By flooring maturities out to two years then, and perhaps longer as a result of maturity extension policies envisioned in a forthcoming operation twist later this month, the Fed may in effect lower the cost of capital, but destroy leverage and credit creation in the process. The further out the Fed moves the zero bound towards a system wide average maturity of seven to eight years the more credit destruction occurs, to a US financial system that includes thousands of billions of dollars of repo and short-term financed-based lending that has provided the basis for financial institution prosperity.
I am surprised we don’t hear this claim more often. When it comes to expansionary fiscal policy, this kind of critique is common, namely that substitution of public debt for private debt makes subsequent “withdrawal” quite difficult. To get to Gross’s point, add on another step or two to the argument. Monetary policy and fiscal policy these days have melded. We pay interest on reserves. We have created a lot more safe securities through bank reserves, but ultimately as a substitute for private intermediation through M3. Through monetary policy, we are trying to expand but at the same time pushing out M3 and getting more bank reserves at the Fed, etc.
The problem with this argument, if interpreted as a critique, is that a superior alternative is hard to outline. It also places too much stress on the term structure rather than the absence of creditworthy borrowers. And besides, who wants extreme deflation? Still, this argument scares me. It illustrates how vulnerable our current position is and it illustrates that we have not solved the fundamental problems which became apparent in 2008-2009.
There is a lot of snorting at people who favor higher interest rates from the Fed. I do not agree with that recommendation, but Gross’s comment gives us some ability to understand it as a recommendation. Think of it as a combined exercise of plug-pulling and collapse of deflationary risk into the present, in the hope that private credit will emerge from the rubble as a source of future economic growth.