martin, bringing back the punchbowl rapidly when the party was getting a little dull.  Because of that, the economy grew more aggressively for a time, but at a price of growing unproductive debts.

The Problem

You can lower the interest rates as low as you want, but it doesn’t change the underlying productivity of the economy.  You might push asset or goods prices higher — it depends whether saving or spending is more important.  At present, actions of the Fed push asset prices higher, which doesn’t do much for the economy as a whole.  Rising asset prices do not stimulate the economy much.  Though it would be dishonest to do it, it would stimulate the economy more if Ben would rev up the “Helicopter of Happiness” and rain dollars from “Heaven.”

The Fed created the housing bubble with their policies 2001-2007.  They did that to stimulate the economy.  You can only use strong sectors of the economy to transmit monetary policy, because they can absorb more debt.

That’s true when not in a liquidity trap. We are in such a trap now, given the profligate prior Fed policy.  They did not let recessions destroy bad debts leading to a reduction in the marginal productivity of capital.  That value is so low now, that companies pay higher dividends and buy back shares.  Relatively little goes into growth via new investment.

My point is that monetary policy has some potency if central bankers are willing to inflict pain in the bear phase of the credit cycle.  With Greenspan and Bernanke, that was absent.  As such, we suffer in a liquidity trap, and one that current Fed policy will not remedy.  Far better to raise short-term interest rates and let some bad businesses fail, and grow from there.


  • Greg says:

    When Easy-Al Greenspan was whining about “irrational hubris”, we all assumed he was referring to financial markets. He was unwittingly talking about the Fed itself.

  • andriclt says:

    Your observation is contrary to Ray Dalio’s theory on “How The Economic Machine Works”
    Aren’t we in a long term debt de-leveraging cycle? Central bankers don’t have much experience in this realm of economic cycle. perhaps Bernake foresaw this phase of the debt cycle and has put US in a much better shape than the EU counterpart. Of course now, no banker knows how to come out of this policy gracefully.

    • We need to be careful here. Did the actions of the Fed save us, or set us up for a different problem that those in the 30s avoided? I firmly believe that there is no free lunch, and so I think there is a new problem coming our way that will will make the name “Bernanke” a swear word. It may be stagflation or default, but we aren’t done yet, unless the government gets the gumption to tax more, particularly in areas where it allows tax deferral.

      • Greg says:

        @david merkel, you wrote: “…stagflation or default, but we aren’t done yet, unless the government gets the gumption to tax more, particularly in areas where it allows tax deferral.”

        I have to challenge you on this, sorry. The data is rather clear: the current level of spending, even if it is politically desirable, is not sustainable.

        I made a chart of “total” federal expenditures as a percent of GDP (aka the nation’s ability to pay in aggregate, ignoring the class warfare debate), using the data from the St Louis Fed. It requires a custom data transformation (dividing spending by GDP) — but the website does not allow custom transformations to be made public (and I don’t want to publish my login info).

        Here is the start of said chart, that shows “total” federal spending:

        Divide that data series (W019RC1A027NBEA) by GDP ( Gross Domestic Product (GDP), Quarterly, Seasonally Adjusted). Both are in billions of USD.

        Back when JFK was president, federal spending was around 19-20% of GDP.

        In the 1970s, when the US was running deficits and fighting silly wars, federal spending averaged roughly 21.5% — stagflation and economic hardship followed. In the 80s, Reagan accelerated spending up to a peak of 24% (of GDP) — for about one year. It averaged much less.

        During Bush I and Clinton, spending as a percent of GDP fell back to JFK era levels (19-20%).

        Bush II channeled the 1970s, increasing spending faster than economic growth. Spending as a percent of GDP went back up to about 21%… not counting various off balance sheet nonsense.

        And then Obama went absolutely berzerk, and accelerated spending to more than 26% of GDP at peak (so far) — again, not counting off balance sheet nonsense. Federal spending in 2012 was down to 24% of GDP, or roughly where it was at the peak of Reagan’s spending spree.

        The problem is spending. We can’t keep spending money faster than we earn it. There is no tax rate that would make this possible. Not to mention, we tax things like alcohol and tobacco that we want less of …

        Who, other than Washington DC, wants fewer jobs and less paychecks?

        Lets not embarrass ourselves with “tax the rich” nonsense. Politicians do not tax their donors; politicians of both parties tax the middle class. It is not a coincidence that the growth of the federal government is highly correlated with the collapse of the middle class.

        Spending needs to be brought under control. It is morally wrong to make entitlement promises that are far in excess of what national income can support — and then stick future generations with the debt.

    • Greg says:

      @andriclt wrote: “Aren’t we in a long term debt de-leveraging cycle?”

      That is not true. Yes, this political opinion is often mindlessly uttered by many central bankers and market pundits — but the data on total system-wide debt clearly refutes their politically motivated argument.

      System-wide debt was at best moved from our left pocket to our right pocket; or it was shifted from select (politically connected) private sector entities to the public sector.

      Here are a few doozies to demonstrate:

      Domestic, non-financial sector debt. Obviously no de-levering here:

      State and municipal debt (not including pensions). Maybe you might argue this data series has stopped growing, but you can only argue that if you also stipulate that government pensions will not be paid:

      And unless you have been living under a rock (or in the Eccles building), the Federal government’s on-balance sheet debt has more than doubled:

      The federal government’s acknowledged debts do not include massive unfunded “off balance sheet debts” (social security, medicare, and now ObamaCare). Some fraudsters will claim this debt “doesn’t count” — but it does count **if** the country intends to pay the benefits. The people who argue these debts don’t count are implicitly saying the US government plans to default.

      Sure, the politicians have told us to read their lips, they didn’t have sex with their interns, WMD slam dunk, hope and change, the sub-prime contagion is well contained … if you are still buying into this sort of nonsense, I will happily sell you bridges and swampland that don’t belong to me.

      Please tell us where this alleged delevering is happening in the real world?

      Bernanke (with a lot of help from others in DC — both parties) essentially robbed the future to avoid having politically connected cronies fail today.

      Stealing from babies is wrong; not something to admire.