Why is ZIRP so bad?

I read an interesting piece at Mish Shedlock's new blog location with the new name Mish Talk where a reader asked him why ZIRP is so bad. 

http://mishtalk.com/2016/02/27/reader-asks-why-are-zero-interest-rates-bad-what-should-the-interest-rate-be/

Mish endeavored to give the reader the answer in layman's terms, but with all due respect, I did not view the answer as very laymanesque, so let me take a shot since in these matters I am very much the layman.

Let me start by noting not all aspects of ZIRP are bad in my view.  I, for one, refinanced my mortgage to a 15 year mortgage at 3% and am quite happy with the savings - not to mention paying the place off years sooner.  Low interest rates used sensibly are a good thing and have undoubtedly been good for many individuals and businesses.

The problem comes in when you focus on the "sensibly" word in my last statement.  Many individuals and businesses use the low interest rates to incur debt they simply would not have incurred before, which is precisely what our friends at the Fed want them to do.  But as mama always told me, debt is to be avoided as much as possible because heavy debt burdens bring with them lots of downside.

But why would folks run up more debt foolishly?  Pause for a moment and think about that question and you will realize that the only thing foolish is asking the question.  People do stupid things if you let them and they can.  Now there are two important parts of the equation - that you let them and that they can.  Let's start with the "that they can" side of it.

Lowering the interest rate brings the price of entry to a point where more people can take out the loan and make the payments (or at least think they can).  Certainly back in the 80's with double digit interest rates a lot fewer people were buying homes and cars.  Now with all sorts of low interest rate deals a lot more people can afford to do this.  For those that really need a car to get a job and commute, this is a good thing.  For those who really do not need the car but want it just for fun and freedom, tying up income in debt payments is perhaps not so good.  Overall an increase in the debt level of society is not a good thing, especially since it not brought with it the golden ring the Fed promised in the form of a booming economy that creates a lot of high paying jobs that let people pay off that debt.  Had the plan worked out that way it may have made sense, but it has not.  So now we have mountains of debt and a shaky economy that is not going to support the job growth needed to pay down that debt.

And aside from the individuals taking out loans they do not need, the low rates also lead to companies taking risks they would not take - or be allowed to take - at higher rates.  This speculation sometimes pays off and sometimes does not.  Just ask all the oil frackers sitting on mountains of debt on which they can no longer even pay the low interest.  Speculation can be a good thing and in some ways is at the heart of capitalism, but when too many are speculating with too much debt on the same bet, excesses are created that lead to bad outcomes.  Presently, HSBC posits that there is $1 trillion out there in distressed corporate debt within the $3 trillion in speculative grade debt outstanding.  To give perspective, subprime loans during the housing bubble in 2007 peaked around $1.3 trillion.

http://www.zerohedge.com/news/2016-02-28/about-1-trillion-distressed-junk-bonds-ubs-responds-wall-streets-shock

Since many companies roll-over their debt by issuing more debt to pay off the old, the increase in rates now being demanded will make this roll-over cost prohibitive, i.e. they are up the creek without a paddle or with one that HSBC thinks will cost them 20-25% a year.

And then there is the other fun thing companies have been doing with their debt.  They have been taking loans to do stock buybacks and pay dividends, not for CAPEX.  This has the double whammy of building debt on the company books while artificially pumping up stock prices.  It also serves to undermine the Fed purpose of building businesses and the economy. 

Now let's visit the other side of the equation - that lenders let individuals and businesses take out the loans.  Indeed, let me rephrase that - that lenders push them and make it way too easy for them to take out the loans.  This happened in the housing bubble, which ended oh so well, and is happening again today.  Not so much in housing - though we recently went back to Fannie Mae supporting 3% down loans - but more so in areas like auto finance and business loans.  Subprime is booming in all these areas and banks and other lending institutions are (or were until recently) pushing folks to take on as much debt as they can.  Even if you credit is so bad you cannot get the low rates, they will now give you the car loan over seven years to make the payments affordable.  How many car ads have you heard asking for folks with bad credit to come on in as it is no problem.  I heard one the other day saying X dollars of income a month qualified you for Y dollars in loan to buy a car.  When I did the math, the buyer would be spending roughly a third of their take home pay on one car payment.  Seriously!?  Well, that is the problem and a big one.  It is peaking now in energy related loans that banks are having to write-off and in the subprime auto area where delinquencies are surging:

http://davidstockmanscontracorner.com/chart-of-the-day-subprime-auto-delinquencies-surging-higher/

Too much debt burden is just a powder keg waiting for a match and we are starting to feel the warmth of that match right now.

So you may be wondering why the Fed's grand plan did not work out as expected, with increased lending leading to increased spending and resulting demand leading to booming business and more hiring with more wages leading to more demand and more profits and so forth.  Lot's of theories on this and probably lots of contributing causes.  Let me point out one; low interest rates are great if you are borrowing money but suck big time if you are trying to save for retirement, and with roughly a quarter of the US population qualifying as baby boomers, you have a lot of folks looking to save and avoid debt.   Unfortunately low rates mean any conservative investment like Treasuries is paying squat, so you have two choices.  Door number one is to save more as you anticipate having to save enough to pay for retirement without any decent investment gains.  Door number two is invest in riskier investments in the hopes of making the returns you need, which works well until, well, it doesn't, and then you might end up back at door number one.  Same goes for all those soon to be bankrupt vastly underfunded pension funds out there that are banking on 8% returns a year just to have any hope of being close to targets.  And as pointed out in this link below from Zero Hedge, Bank of America believes a lot of retirees are choosing door number one, i.e. saving more and spending less, which is the opposite of what the Fed wants. 

Let me add a couple other factors to chew on.  First, we went to ZIRP after the stock market collapse in 2007-2008, right when a lot of baby boomers were retiring or looking to do so soon.   For many their retirements were wiped out.  And given that losses instill a much stronger emotional response in people than gains, you can bet a lot of retirees or soon to be retirees took their money out of the market then and never went back, so they missed out on the gains since then.  Second, add to this the double-whammy that many of the jobs the BLS is reporting were taken by older people who would have normally left the market and you have a number of wage earners who are saving everything they can, not spending it, so the Fed's plan is shooting itself in the foot.

http://dollarcollapse.com/welcome-to-the-third-world/welcome-to-the-third-world-part-17-was-middle-class-retirement-just-a-credit-bubble-fantasy/

Just think what will happen when we go to NIRP.  There are already reports of cash hoarding in Japan where Kuroda just went to NIRP and last I check hoarding is the opposite of spending.

http://www.zerohedge.com/news/2015-10-29/bank-america-looks-europes-record-%E2%82%AC26-trillion-negative-yielding-debt-stunned-what-I

Also see:

https://mises.org/blog/negative-interest-rates-and-fear-mean-well-save-more-not-less

So ZIRP has not had the hoped for response.  It looked good on paper but did not play out as expected.  That, my friends, is the problem with theory based on what economists think people will do versus what in real life they in fact do.  And NIRP I strongly suspect will bring much of the same merely making matters worse for the ultimate collapse..

And by the way, while I have your attention, let me note that if you think January was bad for the markets, wait until you see what happens next, which I believe will be in March.  Madness will only begin to describe it.  If that happens, it will not be just baby boomers saving as much as they can of their hard earned income.