Hard Knocks From Easy Money

By GEORGE MELLOAN

A Federal Reserve fully attuned to the easy money demands of the Democrats and megabanks clearly has no plan to lift interest rates from their near-zero level. The rationale is: “Why should we? The Consumer Price Index (CPI) is rising at a modest 2% annual rate. Banks are getting healthier. Why risk stalling an economic recovery and sending a nervous stock market into a spin if things are going well?”

There are several answers to this rationale. Aside from the growing doubts among serious economists that the CPI is an accurate measure of inflation, let’s examine the assumption that the Fed is financing an economic recovery. In fact, it is mostly financing a massive expansion of a federal government that’s borrowing an unprecedented $1.5 trillion annually. Easy money keeps the government’s interest cost on this pile of IOUs low. The recovery comes second, and last week’s dismal job growth indicated that it is increasingly feeble.

Super-low interest rates also ensure that the big banks, fated to be wards of the government if the new financial reform becomes law, will have generous margins between their borrowing costs and lending revenues. This will enable them to further pad their balance sheets and correct the mistakes of yesteryear.

Oh, and don’t forget Fannie Mae and Freddie Mac, those two government-sponsored mortgage giants that engineered the 2008 subprime mortgage fiasco and are now on the public dole. The Fed kept them afloat by buying over a trillion dollars of their paper. Now, part of the Treasury’s borrowing from the public covers their continuing large losses.

There’s a flip side, however. It only takes simple math to know that when interest rates are kept low, so are returns on savings and investment. To some critics of the Fed and the current Congress and administration, the easy money policy looks like a way to reward the imprudent (reckless bankers and borrowers and spendthrift politicians) at the expense of the prudent (honest earners, savers and investors.) Judging from opinion polls, that perception may go far to explain the mounting disgust among American voters over what goes on in Washington.

One of the most articulate critics has been Jeremy Grantham, chief executive of GMO, a Boston-based asset management company. In a recent speech he complained that under the Fed’s near-zero interest rate policy, low returns on savings are forcing retirees to take greater risks to try to gain a better income.

Mr. Grantham wrote in his latest quarterly newsletter, issued during the spring market rally, that Fed Chairman Ben “Bernanke is begging us to speculate, and is being mean only to conservative investors like pensioners, who cannot make a penny on their cash. Collectively, we forego hundreds of billions of potential interest, but at least we can feel noble because we are helping to restore the financial health of the banks and bankers, who under these conditions could not fail to make a fortune even if brain dead.”

The difficulty of making a penny with conventional investments is a particularly huge problem for managers of big pension funds representing millions of workers. Pension funds have traditionally allotted a small part of their portfolios to venture capital investments but kept the bulk in “safe” investments, including bonds maturing to match future payouts. But after the debacle with Fannie and Freddie mortgage-backed securities rated Triple A, “safe” no longer has the same meaning it had four years ago.

A survey by consultants Watson Wyatt estimates that institutional pension funds globally lost 19% of their asset worth in 2008, dropping their holdings to about $20 trillion from $25 trillion. Because of their losses and the pressures they face to meet future benefit obligations, many public funds are risking more money in so-called “alternative” investments. The alternatives include hedge funds. An article on the website Hedgeweek recently predicted that the percentage of public pension funds allocated to hedge funds will grow to 20% from 3% over the next decade.

A June 20 headline in the St. Petersburg Times reads: “Florida rolls the dice with a chunk of pension funds.” It described how managers of the state’s $113.8 billion public pension fund want to make more unconventional investments in an effort to attain the 7.75% return on investment needed to meet its future commitments.

The Florida managers have plenty of company. New Jersey’s $68 billion fund has $9.9 billion in alternative investments, including $3 billion in hedge funds, as it seeks to make up a huge shortfall, according to Bloomberg News. California’s huge Calpers public employee fund has had a hedge fund adjunct for some time and is currently struggling to get a better performance out of it.

But Washington has rigged the game to favor government borrowing and the big banks. Congress is of course aware of its political vulnerability when pension funds are in trouble. But its answer is selective bailouts, not a change in the low-interest-rate policies that aggravate the problem. Bailouts of course only add to the already swollen federal deficit.

States suffer in another way as their budgets, with few exceptions, bleed red ink. Many states, Connecticut and New York in particular, have highly progressive tax structures and depend heavily on wealthy taxpayers for revenues. But the wealthy, too, have trouble making money on traditional investments. Indeed, the World Wealth Report recently released by Merrill Lynch and Capgemini reports that millionaires also have become wary of conventional investment, in part because of their uncertainty about future Washington policies. They are showing a preference for real assets, like gold or jet planes. Assets of that kind make a good inflation hedge, which no doubt accounts for the choice, but they don’t usually yield much taxable income.

Interestingly, the relative decline in conventional investment returns closely parallels the Fed’s near decade of easy money policy. According to the federal Bureau of Economic Analysis, the percentage of personal income accounted for by interest and dividends, currently declining, has been doing so throughout this decade. In 2000, interest and dividends accounted for 17.2% of personal income. In April, the percentage was 14.5%. Interestingly, transfer payments like Social Security and welfare rose to 18.2% from 12.8%.

There are plenty of winners when monetary policy feeds the growth of the government leviathan. But there are losers too, especially the millions of prudent savers and investors.

Mr. Melloan, a former columnist and deputy editor of the Journal editorial page, is author of “The Great Money Binge: Spending Our Way to Socialism” (Simon & Schuster, 2009).