Thursday, September 1, 2011

Why ZIRP is Bad for the Middle Class


The Fed announced recently that they will continue with their zero interest rate policy (ZIRP) at least until 2013. May be they want to see a wholesale flight out of paper dollars like we saw last fall. Regardless of the market implications, I think that ZIRP is bad for the middle class in many ways, including some that are less quantifiable. As Charlie Munger says, not everything that counts can be counted.

A fundamental tenet of "middle class-hood" is future orientation (vs. present orientation). People with present orientation like to do things without regard to future consequences (driving drunk, having unprotected sex, skipping class, buy now/pay later, etc.) A core middle class value is future orientation: decision-making that takes into account future consequences. This has meant staying in school, not fathering children left and right, and, the focus here, saving: saving for a downpayment on a house, saving for a car, saving for college, saving for retirement. ZIRP discourages saving by stealing the interest earned on savings and encouraging present consumption. This leads to both overconsumption (relative to incomes) and to lower retirement savings (and, in part, to defined benefit plan underfunding).

ZIRP is also bad for middle class jobs. In many businesses there is an optimal choice between capital and labor (sometimes not direct, make something manually internally vs. buy machine-made from outside). A factory owner would love to fire all workers if robots were cheap enough: I know I would prefer to deal with machines than people who stay home when their kid is sick or walk in the office with an offer letter, asking for a raise. ZIRP (and Obama's accelerated depreciation stimulus) heavily favor machines vs. labor. I am all for progress/mechanization but I think that the relationship has gotten a bit distorted.

ZIRP leads to malinvestments: we had a housing bubble a few years ago. We not only ended up with too much (and highly energy-inefficient) housing but also we ended up with a large % of the workforce in the bubble-fueled real estate economy, from the slick jumbo mortgage broker to the gruff plaster guy. Some of these were formerly middle class jobs, especially in smaller communities, and now the sheer decline in business volume has hurt them. The decline in housing prices post-bubble has also cost the middle class dearly in equity.

ZIRP speeds up job exports. Large international companies, like MCD or WMT, can borrow at very low rates here in the US and invest these money at much higher returns in emerging markets. These create not only MCD or WMT front-line jobs: with every expansion come the accountants, the marketing personnel, the buyers, the logistics, the IT, the management, and, perhaps most importantly, the R&D. GE just moved their X-ray R&D work in China. This probably would not have happened so quickly (if at all) if they could not borrow so cheaply to build or acquire abroad.

ZIRP is an implicit policy of dollar devaluation. People argue about the mechanics but the message is that the dollar will be weaker. This means inflation as the US is an oil importer. The middle class is already already struggling the points above (unemployment, reduced wealth, no interest on savings), this hurts even more, be it at the pump, the heating oil delivery, the airline fuel surcharge or the consumer-level price increases due to higher energy costs. The winners here (exporters such farmers and miners) are a small percentage of the workforce. The middle class is not a winner from $120 oil.

ZIRP discourages real capital formation. This is a off-shoot of the savings and employment point: capital formation for small businesses comes from savings- we are talking about rentals, restaurants, car washes, chips delivery routes, hair salons, food trucks, small shops, etc. Most everyday people are not into social media start-ups. A potential entrepreneur (and his/her family) actually loses money after taxes and inflation while trying to save up for the business. This hurts both entrepreneurship and, consequentially, hiring (oft cited stat is that most jobs come from small businesses). There is an argument that loans are cheaper, too, but the contra here is that higher equity businesses are more robust.

ZIRP needs to end. To give you an idea of where the rates "should" be, for a 1-year CD to earn a meager 1% in real after-tax return, the 1-year CD rate should be at about 5.75% (simplified calculation: 1% real return + 3.6% LTM inflation =4.6% after-tax, at 20% total tax rate-Fed/State/Local- this implies 5.75% pre-tax). The average one-year CD is at 0.84% today per  Yahoo Finance. Who benefits from this? Three administrations have worked to double the size of the government in 10 years via cheap deficit spending, while the banks are getting nicely recapitalized.

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