The market's zero-sum game

Near-zero interest rates may have stimulated markets briefly, but central banks will likely find that extended periods of ultra-cheap money will ultimately impede recovery.

Gresham’s law needs a corollary. Not only does "bad money drive out good,” but cheap money may as well. Ultra low, zero-bounded central bank policy rates might in fact de-lever instead of re-lever the financial system, creating contraction instead of expansion in the real economy. Just as Newtonian physics breaks down and Einsteinian concepts prevail at the speed of light, so too might easy money policies fail to stimulate at the zero bound.

Historically, central banks have comfortably relied on a model which dictates that lower and lower yields will stimulate aggregate demand and, in the case of financial markets, drive asset purchases outward on the risk spectrum as investors seek to maintain higher returns. Near zero policy rates and a series of ‘quantitative easings’ have temporarily succeeded in keeping asset markets and real economies afloat in the US, Europe, and even Japan. Now, with policy rates at or approaching zero yields and QE facing political limits in almost all developed economies, it is appropriate to question not only the effectiveness of historical conceptual models but entertain the possibility that they may, counterintuitively, be hazardous to an economy’s health.

Importantly, Gresham’s corollary is not another name for ‘pushing on a string’ or a ‘liquidity trap’. Both of these concepts depend significantly on perception of increasing risk in credit markets which in turn reduce the incentive of lenders to expand credit. Rates at the zero bound do something more. Zero-bound money – credit quality aside – creates no incentive to expand it. Will Rogers once fondly said in the Great Depression that he was more concerned about the return of his money than the return on his money. But from a system-wide perspective, when the return on money becomes close to zero in nominal terms and substantially negative in real terms, then normal functionality may break down.

A good example would be the reversal of the money market fund business model where operating expenses make it perpetually unprofitable at current yields. As money market assets then decline, system wide leverage is reduced even if clients transfer holdings to banks, which then reinvest proceeds in Fed reserves as opposed to private market commercial paper. Additionally, at the zero bound, banks no longer aggressively pursue deposits because of the difficulty in profiting from their deployment. It is one thing to pursue deposits that can be reinvested risk free at a term premium spread – two-/three-/even five-year Treasuries being good examples. But when those front-end Treasuries yield only 20 to 90 basis points, a bank’s expensive infrastructure reduces profit potential. It is no coincidence that tens of thousands of lay-offs are occurring in the banking industry, and that branch expansion is reversing industry wide.

In the case of low yielding Treasuries, the Gresham’s corollary at first blush seems illogical. If a bank can borrow at near 0 per cent then theoretically it should have no problem making a profit. What is important, however, is the flatness of the yield curve and its effect on lending across all credit markets. Capitalism would not work well if Fed funds and 30-year Treasuries co-existed at the same yield, nor if commercial paper and 30-year corporates did as well. It is not only excessive debt levels, insolvency and liquidity trap considerations that de-lever both financial and real economic growth; it is the zero-bound nominal yield, the assumption that it will stay there for an extended period of time and the resultant flatness of yield curves which are the culprits.

Conceptually, when the financial system can no longer find outlets for the credit it creates, then it de-levers. The point should be understood from a yield as well as a credit risk point of view. When both yield and credit are at risk from the standpoint of ‘Gresham’s law’, the mix can be toxic. The recent example of MF Global emphasises the concept, as does the behaviour of depositors in some struggling European economies. If an investor has money on deposit with an investment bank/broker that not only appears to be at risk but returns nothing, then why maintain the deposit? Perhaps an investor would be more comfortable with a $100 bill at home in a mattress than a $100 bill on deposit with a broker – Securities Investor Protection Corporation notwithstanding. If so, system wide de-levering takes place as opposed to the credit extension historically necessary for an expanding economy.

Historical examples and central bank staff models will likely not validate this new Gresham’s corollary. Fed chairman Ben Bernanke blames policy rate increases in the midst of the 1930s for an economic relapse, and a lack of credit expansion for Japan’s lost decades 60 years later. But all central banks should question whether ultra-cheap money continually creates expansions as opposed to destroying liquidity, de-levering and obstructing recovery. Gresham, as opposed to Keynes, may become the applicable economist of this new day.

Bill Gross is founder and co-chief investment officer of Pimco.

Copyright The Financial Times Limited 2011.

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