A Third Reason to raise Interest Rates?
I read Paul Krugman, Ben Bernanke and others. They mention two reasons why some people are calling for interest rates to rise…
- Possibility of Inflation
- Possibility of Financial instability
Now I would like interest rates to rise, but I have never seen any inflation coming. In fact, it seems that inflation will stay low when interest rates stay low in our present economic conditions. I have written about that before in relation to the Fisher effect here on Angry Bear.
As far as financial instability, my concern is more inequality which is subduing effective demand.
But there is a third reason that these economists don’t ever seem to mention… The economic inefficiency of low interest rates.
Look at China. They have over-invested clearly. They have over-capacity in production. Their financial repression with low interest rates has led to over-investment. What do they do now? They roll over debts, keep interest rates low and try to keep these unnecessary firms active. In the US, firms still have debt. They pay interest costs. These low-productivity firms would most likely cut back production, hiring and may even go out of business if interest rates rise. So in order to keep these weak firms active, interest rates must stay low.
Low interest rates make the existence of these marginally weak firms much more possible. Of course, we do not want run-away inflation, nor even financial instability. However do we want these debtor weak firms which weaken the economy?
If we do not want them, we have some options.
- We can write off debts, which could include mortgage debts of households.
- We can raise taxes on corporations and the rich.
- We can close loopholes that allow profits to be hidden overseas.
- We can raise interest rates.
A combination of all four options would eventually strengthen our economy.
Imagine a football team that has some weak players. The team is not replacing these weak players. The team is mediocre from year to year. Then the team starts setting higher standards for its players. It starts cutting weaker players and investing in better players to meet that higher standard. The result will be a better team with better profit potential because they will win more.
If the economy started weeding out weak firms with higher interest rates, they would be replaced with newer-technology firms without old debts from before the crisis. Do you see where I am going with this? Eventually the firms within our economy improve on average. Productivity will increase. Wages have a better chance to rise… and so on.
So arguing that interest rates should stay low because inflation is not likely and bubbles of financial instability should not be popped misses another reason to raise interest rates… to maintain the standard of excellence in the economy in line with medium-run potential. That means raising the Fed rate along an appropriate path so that the short-term real rate rises toward its medium-run natural real rate. Then it is just a matter of how much slack you see for setting that path.
Janet Yellen and the Fed seem to be focused on the slack more than anything. They feel the time is coming to start raising the Fed rate. They recognize that economic growth will slow down some as marginal businesses are tested with a higher interest-rate standard. They may even feel that is a good thing.
You speak of companies that you would like to be put out of business. Your words:
“marginally weak firms”
‘debtor weak firms”
Okay, give me an example of what company you think should be tanked. Try looking at the Russel 2000, or, if like. the Russel 5000. I’m curious what type of company that is existing today that you think should be shuttered for the greater good.
Has Andrew Mellon returned from the grave?
BKrasting
There are signs that you can look for…
http://www.forbes.com/sites/sydneyfinkelstein/2012/02/14/how-to-spot-a-zombie-company/
and also read this article that mentions record lows for bankruptcy rates… That is a sign that weak firms are not being weeded out at normal levels.
http://www.foxbusiness.com/economy-policy/2014/10/30/zombie-land-usa/
I rather suspect that any large company (define large however you want) is not going to be shaken out in the next five years by a change in interest rates because they have capital structure flexibility, or a capital structure that is largely locked in over that horizon.
What you are really talking about is shutting possibly a large number of small to medium sized businesses that are reliant on borrowing at variable interest rates.
All the sudden you aren’t talking about the GMs and Apples of the world, you’re talking about the woman down the street with her autobody shop, running it on her personal credit cards or HELOC who doesn’t have much wage flexibility in the absence of something like a minimum wage hike that causes every boat to rise.
Raising interest rates seems like a very blunt instrument for dealing with issues that are more directly related to the first three items on your list. You may not like the results as much as you think you would.
Wkj
The key is to line up the short-term real rate with the correct path to the medium-term natural real rate.
As for Andrew Mellon, it is not clear that he wanted to purge the rottenness so harshly.
http://en.wikipedia.org/wiki/Andrew_W._Mellon#Great_Depression
Anyway, in my view, Andrew Mellon was not tuned into this concept of a rising path for the short-term real rate. He may have wanted to tighten the economy too soon, which would have been a mistake. However he was also in favor of anti-recessionary policies according to Wiki.
But there is rottenness… How would you purge it? I would purge it through a normalized path for real rates.
J Goodwin,
You make a good point. Miedium sized firms pay higher effective tax rates than larger companies. So raising corporate taxes to weed out weak firms would disproportionately hurt smaller firms.
But isn’t that still a good thing? We would be allowing newer stronger companies to enter the markets, even smaller companies. It would take time, a couple years for this transition to take place, but eventually, firms are stronger, even the smaller ones.
Posted for Jazz (Dan here)
Edward –
I have a really hard time accepting your Andrew Mellon like reasoning.
Are those marginal firms marginal because they are inept, or because of insufficient aggregate [or effective] demand?
Do you really believe raising interest rates a point or two will wash out those marginal firms without reducing the next tier of firms into marginal status?
What about the effect of increasing unemployment in that way on demand?
Don’t you think raising rates would place a burden on already struggling households, and thus further decrease demand?
If labor’s share were to increase, don’t you think that would increase demand? Wouldn’t raising the minimum wage do that directly? Aren’t there policy actions that could do so indirectly [never mind that they are currently politically impossible.]
I don’t see a large downside to writing off household debt, and no downside at all to raising taxes on corps and the wealthy, nor to closing loopholes. I do see significant downsides to raising rates.
Your assertion that marginal firms would be replaced by more efficient ones is based on —- what? If capitalism works, wouldn’t those new firms be doing that already, especially if helped along by low rates? And your cascading conclusions seem simply fanciful.
And wouldn’t raising rates add strength to an already strengthening dollar, and thus impede exports?
In all due respect, you have to do a much better job of justifying your rate raising preference.
Cheers!
JzB
Ed you just made the (inadvertent?) argument that larger = stronger. You try to mitigate that somewhat by arguing that the subsequent space yielded by larger-stronger companies out-surviving smaller companies allows new companies to enter the market, some of which might even be “smaller” but that doesn’t rescue the logic. Nor does it address the problem that surviving larger-stronger companies might just expand to fill the space. Which is something we have seen as 11 “too large to fail” banks somehow yielded to 5 “really too large to fail” ones just as what were universally known as the Big Five Accounting Companies became the Big Four after Arthur Anderson went to the wall over Enron.
All in all you just seem to be embracing your inner Schumpeter. Not to say outer Mellon. How do you ensure that ‘Creative Destruction’ just doesn’t lead to intensified cartels and monopoly?
Or “What JazzBumpa said”
I don’t believe that you get a stronger economy by enabling companies to borrow money to buy their own stock. The holders of stock options benefit but not the rest of us.
I don’t believe that you get a stronger economy by enabling speculators to borrow money to speculate in commodities. They disrupt the markets and create larger booms and busts. Oil is just one example.
I don’t believe that you get a stronger economy by passing paper back and forth between “investors”. And that goes double for those borrowing the money to accomplish the exchanges.
And last but certainly not least, if a Zero Interest Rate Policy (ZIRP) is such a great idea than why did we wait until the economy was foundering? Were all the former FED chairmen too uneducated to recognize the overpowering benefit of ZIRP?
ZIRP last year, ZIRP next year, ZIRP forever. NOT!
Savers have been punished enough, now it is time for debtors and their lenders to take a turn.
Dan and Jazz,
Marginal firms are not inept. They are not marginal due to weak effective demand. They contribute to weak effective demand. They are weak from past excesses and from a financial system that supports them. Weak firms is just natural in an economy. That is why we have bankruptcies. But now we see record lows of bankruptcies in spite of low effective demand. That is a big clue that there are weak firms being kept alive.
The idea is not to just raise the Fed rate a point or two, but to keep the short-term real rate on an appropriate path to its natural rate.
Weak firms bring down demand. They have weak spending. They hold down wages. When you replace them with cleaner firms, demand will rise.
Burdened households and firms are holding down demand. The economy is anemic. Do you want to just move forward like this? It would be nice to wipe debts off the books. We used to have a situation where private debt to GDP was low in the 50’s. Then as private debt to GDP grew, the economy was able to expand. Now we have a situation where private debt to GDP has to drop over time. So debt has to come down. As it does, economic growth will seem anemic. At some point, building more debt has to become more expensive because building more debt has gotten socially more costly.
Stronger new firms need to get into the market. But when weak firms are not going bankrupt at normal levels, they cannot get in as much as they should.
And exports? You have China dropping producer prices anyway. Exports are a smaller part of the equation. If you try to protect your exporting firms, you will create inefficiencies and even weak firms who eventually will be faced with reality when balance comes and protections have to dropped. One big lesson in economics is that it is not efficient to protect export firms in the long run.
Edward:
I think what you are saying is these firms are carried by a low interest rate at which they can borrow money (3 – 4% prime) to sustain there infrastructure within the marginal profitability of their sales. Without low interest rates they would exceed breakeven. If they can not set profit aside to pay down debt, they continue to live on the fringe by shorting Labor to maintain capital.
You explained this before.
China is an anomaly, empty $1 billion manufacturing facilities to support future growth which is somewhere out there and no time soon.
Bruce,
It is not that larger is better. Larger firms pay lower effective tax rates. They have undue advantage over smaller firms. But who is making the big profits? Big firms. Partly due to competing with weaker firms at the level of weaker firms. In that scenario, more efficient companies make bigger profits, while weaker companies make marginal profits since they are being supported by the financial system and not going bankrupt at normal levels.
At the effective demand limit, profits will be a zero sum game. When one company gains profits, another company will lose profits. I see that about a year away now. Then we will see more firms being pushed to the margin in spite of what the Fed rate does anyway.
I’m glad I get to concur with JimH and Edward, even if I have to poke a stick at Jazz, Bruce et al.
I can’t help thinking my current day job is a classic example of the kind of problem company he’s talking about. IBM has become largely irrelevant in most of the markets they (barely) compete in and has managed to keep the lipstick on the pig by borrowing cheap to throw money at investors via buybacks and dividends.
Even after Madame Rometty’s recent recant of an insane EPS forecast made by her predecessor, she is still staying the course, promising to continue with the stock buybacks and dividend payouts. While starving/offshoring product development and selling off assets at fire sale prices. Which I believe would be much harder to sustain in a more normal corporate fixed rate environment.
Having typed that though I realize that the problem could be that she’s just a lousy CEO. Higher interest rates might not make her any better at investing in IBM’s products and businesses than she is now.
“Are those marginal firms marginal because they are inept, or because of insufficient aggregate [or effective] demand?”
Another question is whether those marginal firms are marginal because they are inefficient, or if they are marginal because they are financially precarious.
You are definitely wiping out the second group, you are not necessarily wiping out the first.
J Goodwin,
Marginal firms always exist for many reasons. Bankruptcies are a normal course of business. But doesn’t it seem odd to you that with such a slow recovery so few businesses are going bankrupt? Do you see the effect of that? It’s like a football team that is not getting rid of its weak players, so there is no room for new and possibly better players to get on the team.
If a team raises its standards of performance, any weak player will face consequences no matter what the reason they are weak.
Do we really want to keep bankruptcies low?
Isn’t creative destruction a good thing?
“Attempts to save jobs almost always backfire. Instead of going out of business, inefficient producers hang on, at a high cost to consumers or taxpayers. The tinkering shortcircuits market signals that shift resources to emerging industries. It saps the incentives to introduce new products and production methods, leading to stagnation, layoffs, and bankruptcies. The ironic point of Schumpeter’s iconic phrase is this: societies that try to reap the gain of creative destruction without the pain find themselves enduring the pain but not the gain.”
http://www.econlib.org/library/Enc/CreativeDestruction.html
E.L. You point me to a 3 year old article written by a guy who is hawking his book?
Finkelstein gives some examples of Zombies – Kodak and Borders. Technology did these two companies in. Interest rates were not a factor at all. % rates could have been zero, or 10%, it would not have changed the outcome for these two.
He points to Enron. Interest rates had nothing to do with the success/failure of this company.
He also (foolishly) suggests that BP and Toyota are zombies. these two monsters have market capitalization of $240B and 124B respectively. Changes in interest rates would have very little consequence with this sized equity.
The article ends with:
“Now that you know what a zombie company looks like, who’s on your list?”
Okay, this guy that you point to says this is easy. So I ask again – name me one company in the Russel 5000 that you think should be tanked. Just one and your point will be made.
BKrasting,
Here are some recognizable firms that have underperformed the markets in the past 5 years. I see them as marginally weak and benefiting from low interest rates.
Walmart… Big Lots… Mcdonalds… IBM… Woolworths… Best Buy was weak then made a comeback starting in 2013
I’m sympathetic to Edward’s argument , mainly because of Japan’s experience with forever-low rates leading to zombie-forever companies and banks. Better to rip off the scab , cauterize it , and let the healing begin.
Some heavily-indebted “marginal” firms should go down and some should be rebooted – via debt restructuring. This is what bankruptcy courts are for. The same could be said about households with excessive and/or underwater mortgages , but , unfortunately , we’ve already missed the boat on most of them.
We could do these things while leaving low rates in place , but we probably won’t. Raising rates may be the kick in the ass we need to face reality. Or , we can continue turning Japanese.
Here’s a recent IMF paper suggesting that growth rebounds best from debt hangovers when debt restructuring is both sizable and swift :
” Private Sector Deleveraging and Growth Following Busts ”
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2585382
We need to define those weaker businesses. For instance, how about a company that thinks life isn’t worth living unless they can get their labour for below cost? Or unless they can jettison their pension obligations built up over decades? Or unless they can duck their tax obligations and hide their money overseas?
Those sound like pretty weak businesses to me.
As for new, more vigorous businesses entering the market — if things are so good for the weaklings of existing businesses, what on earth is stopping the young whippersnappers from jumping in?
Noni
Well Edward I do hope your kidding with this list. First off Woolworth no longer exists, Hasn’t in years. You trying to re-kill it?
Walmart has $485 BILLION in sales. It generated $28B of free cash in 2014. The company has $9b of cash on hand. And you think you can put a dent in this behemoth with higher rates?
McDees has $9b of cash on hand. It would make more if rates were to rise. You have this backward.
IBM has $97b in revenue, $46b in profit and $9b of cash on hand. This is another cash rich company that you think you can dent with higher rates??
Best buy is your worst example. It has $1.62B in debt and $3.9b of cash on hand. It has $2.50 of cash for every dollar it owes. Another cash rich company your plan would not work.
Wallmart, Mcdees and IBM have combined employment of 3,200,000 workers. Are you really advocating that these are the companies you would like to see shuttered?
BKrasting,
Woolworth… I threw it in there to show a company that went bankrupt and nobody thinks twice about losing it. It was a big company in its day. Then parts of it were gobbled up by more efficient competitors, even Walmart.
Best buy… I put in there because it was weak, then pulled out of it. It is an example of a company that was on the margin.
Walmart at this moment is putting tremendous pressure on suppliers to lower prices even further. They and Mcdonalds are two companies that have fought higher minimum wages. Now they see that their own margins are hurting because of that social policy to where they are now raising base pays on their own, even though I think their raises are too small.
Some of the poor performance is due to catering to customers with low incomes. Part of the reason why they move to the margin.
Noni,
what is stopping the young whippersnappers from jumping in?
Here is a list or reasons…
http://en.wikipedia.org/wiki/Barriers_to_entry#Barriers_to_entry_for_firms_into_a_market
EL The title of your piece is “A third reason to raise rates”. Your reasoning is that raising rates would cull zombies. The burden of proof on the wisdom of this reasoning is on you.
You provided the names of 5 “zombies” – ones that you thought would be gutted with higher interest rates. But not one of the names on your list would be hurt by higher rates. Just the opposite, the companies you name, with their strong cash position and high annual cash flow, would benefit from higher rates. Sorry – Bad plan! (or you don’t understand what is what)
So if you were calling the shots, making the big choices on things like interest rates, you would do something and it would backfire. You would look silly with the results. It would be bad policy. Not only would it not work to achieve your bizarre ends, it would be hurtful to the consumer side of the economy. You would be fired for doing something so ill thought out as this.
Woolworth disappeared 18 years ago. That story is irrelevant to your position on higher interest rates in 2015.
“….but to keep the short-term real rate on an appropriate path to its natural rate.”
A natural rate of interest that is distinct from the real rate? Is that like growing real carrots until natural carrots can be encouraged to enhance the cook pot? Or is it more like the real ideas of economists which will have to do until we all come to understand the natural inclination of economists to make shit up?
Marko wrote “Raising rates may be the kick in the ass we need to face reality. Or, we can continue turning Japanese.”
Yes, emphatically yes.
Where is the urgency in dealing with our real economy which has been in the doldrums for 7 years?
Jobs one, two, and three were the bailouts of the financial industries which had been slowly deregulated and allowed to play with weapons of financial destruction. Their relief was urgent.
Japan has been at this for about 23 years. What are we doing that will insure a resolution before 2031? Absolutely nothing.
krasting
wonders never cease. you and Webb on the same page…. and even coberly agrees with you.
i can’t see that Lambert wants to do anything that “the rich” haven’t always wanted to do: kill off the weak so the “fittest” can survive.
only it hasn’t worked out that way. the fittest turn out to be predators, and while that may be the law of the jungle, most of us prey animals need to cooperate if we are not going to be wiped out (taking the predators with us.)
there may be good reasons for raising the interest rate (whatever happened to “the demand for money”?) but i am not hearing them here.
i just watched a farmer fail because he got in trouble with his lender. it doesn’t look from here as though he will be replaced with a more “efficient” farmer… maybe one smarter about borrowing money or luckier in his timing vis a vis recessions and dock strikes… but meanwhile there is a family out on the streets in the name of Lambert efficiency.
BKrasting,
What do we see in the news this morning? Walgreens plans to close about 200 stores. There are businesses on the margin.
http://www.usnews.com/news/business/articles/2015/04/09/walgreens-aims-to-close-about-200-us-stores
Lambert
yes, of course, there are always marginal businesses. that’s no reason for the Fed to kick them in the face with interest rates that destroy them to the advantage of their bigger competitors, while making it harder for new potential customers to get the funds to start up.
your model of business efficiency is very congenial to the concentration of wealth, exactly what is wrong with the current situation.
do you honestly think the workers at those 200 stores went out and found better jobs at higher pay with the more efficient companies?
or do you think those more efficient companies will absorb the higher interest by making less profits? or cutting wages?
“higher interest” has traditionally been understood as bad for the economy if occasionally necessary to control inflation. on the other hand it has occasionally been suspected of driving down the cost of labor (through recession) for the benefit of the Big Players.
who are perfectly capable of finding good reasons for doing bad things.
Coberly,
Just look at Japan. They have kept weak firms alive for years with accommodative policies. That is happening here too.
Again, this is from W. Michael Cox, senior vice president and chief economist at the Federal Reserve Bank of Dallas.
“Attempts to save jobs almost always backfire. Instead of going out of business, inefficient producers hang on, at a high cost to consumers or taxpayers. The tinkering shortcircuits market signals that shift resources to emerging industries. It saps the incentives to introduce new products and production methods, leading to stagnation, layoffs, and bankruptcies. The ironic point of Schumpeter’s iconic phrase is this: societies that try to reap the gain of creative destruction without the pain find themselves enduring the pain but not the gain.”
http://www.econlib.org/library/Enc/CreativeDestruction.html
We have a democracy. And the beauty of a democracy is that once you blend the various points of view, you should end up with the best policy. The government is taking into consideration the concerns of the low and middle income groups. They are not taking into consideration labor’s voice. So the government is not working well.
But as an economist, I seek to blend both sides, fresh and salt. My view on economically inefficient businesses staying alive comes more from the fresh water side. The Dallas Fed has some good people. I even like Stephen Williamson. I even like David Beckworth.
Yet I find myself agreeing with the Fed about raising the Fed rate. There are reasons to do so. And if we simply say they are wrong, then we are not understanding the democratic process of balancing various concerns.
The economy will become more efficient from a higher minimum wage and an appropriate short-term real rate. The key is to understand where the appropriate levels are. If the short-term real rate stays too low, we will see inefficiencies accumulate. That is not good… Therefore, this looks to me to another reason to start raising interest rates.
EL Now you throw Walgreens into the pile of zombies? Do you even bother to look at things before you blurt them out? Or do you just not understand corporate America?
Walgrees is a very successful company. Yes, they are closing 200 stores, but they have 8,232 stores. So they are only closing 2% of the stores they own. This is not a sign of weakness, this is a sign of strength. The stock is up by 4% today as investors cheer this development – yet you think it is a sign of being a zombie. The market is not wrong Edward – you are!
Walgreens has a market cap of 72B. It has sales of $77b, it has $13B of cash on hand. Total debt – most of which is long term fixed rate leases- is $14B. So Walgreens has next to zero net debt.
Once again you have identified a company that would BENEFIT from higher interest rates. You think higher interest rates would gut Walgreens, the reality is would make it stronger. So, once again, you have things backward.
Most important – this healthy company has 251,000 employees currently working for it. And E.L. wants to try to shut it down. Either he does not understand corporate finance, or monetary policy and how it works, – or both. Putting Walgreens into the pile of zombies proves he has no clue what he is talking about.
Edward
thank you for your patience with me. as i have said before, you might be right, but i don’t find your reasons very convincing.
my daughter worked in japan some years ago. the “economy” was bad but the people weren’t complaining. maybe they have figured out how to have a good life without a good economy.
beyond that, neither “democracy” nor “chief economist of the federal reserve bank..” strike me as compelling arguments.
holding a struggling business head under water with higher interest rates does not commend itself to me as a way of improving the lives of the people.
Edward,
Thought you might be interested in this related paper , which just showed up in Thoma’s links :
abstract :
http://www.nber.org/papers/w21069#fromrss
full pdf ( prelim) :
http://sticerd.lse.ac.uk/seminarpapers/dg28042014.pdf
They find that increased turnover of those marginal companies ( i.e. “creative destruction” ) raises welfare generally , particularly in states that dampen the resulting turmoil via generous unemployment benefits.
Edward,
1. Companies that are currently marginal are not necessarily always and everywhere marginal and vice-versa.
2. All that bankruptcy does is it redistributes wealth (since a bankruptcy is a transfer of wealth from the creditor to the debtor). It also increases business uncertainty since bankruptcy takes time. The resources are still there, the employees are still there (although many may lose their jobs). But as others have pointed out, the likely result is more concentration of power and wealth. Is that what we really want?
3. A depressed economy is structurally different from a rapidly growing economy. So companies doing well in a depressed economy will not necessarily do well in a rapidly growing economy and vice-versa.
4. As others have pointed out, given its demographic transition, Japan has not really done that badly. The main argument about “Zombie” companies relates not to manufacturing firms but to the financial sector. Zombie companies grow slowly, and so will lose importance over time.
P.S. The reason that bankruptcies are so low is that many troubled firms have already gone bankrupt and there are relatively few startups.
Another thought. You seem to misunderstand creative destruction. It is not the destruction that does the creation, it is the creation (of new products and processes) that does the destruction. Destruction by itself is just destructive.