Yellen Agrees with The Austrians

In a recent interview, former Fed Chair Janet Yellen warned that excessive corporate debt could exacerbate the pain of the next economic downturn. The argument goes that if something triggers a slowdown in the economy, and companies' sales decline, their higher debt service burdens will force them to lay off employees and shrink investment which could cause a sputtering recovery, or even a recession.

The strange thing about this argument is how quickly Yellen changed her mind. Back in June 2017, when she was still Fed chair, Yellen stated "I don't believe we'll see another financial crisis in our lifetime." Since her departure from the Fed, the pace of actual rate hikes - as exposed by the Fed's dot plots - has been adjusted upwards under Jerome Powell by only 25 basis points. This is an insignificant change and makes us think these comments have more to do with politics and no longer being in power than her being truly concerned with cracks in the system.

What's even more confusing is that expanding credit to increase corporate borrowing is straight out of Yellen's own Keynesian playbook. This was the entire idea behind QE and the Fed's own zero percent interest rate policy. If you can lower overnight rates to the point that money is free and communicate that rates will be there for some time, then companies will borrow and use those resources to hire and expand operations. This is supposed to jumpstart a recovery and lead to a virtuous cycle of economic activity that will replicate or make up for output that was lost during the recession, and eventually allow policy to return to normal. Boosting corporate debt levels isn't a symptom, it's the prescribed antidote.

Ironically, Yellen's warnings also echo the critiques of the Fed's biggest ideological opponents, the Austrian school economists. From an Austrian perspective, driving interest rates to an artificially low level leads to a mismatch in the coordination of resources over time. Companies that otherwise wouldn't see future demand for their products interpret low rates as a green light to expand even though consumers don't want more of what they're producing. This leads to widespread "malinvestment" throughout the economy as less efficient and innovative firms take on debt they won't be able to service in the future. Finally, as central bank interventions run their course - and rates rise once again - those companies that misinterpreted the signals go belly up. It sure seems that sounding an alarm over rising interest rates and a debt hangover fits this Austrian framework, but we never in a million years expected to hear it from Yellen.