In the 1997-2007 mortgage housing bubble the enablers of the bubble tried to rationalize using the Gaussian Copula theory that a Mortgage Backed Security holding mortgages from different states would act diversify the risk of a default. But that rationale was wrong because it was assumed that the successful borrowers would offset the damage caused by the losers. Instead the winners, who are borrowers, are not obligated to bail out the loser or to pay extra to the lender to make up for the loss caused by the defaulting borrower, so the “diversification” was bogus.
A similar phenomenon is happening where financial experts assume the central banks can bail out the economy by cutting rates deeply. The problem is rates would have to be cut to negative 3% or even negative 5%. This would mean that insurance companies who need to charge a 2% margin would have to charge their clients 7% (meaning the client would need to pay 7% or “earn” a negative 7% rate!), in an economy where negative 5% yields are normal. This would be such a problem for the clients of insurance companies and banks so that it could cause a massive cancellation of insurance contracts, severely damaging the insurance industry and damaging clients who need insurance. A client who gave up insurance and then suffered a catastrophe would be impoverished. Consumers who are retired would become despondent if their savings account yield went down to negative 5%. From the view of retired consumers and those people who are thinking ahead about future retirement, the effect of QE’s low rates was deflationary (the opposite of what was intended), as it took purchasing power away from retirees holding bonds and savings accounts.
These problems would create a depression, besides destroying the banking and insurance industry, so an attempt to cure a recession by imposing negative interest rates would make things worse. This means that Federal Reserve tools of cutting rates won’t work in the next recession and thus they are going to be trapped in a Japan-style soft depression.
Bernanke claims Quantitative Easing cut rates by 0.5%, but that doesn’t prove it made the economy better. Stocks went up a lot since the start of QE3 in October, 2012 because of low interest rates, but the real economy of corporate earnings was flat from 2012 to present, except for the benefit of the 2017 corporate tax cut.
Cutting rates only fools some of the people (the ones with modest intellect and discipline who soon run out of money). Cutting rates doesn’t fool the captains of industry who are needed to authorize a massive capital outlay by giant corporations. Rate cutting gave the appearance of working during mild recessions of 1945-1979 era because the U.S. economy had tremendous tailwinds from the post-war prosperity before other countries healed from war and competed away this prosperity. The economy would have improved without rate cuts during the economically strong era of 1945-1979. The rate cuts of 2001 to 2003 weren’t as important as the tax cuts.
If the Federal Reserve cuts rates by 0.75%, in three 0.25% increments, during late 2019, that won’t much difference since the borrowers still have to pay principal payments and they will get a smaller tax deduction if interest rates are lower. Cutting the rate 0.75% on a $20,000 car loan saves $12.50 interest a month, hardly enough to motivate a buyer.
Investors need independent financial advice about the risks of being fooled by rate cuts.