Monday, January 31, 2011

The Market, not the Central Bankers, Should Decide Interest Rates

Like Paul Krugman, I have little or no pity for the Banksters who are demanding that the rest of us stop saying nasty (and true) things about them. Unlike Paul Krugman, I believe that interest rates should be permitted to rise -- if that is where the market says they should be.

Krugman claims that Banksters believe that low interest rates are "feeding inflation," something he claims is not true. Yes, oil prices are rising, and so are gold and other commodities, but Krugman has an explanation for that: natural volatility and "emerging markets." (He also appeals to the same excuse that the Soviets used to explain decades of bad harvests: bad weather.)

Here is the problem: interest rates should not be decided politically. According to Krugman, any raising of rates will trigger a new bout of unemployment, and at one level he is correct. However, the artificially low interest rates that Krugman endorses are having the perverse effect of preventing the necessary relocations in the economy that will bring about a recovery. Explains Bob Murphy:
...at some point reality rears its ugly head. The central bank hasn't created more resources simply by buying assets and lowering interest rates. It is physically impossible for the economy to continue cranking out the higher volume of consumption goods as well as the increased output of capital goods. Eventually something has to give. The reckoning will come sooner rather than later if rising asset or even consumer prices makes the central bank reverse course and jack up interest rates. But even if the central bank keeps rates permanently down, eventually the physical realities will manifest themselves and the economy will suffer a crash.

During the bust phase, entrepreneurs will reevaluate the situation. If the government and central bank don't interfere, prices will give accurate signals about which enterprises should be salvaged and which should be scrapped. Those workers who are in unsustainable lines will be laid off. It will take time for them to search through the developing opportunities and find a niche that is suitable for their skills and is sustainable in the new economy.

During this period of reevaluation and search, the measured unemployment rate will be unusually high. It's not that workers are "idle," or that their productivity has suddenly dropped to zero; rather, it's that they need to be reallocated, and that takes time in a complex, modern economy. This delay can be due to simple search, where the workers have to look around to find the best spot that is already "out there," or it can be due to the fact that they have to wait on other workers to "get things ready" before the unemployed workers can resume.
Since Krugman holds that factors of production (for analytical purposes) are homogeneous, then raising interest rates makes no sense, as all that needs to happen is for government to stimulate more spending, which then will automatically translate to producers ramping up their productions lines, and all soon will be well. If this were the case -- and it did not matter where capital investments were made -- then Krugman would be correct.

However, if factors from labor to capital ARE heterogeneous, and that the value relationship between those factors matters, then Krugman actually is fighting against the very necessary economic readjustments that are needed to create a meaningful recovery. Furthermore, we forget that this country had an economic recovery -- a substantial recovery -- in the 1980s even though interest rates were substantially higher than they are now. The image below demonstrates my point:


Now, it is true that interest rates fell during the recovery, but they still remained in double-digits through much of the 1980s when the economy was going strong. Unfortunately, because Krugman continues to stick to his "aggregate demand" thesis, all of this to him is white noise.

As I see it, the issue is not whether the government or central bank or anyone else should decide if interest rates rise or fall. I want to know what the market says about rates of interest, and I cannot help but believe that with the Fed trying to flood the world with dollars, that they are going to go up sooner rather than later. But they will rise.

35 comments:

Anonymous said...

Low interest rates are generally a sign that money has been tight, as in Japan; high interest rates, that money has been easy. After the US experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die.

-Milton Friedman

I'm sure easy money couldn't have possible caused hyperinflation in the Weimar Republic because interest rates were so high!

Dan said...

Letting the market decide interest rates would have proved disasterous during the financial crisis. How many otherwise viable businesses would have failed because they couldn't receive access to short-term credit?

Not so for the Austrians. Let it all go to hell for purity's sake and it'll come back stronger than ever before right?

Anonymous said...

"Letting the market decide interest rates would have proved disasterous during the financial crisis"

But that's exactly what the fed did in 2008 and the economy collapsed!

http://research.stlouisfed.org/fred2/graph/?chart_type=line&s[1][id]=WFII5&s[1][range]=5yrs

Look at that spike. That was the biggest interest hike since Volcker.

zackA89 said...

The financial crisis was caused precisely because the FED prevented the market from determining interest rates and intervened in order to artificial lower them, in an attempt to “stimulate the economy” when all the FED did was stimulate and artificial asset bubble, that of course, inevitably results in a bust.
If you don’t want things to go to hell in the first place, don’t manipulate interest rates in an attempt to “stimulate the economy.” If you don’t want to deal with a bust, don’t artificially inflate an unsustainable boom with monetary stimulus.

Joe said...

How can we have a shortfall of demand, but a current account deficit that once again seems to be expanding?

How are corporate profits bad, when personal savings are so low that domestic capital cannot be found any other way? Especially when what savings do exist are being sucked up by the government?

How can we be competitive, when the low middle-class savings rate has bid up the cost of living (and labor)?

Must be constantly use the wealth of Asian poor people to stimulate over-indebted middle-class people to spend, take out more debt, and make their lives ultimately worse?

Joe said...

Ah crap, wrong post. That's not on topic for this one.

Spencer said...

"How many otherwise viable businesses would have failed because they couldn't receive access to short-term credit?"

you mean, unprofitable businesses?

Anonymous said...

The word "banksters" has to be one of the most childish words in discourse today, period.

AP Lerner said...

Dear Prof. Anderson - I wanted to share with you this paper by Austrian economist Vijay Boyapati on the banking system. In this paper, he demonstrates that the banking system of the US is never reserve constrained, and reserves do not factor in a banks lending decisions. He shows, in this fantastic paper, that the excess reserves that Austrian economists claim will lead to increased lending and ultimately inflation, are, in fact, meaningless when it comes to lending decisions, and will have exactly zero impact on inflation.

Does any of this sound familiar? It's exactly what I have been saying on this blog for months. Finally, an Austrian economist that has realized the US left the gold standard, and has updated his thinking to match a modern monetary system!!!! This paper basically takes everything Austrian economists (mis)believe about the banking system, and turns it upside down and inside out.

I would love to see you devote a blog post to refute this paper, since, in the past, you never really responded to my claims (facts) that that banking system is never reserve constrained and all those excess reserves do not impact lending decisions by banks. Do you disagree with Mr. Boyapati? And if so, then why?

PS - maybe you could forward to Mr. Murhpy. I'll try and post it on his blog, but he basically ignores me now since I ask questions he can't answer.

PPS - yet another point for AP Lerner..hey, that guy actually knows what he is talking about :)

http://www.docstoc.com/docs/document-preview.aspx?doc_id=69224923

Anonymous said...

AP Lerner, not sure if you were around, but Murphy actually wrote a post on that subject a few weeks back. I was surprised you didn't respond.

http://consultingbyrpm.com/blog/2011/01/bank-reserves-thesis-antithesis-synthesis.html

AP Lerner said...

Thanks for sending that; I missed it. I stopped reading/posting on his blog a while ago. His arrogance became to much to handle, and when it became obvious he was more interested in fixing my grammar and 'teaching' me debate techniques than responding to my questions, I stopped posting. He likes to shift the subject away from the question at hand when he has no clue how to answer something. It's a common debate technique. It's his blog so its his rules, but it was pretty clear he only takes to people that will insult Krugman or kiss his butt.

So I guess it took a fellow Austrian to finally get him to respond to my questions on excess reserves. Good to see he responded to Vijay; Murphy's ignorance of the monetary system of the US is now on full display for all to see and critique.

Of course, he still doesn't get it. He fails to see loans create additional deposits, which can then be used to satisfy reserve requirements in a fully functioning inner bank market. The Fed has does not create reserves which are ultimately lent out. If that were true, then why did a credit bubble form in the early 2000's when excess reserves were next to zero?

The problem is once Mr. Murphy and other Austrians realize that the money multiplier is a total myth and fractional reserve banking disappeared with the gold standard, then their entire views on inflation and disdain for the Fed comes apart at the seems. And once that happens, the have lost the debate. They are living in the 1930's - fyi, its 2011.

Anyone see a response from Peter Schiff on this? I'm sure he can't stand this truth coming out as well....

Oh, and while I'm here, I'll say I agree with Prof. Anderson when he says 'The Market, not the Central Bankers, Should Decide Interest Rates' Anyone that understands the monetary system knows the natural rate of interest is zero, and the market should determine there credit/term structure of rates.

Mike Cheel said...

@AP Lerner - The document you linked to says the author is a former google engineer pursuing independent study in Austrian Economics. That doesn't make him a 'fellow' Austrian (or an Austrian at all). It only means he is studying Austrian economics on his own (kind of like you are I suppose).

I'm just clarifying that because you have made it seem that he IS an Austrian and is going against the mainstream Austrian thinking.

AP Lerner said...

Let's see Vijay contributes to Mises

http://mises.org/daily/author/1486

And contributes to LewRockwell

http://www.lewrockwell.com/orig11/boyapati2.1.1.html

So are you saying any swinging dick can contribute to Mises? Or are you saying the ones you disagree with should be ignored? If it's the latter, please let me know who else should be ignored. And if its the former, please explain why anyone should continue reading mises.org.

Mike Cheel said...

@AP I wasn't saying any of that. All I was mentioning was what I saw the guy's paper stating about himself.

Why are you getting so defensive?

Bob Roddis said...

Austrian theory is based upon ignorant acting man, subjective value and economic calculation. It is not based upon the proper deciphering of a complex criminal enterprise such as our current banking system. Of course, it provides guidance regarding the results of banking policy but says nothing about what the evidentiary facts are which demonstrate how the system actually operationally “works”.

AP Hut Tax Lerner hasn't the faintest familiarity with Austrian School principles or theory, basic or otherwise. Mish Shedlock has been claiming that we face a credit deflation crisis not an inflation crisis for quite awhile.

http://tinyurl.com/29sglm3

He's still an Austrian and he still attacks the Fed.

AP Hut Tax Lerner inexplicably (and without explanation) insists that the study of individual exchange is irrelevant in a fiat money system:

http://tinyurl.com/4rf8pg9

Stephan Kinsella is the editor of the Libertarian Papers which published the article by Vijay Boyapati. He’s a Rothbardian attorney is currently teaching a course for the Mises Academy.

http://tinyurl.com/6z7gz7w

AP Hut Tax Lerner generally refuses to respond to my comments because I generally have nothing to offer.

Bob Roddis said...

Taylor Conant explains the world to Warren Mosler:

You treat government finance as if it's an accounting problem, not an economic problem. I don't disagree with you on the "operational" aspects of how government finances itself. I don't disagree because I don't care. The government could physically extract resources from private citizens, it could establish legal tender laws and then use its monopoly on the ability to increase the money supply to finance itself or it could use any other scheme it could imagine to gain control over resources which do not belong to it-- it doesn't change the fact that those resources were not handed over via voluntary exchange and therefore the economic nature of such an exchange is completely different than what it would be if the exchange occurred voluntarily.

You treat the problem as if someone like me is concerned the government is about to run out of paper, ink and megabytes of data storage on its hard drives and accounting matrix spreadsheet servers. I am not concerned by this.

What I am concerned about is the coercive nature of government financing-- however it is accomplished!

The point I seek to address in my entire series of refutations, which you only slowly and somewhat sneakily pay any heed to, is that government controls what economic resources it controls by theft. Because the government is stealing all the resources it utilizes for its various economic programs and schemes, it necessarily means that your entire program for getting the economy going again by policies adopted by the government boils down to the idea that some forms of theft are more noble than others and furthermore that these noble thefts can be of net economic benefit to society.

In other words, you advocate a system whereby theft is to be the foundation of sustainable economic production.

This is wrong. Theft redistributes existing resources, it is not responsible for producing new ones. If you're unclear on why it's wrong I'd be happy to discuss it with you at any time.


http://tinyurl.com/4hc6mqh

Bala said...

AP Lerner,

Even if I were to accept your argument that banks are not reserve constrained but capital constrained, how does the following become true?

" then their entire views on inflation and disdain for the Fed comes apart at the seems. And once that happens, the have lost the debate. They are living in the 1930's - fyi, its 2011."

Which views on inflation comeapart at the seams? Which debate have they lost? Does it matter from an economic standpoint whether the source of the credit expansion+monetary inflation that creates the business cycle comes from fractional reserve banking or from the ability to inflate as much as you want as long as you meet capital adequacy norms?

Does the fact that monetary inflation by banks is capital constrained adversely affect the argument that such monetary inflation in wealth redistribution from everyone else to the banks?

Just wondering.

Joe said...

AP Lerner, about "why did a credit bubble form when excess reserves were zero": Two points: Nonbank credit expansion, and global capital flows.

The shadow banking system took capital from global investors, and borrowed on the short-term money market or repo to fund long-term assets. They were essentially fractional-reserve banks, but without taking deposits.

You cannot fully eliminate fractional-reserve banking (we tried in the 30s), since maturity transformation can still happen (e.g. borrowing at 1 year to fund a 30 year loan).

Joe said...

Bala, you're forgetting that in a fully expanded credit market, banks can't create new credit that isn't first saved.

The savings can come from abroad; e.g. high-savings Asian nations like China. Foriegn savings isn't beneficial, IMHO--but it's still real capital.

Long-term interest rates continued to decline *after the Fed had begun hiking rates in 2004*. Capital inflows is why we had a bubble.

The 1997 Asian financial crisis created a lot of remand for investing in the U.S., and once our short-term interest rates begun to climb we were flooded with foreign capital.

Most of the inflationary, shadow banking credit expansion came later, when access to global capital started to dry up and investment banks could no longer sell mortgage-backed securities to global investors.

Joe said...

Hrm, I'm contradicting myself a bit here. I guess what I'm say, is when global capital began drying up shadow banks really started relying on short-term funding, and started buying a lot of their own stuff (presumably since they couldn't sell it).

In effect, they substituted real capital for artificial credit expansion, done almost entirely outside the commercial banking system.

Bala said...

"Bala, you're forgetting that in a fully expanded credit market, banks can't create new credit that isn't first saved."

If capital adequacy norms all that need to be fulfilled, I don't see how the credit market gets "fully" expanded. Please explain the term "fully expanded credit market" without reference to reserves.

I am afraid your reply misses the point that the very meaning of the term "credit expansion" is lending out money that does not constitute prior saving by anyone at all, domestic or foreign.

Bala said...

"Hrm, I'm contradicting myself a bit here."

Considering what you are trying to say, I doubt if you can ever avoid it.

"when global capital began drying up shadow banks really started relying on short-term funding, and started buying a lot of their own stuff (presumably since they couldn't sell it)."

No. Seen through the capital adequacy lens, it was just a circuitous route to get mortgages and other "assets" AAA rated so that their contribution to meeting capital adequacy norms is maximised.

AP Lerner said...

Loans create desposits. Investment creates savings. Always. It's called reserve accounting. Learn it.

“Even if I were to accept your argument that banks are not reserve constrained but capital constrained”

Not an argument. Operational fact.

“Which views on inflation comeapart at the seams?”

Mr. Murphy. See this. http://consultingbyrpm.com/blog/2011/01/bank-reserves-thesis-antithesis-synthesis.html

“The shadow banking system took capital from global investors, and borrowed on the short-term money market or repo to fund long-term assets. They were essentially fractional-reserve banks, but without taking deposits.”

Proving my point that reserves are not required to create loans.

“You cannot fully eliminate fractional-reserve banking (we tried in the 30s),”

Fyi – the US left the gold standard.

“Bala, you're forgetting that in a fully expanded credit market, banks can't create new credit that isn't first saved.”

100% false. Loans create deposits. Investment creates savings. This is basic reserve accounting. Never fails. Why is reserve accounting so hard to get?

“Most of the inflationary, shadow banking credit expansion came later, when access to global capital started to dry up and investment banks could no longer sell mortgage-backed securities to global investors.”

False in so many ways.

Take care guys. I was hoping Mr. Anderson would address this essay. What a shame if he doesn't. But I guess the never ending pissing match with Krugman is more intellectally stimulating (easier) to the followers of this blog.

Joe said...

Bala, you realize not all loans are done by short-term checking accounts? There are reasons why savings accounts still exist.

A fully-expanded credit market is one where there are no excess reserves, capital requirements are all met, and the only source of additional capital is 1) savings, 2) foreign capital flows, 3) quantitative easing (eww).

What the Fed does to tweak interest rates really doesn't create significant reserves (normally); most base money growth in the past two decades was to meet foreign demand (the Cato Institute has a paper on this).

Joe said...

Other then the past two years, I mean!

Joe said...

AP Lerner, accounting identities are backwards-looking. No nation is a closed system.

Saving is abstaining from consumption so investors can consume. It's as simple as that. If no one is abstaining from consumption, investors appreciate the currency (either through inflation, or by borrowing from abroad and appreciating the nominal exchange rate).

Investment does not have to equal savings. Non-inflationary investment does, but only under floating exchange rates (where nominal appreciation automatically cancels out the inflationary effect of capital inflows).

Joe said...

"Investment does not have to equal savings. Non-inflationary investment does--" To be clear, I mean non-inflationary investment must be matched by someone, *somewhere*, saving--and under floating exchange rates, you can import that savings.

Bala said...

"Not an argument. Operational fact."

Irrelevant for the discussion.

"Mr. Murphy. See this. http://consultingbyrpm.com/blog/2011/01/bank-reserves-thesis-antithesis-synthesis.html"

I've seen this, but I think you have misunderstood my question. I did not ask whose views come apart at the seams but asked which views do. Is it the view on the definition of inflation or on the relationship between inflation and prices, especially relative prices or something else?

"100% false. Loans create deposits. Investment creates savings."

WOW!!! And photosynthesis creates sunlight. Expelling faecal matter causes us to ingest food. The motion of an automobile causes the fuel to combust inside the engine. Brilliant exposition of topsy turvy thinking that can come only from a person who has completely mixed up accounting and economics. Looks like LK, you think studying and explaining data that comes from financial accounting or national income accounting is what economics is all about.

"This is basic reserve accounting. Never fails. Why is reserve accounting so hard to get?"

You could call it reverse accounting for all I can see. And it's not that reserve accounting is difficult to get. What is is the claim that it constitutes economic analysis.

Bala said...

" Anyone that understands the monetary system knows the natural rate of interest is zero"

Anyone who understands economics knows that saying that the natural rate of interest is zero is tantamount to saying that time preference is a myth, unless of course you have a different definition of "natural rate of interest".

Bob Roddis said...

We again learn the insidious nature of wealth transfer due to fiat money from Vijay Boyapati’s paper:

8. The Politics of Deflation
The reason that public sentiment has always been biased against monetary deflation can be found in the manner in which wealth transfer occurs under inflationary and deflationary environments. During an inflationary credit expansion, wealth is transferred from the public in general to the earliest recipients of the newly created credit money. In practice the earliest recipients are interest groups with the strongest political connections to the State and, in particular, the State institutions that control monetary policy (i.e., the Federal Reserve in the United States). Importantly, the wealth transfer that takes place during an inflation is hidden and largely unrecognized by the majority of the population. The population is unaware that the supply of money is increasing and the attendant rise in prices, ostensibly beneficial to business, initially:

produces [a] general state of euphoria, a false sense of wellbeing, in which everybody seems to prosper. Those who without inflation would have made high profits make still higher ones. Those who would have made normal profits make unusually high ones. And not only businesses which were near failure but even some which ought to fail are kept above water by the unexpected boom. There is a general excess of demand over supply—all is saleable and everybody can continue what he had been doing.

In an inflationary environment wealth transfer proceeds insidiously and is masked by a perceived prosperity. The unmasking finally occurs at the end of the credit boom when the market’s deflationary tendency to clear prior losses takes hold. Failed businesses are liquidated and their capital is transferred, usually through bankruptcy, to creditors who must acknowledge losses on these misguided investments. Unemployment soars and social unrest replaces the former sense of euphoria attending the credit boom.

Joe said...

Money creation isn't all there is to it. We Americans always forget the rest of the world: the current and capital accounts really do matter.

Ultimately, people will always find ways to create money (whether property, bank deposits, bonds, stocks, etc). What matters is whether the aforesaid money is backed up by someone, somewhere, choosing to postpone consumption.

jason h said...

"What matters is whether the aforesaid money is backed up by someone, somewhere, choosing to postpone consumption

Careful Joe, this is one of those pesky a basic Austrian principles, so it'll likely be ignored.

Bob Roddis said...

this is one of those pesky a basic Austrian principles, so it'll likely be ignored

Perhaps as you all can tell, I'm getting quite creeped out by our opponents ignoring (on steroids) basic Austrian ideas. I would think that when challeged with a firm "You haven't the slightest familiarity with basic Austrian ideas", the normal response would be in the form of, "Oh yes I do, yada yada". But, of course, they say nothing. Ever. And they act like they have not been so challenged.

Therefore, I hereby declare total and complete victory over the mindless opponents of the Austrian School in a forfeit win.

Tel said...

"yet another point for AP Lerner..hey, that guy actually knows what he is talking about"

Are you still bullish on the US dollar? I notice your favored DXY index looking rather lack-luster.

The Chinese arbitrarily decided that getting burnt by Greeks was an entertaining change to getting burnt by US Treasuries. I guess someone explained to them the benefits of di-worse-ification.

How about we make some predictions on US food prices for the coming year? I predict they will go up; that is to say the power of the US dollar to buy food will be diminished. I predict this will cause significant grumblings and put a great deal of pressure on Obama's voter base. This could be called inflation, although Krugman would no doubt use the "core" inflation concept and ignore food prices. I wonder how Obama is going to be able to ignore it.

Tel said...

The word "banksters" has to be one of the most childish words in discourse today, period.

I agree completely. Only the cleverest of people can see the Emperor's new clothes. The childish, the simple and the fools of this world think he is just naked.

Errr, nod to Steve Keen... just for politeness sake.