Zero Interest Rates, the Cruelest Tax of All

The zero-interest-rate policy of the Fed is sold to the public as a benign economic rescue in the public interest. The stark reality is that this policy is a disguised tax implemented by the Fed. It takes income from savers and hands it as a subsidy to borrowers. It also facilitates and funds the fiscal deficit policies of central government. Such a well disguised tax is a boon for governments. The cruelest tax of all is this 100 percent tax on interest income, disguised and rationalized as "good" policy.

The zero-interest-rate policy deserves closer scrutiny. Would a saver willingly agree to an economic environment of zero interest rates? Certainly not. Would a debtor prefer a zero interest rate? Absolutely. The saver and the debtor would, under normal, willing-economic-participant conditions, negotiate a "price" for the use of money saved. That price for the use of funds is interest.

The central bank enters the negotiation between saver and borrower, and by counterfeiting money it destroys the negotiating base of the saver. Counterfeiting money through policies of unlimited liquidity provision is a "price control" over interest rates, instituted to force interest rates down and eventually spiral them downwards out of control to zero. The interest income of the saver is eventually taxed to extinction at zero interest rates.

It is basic economic theory that price control actually reduces the availability of the item subject to the control. It should therefore come as no surprise that available credit is falling despite unrestrained liquidity provision at zero interest rates. Banks have no direct cost implication when they hold funds at zero (apart from opportunity cost). Thus there is no direct cost penalty for doing nothing.

Not exploiting a lending opportunity in a high default-risk environment, where the margin between a zero-interest cost of funds and the lending rate is insufficient to protect bankers against default risk, is an entirely rational choice for bankers. While the intended consequence is to increase the availability of credit, the ultimate "zero-rate" intervention actually reduces credit availability. One wonders how significant this unintended consequence would be in the absence of Cash for Clunkers, the now-expanded subsidy policy for housing purchases, and the constant Fed, Treasury and Federal Housing Finance Agency support for Freddie Mac and Fannie Mae. We shall find out when fiscal deficits can no longer fund such excesses.

Savings will migrate to term assets for meager interest income but that income has more to do with a term premium than with interest, the cost for the use of funds. The stated policy is to start the yield curve at zero and to use all the influence and tools of the Fed to apply downward force on the slope of the yield curve. No one has any moral standing to defend any policy that dispossesses the interest of the saver; however, the indiscriminate redistribution of this interest tax is exceptionally unjust.

"The central bank enters the negotiation between saver and borrower, and by counterfeiting money it destroys the negotiating base of the saver."

The normal standards for a tax are that it must be fair and it must be evenly distributed. The "for the public good" argument is that tax may be levied disproportionately usually with reference to some wealth measure. In simple terms, the rich must pay more and the poor must pay less.

The tax of a zero-interest-rate policy fails dismally when it is tested against this framework. There is no discrimination in taxing savers' interest. All savers are taxed by a zero interest rate. Some savers, usually the wealthier and more sophisticated savers, can institute countertax measures and are able to avoid or escape the zero-interest-rate tax to some extent. Most savers can't, and they fund the redistribution and subsidies to the borrowers.

Indiscriminate principles are applied in allocating the interest subsidy. Its distribution is not monitored fairly and equitably in the interest of society. The recipients are random borrowers, selected with no reference to the wealth, income, or other discerning standards that would normally apply. It is appropriate to ask by what standards society decides that a homeowner who bought a property priced beyond his means must be subsidized by a pensioner who had saved to survive the income drought of old age? Why must a big bank have access to zero or near-zero cost of funds to carry all those losses making loans while an ordinary saver can no longer afford his child's tuition?

The zero-interest-rate tax strips the interest income from savers and hands it to government, and morally justifies this as stimulating the economy through deficit funding. The justification is that it is of no use to run up huge deficits if it involves paying a high interest rate. Strip the interest and hand it indiscriminately to over-extended borrowers, many of whom used the borrowings to speculate on asset inflations. Strip the interest and hand it to the banks to "repair" their balance sheets and to "carry" the bad debts. Strip the interest and hand it to the developers who overinvested in property, capacity, or trading. Strip the saver of interest to fund the carrying of compounding, unliquidated losses.

How totally one-sided! Rip off the savers and give to the borrowers. Not even the socialist dictate that everybody should contribute according to ability and receive according to need can contain the injustice of a zero-interest-rate-policy tax. Surely nobody can have a zero need and a 100 percent obligation to contribute. Neither can anyone claim 100 percent contribution from savers against a zero contribution from borrowers (the bank margin excluded).

It is not fair, moral, or just for central banks in their quest for self-preservation to strip savers of their income. The phrase, "interest rates will remain at zero for longer" simply means the imposition of hardship on the saver for longer. Placing the weight of the interest-tax burden on a small and responsible portion of society is self-serving behavior by central bankers who have the encouragement, support, and consent of central government.

Robbing the saver is immoral. The indiscriminate redistribution of income rights from the responsible and the cautious to overburdened borrowers, speculators, government, and risk-seeking banks serves not the short- or long-term interests of economic society. Rationalizing this mean policy and indiscriminately cruel tax into a benign and caring action by central banks is certainly folly.

Sarel Oberholster is a South African living in Johannesburg, Gauteng province. He is an economist by training, a specialist financial engineer by craft, and an inquisitive spirit by nature. He has been involved in banking for over 30 years. His quest for understanding complex economic phenomena is his muse for writing and he shares his insights on his blog. Send him mail. See Sarel Oberholster's article archives. Comment on the blog.

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Comments

Ned S

26 Nov 09, 20:50 It isn't "nice" is it?

I agree - But what to do? And the other point is that the system is based on leveraged debt - So for every 100 dollar in deposits, the banks lend maybe 10 times that. As such, dropping the interest rate by 1% deprives the chap who saved $100 of $1 in income - But relieves the 10 borrowers of $100 the burden of having to pay back $1 in interest. That's maybe going to be about 10 times more popular in a debt riddled democracy than the alternative? And it's a good deal for governments in that while the worst case scenario is they lose the tax on the $1 income the saver might have spent, they gain the tax on all the extra dollars the 10 debtors probably spend because they are feeling collectively richer by $10. The fact that is how it works should be taught in schools I guess. But then we'd have no savers and the government needs the savers to keep the whole system ticking along. So they aren't going to tell people their game - The exact opposite in fact - Where they usually have their central banks pretend to be inflation hawks - Just one's that are never actually successful. Smile! So yes, saving is for suckers - If the GFC has taught savers that they'll be sacrificed mercilessly to support their debt ridden fellows then they definitely have not been paying attention. It doesn't help to whinge though - They trick is to understand how the game works then you at least have a chance of positioning yourself on the winning side. (Unless you are can't get credit for some reason.) At least that's my layman type take on it.

Meremortal

28 Nov 09, 02:07 FED-SPEAK

It doesn't matter, the FED and politicains are just delaying the inevitable, just as they have for years. They could raise short term rates to 1%. Savers would get squat, and the interest payments on the federal deficit would increase by $600 billion. Gee, that doesn't sound very good either. That's what you get when you kick the can far enough down the road rather than allow the markets to adjust on their own. FED-SPEAK (between the lines): "We will put off the collapse by creating years of grinding, slow deflation. That will give most of us time to leave town before things get really bad."

