Why Low Interest Rates Are Bad?

When long-term low rates cause the global economy to overheat and over-invest, the world produces more than it consumes and inevitably prices will dramatically decline. Falling prices create a vicious cycle of lower consumption, lower corporate profitability, bank failures caused by non-performing loans, and higher unemployment. Economists call this deflation.

WHAT IS DEFLATION?

Deflation is a negative inflation rate. Price drops give dollar holders strong incentives to save rather than consume or invest.

Depressions usually evolve from deflation. In our fractional reserve system, banks magically create money when they create loan ledgers. When you deposit $1000 into Wells Fargo at 3%, your bank can turn around and loan $10,000 (10 times the cash reserve holding requirements) at 24% in the form of a credit card loan. When debtors start defaulting on promises to pay, it can snowball into credit compression, cause massive bank failure, and create deflation. As asset prices drop for the underlying collateral of loans, banks typical see an increase in their non-performing loan portfolios.

CAN’T YOU SIMPLY PRINT MONEY TO PREVENT DEFLATION?

Not necessarily. Printing excessive money devalues the currency and causes import prices to increase without a corresponding increase in export prices. Even when interest rates hit zero, consumers and businesses will not borrow if they do not expect to earn profits or wages that exceed the interest on the loan.

The Fed stimulates the economy through credit expansion. To increase the money supply, the Fed Open Market Committee (FOMC) purchases assets (such as US Treasury bonds) from banks to increase their liquidity. Theoretically, banks should be able to jump start the economy by increasing their loans to consumers and businesses. As seen in 2010 and 2011, lending does not necessarily increase during a financial crisis because 1) the banks focus on eliminating their non-performing portfolios 2) loan eligibility falls as consumer and business credit and income decreases and 3) the demand for loans by consumers and businesses diminishes.

For over a decade, the FOMC kept interest rates at historical lows with all indicators signaling low levels of inflation. Despite record levels of credit expansion, low-wage labor from countries such as Bangladesh, Vietnam and Mexico drove down import prices and kept inflation in check. Through modern advances in manufacturing and logistics, global corporations now have unlimited access to $4/day labor around the world. In other words, global wage deflationary pressures tricked the Fed into believing that we were experiencing low inflation.

As a result of the FOMC’s decision to sustain long-term rates, this “easy money” led to asset price overvaluations in both the US stock and real estate markets. Asset price hyperinflation (as argued in prior blogs) resulted from global trade imbalances with the US running massive account deficits and China running account surpluses. As consumption in America decreases due to economic anxieties (especially for retirees) and labor contractions, the trade gaps will continue to widen unless the dollar falls comparative to America’s trading partners. As a result of these trade account deficits, the resulting foreign capital inflows fueled the bullish trend of the US stock market in the last twenty years. Unfortunately, what goes up must come down.

The global economy will soon enter a deflation-induced depression similar to what Japan has experienced since 1990. Technical analysis of the Dow Jones (in the graph at my blog at zempower.com/archives/330) shows a historical “M” pattern called the “Kiss Goodbye,” which forecasts the coming of a huge market crash. I’m forecasting that the Dow Jones will crash to 5,000 in 2011 or 2012. Unfortunately, millions of Americans will lose their retirement savings held in 401(k)s and mutual funds. Governments will try to jump-start the economy through fiscal stimulus but this time they are handcuffed by unsustainable national debts.

Even if fiscal and monetary stimulus comes to the rescue during this crash, the result will be an even bigger bubble that will crash more severely in the future. In some nations, running the currency printing press to fight deflation can cause the possibilities of hyperinflation similar to that experienced in Indonesia after the 1997 Asian Banking Crisis.

By: Zempower

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