What Happens When Credit Is Mispriced?

 

The 1-year US Treasury bond pays a yield of 0.23 percent (not a typo), and the 30-year bond has a scant yield of 2.9 percent. That’s nothing compared to Switzerland, where the yield is negative on all bonds maturing in five years or less. Yes, you actually pay them when you lend to them.

These rates are the result, not of a market, but of central planning. The Federal Reserve and its counterparts around the globe have bought up bonds relentlessly. A higher bond price is the same as a lower interest rate (the bond price and interest rate are inverses). Now rates are obscenely low.

What happens when the government sets the price of something too low? Most people could tell you that the end result is a shortage.

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The government can’t create more stuff. What happens is that economically lower uses displace higher uses. Normally, price acts as a filter. Those who are willing to pay the most, get the goods. They outbid everyone else. For example, a trucker can have all the diesel fuel he needs but a teenager hoping for a weekend cruise in her parents’ yacht is left high and dry. This is the best outcome, because the truck is carrying tons of valuable products to customers who want to pay for them. Delivering products is a higher use of fuel than amusing a teenager.

If the government dictates a 25-cent cap on the diesel price, then that bored girl can afford to tank up. She’ll be happily at sea, for a while. Then trucks will stop rolling for lack of diesel—perhaps even those delivering fuel. Then it gets worse. No new fuel will be ordered to replace what’s consumed, because gas stations cannot operate at a loss. That’s when the shortage begins in earnest. Venezuela is now in this stage, its people suffering from a lack of everything from medicine to toilet paper.

It’s important to understand that there is nothing intrinsically wrong with yachting. However, if a teenager can’t afford diesel fuel at the market price, then she should not be burning it. What’s bad is to force an uneconomic use of resources, which is what price controls do. The diesel price cap enables her weekend cruise at the expense of someone else, the diesel retailer. She’s literally burning his capital.

Fortunately, the government doesn’t try to cap fuel today. Unfortunately, it caps the interest rate instead. The interest rate is the price of credit, the cost of borrowing money. Artificially low interest enables uneconomic uses of credit. This uneconomic use create volatlity and bubbles in home and stock prices. But the rich are able to exit the bubbles early enough while ordinary people often remain with the losses. But not only there….

A recent example occurred in shale oil producers. A brief look at Energy XXI illustrates the problem. About a year ago, when oil was over $100, the company borrowed half a billion dollars. Moodys rated its bond b3, which is at the bottom of the category described as “high credit risk,” and one step above the one labelled “poor quality.” Energy XXI paid 7.5 percent interest. That’s not enough to compensate investors for the risk of default, much less provide an acceptable rate of return to lock up cash for seven years.

Many oil producers shouldn’t have been given credit. They couldn’t afford it, until the Fed pushed the rate of interest down. Like our young wannabe yachter, price suppression enabled oil companies to consume someone else’s capital. Now that the oil price has dropped 47 percent, from around $107 to $57, the defaults will begin. The destruction will be obvious, especially to the buyers of these bonds.

No one wants to be left out in the cold, but not every desire to consume resources can be satisfied. The function of the price system is to sort activities that produce wealth from those that destroy it. Government-imposed distortion only enables resource consumption that would otherwise not be possible. This harms the owner of the capital that’s destroyed.

It also harms the rest of us. That squandered capital is not available to finance a cancer cure, self-driving car, or anything else which benefits millions of people.

Keith Weiner is president of the Gold Standard Institute USA in Phoenix, Arizona, and CEO of the precious metals fund manager Monetary Metals. He created DiamondWare, a technology company that he sold to Nortel Networks in 2008. He has his PhD from the New Austrian School of Economics. He lives with his wife near Phoenix, Arizona. In March 2015 he moved his Gold Standard column from Forbes to SNBCHF.com.
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