Raghuram Rajan doesn’t want the Fed to “do something”

Here’s Rajan:

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.  :)


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20 Responses to “Raghuram Rajan doesn’t want the Fed to “do something””

  1. Gravatar of David Pearson David Pearson
    23. July 2011 at 08:25

    Rajan writes, “There is, however, scant evidence that the real problem holding back investment is excessively high wages.”

    Is there anything “holding back” corporate investment? Spending on (domestic) equipment and software has been the strongest component of this recovery, far outpacing its contribution to the previous two:

    http://modeledbehavior.com/2011/07/22/deconstructing-the-recovery-the-capital-surge/

    The WACC for large corporations is quite low, which helps explain this robust investment boom. The 18x trailing market P/E is in the top 28% of observations since 1900; and real corporate borrowing rates have never been lower.

    Moreover, marginal (domestic) corporate profits have soared: 92% of income growth in this recovery (up to 1q11) has come from the growth in corporate profits, only 0% from wage growth. By comparison, the numbers for profits contribution to income growth were 28% in ’82-84 and -1% in ’91-92 (Sum, Khatiwada, et al).

    Thus, corporate margins have been increasing at an unprecedented rate. Further, the level of AVERAGE profits is important: they are at peak as a % of gdp, indicating that further marginal increases would take us to unprecedented levels of profit share of gdp — this, in a series that exhibits mean-regression. Contrast to the GD, when the corporate profit share of gdp was coming off highly depressed levels.

    Given the above, it would be interesting to hear more specifics on how lower real wages will lead to higher aggregate income. In particular, why have higher margins — up to peak levels — not produced a higher marginal benefit to adding employees? Would even lower real wages change this dynamic? How much lower? Say, if inflation went from 2% to 4%, would this 2% make a difference to the marginal employment benefit to in the short term? Enough to offset the likely drop in real spending by the already-employed? The recent experience is that falling real wages have led to lower aggregate income.

  2. Gravatar of David Pearson David Pearson
    23. July 2011 at 08:33

    Just to be clear, when I say, “higher margins”, I mean the robust increase in those margins, not the average margin. The average is important, again, in that it points to those increases coming off of a high base rather than a low one.

  3. Gravatar of Benjamin Cole Benjamin Cole
    23. July 2011 at 09:54

    Note to all economics bloggers and commentators: please shut up and run Scott Sumner’s blog in your place.

    BTW, a do-nothing policy is a policy. It may be a policy to maintain an ineffectual, feeble monetary policy, and that is what we are doing.

    Maybe Rajan will next suggest we subcontract out Fed policy to the Bank of Japan. They have done nothing successfully for 20 years. What a brilliant success.

    As Ray Dalio (world’s largest hedge-fund manager) suggests, we have 10 years of economic rot in front of us as we deleverage with glacial speed. Or, we couold coud pritn more monet, and speed up the process through inflation and grwoth.

    Are 1-2 percent inflation rates worth 10 years of economic rot?

    Tell me again of the moral virtues connected to ultra-low inflation rates. Is it similar to self-flagellation to show faith in God?

  4. Gravatar of Tomasz Wegrzanowski Tomasz Wegrzanowski
    23. July 2011 at 11:30

    Sticky wages are half of the story, debt deflation is the other half.

    Massive debt burdens make it even harder for people to accept pay cuts.

  5. Gravatar of Scott Sumner Scott Sumner
    23. July 2011 at 12:18

    David, That’s a good point about corporate investment being relatively strong. I saw a recent study that suggested that the problem is services. Lower real wages (via monetary expansion) could boost industries like restaurants, and other service sector firms.

    You said;

    “Say, if inflation went from 2% to 4%, would this 2% make a difference to the marginal employment benefit to in the short term?”

    As you know I’m strongly opposed to using inflation as an indicator of stimulus. If inflation rose to 4% because of supply shocks (by far the most likely explanation) then it would do zilch for jobs. I am talking about faster NGDP growth. That hasn’t been tried yet, but I’m convinced that 6% to 7% NGDP growth (until we catch up a bit toward trend) would mean faster real growth as well. Right now we have 3.9% NGDP growth. Do you think that’s enough for a fast recovery? If so, what plausible P/Y split could produce a fast recovery with 3.9% NGDP growth?

    Thanks Ben.

    Tmomasz, You said;

    “Sticky wages are half of the story, debt deflation is the other half.”

    You need to specify the “story” you are trying to explain. Is it “what causes NGDP to slow” or “given NGDP slowed, what causes RGDP to slow.”

    I see sticky wages answering the second question. I think most people believe debt deflation answers the first, but I’m not so sure.

  6. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    23. July 2011 at 13:14

    Sheesh, I was just having a good second laugh at Aaron, Blinder and Munnell for writing ten years ago that SS could be put back in balance by increasing the interest rate paid on Trust Fund bonds, and now David Henderson at Econlog is playing find the pea under the walnut shell, that’ll do it:

    http://econlog.econlib.org/archives/2011/07/tom_saving_on_t.html

    ‘Simply by a transfer within government, the Social Security Administration can come up with funds to pay benefits for a long time–without adding any new debt to the gross debt.’

  7. Gravatar of Charlie Charlie
    23. July 2011 at 14:19

    Isn’t the problem with Chicago macroeconomics that we’re actually not quoting Chicago macroeconomists? Rajan, Cochrane, and Fama are all finance professors at Booth. Cochrane does some macro, but the lions share of it has nothing to do with monetary policy. In Rajan’s case, banking is a different field than macro even if banking can affect the macroeconomy.

    Maybe it’s not such a dark age in macro as it is a dark age for finance professors who think they are qualified to talk about macro. As someone entering a finance department, I wouldn’t go to any of my professors for their opinion on fed policy. It’d be like asking a world class cardiologist to perform your brain surgery.

  8. Gravatar of Charlie Charlie
    23. July 2011 at 14:25

    Also, isn’t this backwards as well?

    “Finally, what of inflation itself? While wage inflation in the US is contained, global monetary policy is probably excessively loose – one reason that oil prices have taken off. The Fed blames (rightly) foreign central banks that are keeping interest rates too low to prevent their currencies from appreciating against the dollar;”

    If foreign central banks are printing money and buying dollars, the net effect is to make fed policy more contractionary

    “but the Fed cannot set policy assuming others respond with a theoretical ideal. High oil prices now curtailing growth in the US are partly an unintended consequence of current policy.”

    Assuming the Fed’s goal is to set monetary for the benefit of the U.S. (according to its mandate). Adjusting from the theoretical ideal should cause it to be more expansionary. The high oil prices would be more than offset by the higher nominal income.

  9. Gravatar of Morgan Warstler Morgan Warstler
    23. July 2011 at 14:32

    I think if you are honest you must compare Rajan to Mundell.

    Mundell would say to the ECB, the Fed and China: do nothing. He’d say BANKERS STOP TOUCHING THE STEERING WHEEL.

    Establish free trade, peg your currency, and act like there is only one global currency.

    When I read “do nothing,” that is EXACTLY what I think… eggheads stop doing things, eggheads stop pretending they count.

    What matters is the spirit, not the letter.

  10. Gravatar of E. Barandiaran E. Barandiaran
    23. July 2011 at 15:42

    Scott, thanks for linking to Rajan’s column because I agree with his analysis and conclusion. More important, I want to complement his arguments to explain you my claim that economists must forget about monetary policy as different from fiscal policy.

    As a veteran of many economic, fiscal and financial crises in the past 60 years, I know when the situation is bad and the prospects terrible. Although Rajan is not certain about how bad the U.S. situation is today –indeed it’s much worse than he thinks– he can hear the loud calls on the Fed to do something. He can hear pundits’ cries from the battlefields: Bring Friedman’s helicopters now! Bomb them with billions of $100 bills! Tell them that the bombing will continue forever! Rajan is right: “More than any other policy action, monetary policy suffers from the sense that there is a free lunch to be had”.

    We are told that bombing the economy with currency will bring interest rates down, aggregate demand will increase, output and employment will increase, and unemployment will be back to its natural rate. How can that happen? Well, once people’s pockets are full of bills they will go to the banks with some of their windfall to deposit it and to pay back loans. They will also spend part of the windfall on consumption and investment goods. And they may keep some of the windfall under their mattresses, but let us hope they do not mistake the bills for confetti and assume that the windfall is either saved in the banks or spent in goods. Banks will lower their interest rates and prices will increase leading to expectations of inflation. Real interest rates will become negative, and people increasingly will prefer to spend rather than save. Nominal GDP will increase to absorb all the increase in currency, although we can hardly say in advance how the increase in nominal GDP will be divided between higher prices and higher real GDP.

    Is that possible? Well, I know some experiences in which a lot of currency was thrown away and the record is clear: at best prices increase without a decline in real GDP, but don’t be surprised if prices increase and real GDP declines. Why? The easy answer is simple: because you cannot fool people long enough to get out of a bad situation without a huge sacrifice –there is no free lunch. The technical answer is that politicians that want to play the Friedman’s helicopter game need to take into account how people’s expectations about politicians’ behavior will change (yes, the rational expectation hypothesis). If you say yes once, why should I expect you to say no the second time? How are you going to persuade me that next time that I need money you will not send the helicopter? If necessary, I could illustrate these ideas with many experiences of giving money away in poor and rich countries. The point to remember is that once you do something, don’t be surprised that other people expect you to do the same in similar circumstances (it’s called reputation). And more important, the many failures of politicians to keep their promises have made their reputation worse than car salesmen’s.

    Indeed, Rajan prefers to analyze a different policy, one that Bernanke can implement. Let us assume that Friedman’s helicopter stops at Bernanke’s office and gives all the currency to Bernanke to undertake open market operations and the pilot tells him that he is free to buy and sell any assets he wants to reduce interest rates and/or to increase asset prices. Size matters. Is one trillion dollars (doubling the current stock of currency) enough to move at least some interest rates and prices? Which ones? If Bernanke sticks to the textbooks he will deal only on Treasury bonds and his choices will be limited largely to the ends of the term structure of rates. Let us assume that one trillion dollars is enough to increase bond prices and lower rates in world markets. If the Fed opts for short-term bonds, one may argue that it is not the relevant time framework for corporate investment decisions, so let us assume that it opts for long-term bods so corporations can get a “subsidy” to invest in inventories and output capacity. If Bernanke is willing to take some risks he may buy houses, a lot of houses, and drive their prices up implying a large incentive to build new houses (to explain this effect just apply Tobin’s q). Both owners of the old houses sold to the Fed and construction companies will get a subsidy paid by both seignorage and people still owning their old houses (the new long-rung equilibrium implies a larger stock of houses).

    What should Bernanke do: buy long-term Treasury bonds or houses? Well, assuming that the ultimate objective is to increase real GDP and employment and that an increase in aggregate demand is a sufficient condition for achieving it, can we say anything about the relative effects of buying bonds and houses on aggregate demand? I’m sure there must be some large macro-econometric model that can provide some estimates of these effects. More important, there exists the possibility that the Fed may have a larger effect by buying other type of asset –for example, what would be the aggregate demand effect of buying shares in the stock market (the Hong Kong Monetary Authority did this in early 1998 to increase aggregate demand)? Once we focus on the particular type of asset that the Fed may buy to reactivate the economy, the question arises as to why the Fed does not borrow in world markets and fund a portfolio of the types of assets that have chosen to manage aggregate demand (in other words, why the Fed is not like the World Bank or any other state development bank). The point is that there is nothing special to argue that the Fed is funding its asset portfolio (whatever the assets are) with currency –this currency is government ‘s equity in the Fed (remember that I started with Friedman’s helicopter delivering currency to the Fed).

    We can discuss forever the types of assets the Fed should buy and sell to manage aggregate demand. We can agree quickly about the Fed’s liabilities because we know that Friedman’s helicopter can deliver a huge amount of currency only once every ten (or twenty or thirty) years, and therefore if the Fed is going to be responsible for managing aggregate demand, it will have to be funded by borrowing from government, commercial banks, or other intermediaries. Indeed, economists that don’t believe that the Fed can manage aggregate demand will argue that the Fed must be closed. And I agree with these economists. If a government wants to manage aggregate demand, it must do it occasionally and through fiscal policy (including the issue of currency since seignorage is a source of government revenue).

  11. Gravatar of Scott Sumner Scott Sumner
    23. July 2011 at 18:01

    Patrick, I read that, but he knows about SS. I’m pretty sure that doesn’t mean what it seems to mean. I think he’s just talking about accounting gimmicks to get around the debt ceiling, but can’t be sure. That accounting stuff makes my hair hurt.

    All I know is that the trust find is like if I wrote “I owe Scott Sumner trillion dollars,” on a slip of paper, and put in in a cookie jar. That cookie jar would be my retirement trust fund.

    Charlie, Those are good points. If people make macro pronouncements, they’ll be judged as if they are macroeconomists. When I was at Chicago the macro contingent was rather small. Mostly Bob Lucas. I had class from visiting profs like Patinkin and Mishkin. I don’t know the situation know.

    Morgan, When you say stop touching the steering wheel, does it matter which direction it’s pointed when we let go?

    E, Barandiaran, You said;

    “We are told that bombing the economy with currency will bring interest rates down,”

    That’s what Rajan would tell you, I’d never say something like that.

    I’d suggest shorter comments, which actually address the points I made.

  12. Gravatar of Lee Kelly Lee Kelly
    23. July 2011 at 18:45

    E. Barandiaran,

    You said, “economists must forget about monetary policy as different from fiscal policy,” and then proceeded to explain this claim.

    Here’s the problem: I find nothing particularly objectionable in your explanation, but I have no idea how it entails your conclusion. The implicit “therefore, economists must forget about monetary policy as different from fiscal policy,” seems like a complete non-sequitur.

  13. Gravatar of David Pearson David Pearson
    23. July 2011 at 19:45

    Scott,

    It seems to me that the mechanism of “converting” NGDP growth into RGDP growth is lower real wages. My point is the mechanism works much better when corporate margins are at trough (1933) than at peak (today).

    Beyond the large corporate sector, the small business service sector has not recovered — the NFIB index is at recession levels, and net new firm creation is abnormally stagnant. For the first time in history, the service sector accounts for the majority of recessionary job losses. Clearly, structural factors are at work. Would that picture change much with a 2-4% decline in real wages over two years?

    The implication of the above is that the transmission mechanism between price level increases and RGDP is possibly impaired. However, one could easily be convinced otherwise. Just play out a narrative that explains the impact of a marginal price level increase on various sectors of the economy, showing how the net effect is aggregate income growth.

  14. Gravatar of Morgan Warstler Morgan Warstler
    23. July 2011 at 21:31

    “Morgan, When you say stop touching the steering wheel, does it matter which direction it’s pointed when we let go?”

    not in the aggregate scott!!!

    we hate your driving so much, we don’t care, just get everyone off their wheel and we’ll trust the random outcome of of undriven cars en total.

    have you ever see that video of people walking on millennium bridge?

    http://www.youtube.com/watch?v=eAXVa__XWZ8

    read about it here:

    http://en.wikipedia.org/wiki/Millennium_Bridge_%28London%29

    —-

    stop touching the wheel, stop trusting your own mental feedback loop. act without reacting.

  15. Gravatar of Scott Sumner Scott Sumner
    24. July 2011 at 05:46

    David; You said;

    “the small business service sector has not recovered — the NFIB index is at recession levels, and net new firm creation is abnormally stagnant. For the first time in history, the service sector accounts for the majority of recessionary job losses.”

    This strongly supports my argument, and undercuts yours. You had claimed that corporations were already rich, and that more profits would not mean more jobs. But the real problem is the struggling service sector. If we boost NGDP growth, that means much more revenue being earned by those struggling service firms, and hence more jobs.

    By the way, my transmission mechanism is not real wages, it’s W/NGDP. This variable has increased during the recession. We need to bring it down by boosting NGDP.

    You said;

    “The implication of the above is that the transmission mechanism between price level increases and RGDP is possibly impaired.”

    Maybe it never existed in the first place. Maybe the mechanism was always between NGDP and hours worked.

    Morgan, So if we are driving toward the edge of the cliff it doesn’t matter? Remember, if they take their hands off, the market can’t put their hands on (unless we legalize counterfeiting.)

  16. Gravatar of David Pearson David Pearson
    24. July 2011 at 06:07

    Scott,

    You are right to point out the dichotomy between sm. business and large corporate profits. The question is whether raising the price level is the answer. The key for small business employment is net new firm creation. Small businesses are typically started with collateral and capital from the middle class would-be owner’s net worth. That net worth has plummeted along with house prices. How would your proposals raise house prices? The evidence so far is that QE has not been able to reverse their fall. This is a structural issue: the QE helped the top 5% of wealth holders that own 80% of financial assets and act as creditors; (by reducing real wages) it hurt the other 95% that have their net worth in housing and act as debtors. The top 1% does not contribute much to net new firm creation, and they are not providing capital to the small business sector through the financial system. Again, these are structural factors that impede the workings of monetary policy.

    The picture for monetary policy improves markedly if you assume it does not disproportionately impact middle-income debtors by raising food and energy prices. Further, one can assume that monetary policy automatically raises house prices. One of these assumptions goes against theory, the other against recent evidence.

  17. Gravatar of morgan warstler morgan warstler
    24. July 2011 at 09:25

    Scott you say never reason from caprice change. I say never reason from fear.

  18. Gravatar of Scott Sumner Scott Sumner
    24. July 2011 at 17:19

    David, You said;

    “You are right to point out the dichotomy between sm. business and large corporate profits. The question is whether raising the price level is the answer. The key for small business employment is net new firm creation. Small businesses are typically started with collateral and capital from the middle class would-be owner’s net worth. That net worth has plummeted along with house prices. How would your proposals raise house prices? The evidence so far is that QE has not been able to reverse their fall.”

    A couple points. I’m proposing that we raise NGDP, although I concede the price level would rise a bit. I propose we raise NGDP at above trend for a couple years to catch up. So far we’ve raised it below trend. Thus as far as I’m concerned we haven’t even tried monetary stimulus. QE2 made policy less contractionary, that’s all, so I’m not dismayed that house prices haven’t risen.

    I see why you are dismayed by recent trends. I just don’t see those reflecting monetary ease. Regarding oil prices, I think the world needs to deal with the fact that if we are going to allow non-white people to escape poverty, we’ll have to pay a lot more for oil. We lucked out in the 1990s with cheap oil and cheap Chinese goods, that combo can’t last forever.

    Morgan, We are getting far removed from optimal monetary policy. Slogans don’t solve complex problems.

  19. Gravatar of Philip George Philip George
    25. July 2011 at 19:14

    Why have interest rates on T-bills etc not gone up? It’s simply because the Fed has put in more cash through QE2 than the government has taken out through borrowings. The arithmetic can be seen at http://www.philipji.com/item/2011-07-06/brad-delong-and-the-law-of-demand-and-supply

    In the first six months of 2011 the government borrowed only $300 billion, almost certanly less than the amount put in through QE2 during the same time.

    The idea that low interest rates are contractionary is not as strange as it sounds. It sounds odd only to those who look only at the demand side of the equation. From the supplier’s point of view it makes perfect sense. From 2001 to 2011 the evidence is that during periods of rising interest rates bank lending has grown.

    Look at http://www.philipji.com/item/2011-07-24/why-banks-do-not-lend-at-near-zero-interest-rates for both the logic and the data.

  20. Gravatar of Scott Sumner Scott Sumner
    26. July 2011 at 06:50

    Philip, T-bill yields are low because NGDP is low.

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