The Law of Unintended Consequences Strikes Again…How ZIRP and NIRP Destroy Wealth

By Kevin Freeman
September 16, 2016Sep 16, 2016

The new millennia has certainly had its share of crises and turmoil. We started with an Internet/tech bubble, suffered from the repercussions of the worst terror attack on American soil in history, witnessed a housing bubble fueled by interest rates held too low for too long (or so we were told in the immediate hindsight), watched the bursting of the bubble with the response of even lower rates and massive monetary stimulus. We now find ourselves with endless ZIRP and NIRP, names befitting cartoon characters for toddlers.

ZIRP is Zero Interest Rate Policy–essentially keeping rates at or near zero with the hope of stimulating growth. NIRP is Negative Interest Rate Policy–essentially dropping rates below zero where the borrower gets paid by the lender.

In hindsight analysis, it seemed so clear that we had a real estate bubble that ultimately burst in 2008. There was lots of hand-wringing. Everyone seemed to agree that the lenders made mistakes and perhaps were poorly regulated. Few saw the problem before it happened although most felt the economic environment was quite unusual. Of course, there were many other factors at work like excessive derivatives, bad banking behavior, a contentious election, and (as we have shared) financial terrorism. [Never mind that we have excessive derivatives, bad banking behavior, a contentious election, and financial terrorism at work today as well.] It was exactly eight years ago that Lehman Brothers failed triggering a meltdown across markets and around the world.

Mark Twain said that history does not repeat itself, but it often rhymes. Anyone catching the rhyme of markets today?

One of the most troubling aspects of today's economy has to do with NIRP and ZIRP. These are truly unprecedented events and should not be ignored. And, they are destroyers of wealth for the middle class. This is an entirely different type of global economic warfare but can still be devastating. Typically, we talk about what Russia, China, North Korea, Iran, or jihadists have planned to destroy our economy. But the internal threats, regardless of intention, can prove to be just as deadly.

Rather than diving into complex and tedious arguments used by theoretical economists, let's just consider the obvious.

  1. Low or negative interest rates benefit larger borrowers the most. The largest borrower? The United States government. By far. The other largest borrowers are other sovereign nations.
  2. The second beneficiary is any alternative to savings. The stock market has powered higher because savers see dividend-paying stocks and are attracted to the yield. In addition, companies can borrow money at low rates and buyback their own shares. This is financial engineering that makes stocks artificially attractive, at least temporarily. Few see the new risks added as a result.
  3. The third beneficiary has been the very wealthy who have access to borrow at low rates and also the ability to invest in a very diverse set of assets.
  4. Who gets hurt the most? Savers and lenders. That includes retirees and the middle class.

Beyond the obvious, however, there are economic dislocations that only become evident over time. Negative interest rates are corrosive even if the effects are not obvious immediately. Mathematically, they do not work. It's like an equation that divides by zero. My friend John Mauldin has written a very important piece on the multitude of problems that negative rates are causing and will cause. You can read his superb September 14, 2016 Thoughts from the Frontline HERE.

Bill Gross of Janus has likewise warned that capitalism doesn't work with zero or negative interest rates.

As for unintended consequences, just consider two impacts on life insurance. One for the beneficiaries and the other for the companies.

The beneficiaries will require far higher amounts of insurance given the low rates. There are no safe places for savers. So imagine the loss of a loved one who had planned to provide a permanent income for a spouse and children. If safe interest rates were 5%, a $1 million policy would provide a reliable $50,000 per year. But if interest rates are 2% instead, the income is just $20,000 per year. Even assuming a reasonable reduction in principle, you can easily see how the need for insurance rapidly expands the lower rates fall. Negative rates make things far worse as principle erodes no matter what you do.

Unfortunately, that is only half the equation. Low or negative interest rates hurt the insurance companies as well. Insurance companies are built for stability. They know with a great deal of certainty what their risks are using sophisticated actuaries. They have a deep understanding of life expectancy. But to guarantee a payout of a certain amount they also need reliable income and growth in their investment portfolio. Losing the opportunity of reasonable returns from a high-quality bond portfolio can prove catastrophic. It necessarily forces the insurance companies to take on riskier strategies to be able to provide the payouts promised.

So far, this corrosion to the foundations of our economy has been masked by high stock market returns. What happens, however, if the stock market falters.

For the insured, this problem doesn't become personally obvious until they pass away. Unfortunately, pension plans face similar problems. They have promised to provide a payout at retirement. This too is a potential crisis in the making with enormous implications. If you wipe out pensions, the government will have to intervene and this will increase dependency. And, the government, already deeply in debt, will have to borrow ever more. It is a vicious cycle.

All of this makes our economy more vulnerable to foreign attack. We already have nearly $20 trillion in debt, up from around $10 trillion eight years ago.

There is only one reasonable escape opportunity and that is stronger economic growth. We have to be able to grow our way out of this problem. We can't borrow our way out of debt. Therefore, anything that strengthens our economy is essential. I wrote an eight-step program for American prosperity in Chapter 12 of Game Plan. Several of the steps directly address the need for private sector growth.

Here is a summary:

  1. Recognize the global war we are in. [How can you win if you don't know you are fighting? We have numerous advantages but have failed to focus on them.]
  2. Take reasonable precautions. [Essentially, shore up glaring weaknesses.]
  3. Get money moving without money printing. [This one speaks directly to the tax code. American corporations have trillions of dollars earned but trapped overseas. A good chunk of this money would come home with intelligent tax policy. And, on a net basis, it wouldn't cost the taxpayers a dime but would start our economy moving forward.]
  4. Achieve energy independence. [Every barrel of oil we produce is one we don't have to buy from our enemies.]
  5. Reduce regulation. [We have strangled innovators. We need to make it easier, not harder for entrepreneurs.]
  6. A workable tax code. [We should not be 32nd in the world. Period.]
  7. Teach what America is all about. [Too much of our education system seems dedicated to denigrating the American experiment. We should at least balance that with a focus on the good America has done and can do in the world.]
  8. Return to our spiritual roots. [Quoting Jefferson: "God who gave us life gave us liberty. Can the liberties of a nation be secure when we have removed a conviction that these liberties are the gift of God? Indeed I tremble for my country when I reflect that God is just, that his justice cannot sleep forever." If we know that our liberty is from God and not the state, we will fight to keep it as a divine gift. If we believe it from the state and not from God, then we may accept the state removing our liberty. ]

Bottom Line:  Be aware of the factors working in today's economy. We can't afford more of the same.