Global Agenda: <i>ZIRP</i>

Never heard of it? Well, get used to the slightly unpleasant sound of this acronym: Zero interest-rate policy.

By PINCHAS LANDAU
Never heard of it? Well, get used to the slightly unpleasant sound of this acronym, because there is every likelihood that you will hear it ad nauseam over the next year or more. Worse, if you are retired and trying to live off the income deriving from your investments, it could inflict serious damage on you. But not knowing about it, or ignoring it, certainly won't help - so you might as well get to grips with it now. ZIRP is zero interest-rate policy. It's the state of affairs reached when central banks, in their efforts to cut interest rates so as to stimulate economic activity in their countries run into the brick wall that ultimately ends their rate-cutting: the simple mathematical fact that nominal interest rates cannot be negative, they must be at least zero. Negative interest rates would require people to be stupid enough to lend their money to someone on the basis that they will get back less than they gave. True, there was an extreme situation in which banks "offered" negative rates, in Switzerland in the late 1970s, when foreign investors were so keen to put their money in Swiss francs and hold it in Swiss banks that the Swiss central bank forced the banks to charge depositors for holding their money instead of paying them interest on it. But that was abnormal and virtually unique. Even zero interest rates are considered an extreme state of affairs. In fact they were virtually unknown as an ongoing phenomenon until the 1990s. But the collapse of the Japanese real-estate and stock-exchange bubble in 1990 led to a prolonged slump, which the Bank of Japan addressed by cutting interest rates - and cutting and cutting until they got to zero. None of that helped and the Japanese remained mired in deflation - a situation in which the general price level continues to fall, so that holding cash is preferable to buying goods - for many years. Intuitively, zero interest rates sound like an idyllic situation: money costs nothing. But that doesn't make it free, because the people who have it (the banks) don't want to give anybody else any of it; they get such little interest, it doesn't compensate them for the credit risk (that the borrower might go bust). The borrowers, for their part, also don't want the money, because they don't want to buy or invest today, since in a deflationary economy the price of everything will be cheaper tomorrow. So intuition doesn't help much in a deflationary situation; it's a looking-glass world and everything is the opposite of what we have learned to think of as "normal." It's also worth noting that most professional economists consider deflation to be a much worse disease than inflation - and much more difficult to cure. In a deflationary and ZIRP environment, borrowers with loans from normal times, carrying interest of 4 percent, 6% or whatever, have a very hard time, because deflation means that in real terms, the value of their loans is increasing all the time (the mirror image of inflation). But depositors and savers also have a miserable time, because their money earns no income - so if they were planning to live off the income from their capital, that becomes impossible. Unfortunately, this state of affairs is no longer an interesting curiosity relating to Japan. This is happening now, in the US, where the official short-term interest rate of the Federal Reserve is officially 1%. But "Fed funds" have been trading in the market at an effective rate of about 0.3% for several weeks, without the Fed doing anything about it. The official rate will be cut to 0.75% and 0.5% soon, and then the effective rate will probably fall further, but it's already so near to zero it makes no difference. Interest rates on the euro will also be cut sharply over the next few months, to between 1% and 2%, according to many analysts. The same will happen in the UK and Canada, so that during 2009 most of the developed world will move toward, or arrive at, the unpleasant state of ZIRP. Since the severe recession now getting underway is likely to last for some time, and the recovery from it is likely to be slow and hesitant, the ZIRP could drag on for a couple of years or more, forcing people to live off their capital in the absence of interest deriving from it. That's a grim prospect. But if the scenario of deep recession and deflation proves correct, it's likely to become and remain a reality, so it's best to start thinking about it and preparing for it now. landaup@netvision.net.il