Tuesday, 25 March 2014

“A falling interest rate is deadly poison to business.”

Here’s something counter-intuitive that might help you feel better about rising interest rates: “A falling interest rate is deadly poison to business.” 

Making the point is Keith Weiner, who argues the trillions of dollars pumped into the financial system by central banks since 2008 in an effort to push down interest rates, has not just spilled over into markets but led to deadly unintended consequences even on its own account.

An artificially low interest rate is bad enough, as it hurts savers and retirees on a fixed income. However, a falling rate is deadly poison to business. This toxin operates by two different mechanisms…
    The first mechanism of falling rate toxin is layoffs across the economy…
    The Fed’s rate suppression has a second path of attack… when the Fed pushes down the rate of interest, the rate of profit tends to follow, with a variable lag.  The end result is not wealth creation, but profit margin compression.

The low interest and compression of profit margins between them encourages competition, but competition of a particularly unproductive kind:

Consider a restaurant, Sleepy Steak & Potatoes. Sleepy borrowed at 5 percent to build a nice store. What if their competitor, Hip Hotpot Fusion can borrow at 2.5 percent? Hip Hotpot builds a bigger place with taller ceilings and high-end finishes.  Former Sleepy customers switch to Hip. This is churn—one business simply supplants another, creating little or no wealth.

As just one example of this: Cisco’s decision this week to spend $1 billion of mostly borrowed money to go head to head with Amazon and others to offer cloud computing  -- a business (as Weiner points out) with already thin margins that are obviously shrinking.

This phenomenon, churn, is not the normal “creative destruction” of wealth production when new technologies supplant the old, instead it is non-creative destruction with the end result of higher debt with  little to show for it but higher churn and severe market dislocations.

    It’s pretty obvious that lower interest rates encourage more borrowing, and we’ve looked at two ways that each downtick incentivizes businesses to load up on more debt.
    The effect on the stock market is not simple. Rising profits tend to push
stocks up, but that’s not the whole story. Higher debt makes companies more dependent on credit market conditions, and lower profit margins make them more sensitive to consumer spending. Companies and their stock market valuations become brittle, vulnerable to small changes. Stocks can crash if credit stops flowing, like it did in 2008.
    When the next heart attack strikes, the Fed deserves the full blame.

Read Keith’s whole commentary here to understand How the Fed Poisons The Stock Market – FORBES

1 comment:

  1. This implies that the original loan is at a fixed rate. For business loans this is rarely the case. Therefore the falling rate would offer Sleepy more working capital, which would allow him to either undercut Hotpot, or refurbish his property. He could also just bank the higher net profit margin and get his debt down.

    Also, while I accept the concept of churn, as a consumer I now have the choice of 2 eateries. Since there is more competition prices may come down, and quality up: a good thing for me. Incremental employment gains together with additional rental income to a commercial landlord would mean that the knock on effect of the lower interest rate is actually very big. And no, it is not an example of the broken window fallacy.

    If we accept churn as being only destructive, then the ideal business model is always a monopoly, which is ridiculous.

    None of this is a defense for a central bank to artificially lower interest rates, of course. But lower rates, per se, are not "deadly poison", but rather quite the opposite.


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