29 July 2011
The answer is obviously leverage.
Consider a hedge fund with an equity capital of $5 that borrows $95. It invests the money in the stock market.
At an interest rate of 0%, when the market rises 1% the fund earns a return of 20% on equity. Given five such days in a year when the market rises 1% the fund can easily earn a return of 100% on equity. Nice bonuses all around. Thank you, Mr Bernanke!
When the interest rate is 1% the annual cost of financing is 0.95%. So the market needs to rise nearly 2% to give a return of 20% on equity. If the market remains stationary, the fund undergoes a loss of nearly 20% on equity.
When the interest rate is 2% the annual cost of financing is 1.9%, so the market needs to rise nearly 3% to give a return of 20% on equity. If the market does not rise, the fund suffers a loss of 38% on equity.
When the interest rate is 5% the annual cost of financing is 4.75%, so the market must rise 5.75% to give a return of 20% on equity. If the market does not rise, almost all the fund's equity gets wiped out.
We have not considered staffing and other costs or the fact that a hedge fund can bet on the market's fall as well as its rise. But despite the simplification the idea is clear. Each percentage rise in interest rates increases the risk that a highly leveraged hedge fund can go bankrupt. It is not surprising, therefore, that a Fed Funds Rate of 5% is enough to pop most bubbles.
So what are the implications for policy? The US government has tried to set limits on bonuses, on the transparency of hedge funds and other financial institutions, on capital requirements and so on. I rather agree with Alan Greenspan that no regulator can keep pace with changes in financial engineering. To remove all risk from the system one would need to have a regulator looking over the shoulder of every trader. That would be going the way of the Soviet Union. And I doubt whether even that would prevent catastrophes.
On the other hand, a Fed Funds Rate of about 5% seems guaranteed to prevent any asset bubble from growing, judging from the past decade. But won't that also penalise businesses producing real goods and services? I have argued in Why banks do not lend at near-zero interest rates that both the economics and the evidence give the lie to this fear.
For a firm producing real goods and services, an interest rate of 10% probably won't add more than a percentage point or two to total cost. And this can easily be absorbed or passed on to customers. For financial trading firms, though, such an interest rate would be disastrous.
There is a curious corollary to the above thesis. I argued that raising the interest rate to moderate levels prevents any money from going to feed bubbles. Carrying the argument a step further, low interest rates, by diverting money to asset inflation, keeps the inflation of real goods and services down.
This conclusion militates against all common sense. In its favour, consider the fact that before the Great Depression, the crash in Japan, and the Great Recession, inflation was very low. That is to say, low inflation need not be a sign of slow monetary expansion, but quite the opposite: an indication that money is growing steeply.