This seasoned journalist earned his MBA from the University of Chicago Booth School of Business. So I was delighted to learn that Douglas Diamond, one of his eminent professors, has just shared the Nobel Prize in Economics with former Fed Chairman Ben Bernanke and frequent Diamond collaborator Philip Dybvig of Washington University in St. Louis. I have sadly missed having Diamond as my teacher since I graduated in 1973, six years before he joined the faculty. But during my years in Chicago, the university was teeming with future Nobel laureates in economics, and I saw many of them, mostly at the faculty tennis club.
A diminutive Milton Friedman double-teamed with the hulking George Stigler, who insisted on parking the tall Monetarist in the driveway while wielding his own wingspan to cover most of the ground. In the spring, I played almost daily with 2013 winner Eugene Fama, pioneer of efficient market theory, who displayed a singular style, serving right-handed and hitting left-handed groundstrokes, most of those latter lobs seeming magnetized at the baseline. Fama swung an early rickety metal racquet called the T2000 that made his misses sound like minor car crashes.
Since Diamond is a specialist in banking economics, I wanted to get his perspective on what the surge in inflation and the Fed’s hawkish stance in rapidly raising rates and rolling out quantitative tightening (QT) mean for businesses and individual borrowers, and the lenders themselves. On October 11, we spoke at length over the phone. Diamond was quick to note that his expertise was not in “macro” issues like Fed policy, interest rates, causes and solutions to inflation, but rather how the banking system works and how to ensure its stability.
Still, he added that central bank decisions have a huge impact on the lending ecosystem. And he expressed strong opinions on what he sees as the Fed’s recent big mistakes in promoting easy money, and the potential dangers of tightening too quickly in its quest to tame the raging CPI. . “One of the Fed’s purposes is to promote financial stability,” he told me. “But when the Fed changes real and nominal rates, it has a ripple effect on financial institutions and their borrowers that best not be ignored. The Fed has left rates too low for too long with no trickle down. Now they have to release the brakes. But if they slam on the brakes, they will cause an accident.
The research that won Diamond the Nobel Prize
Diamond won the prize for his research on the role of banks in society and how the model that makes these essential institutions so valuable also makes them vulnerable, demanding that governments and their own internal practices assure the public that the system is extremely safe. Banks take deposits from customers and channel that money into often long-term loans for everything from new factories to mortgages. As Diamond showed in an article with Dybvig, this process is much more efficient than the scenario in a non-banking world where people invest directly in projects that take years to complete. Why? Because whenever people need money in the short term, they withdraw funds from that investment and stop the factory or the housing development.
Banks solve this problem by keeping plenty of funds in reserve so that their depositors can withdraw cash at will for day-to-day needs, and by transferring their money to finance multi-year investments that stimulate growth. But the system, Diamond said, only works if people are confident it will continue to work. He is inherently vulnerable to rumors and frenzies. Because so much of all deposits are tied up in loans that don’t mature for years, banks can’t return most customer deposits, so they panic and demand payment right away. If word spreads that banks might fail, depositors will rush to withdraw their money, causing a collapse when the institutions were truly solvent.
Diamond emphasized the importance of government-backed deposit insurance that guarantees the security of depositors’ money and significantly reduces the innate fragility of banks. He also found that by diversifying their loan portfolios, banks increased security and reduced the costs of turning savings into productive investment. His models showed that by monitoring that their borrowers are using loans responsibly (for example, how lenders check the progress of property developments and advance more money for the next phase only when the previous one is successfully completed) , banks have served as watchdogs preventing fraud and waste. As the National Bureau of Economic Research stated after the Nobel Prize announcement, the “ideas of Diamond and Dybvig form the basis of modern banking regulation.”
Borrowers mistakenly thought the Fed-orchestrated low-rate world was the new normal
Diamond observes that a combination of questionable monetary and fiscal policy kept rates artificially low for an extended period that was to end, perhaps in heartbreak. “Government policymakers thought they could create as much debt as they wanted without causing inflation or driving up rates,” he told me. “Some stupid economists have been pushing the same crazy idea known as ‘modern monetary theory.’ He says that when real interest “rates” [rates adjusted for inflation] suck, you can borrow anything you want for a long time. The Fed created money to buy bonds issued by the Treasury, and all the easy money kept rates at zero. He says setting rates too low and running large deficits are both inflationary separately and in combination send prices skyrocketing on steroids. “If policymakers think real rates will stay at zero, they will do things to push them out of zero. High deficits and zero rates guarantee inflation will eventually rise,” Diamond says. Then the Fed will be forced to raise rates significantly to fight the inevitable outbreak, exactly what we are seeing today.
Rapid increases in the federal funds rate which, in turn, drive up yields on everything from two-year Treasuries to junk bonds, will hit our financial system with an unusually strong shock. “We went through a huge period from 2011 where rates were extremely low,” he says. “Zero real rates, putting the cost of borrowing at or below inflation, were hugely stimulative for borrowing. People thought the era of super low rates was going to continue. This brought borrowers to believe that it is very safe to finance itself by renewing short-term debt, always at the same rates.Why buy “insurance” on a sharp rise in rates that will never happen?In the past, companies protected themselves usually against spikes by locking in rates for a long time.This time the thought was, if you don’t think they will go up, stick with cheap short-term rates.
The rate jump that blind borrowers, Diamond says, will hammer them with unforeseen losses. “Government interest expense will increase, but the Treasury can continue to issue new bonds to cover the increase,” he says. “It is the private sector that is vulnerable. The high-yield and leveraged debt that has exploded over the past few years is mostly floating above Libor, and when current rates rise, interest charges for borrowers rise, and do so suddenly. As a result, many companies will face much higher interest charges that will erode profits, both on this variable debt and on other short-term borrowings that they considered such a big and long-lasting business. .
What about the institutions that provided the loans? The risk is different for big banks that fund loans through deposits than for their customers, Diamond says. “The big banks are well protected against interest rate changes,” he says. “The problem is that once rates rise quickly, some of their borrowers can’t repay the loans and default, forcing the banks to put the loans on their books.” He is particularly concerned about the likes of hedge funds, mortgage companies and other non-bank lenders who sell securities in capital markets to fund their loans. “This could cause problems not only for corporate borrowers and large banks, but also for non-bank institutions that have followed a similar path.”
The Fed may overtighten
Given the situation it created, Diamond says, the Fed had no choice but to raise rates dramatically. “The Fed has been doing a lot better lately,” he says. “They can keep raising rates, that will be the right thing to do.” But he raises a warning from Milton Friedman. “I worship Milton Friedman,” Diamond says. “He had a famous quote along the lines of ‘Fed policy has long and variable lags’.” real estate loans. Diamond believes that to defeat inflation, the Fed must achieve a significant “real” margin on the Fed Funds rate and on all maturities of government bonds. “If the ‘neutral’ real rate that achieves the Fed’s long-term inflation target of 2% is 1%, we need a higher real rate now to rein in inflation,” a- he declared. “It would take a real rate of at least 2% or even 3%.”
Currently, “core” inflation according to the Fed’s preferred measure, the Personal Consumption Expenditure Price Index (PECPI), stands at 4.9% in August. Reaching the 2% real rate that Diamond considers essential, and a minimum, would bring the Fed Funds benchmark close to 7%. That’s more than double the current reading of 3% to 3.25%. No wonder Diamond is so worried that any rate hike it deems necessary could do great harm to borrowers and the economy.
To prevent a collapse, he advises the Fed to act slowly and carefully. “The Fed needs to raise rates in a measured way over a long period of time because of the lag that Friedman was talking about,” Diamond says. “That’s how all those people who haven’t hedged and have taken on all the short-term, floating-rate debt can handle the shock.” He is also concerned about the unpredictable effects of QT. “It takes out cash and raises long-term rates relative to short-term rates,” he says. “If the Fed goes too fast on QT, it will cause all kinds of problems. A warning sign is that when they stopped quantitative easing in Britain, it almost triggered a crisis.
In conclusion, Diamond offers its own version of Warren Buffett’s famous line, joking that when the tide goes out, you can see who’s swimming naked. “It’s one of my favorites,” says Diamond. “The water has been so high for so long that people haven’t even put on a bathing suit. A lot of embarrassing things are about to happen. The Fed who blundered by filling the pond to such heights is the naked swimmer who should be most embarrassed of all.