Thursday, January 31, 2013

Is the Fed Hampering the Recovery?

In his blog post on "Calvinist Monetary Economics," Paul Krugman claims that a recent Wall Street Journal op-ed by John Taylor on why he believes the Fed is hampering the recovery by keeping interest rates low falls into the "Calvinball" category. Writes Krugman:
For those who don’t read the classics, Calvinball is a sport in which you change the rules whenever you feel like it, very much including in the middle of games.

Back then the tight-money types were inventing new and peculiar principles of monetary policy on the fly; it was obvious that they were looking for some reason, any reason, to justify a rise in rates, because, well, because.
Krugman goes on:
Now Taylor is doing the same thing. He claims that he can show that the Fed’s low-rate policy is actually contractionary, using “basic microeconomic analysis”. Actually, as Miles Kimball points out, he’s committing a basic microeconomic fallacy — a fallacy you usually identify with Econ 101 freshmen early in the semester (and as it happens the same fallacy committed by Rajan).

For Taylor argues that low rates engineered by the Fed are just like a price ceiling that reduces the supply of loans, and therefore reduces overall lending.

Wow. No, the Fed’s interest rate target isn’t a price control; there is no legal or other restraint on the rates lenders can charge. The Fed is driving down interest rates, or equivalently driving up the price of bonds, by buying bonds; I can’t think of any kind of economic analysis in which that would reduce the quantity of bonds sellers end up issuing, that is, the amount of borrowing (and lending) in the economy.
 I'll put all of this controversy in the simplest of terms: Keynesian orthodoxy claims that lower interest rates will always have a positive effect upon the economy because the low rates encourage more borrowing, ceteris paribus, even in a so-called liquidity trap. The issue of the "liquidity trap," according to Keynesians, is that other factors are holding back "aggregate demand" so that lowering rates by themselves cannot create enough aggregate demand to lift the economy out of a downturn.

That is where fiscal policy comes in, and that is what Krugman has been saying. Thus, anyone who might claim that attempts by the Fed to push down interest rates might have an opposite effect of what is intended is playing "Calvinball."

The Keynesian approach is pretty straightforward, maybe even crude. All economic activity of an economy, all of the relative prices, all of the relations of production, the products creates, everything, can be put into two functions, aggregate demand and aggregate supply. Push aggregate demand to the right, and as long as the AS curve in not in its steep region, economic growth will occur without too much inflation.

Should the economy be in a "liquidity trap," then the only way to get the AD curve to move to the right is for government to engage in lots and lots of spending. The positive results from the spending then will trickle down to everyone else, provided government spends "enough." However, as Bob Murphy has noted, it seems that Krugman is playing some "Calvinball" of his own:
Here is my observation: Paul Krugman will say that government spending has surged under Obama (and Bernanke has engaged in monetary stimulus) when he wants to blow up right-wingers for their failed predictions, yet referring to the same period of time he will say that government spending has actually been either normal or even contractionary, when explaining why his Keynesian solutions haven’t fixed the economy.
 Certainly, Krugman is not above using the "Heads I win, tails you lose," method of arguing. However, I'd like to address a larger question: Can the Fed's "expansionary policies" actually have a contractionary effect upon the economy?

I'd like to take a different approach than has Taylor and point out that the Fed's purchases of securities of all types -- government, mortgage securities, private assets -- is done in order to keep the asset prices high and send false signals to the markets that these securities are worth more than they really are. (The only word for it is fraud and I should point out that when someone in private business, as opposed to Ben Bernanke, tries to artificially jack up the price of securities, he is likely to be prosecuted.)

The Fed wants to drive money toward those assets by keeping their prices artificially high, and I would argue this has two problems that do hamper the economy:
  • First, it prevents the needed liquidation of those assets which cannot be supported by market activity so that investors and entrepreneurs can follow real price signals to see where lines of sustainable investments are located. By throwing in what essentially are false prices, the Fed is making it harder for entrepreneurs to find the suitable production lines;
  • Second, the Fed's policies discourage savings (which makes Keynesians very happy, given their vaunted "multiplier" is 1 over the savings rate, so the less we save, the greater the "multiplier"), as real savings provide the liquid capital for long-term investments.

Given Krugman's mechanistic views of the economy and his overt hostility toward economic activity that is not created by government fiat, I doubt what I have said would convince Keynesians of anything. To them, the economy is a simple thing controlled by levers of spending with the Really Smart People in Washington and at Princeton knowing at all times when to "step on the gas" and "when to apply the brakes."

Nonetheless, I also would argue that the Fed is holding back the recovery, even as it acts in the name of "aggregate demand." This isn't "Calvinball." It is economics.

27 comments:

Anonymous said...

This is off-topic, Professor Anderson, how familiar are you with market monetarism and if so, what are your thoughts on the subject?

Bob Roddis said...

Outstanding analysis. Further, by imposing perpetual bad times, the low rates make the "safest" apparent place to put money for one's savings is government bonds. The entire scam allows the government to fund its ever growing activities which is basically a continuous process of enticing the loyalty of new voters with more and more government goodies and handouts. Who said Keynesians were stupid?

Bob Roddis said...

TYPO: The second sentence should say:

Further, by imposing perpetual bad times, the low rates apparently make government bonds the "safest" place to put money for one's savings.

Lord Keynes said...

(1) The Fed's asset purchases are mostly government bonds. Investors all over the world have fled to US government treasuries since 2008, so demand from them would still be high.

Anyway, these bond purchases do not stop or impair businesses from their capital goods investment projects.

If anything, it is shortfall of demand for products that impairs business expectations and investment.

(2) "Second, the Fed's policies discourage savings ... etc.

And yet savings rates have significantly increased since 2007. If QE has discouraged savings, strange that savings have risen:

http://www.creditwritedowns.com/2010/02/chart-of-the-day-u-s-savings-rate-over-last-60-years.html

As for actual funds available for investment, there is a vast reserve of them now: literally all those excess reserves created by QE. Real resources are also available in the US economy - or from overseas.

The main problem is insufficient demand for products, the principal consequence of which is poor expectations by businesses and unwillingness to investment enough.

William L. Anderson said...

Gee, those "unwilling" businesses ought to be forced at gunpoint to "invest enough," right? I'm sure, LK, that you and other Keynesians know the "optimal" amount of business investment since Keynesians know everything.

Has it ever occurred to you that your view of an economy is nothing more than that of a mechanistic model in which consumption is not done by individuals acting purposely to meet their need, but rather is an activity which is done in order to clear the shelves so that there can be more production? I guess that is why you believe that bureaucrats should be in charge and that central planning always will work perfectly.

Lord Keynes said...

"Gee, those "unwilling" businesses ought to be forced at gunpoint to "invest enough," right? "

And the prize for laughable straw man argument goes to .. William L. Anderson.

No, businesses will invest if demand is sufficient. Tax cuts and fiscal stimulus will create the demand. But perhaps in your mad world a tax cut leading to more demand is forcing businesses "at gunpoint," or some such nonsense.

"I guess that is why you believe that bureaucrats should be in charge and that central planning always will work perfectly. "

Keynesian macro-management is not central planning.

If "central planning" is to have any coherent meaning in economics, it means Soviet style economies where ALL production and consumption is planned.

Mule Rider said...

Somehow "Keynesian macro-management" feels an awful lot like "oppressive micro-management."

John S said...

"Tax cuts and fiscal stimulus will create the demand."

I'm quite certain Prof. Anderson would endorse tax cuts.

"perhaps in your mad world a tax cut leading to more demand is forcing businesses "at gunpoint," or some such nonsense."

I don't follow--why would he conclude this? He would certainly say this of govt directed fiscal stimulus, but I can't imagine him saying it of tax cuts.

Martin Stoyanov said...

Actually, Professor Anderson, central planning worked spectacularly well when it came to keeping shelves clear.

William L. Anderson said...

Good point, Martin. The Soviets had a much more efficient economy than ours, as they had perpetually bare shelves!!

If the "underconsumption" theories that LK and people like Robert Reich are promoting are true, then why don't we see the pattern of unemployment rising along the consistent lines of the inequality measures? Instead, we see boom and bust, but I would like to know how inequality creates that.

As for tax cuts, I would support them in the sense that they allow producers to make more goods, and it is the creation of goods that gives us the ability to demand more goods. LK and Krugman believe that the government can create "demand" out of thin air, which is to say the government creates wealth out of nothing. Amazing.

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Mike said...

LK said: “No, businesses will invest if demand is sufficient”

Really? Let’s rewind the time machine back a few years shall we. What was the “demand” the general category of a “smart” phone before the even existed? How could the public demand something that didn’t exist? You mean to tell me that companies actually invested capital in R&D, development and production of a product on the speculation of demand? Silly capitalists.

Mike said...

LK said: “Investors all over the world have fled to US government treasuries since 2008, so demand from them would still be high.”

So that’s why the Fed has to engage in a money printing…errr FOMC Strategic Asset Purchase program to the tune of $85B per month. Right? Gee I hate to see what the program would need to be without “high demand.” Wait a bit we are probably going to find out.

Joseph Fetz said...

Mike, I believe that according to JPM, the Fed will be purchase about 90% of all net new bonds, and almost 70% of Treasury issued government debt. Not to mention that it is already the largest holder of such Treasuries. So yeah, LK's statement is pretty laughable.

Joseph Fetz said...

Also, I'd be willing to bet that interest rates will start to tick upward over the course of this year.

Mike said...

Joe, respects interest rates I agree with you fundamentally. According to my modeling the 10 yr T-Note should have a yield presently between 5.5% and 6%.

However the system can’t tolerate a rate increase without crashing it. The stock of debt and new flow into that stock is too large. The USG is on a trajectory to be at a debt of $20T excluding unfunded liabilities. At a normalized historical 5% interest rate (and that is a bit low) you’re looking at $1T in annualized interest costs. Not sustainable.

Under this environment the Fed is left with QE to infinity to suppress interest rates until the currency/sovereign bond market implodes. The system resets and the associated social chaos is worked through. I’m not suggesting that’s the only path it will follow, just the most logical based on the facts and policy actions we have at present.

Progressives have their heads stuck in a vacuum sealed utopian vision. Thus they can’t or won’t see the obvious.

Mike said...

Sorry. Clarification $20 by end of 2017

JG said...

@ Anderson,

"The Fed wants to drive money toward those assets by keeping their prices artificially high..."

Is that really what the Fed's goal is? To keep prices high? Do you really believe that QE is really a conspiracy to inflate MBS prices?

Someone less given to conspiracy theories would assume that the Fed was buying MBS to maintain liquidity in the financial system to faciliate lending during a time of weak demand.

Bob Roddis said...

Is that really what the Fed's goal is? To keep prices high? Do you really believe that QE is really a conspiracy to inflate MBS prices?

Someone less given to conspiracy theories would assume that the Fed was buying MBS to maintain liquidity in the financial system to faciliate lending during a time of weak demand.


If people want cash and not stupid securities, they could just sell them to other mundanes, right? They would then have cash and not securities. If the Fed buys anything, it's obviously the highest bidder, bidding up the price higher than it would otherwise be. Otherwise, someone would have outbid the Fed.

If there is "weak demand", it means "consumers" are broke. Why should anyone lend money while "consumers" are broke?

Bob Roddis said...

People who own crummy MBS don't need "liquidity". What they need to know is the actual price that free people will pay for the securities in a voluntary exchange. If no one will buy them, that is ok, because the owners of the securities might learn an important lesson in life from a bad experience.

Bob Roddis said...

In the weak, corrupt and narcissistic brain of a Keynesian, average people are helpless and hopeless without the firm guidance of the Keynesian with his SWAT team. For example, people are too dumb to save up so that they can afford to buy finished products*. They must be provided with new and additional purchasing power which, unfortunately for them, is stolen via funny money dilution and Cantillon Effects from other average people. And vice versa from them to others. What a brilliant solution to a problem that does not even exist.

*Of course, those same people are smart enough to elect the proper "progressive" bureaucrat.

Mike said...

Bob, here comes the "help"

http://www.bloomberg.com/news/2013-01-18/retirement-savings-accounts-draw-u-s-consumer-bureau-attention.html

Mike said...

JG asked "Do you really believe that QE is really a conspiracy to inflate MBS prices?"

Not a conspiracy. Its part of the policy objective

Bob Roddis said...

Not a conspiracy. Its part of the policy objective

That is the big mystery. Do Keynesians destroy the economy because they are stupid or because that is their intended objective? I don't think that is a trivial question.

Joseph Fetz said...

Mike, I don't doubt that they'll try to keep rates suppressed, I just don't know that they'll be able to. Also, they are now having the problem that some sectors of the economy are starting to really heat up again (mainly housing and construction). That puts them in quite a difficult position.

Trust me, I know what kind of damage a rise in rates can do to the fiscal situation. Even an uptick of 100 basis points will be very problematic. But keep in mind that they cannot fully control what the rate of interest is, they can only influence it (albeit very heavily). Ultimately, the market will decide.

Mike said...

Joe I concur. Ultimately the market is bigger than government. They can keep things suppressed longer than the rational mind would think possible but you can't hold the beach ball under water forever.

Dinero said...

"Second, the Fed's policies discourage savings (which makes Keynesians very happy, given their vaunted "multiplier" is 1 over the savings rate, so the less we save, the greater the "multiplier"), as real savings provide the liquid capital for long-term investments."

Actually the interest rate is low because there is a high quantity of funds available for capital investments.

As Krugman did cover in the article
Krugman-
" The Fed is driving down interest rates, or equivalently driving up the price of bonds, by buying bonds; I can’t think of any kind of economic analysis in which that would reduce the quantity of bonds sellers end up issuing, that is, the amount of borrowing (and lending) in the economy."