Low rates aren’t the answer, they are (a symptom of) the problem
This WaPo story is slightly worrisome:
The Federal Reserve would consider reopening its program to support the mortgage market if interest rates spiked or the economy showed new weakness, Federal Reserve Bank of New York President William C. Dudley said in two new interviews.
Low long term rates are usually the sign of a weak economy, and rates normally rise as the economy recovers. We saw this during 2009, when rates moved up somewhat after the economy seemed to pick up a bit in the second half. I would be happier if the Fed was saying that they stood ready to respond with more stimulus if long term rates declined.
Why do I say that I am only slightly worried? Because Dudley also mentions that signs of further economic weakness would trigger additional stimulus. Of course that begs the question: How weak does the economy have to get before the Fed decides the US would be better off if aggregate demand were a bit higher?
Part 2. I found the WaPo excerpt in an Arnold Kling post. Kling makes the following observation:
Rates on 30-year, fixed-rate mortgages are 5 percent. The market wants those rates to be higher. Down the road, the market probably will want those rates to be much, much higher. If so, the ultimate lenders are going to take huge losses, as the interest rates they pay to keep these mortgages in portfolio will exceed 5 percent.
Who will bear these losses? As taxpayers, we will.
I’m no expert on the default risk on these securities, but I’d like to make one observation about interest rate risk, which is the subject of Kling’s remarks. He is of course correct in noting that if rates rise sharply, the value of the Fed’s MBS portfolio will drop sharply, and ultimately the taxpayers will bear the cost. I would add, however, that by far the strongest determinant of long term interest rates is the level and growth rate of NGDP. Rates tend to be low when NGDP is falling, or is rising from a very low level (like right now.) In my view the sort of macroeconomic environment that would produce much higher interest rates would also produce a robust recovery in the economy. If we abstract from default risk, and consider Treasury bonds for instance, the worst thing that could happen would be if the Fed made a large profit on the T-bonds it accumulated in the so-called QE program. That would indicate that long term rates had fallen to Japanese levels, and that for every dollar the Fed gained in higher asset prices, the Treasury was losing $10 in lower tax revenue and higher unemployment and welfare payments.
This is not to excuse the Fed for its purchases of MBSs. I’d rather they would buy enough ordinary Treasuries to boost NGDP very sharply. That’s the best way to help housing. Trying to micro-manage specific sectors almost never works.
Part 3. Tim Duy; devil’s advocate
Tim Duy has also been a critic of the Fed’s passivity in the face of a severe recession. In this post he tried to play the devil’s advocate and look at things from the Fed’s perspective. I think he makes a lot of excellent points, but I want to comment on this assertion:
We need to see sustained growth at more than twice that rate to bring unemployment quickly down to acceptable levels. But there is simply no faith that such a feat can be achieved. Most doubt there is sufficient pent up demand in the consumer to do the job, while Calculated Risk has repeatedly stated the case against a quick rebound in housing. With fiscal stimulus set to slow, that leaves investment and the external sector to big up the slack – neither of which packs the weight of the consumer. Consequently, the Fed can hold policy steady on the back of the current forecast, which lacks the post-1982 surge.
This is a fairly standard Keynesian approach to evaluating the prospects for a rise in AD. I read similar things every recession. But do you recall the phrase “it’s darkest just before the dawn?” In almost every single recession things look bleak right before a rapid recovery occurs. If you are deep in recession, and consumers are suffering massive job losses, you’d naturally expect sluggish consumer spending going forward. The same would be true of business investment, as factories have excess capacity. I grant you that housing is one area where we are worse off than usual. In past recessions low rates have sometimes led to an early recovery in that sector. But I still maintain that this approach to AD is wrong. It seems to look at AD as a real variable, a collection of sectoral demands that must be added together.
The fastest AD growth in US history probably occurred between March and July 1933, when by all accounts no sector of the economy should have been doing well. We had 25% unemployment. Where was all that AD going to come from? Now instead of thinking of AD as a real variable, think of it as a nominal variable; NGDP. And think of monetary policy (broadly defined as MV, not just M) as the driving force behind AD. Then the only question is whether or not when NGDP grows rapidly (as it did after March 1933), the growth is prices or output. It was mostly output in the spring of 1933, and I expect it would be today as well.
In the end I agree with Tim Duy’s conclusion that the recovery will muddle along at a slow rate. After today’s drop in unemployment I am a bit more optimistic than last night. But I think the real AD approach (C+I+G+NX) obscures the transmission mechanism of monetary stimulus in a deep recession, leading the casual observer to think more G is the only answer. If people did draw that conclusion, it would be unfortunate. At the same time I do understand the appeal of this approach. Remember I am also a teacher. I know how easy it is to explain ideas like the expenditure multiplier to students, and how hard it is to get them to grasp the essence of monetary economics–that people’s attempts to get rid of excess cash balances drives AD higher, even if you cannot see the effect in your own behavior.
Part 4. Brad DeLong solves the age-old problem of estimating crowding out.
Many researchers have tried to estimate the extent to which government expenditures crowd out private expenditures. We basically know that the crowding out is roughly one for one if at full employment, and also if the central bank has some sort of nominal target, such as inflation. In other cases it is hard to tell. As you know I am skeptical of the estimates for all sorts of reasons. But as David Henderson points out, DeLong basically ignores the ceteris paribus problem in his criticism of a recent post by Steven Horwitz. Here is Henderson making the sort of comment I had planned to make:
If wages are not falling, then that well could be due to extension of unemployment benefits and some of the additional spending in the stimulus package. DeLong has arbitrarily chosen zero real-wage increase as his baseline. But in a readjustment, what Arnold Kling calls a recalculation, there’s a case to be made for some real wages to fall. At those lower real wages, some of the currently unemployed would be employed. Those jobs that aren’t created, therefore, are a cost of the stimulus package. No one, including Steve Horwitz, claimed that there was a one for one. So the jobs not created by the private sector are indeed a cost of the stimulus package.
I was going to make a similar point about both wages and interest rates. If DeLong’s evidence was really as definitive as he claims, then the whole crowding out debate should have been resolved long ago. Just look at wages and interest rates! They tell us everything we need to know. No need for messy multiple regressions.
I’ve never met Mr. Horwitz. But when I saw him insulted in DeLong’s headline, I knew he must be a fine economist. One of my proudest days was when DeLong treated me in the same way he treats distinguished economists like Fama and Cochrane. I still proudly display the post on my office door. “Scott Sumner simply loses his mind.”
PS. If you ever forget DeLong’s blog address, just Google ‘Scott Sumner loses his mind.’ It will take you right there.