The Quantitative Beatings will Continue Until Economy Improves

The Fed’s purpose, when it comes down to it, is to buy bonds. Under their various “Quantitative Easing” (QE) programs, they sure have bought a lot of bonds. This pushes up the price of the bonds. Since the yield is basically the inverse of the bond price, this means the rate of interest falls.

This month, on rumors that QE will be tapered off and despite continued Fed bond buying, the yield on the 10-year Treasury bond has spiked from 1.63% to 2.12%. Will this be the end of the bull market in bonds and the start of rising interest rates in the US in earnest? I rather doubt it, as all of the dynamics that have created this bull market are still in place. And as the other bond markets of the world experience greater trouble (such as Japan today), capital will come pouring into the dollar and the Treasury.


It has been quite a bull market in bonds. Here is a chart of the yield on the 10-year Treasury.


The recent blip is hardly noticeable on this chart, which shows the fall from 16%.

This is all good, right? It’s a bull market, so people are making money. The cost of borrowing to finance a new business is near its all-time low. The deficit to GDP ratio is kept in check by low interest payments too, as any Keynesian will tell you.

Not quite.

In the spirit of the boy who said, “The emperor has no clothes,” let’s ask a question. Where do the profits of the bond speculators come from? Who is on the other side of the trade? Who sold the bond short?

The borrower, who sold the bond, incurs a capital loss as the bond speculator gets his gain. Changes in the bond price are zero-sum: one side loses and one side gains. While they can borrow more money at a cheaper rate tomorrow, they can never make up the loss on the money borrowed at a higher rate yesterday. Their burden of debt rises as the rate of interest falls.

How does this manifest in the economy? A competitor can enter the business more easily. If the interest rate is lower, that means he can borrow the same amount of money and have a lower monthly payment. Or he can borrow more and have the same payment. Either way, he has a sustainable competitive advantage over the established business. If the rate falls again, then another new competitor can enter the market. The established business is pushed into bankruptcy, the first new competitor is on the ropes, and the newest is doing well. That is, until the next decline in the rate. The penalty for borrowing at a too-high rate is harsh.

This is certainly not good for the economy. To the extent that new money goes into the productive sector at all, it may be used to cannibalize existing businesses. The old debt is defaulted, and net debt increases slightly as the new loan is bigger than the old one. Churn is not real activity.

Even more pernicious, our endless non-recovery is not in spite of the Fed’s effort, but because of it. The interest rate is not exclusive to just one business. It is universal, applying to the whole market. Every business can borrow at the prevailing rate. When will they borrow? To oversimplify slightly, they will borrow when they see an opportunity with a net profit greater than the interest rate. This will push down the rate of profit of their market. The actions of a myriad of other businesses will push down the rate of profit in every market.

Let’s pause to consider this for a moment. The rate of interest is falling. This invites businesses to incur more debt. At the same time, their opportunities to profitably deploy the borrowed money are declining due to the very reason of falling interest rates.

The falling interest rate not only sucks capital off their balance sheet and threatens them with death by competitors who wait for a lower rate, but it encourages more leverage and makes them more fragile by lowering their profit margin. Who in their right mind would go deeper into debt for a reduced profit and a longer time to amortize the debt?

The Fed can no more improve the economy by buying bonds than a boss can improve morale by punishing employees. Their low interest rate forces the economy down into the mud and keeps it pinned. The Fed purportedly helps stabilize the economy compared to the gold standard, but it really achieves the exact opposite.

The chief virtue of the gold standard is that it keeps the rate of interest stable. Look at this long-term chart that goes back to 1790. There are spikes due to wars and policy blunders, but it is striking how stable it was prior to 1913 especially in comparison to the era of the Fed.

Interest Long Term

Today, the saver is disenfranchised. If he does not like the rate of interest, he can complain, but there is not much he can do, short of speculating on commodities or stocks. According to many sources I read, pension funds are becoming more underfunded. Why? It is because the net present value of the payout they must make to retirees is rising (as a mathematical function of lower interest), while their ability to earn a yield is falling.

Under gold, if the saver did not like the rate of interest he could sell the bond and take home the gold coin. His preference sets the floor under the rate of interest. No yield, no lending. No lending, no bonds can be sold. So the rate was forced higher. (There was also a ceiling, but the mechanism is only of academic interest today with falling rates.)

Stable rates preserved the saver’s ability to earn a yield, and also protected the capital of borrowers.

How do savers today expect their money to work for them so they can retire comfortably? Those with a defined-benefit pension plan don’t worry about it; they have outsourced the problem of finding a yield to third party money managers behind an opaque structure. As I noted above, most are badly underfunded and the prognosis is that underfunding will become worse.

Everyone else has a choice of believing in one or another myth. The first myth is that everyone can become a great trader, who is nimble, quick, and has superior and timely information. Burt Malkiel wrote a book called A Random Walk Down Wall Street, which debunks this notion. The average investor will not beat the market average. Net of costs and fees, he underperforms.

The other myth is that stocks and other assets will go up and up without limit. So one simply must buy and hold. Then the capital gains will pay for a comfortable retirement. This plan is no more feasible than the first.

The only thing that can pay for retirement is the return on capital put to productive use. This is a serious problem in our era of wholesale capital destruction.

Another reason why rising prices cannot pay for everyone’s retirement is unique to gold. A rising gold price is not a gain. It is just an artifact of using a falling dollar to measure gold’s value. If you have an ounce of gold, and the price doubles to $2800, you have twice as many dollars, but each of those dollars is worth half as much. You still have one ounce of gold. Only if you make a profit by earning more gold do you have a gain. While this was how people made a profit 100 years ago, today few are even thinking about how to do this.

It is high time they started again.

8 replies
  1. advsys says:

    I am intrigued by the last couple of lines but I don’t think I fully understand them?

    “Only if you make a profit by earning more gold do you have a gain. While this was how people made a profit 100 years ago, today few are even thinking about how to do this.”

    How does one make more gold from your gold investment?

    Even if your gold does not change in relation to dollars, wouldn’t it be more accurate to measure ones wealth in gold by some standard other than against the dollar? Something that we buy with dollars? Like how many loaves of bread can one buy for that ounce of gold? (or possibly, how may cows? How many pairs of pants? )

    Thanks in advance

  2. petter_w says:

    One thing I have never understood is why banks refinance mortgages and offer their clients lower monthly payments. In this case the bank takes the loss or am missing something?
    The only problem with Feketes falling interest rate destroys capital is that when the interest rate falls – why cannot the guy who invested first at the higher interest rate just refinance? I suppose there is a difference between a homeowner and a business in that any capital gain is tax free for the homeowner but not so for the business owner.
    I suspect there is a tax reason behind this or is this refinancing a government scheme to ‘help’ homeowners. Clearly, there is no refinancing when the interest rises, so why this lopsidedness?

  3. Keith Weiner says:

    Thanks for your comments.

    advsys: There used to be an interest rate in gold, as there is with the dollar today. One cold go into a bank, deposit gold and get more gold at the end of the deposit period. Or buy a gold bond. Or buy a gold bill. Today, Monetary Metals is embarking on this path to offer a yield on gold. Otherwise, one can trade in and out of other assets keeping one’s balance sheet in gold to be sure that one is measuring profit and loss accurately. The problem with consumer prices is that they are moving all over the place for many reasons, most of them non-monetary. The government passes a regulation demanding corn ethanol and the price of not only corn but pork rises. The weight of gold one commands is the best and most objective measure.

    petter: A residential mortgage is unusual in the world of borrowing. The business borrower may or may not have the ability to prepay a loan without penalty (if he does, he paid extra for this feature). But a bond cannot be prepaid, and the bond is how government and big businesses finance projects. You sell a bond into the market and use the proceeds to build or buy an asset. If the rate goes down, then the market price of the bond goes up. Your question about banks touches on another aspect of the problem. The banks are increasingly borrowing short to lend long. In this case, if a borrower wants to prepay early, it does not cause a problem for them. In a normal world, they would scrupulously match the duration of their funding to the duration of their lending. Without regulation forcing them to allow homeowners to prepay without penalty, I suspect there would be a penalty to cover their cost of having to continue to pay interest on their funding without receiving interest from the borrower (until they find another borrower) and to cover any change in the interest rate that may have occurred in the meantime.

  4. jmf says:

    Don’t forget the crazy world of derivatives too especially interest rate swaps. These are all fixed rate contracts with what is mostly corporations paying the fixed rates to the banks.

    If you check the bank for international settlements report for:
    Amounts outstanding of over-the-counter (OTC) derivatives

    The notional amount outstanding for interest rate swap contracts as of June 2012 was more than 379 TRILLION dollars.

  5. happel says:

    This may sound like a bit of a dumb question: what happens when these unfunded pensions no longer have the assets for their obligations… and in great numbers… all at similar times (whether it be next month, year or decade)?

    People often gripe about Congress getting pensions for life; a small group of people. How about local municipalities that have lifetime pensions, whose asset managers can no longer secure 7% annual returns on long dated and insured govt. bonds. As people live longer and longer this seems to the layman like myself like a floating time bomb. I would relish in Keith’s commentary about unfunded pensions and the future.

  6. blackwater03 says:

    Keith, you started my early morning off with a chuckle from the title of this article. I think its hilarious, yet, most would not understand nor appreciate the humor. Being a former Green Beret and Ranger while in the Army, I appreciate a good beating now and then.

    Once again, a great article.

    I am sure most reading your articles are very well informed people. So, I am sure I am mostly preaching to like minded readers.

    I live in Phoenix and it is amazing to drive around and look at all the empty commercial real estate buildings from small to large. One area, near the Deer Valley airport has modern new commercial buildings that were built sometime at the beginning of 2005. 40% of those buildings are still vacant and have never had tenants in them. And there are more being built now in various areas of Phoenix yet we have all this empty commercial space!

    Your article Keith, shows the parallel between the current economic malaise of today with the depression of the 30’s. Murray Rothbard in his book, “America’s Great Depression”, ponders the question of why so many businesses failed.

    He wondered, or presents it as a question to the readers, why businesses failed in such great numbers. He said most business people are pretty good at running their businesses, yet there were so many failures.

    Keith, your article expresses exactly what Rothbard presents in his book. As rates fall, it allows for new businesses to enter and drive out the old businesses, only to have another entry and again another business failure.

    Not only do low or negative rates drive out old businesses, but capital is destroyed in many ways by low or even negative interest rates. But, I am sure your readers understand this.

    Thanks again, Keith on another great article.


  7. blackwater03 says:


    When I worked in commercial lending, one of our policies was that we would not lend to any business which had weak barriers to entry.

    I am kind of thinking that low or negative interests actually make all old businesses exist in an environment where another barrier is weakened at their detriment.

    Would you concur that low rates represent a weak barrier to entry for new businesses and thus create more cheaply capitalized competition for existing businesses?


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