I find it really depressing that I have to write this. But it seems I have to write it.

Substantially all of the TARP funds advanced to banks have been paid back, with interest and sometimes even with a profit from sales of warrants. Most of the (much larger) extraordinary liquidity facilities advanced by the Fed have also been wound down without credit losses. So there really was no bailout, right? The banks took loans and paid them back.

Bullshit.

Suppose you buy fire insurance from Inflammable Insurance. You pay $1000 for a year of insurance. There is no fire, so you make no claim. Next year, you find a different provider offering a better price, and you switch.

Soon after your relationship has ended, you discover that Inflammable failed to pay any claims at all during the year you were insured, because all customer premiums were diverted to the Cayman Islands and then spent on kiddy porn and Pez. Were you defrauded? Do you have any cause for complaint? After all, ex post your cash flows turned out to be the same as if you had been dealt with fairly.

Of course you have been defrauded. You did not get what you had paid for. You had paid for Inflammable to bear risk on your behalf. It did not do so. The money you paid was simply stolen.

In financial markets, risk-bearing is the ultimate commodity. It is what financial market participants buy and sell. As a financial speculator, I spend exorbitant amounts of money buying out-of-the-money options to limit my downside risk. The vast majority of those options expire worthless, just like the vast majority of fire insurance policies end with no claims paid. If only someone would give me all those options for free, or sell them to me for half the market price, or reimburse the cost of the options that I never end up using, I would be rich. Seriously, given the years I’ve been in this game, I’d be pretty set if I had my option premiums back. It doesn’t seem fair at all that I am confined to a modest middle-class life because I had to buy all this insurance I never used.

Cash is not king in financial markets. Risk is. The government bailed out major banks by assuming the downside risk of major banks when those risks were very large, for minimal compensation. In particular, the government 1) offered regulatory forbearance and tolerated generous valuations; 2) lent to financial institutions at or near risk-free interest rates against sketchy collateral (directly or via guarantee); 3) purchased preferred shares at modest dividend rates under TARP; 4) publicly certified the banks with stress tests and stated “no new Lehmans”. By these actions, the state assumed substantially all of the downside risk of the banking system. The market value of this risk-assumption by the government was more than the entire value of the major banks to their “private shareholders”. On commercial terms, the government paid for and ought to have owned several large banks lock, stock, and barrel. Instead, officials carefully engineered deals to avoid ownership and control.

But still. Everything worked out, right? It turns out that banks didn’t need to use the government’s giant insurance policy. It was just a panic after all!

Bullshit.

Suppose my kid’s meth habit got the best of him. He needs to come up with $100K quick or his dealer’s gonna whack him. But he’s a good kid, really! Coulda happened to anyone. So I “lend” him the money, even though he has no visible means of support and the sketchiest loan sharks in town wouldn’t give him the time of day. Now I believe in bootstraps and hard work, individualism and self-reliance. So I tell my son. “Son, you are going to pay me back every penny of that loan. You are going to work it off. I have arranged with one of my golf buddies, a guy who owes me a favor or three, a job that pays $200K a year. You’d better show up every day at 9 a.m. and sit behind that desk, and get me back my money!” And he does! After a year, he’s made me whole. What a good kid.

No bail out, right? He paid me back every penny! Worked it off!

Bullshit. The opportunity I provided him, the $200K job that he would not have received without my intercession, was a huge grant. On the open market, if I were to accept bribes from the highest bidder to wangle the job from my friend, that opportunity would be worth more than the $100K advanced. I paid my son’s loan with my own money. I just obscured the cash flows, so my son and I can pretend and sustain our mutual self-regard and our righteous disdain for the moochers and the hippies and the riff-raff.

After assuming the banking system’s downside risk, the US government engineered a wide variety of favorable circumstances that helped banks “earn” their way back to quasi-health. The government provided famous and obvious transfers like unwinding AIG swaps at 100¢ on the dollar. It forced short-term yields to zero and created an environment in which medium-term interest rates would be capped for several years, granting banks a near-risk-free arbitrage for a while. It emitted trillions in excess reserves on which it continues to pay interest. It forewent investigations and prosecutions that by law it should actively pursue, and settled what enforcement it could not avoid for token fees. Then there are the things conspiracy theorists and cranks like me suspect but cannot prove: that the government and the Fed have been less than aggressive in minimizing their costs when they or entities they control (AIG, Fannie, Freddie) transact with large banks, that they have left money on the table where doing so could be hidden in arcane accounts or justified as ordinary transaction expenses and trading losses. Large banks have enjoyed some rather extraordinary results for allegedly efficient markets, quarters with large trading profits and no or very few losing days. Government housing policy is pretty overtly subject to a constraint that interventions must not provoke loss realizations for banks carrying bad loans at inflated values, or interfere with servicing revenues. (If you think I am overconspiratorial, I’m still waiting for an innocent explanation of this, from 1991.)

Pulling back from a shell game whose details are, by design, labyrinthine, check out the big picture. Since the beginning of the 3rd quarter of 2008 (Lehman quarter), US debt held by the public increased by 84%, from $5.28T to $9.75T (as of the end of Q2 2011). Depending on where you start, the growth rate of publicly held US debt prior to Q3 2008 had been ~8% per year (starting in 1970 or 1980) or ~4.5% (starting in 1990 or 2000). The growth rate since Q3-2008 has been 22.6% per year. The United States has issued between $3T and $4T more debt than would have been predicted by any reasonable estimate prior to the financial crisis. So far.

Hyman Minsky famously described crisis stabilization as a two-step process: First, the state/central-bank steps in as lender of last resort to halt the panic. Then the state must underwrite a program of massive deficit spending in order to “validate” — Minsky’s word — the fragile capital structures and the “innovative” business practices that proliferate during periods of tranquility.

Translating into current buzzwords, when the trouble begins there is a solvency crisis. It is converted into a liquidity crisis ex post by a firehose of net spending by the state. The current crisis has followed Minsky’s script perfectly. Banks’ ability to “pay back” bailouts has depended upon continued regulatory forbearance, tacit expectations of support if shit hits the fan again, and massive government debt issuance which resuscitated assets that would otherwise be worthless.

But who has lost anything from the bailouts? Wasn’t it a win-win? This all sounds very abstract. Where are the transfers?

If the government borrowed or printed a trillion dollars and gave the money to me, would there be any losers? If you don’t think there has been a wealth transfer, if you don’t think ordinary people have lost, please call your Congressperson and ask her to cut me a trillion dollar check. In some abstract sense, this policy of giving me money would push government debt higher. But that is so very vague a cost! I promise I’d do great things with a trillion dollars. My ideas are so much cooler than Goldman Sachs’, despite all the wholesome commercials they are running.

During the run-up to the financial crisis, bank managers, shareholders, and creditors paid themselves hundreds of billions of dollars in dividends, buybacks, bonuses and interest. Had the state intervened less generously, a substantial fraction of those payouts might have been recovered (albeit from different cohorts of stakeholders, as many recipients of past payouts had already taken their money and ran). The market cap of the 19 TARP banks that received more than a billion dollars each in assistance is about 550B dollars today (even after several of those banks’ share prices have collapsed over fears of Eurocontagion). The uninsured debt of those banks is and was a large multiple of their market caps. Had the government resolved the weakest of the banks, writing off equity and haircutting creditors, had it insisted on retaining upside commensurate with the fraction of risk it was bearing on behalf of stronger banks, the taxpayer savings would have run from hundreds of billions to a trillion dollars. We can get into all kinds of arguments over what would have been practical and legal. Regardless of whether the government could or could not have abstained from making the transfers that it made, it did make huge transfers. Bank stakeholders retain hundreds of billions of dollars against taxpayer losses of the same, relative to any scenario in which the government received remotely adequate compensation first for the risk it assumed, and then for quietly moving Heaven and Earth to obscure and (partially) neutralize that risk.

The banks were bailed out. Big time.

Oddly, the toy model in the appendix of my previous post got a bit of attention. Megan McArdle is unimpressed. In the model, I posit a world in which abundant labor and scarce land yield an unstorable crop in great quantity. But because labor is so abundant (and so the marginal labor unproductive), wages are low and a vast surplus accrues to the landowners, far more than they can possibly consume. I posited that in this economy, the interest rate would be -100%. Laborers would be eager to “borrow” but would have no way to repay. Land owners would lose nothing to “lend”.

McArdle takes issue with this: “[A]t the limits of land scarcity and labor abundance..land-owners receive approximately all the bread and laborers receive approximately none of it.” She asks why laborers don’t die, but then answers her own question, and poses one for me.

[I]t’s a simplifying model. But…[o]nce you add in complications — the workers do need to eat, which means positive earnings — then it’s not clear you’re still in a model where persistent negative interest rates are possible. Once I am appropriating some subsistence amount of my marginal product, then, well, I can skip dinner today in order to enjoy two dinners tomorrow. Interest rates are positive.

She’s not entirely wrong and not entirely right here. Picking a nit, paying subsistence is not sufficient to generate an inter-worker lending market. You also have to sprinkle in some uncertainty or heterogeneity of circumstance. Identical laborers with identical wages never borrow or lend to one another. That’s a stupid point to a reader, since any realistic world has plenty of heterogeneity and uncertainty. But it’s a crucial point for the model writer, because, in the kind of models I tend to think about, the structure of uncertainties drives the results.

So, let’s posit idiosyncratic shocks to circumstance among our laborers. Then, as McArdle suggests, an inter-worker lending market with positive interest rates might arise. Or it might not. As I’ve sketched the model, land owners are indifferent between i) mocking the peasants’ hunger while bread rots; ii) “giv[ing] their excess bread to charity in return for a nice smile and tip of the hat” (Nick Rowe); or iii) participating in a lending market. If land owners don’t lend, McArdle is right — laborers face positive interest rates. If land owners do lend, we need to know more about laborers’ preferences and circumstances, but the market clearing interest rate might well remain negative -100% because the land owners will have flooded the market with bread. Loan demand will tell the tale:

So, even if the laborers have wages and can lend to one another, it’s perfectly possible for a wall of hot money from the rich to drive interest rates negative. Yay me.

(The shape of the supply curve is exaggerated, but I could use this diagram to summarize my view of the last decade. Pre-crisis, financial alchemists kept us on the high loan demand equilibrium. Post-crisis, effective loan demand has fallen, as people less likely to repay have been rationed out of the market. The result is a new equilibrium at a negative rate.)

My toy model is unsatisfying so long as we don’t understand why, as Nick Rowe wonders, the rich don’t simply give their surplus bread away. Rowe overprojects his own goodwill when he suggests the smiles of peasants would engender certain charity. But we’ve no reason to privilege sadistic withholding or ritualized lending either. Suppose the usual selfish homo economicus. Under what circumstances would the land owners be driven to lend of their own self-interest? It is not enough, as it would be among the peasants, to posit idiosyncratic, symmetric shocks for landlords that leave them sometimes hungry. That would lead to some kind of mutual insurance between lenders — I’ll give you my surplus this period if you give me yours when I have a drought. In order to drive lending to laborers, we need there to be some state of the world in which laborers as a group would have some wealth when landowners are short. If there is even a small probability of such a state, even if both the probability of that state and the expected recovery on loans is small, land owners will lend at negative formal rates rather than give charitably or horde sadistically.

In theory, it is enough to posit kitchen gardens among the peasants whose three-radish harvests are independent of land-owner droughts. That would break the indifference and tip the scale to lending. But it feels like a cheap modeling trick. What kind of shocks could make land owners really prefer lending at an expected loss over other uses?

An obvious possibility is political risk, or in extremis revolution. Suppose there is mobility between peasants and landowners, so that they must sometimes trade places (the king elevates a peasant to a lord, and demotes the old lord to a peasant). If loan contracts might survive the demotions, so that a new lord would honor a debt to his predecessor, that would be a strong reason for land owners to prefer lending over charity or waste, even if the lending rates are negative and the likelihood of demotion is small.

In the modern real world, we don’t have kings and nobles, but we do have billionaires who face some risk of expropriation. After their expected consumption needs are seen to, it is perfectly rational for these investors to accept sharply negative rates on loans whose repayment would resist such misfortune. Unfortunately, billionaires’ recovery of loans to their own nations’ poor might be negatively correlated with revolution. So they should prefer to supply loans externally rather than domestically, even at low or negative interest rates. The increased likelihood of surviving a revolution would offset the cost of any price concession.

This model would predict a positive correlation between within-country inequality and gross capital outflows. If nations are homogeneously unequal and unstable, there might be symmetrical diversification and little net imbalance of flows. But if some nations less unequal or are viewed as unusually reliable loan destinations, they’d experience net inflows. Price-insensitive capital flows would engender trade deficits, as risk-averse foreign elites accept low returns from safe countries despite much better returns elsewhere on a conventionally risk-adjusted basis. To very wealthy investors, the correlation structure of tail risk would be the primary driver of investment behavior, far outweighing questions of price.

Paul Krugman argues that if there’s a savings glut exerting a downward pull on US real interest rates, it must be driven by foreign saving rather than domestic inequality, as net saving by US households was on a secular decline prior to the current crisis. I’d need more evidence, because, as Kevin Drum points out, low net household saving could include accelerating saving by the very wealthy masked by debt-financed consumption of the less affluent. Domestic inequality may yet be an important part of the story. But I agree with Krugman that price insensitive foreign capital has been the clearest source of interest rate gravity. The secular decline in US real interest rates since the 1980s has been matched by a secular deterioration in the US balance of payments. Ben Bernanke’s famous 2005 speech on a “global savings glut” was all about foreign capital inflows. As a long-time Brad Setser groupie, I would never downplay the scale or role of financial imbalance in reshaping the world economy.

But financial imbalance is at least in part an inequality story, and may be only the tip of an iceberg of gross cross-border capital flows from sources willing to pay for insurance or other goods rather than seek return in units of consumption. The supply of capital, like any other good, reflects the opportunity cost of its providers. The quantities we observe are effects more than causes. For a Chinese government purchasing development and domestic stability, or a Saudi prince exchanging appreciating oil for depreciating London bank deposits, or an American oligarch overpaying for apartments in far flung countries, the opportunity cost of capital has little to do with units of CPI foregone. As the marginal supplier of capital, domestically and internationally, comes to look less like an individual balancing present vs future consumption and more like a billionaire or a state, models of capital allocation that focus on investors seeking “real return” fade into irrelevance.

I don’t think we have any sense of how a “market economy” behaves under this form of capital allocation. Unfortunately, I think we are a long way down the road towards finding out. Even wealth allegedly invested on behalf of modest savers is increasingly centralized and managed by agents whose choices are dominated by professional trends, regulatory safe harbors, and front-loaded asymmetric payouts. It’s a brave new world, unless we find some way to restore investment decisionmaking to people whose trade-offs of current for uncertain future wealth more closely resemble those faced by ordinary, nonsatiated consumers.

David Andolfatto points out that US five-year real interest rates are now negative. Nick Rowe discusses the possibility that the so-called “natural” real interest rate could be negative, referring us to Frances Woolley’s discussion of the drag demographics might exert on real returns. (I’ll respond to Rowe and Woolley specifically in a little appendix to this post, but I want to start more generally.)

When we observe negative real rates, they are often attributed to something abnormal. Perhaps it is “depression economics” which has driven interest rates underground, or, as Andolfatto rather charitably considers, a misguided tax and regulatory regime.

I think this aberrationist view is quite wrong. I don’t think you can make sense of the last decade without understanding that the so-called real interest rate has been trying to fall through zero for years. Only tireless innovation by the men and women of Wall Street prevented negative rates long before the traumas of 2008. A deep cause of the financial crisis was a simple expectation: That lenders ought to earn a “decent” real, risk-free yield even while a variety of trends — skyrocketing incomes for the 0.1%, the professionalization of investing, leverage-induced risk aversion, China — were creating Ben Bernanke’s famous savings glut. The market response to a global savings glut ought to have been sharply negative real interest rates for low risk savers. But as a society, we resent and resist that capitalist outcome. It is well and good for markets to drive the price of undifferentiated labor asymptotically towards zero. But God forbid that “savers” not be paid for supplying a factor that turns out not to be scarce. Instead, an alphabet soup of financial innovations was conjured to transform bad lending into demand for low risk money, and thereby support its price. Now those innovations have failed, and the fact of negative real interest rates is plainly before us. But we are still, desperately, resisting it.

There is no such thing as a “natural” anything in economics. Economic behavior is human artifact and artifice. When economists call anything “natural” — the natural rate of interest, or of unemployment — you should recall Joan Robinson’s famous quip:

The purpose of studying economics is not to acquire a set of ready-made answers to economic questions, but to learn how to avoid being deceived by economists.

The word natural is always used to hide the constructed context in which an outcome occurs, to disguise human institutions as immutable facts and thereby exclude them from controversy. What was the “natural” real rate of interest in 2006? According to TIPS yields, 5-year real interest rates were about 2.5%. But those rates were observed under the institutional context of a structured finance boom which transformed a lot of loose credit into allegedly risk-free lending demand. Was that rate “artificial” then? Today those same rates are -1%. Is this “natural”?

Ultimately, the words are meaningless. The level of interest rates that prevails in the market will be the result of a mix of institutional choices and economic circumstances. For now, we are in a bit of a pickle, because if we are “conservative” — if we stick with familiar institutional arrangements — we end up with outcomes that are violently disagreeable to our cultural prejudices. In social terms, a negative real rate of interest means that prudence is a cost, not a virtue. Caution is a greater vice than spending what you have and hoping for the best. Savers must be punished for their thrift.

In a sense, this is perfectly “natural”. Current spenders assume risks of future deprivation that current savers are unwilling to accept. Why shouldn’t spenders be paid to bear that burden? Transforming present resources into future wealth is uncertain and difficult work. Savers’ expectation of a positive real interest rate amounts to a demand for time travel cheaper-than-free. Why should such unreason be accommodated? The sense of entitlement carried by savers in our society would put any welfare queen to shame.

So, are negative real rates the way to go? Should we just tell savers exactly what we tell laborers? The price of the factor you supply has fallen. This is capitalism, quit whining and deal with it!

Maybe. But maybe not. In theory, a sufficiently negative rate of interest could restore a full employment, noninflationary equilibrium. I think that’s the market monetarist solution.

But it might not work out so well. Debt is a particular and problematic institution. If savers must pay borrowers for the privilege of carrying forward wealth, it matters in the real world whom they pay and how well those people do their jobs. Borrowers can always default, even after they have contracted loans at negative interest rates. If we try to restrict lending to only very creditworthy borrowers, we’ll find that real interest rates have to fall sharply negative to induce spending by people who would otherwise be inclined to save. If we allow more liberal credit standards, we’ll observe higher notional interest rates, but only as prelude to widespread defaults. We’ve seen that movie and it isn’t entertaining.

Ideally, a special class of borrowers, entrepreneurs, would invest borrowed funds in projects precisely designed to meet savers’ future consumption requirements. But in a sufficiently unequal society, the marginal saver may have vastly more wealth than is necessary to endow her own future consumption (including proximate bequests). There may be lots of ways to turn today’s resources into “future wealth” in a general sense, but goods and services in excess of what today’s lenders will be able to consume or reinvest in future periods are worthless to the people who set the price of money. The marginal productivity of investment may remain high technologically even as its marginal productivity to existing lenders turns sharply negative. (More accurately, both the marginal present and future dollar may have no consumption value to a lender, but in a accounting terms the value of a present dollar is fixed, while the relative value of a future dollar is flexible as long as there is inflation or some other means of circumventing the nominal zero bound.) It is the marginal productivity of investment to existing lenders that sets a floor beneath market interest rates. If we posit satiable consumption and sufficient inequality, market interest rates can approach -100% even while technologically fruitful projects go unfunded, because the projects would be of benefit only to people with little to offer the marginal lender.

The horizons of the future are broad, and lenders can invest in speculative future consumption like traveling to outer space rather than throw away money on nonproductive, low risk projects. People who seem now to have little to offer potential lenders might come up with new goods and services that savers will desire in the future. But debt is not the right instrument to fund speculative outlays, most of which will not be repaid. It would be an answer to the problem of negative real interest rates, if today’s risk-averse lenders would finance an exuberance of uncertain ventures. The majority would fail, but rare successes might be more valuable to lenders than certain negative returns on risk-free loans. This would require big changes on the part of current lenders and the institutions through which their funds are channeled. Rather than regulate a risk-free interest rate or scalar cost of capital, we’d need to find ways to encourage exploration, idiosyncratic judgment calls, and equity finance. It is foolish to presume that negative real interest rates alone will inspire a golden age of speculative investing.

If we rely too heavily on negative real interest rates to spur the economic activity, my prediction is that we will see a lot of false dawns and social strife. Savers of modest means are harmed and outraged by low market interest rates and use the political system to try to raise them. Regardless of macro models or market outcomes, we have a cultural bias against negative real rates. We hold prudence dearer than profligacy. We don’t work to teach our children to spend their allowances. We work to teach them to save. More people are willing to spend incautiously than are able to husband savings carefully. If we were to cast away the norm that saving is praiseworthy and spending decadent, rather than getting contingent, market-price-regulated spending/savings behavior, we might end up with a culture incapable of saving. We want most people to face a positive real interest rate, not because that is the price that equilibrates a market, but because positive real interest rates reward behavior we wish to uphold as a virtuous.

Our current negative real interest rates are not an aberration, but a product of longstanding and continuing trends. However, since neither those trends nor the negative rates are conducive a decent and prosperous society, it is foolish to refer to them as “natural”. We need to alter the circumstances under which full-employment requires that lenders pay borrowers to spend. We need to reshape “nature” until the new natural rate is positive. We need to understand the circumstances that lead investors to accept negative real returns rather than finance new ventures. We have to think about issues like income and wealth inequality, the structure of labor markets, institutional investor incentives, financial risk-aversion and deleveraging. We need to transform existing institutions, or invent new ones.

Appendix: Persistently negative real interest rates might have many causes. Nick Rowe and Frances Woolley tell stories that are essentially technological: Suppose we can bake a lot of bread today, but no so much bread thirty years from now. But we’ll need bread thirty years from now, and bread cannot be stored. Then no matter what we do with our surplus of bread, no matter who consumes and who saves, we’ll end up with a shortfall of bread in the future. Whatever we try to save, we’ll not recover. Institutional innovation can’t help us out very much, other than to arrange an allocation future pain.

But technological incapacity is not the only possible cause of negative real interest rates, nor I think the relevant cause at the moment. Unequal distribution can drive interest rates negative as well.

Suppose that land to grow wheat is scarce but labor to farm and bake it into bread is abundant. Land-owners and laborers are paid their marginal products, which at the limits of land scarcity and labor abundance means that land-owners receive approximately all the bread and laborers receive approximately none of it. Suppose that people prefer a bite of bread now to a bite of bread later, but that in each period, no individual can eat more than twice what their share of total output would be if total output were evenly divided. Land owners at full gluttony can eat no more than a small fraction of potential output, and they cannot store the surplus. Technology and population are stable, but land owners face negative real interest rate. There are laborers who would be glad to borrow the surplus bread, but they have no capacity to repay. The real interest rate on the bread lending market would be -100%.

In this economy, if a government were to tax land owners in every period and redistribute total production by lottery, so that each individual receives a per capita share of production in expectation, but variable amounts in practice, a wheat lending market would arise in which people receiving lower-than-average shares borrow from lend to people receiving greater than average shares at a positive real interest rate determined by agents’ time preference. Technology and population remain perfectly stable, but positive real interest rates arise as a function of institutional choices.

To be clear, I don’t think that the bread economy I’ve described is a remotely useful model of our actual economy, or that stochastically equal redistribution is remotely desirable public policy. But in response to Rowe and Woolley, while it is certainly true that technological limits can force real interest rates negative, it does not follow that observed negative real interest rates reflect technological limits. Observed interest rates are a function of distributions and institutions as well as technology, and it is perfectly possible that institutional innovation could cure observed negative real rates, if in fact we want them to be cured.