Recoveries are rarely without blips, especially when they are as weak as this one. But, regardless of whether the factors behind the latest slowdown are fleeting or enduring, there will be calls on the US Federal Reserve to do something.
What does that mean? Does he want them to do nothing? What would it mean to do nothing? Keep interest rates unchanged? Keep the money supply unchanged? Keep expected inflation unchanged? Keep the price level unchanged? Set the money supply at zero? He doesn’t say. Bernanke did QE2 because core inflation had fallen to 0.6%. If Rajan disagrees with the Fed’s 2% implicit inflation target, then say so. And he should tell us what he favors instead. “Do nothing” is not a policy.
There is, however, scant evidence that the real problem holding back investment is excessively high wages (many corporations reduced overtime and benefit contributions, and even cut wages during the recession).
Wage reductions are exactly what you’d expect to see if sticky wages are a problem. Thus if the Walrasian equilibrium wage falls 4% and actual wages fall 2%, the sticky wage theory predicts high unemployment. Indeed the biggest weakness of the sticky wage theory is that wages aren’t falling even more—wage growth has slowed from about 4% to 2%, but then leveled off. Sticky wage proponents like me have a hard time explaining that fact. Rajan has things exactly backward. BTW, the sticky wage theory applies to all output, not just corporate investment.
A third channel through which easy money might work is by pushing up the value of assets like stocks, bonds, and houses, making people feel wealthier – and thus more likely to spend. For this channel to be sustainable, though, the wealth gains must be permanent. Otherwise, what goes up will come down, leaving households even more frightened of financial markets.
I thought Chicago economists accepted the EMH.
Clearly, someone is paying a price for ultra-low interest rates: the patient and uncomplaining saver. Interestingly, if traditional spenders such as firms and young households are unwilling or unable to take advantage of low interest rates, low rates could even hurt overall spending, because savers like retirees receive lower financial incomes and curtail spending.
Rajan assumes the Fed can reduce interest rates by increasing the money supply. This occurs because prices are sticky–once prices adjust rates go back to their original equilibrium. But if he accepts short run price stickiness, how can he argue that monetary stimulus will reduce real spending? Is the SRAS upward sloping, or not?
Some Japanese now wonder whether their ultra-low interest-rate policy could be contractionary.
Equally worrisome are the distortions that easy money creates.
From a University of Chicago economist! Milton Friedman must be rolling over in his grave. Friedman pointed out that low rates in Japan were a sign that money had been very tight. Funny how extremely “easy money” always seems to produce deflation (US 1932, Japan 1997, US 2009) and ultra-tight money (very high rates) often gives us hyperinflation.
There are many things that the US needs to do to create sustainable growth, including improving the quality of its work force and infrastructure. Easier money is not one of them.
The interest rate is not the price of money, it’s the price of credit. Money is not easy.
PS. This Nick Rowe post covers some similar ground, but is actually much more interesting. I highly recommend it. Interestingly, I wrote my post before his, but didn’t post it until now. Our two posts contain an almost identical passage. Here’s Nick:
Talking about monetary and fiscal authorities “doing nothing” is just as problematic. Does it mean holding a rate of interest fixed? Holding the money supply fixed? Holding the exchange rate fixed? Holding the price of gold fixed? Holding the inflation target fixed? Holding the NGDP target fixed? Or what?
Great minds think alike. 🙂