The following post is a sort of response to Raghuram Rajan’s recent post at Freakonomics:

If you are a college econ teacher, you’ve had this experience.  You explain how an expansionary monetary policy can boost AD.  A student raises his hand:

“But isn’t low interest rates just like the government providing a subsidy to borrowers?  And aren’t government subsidies bad?”

The student is so far off base you wonder how you are going to fix things with a short answer.  But let’s try anyway.

1.  Yes government subsidies are bad for two reasons.  They require higher future taxes, which impose deadweight costs.  And they distort relative prices.

2.  Now let’s think about monetary policy.  The first misconception is that the Fed “controls” interest rates.  In fact, the Fed controls the monetary base, and targets interest rates.  Rates are always allowed to find their free market values, given the setting of the monetary base.   So if the Fed wants to reduce rates, it might increase the monetary base until the equilibrium free market rate falls to the desired level.

3.  But doesn’t the Fed distort the bond market when they swap cash for T-bills?  Maybe a tiny bit, but that’s not really why rates fall when the Fed increases the monetary base.  The same liquidity effect used to occur in the old days when the Fed bought gold.  The effect occurs because there is more non-interest bearing money in the public’s hands.  Until consumer prices have had a chance to rise, the only way to get people to hold this extra money is for free market rates on alternatives assets to fall.  These rates are the opportunity cost of holding cash.  So monetary policy is fundamentally about the supply and demand for money.  Interest rates are just one of many variables that change as a result of changes in the money supply.  Exchange rates and consumer prices also change.  Imagine someone criticizing a reduction in the inflation target from 3% to 2% on the grounds that it would be a subsidy to consumers!

4.  Interest rates are (as a first order approximation) a zero sum game for the public.  Lower rates mean one group pays less, and the other group receives less.  But isn’t there some sort of “natural rate” and isn’t the Fed messing things up by setting rates below that natural rate?  All serious attempts to find a natural rate of interest look at the macroeconomy, especially inflation and NGDP.  Obviously credit markets (financial asset prices) can adjust to any inflation rate, but the real economy has trouble when inflation (or NGDP) rises or falls unexpectedly.  So if there is a “natural rate of interest” it would be the rate where inflation or better yet NGDP is optimal, where the macro economy is in some sort of equilibrium.  Where you don’t have mass unemployment, or overemployment, because nominal wages are temporarily stuck at the wrong level.  Even if you don’t believe in sticky wages or prices, and simply support steady 2% inflation, there is still a natural rate; it is the rate that generates that target inflation rate.  But one shouldn’t even focus on the natural interest rate, as we don’t have any way of directly estimating it (Taylor Rules notwithstanding.)  Instead, the focus should be on NGDP and inflation expectations.  Get those variables right, and then interest rates will also be at the proper level.

5.  Thus the question is never whether low rates unfairly subsidize borrowers, or whether high rates unfairly tax borrowers, because the Fed is not directly fixing interest rates, or driving any sort of tax or subsidy wedge between lenders and borrowers.  Rates are set in the market.  The question is whether the money supply is set at a level that produces the sort of interest rates, exchange rates, prices, NGDP, etc, that are consistent with optimal macroeconomic performance.

6.  Of course right now expected inflation and NGDP growth are much too low for macro equilibrium, so we need easier money.  Does that mean we need lower rates?  Here is where things get complicated.  If both long and short term rates are very low, it is generally a sign that money has been too tight, and the level of nominal spending is too low to provide optimal macroeconomic conditions.  So can you solve this problem by raising rates?  It depends what you mean by raising rates.  If you mean setting a higher fed funds rate, and implementing it through a reduction in the base, then the answer is no.  If you mean trying to raise rates by printing lots of money and promising to do more in the future, or promising higher future inflation, or promising to steadily devalue the dollar, then the answer is yes.

The problem with recent essays by people like Rajan and Kocherlakota is that they don’t seem to understand this distinction.  Or if they do, they express their ideas in a rather garbled fashion.  They both think that higher rates might be desirable for various reasons.  So far so good.  But both also strongly imply that the way to get higher rates is through the Fed raising its short term fed funds target.  But that requires tighter money–which would be a disaster right now.  I’d also like to see higher rates on long term bonds (I’d love to get back to the 4% rates we saw on the 10 year bond a few months back) but want to get there through easier money.  Since the fed funds target can’t be lowered much further, I support unconventional methods of boosting inflation and NGDP growth expectations.

Steve Williamson left this comment over at Nick Rowe’s blog, in support of Kocherlakota:

Andy Harless and I have recently been picking on this Kocherlakota quotation:

If the FOMC hews too closely to conventional thinking, it might be inclined to keep its target rate low. That kind of reaction would simply re-enforce the deflationary expectations and lead to many years of deflation.

Let me emphasize that I do understand that there is a problem with promising low rates as far as the eye can see.  My problem with Kocherlakota is that he seems to think that the solution is tight money.  At least that’s what I infer from the totality of his comments.

I’ve been so frustrated by the events of the last few weeks that I worry I am getting too negative in my posts.  I’d like to maintain a high level of courtesy, like Tyler Cowen or Nick Rowe.  Instead I often get too sarcastic, like  .  .  .  like those other guys.

Thus I was a bit surprised, but also heartened, to read this comment from my favorite monetary blogger (and cattle herder), Nick Rowe:

That speech by Narayana Kocherlakota is really disturbing. This guy is a top macroeconomist, and he totally f***s it up. I mean totally. It wasn’t just misspeaking, because he is quite clear the second time he makes the mistake. If the natural rate of interest rises exogenously, and the Fed doesn’t raise the nominal rate in response, the result will be….DEflation! And he’s a Fed President (so presumably this guy has some sort of power over monetary policy?).

You guys in the US are so scr***d. (And maybe we up here are too, since you are so big, even though we’ve got flexible exchange rates).

He went straight from a math undergrad into a PhD. I bet that’s the problem. He missed Intro Economics. (And he has the nerve to cr*p on Intro Economics too).

If even mild-mannered Nick Rowe is this upset, then you can imagine how a hot-head like me feels.

And then there is the financial press.  Here is something Marcus sent me from the Wall Street Journal:

So what’s the problem? Here it is best to depart from monetarist terminology, with its heavy emphasis on the magical powers of the central bank. Those magical powers are highly overrated, as almost anyone who has ever run a central bank will likely tell you. The Fed can flood the banks with liquidity in an effort to stimulate economic growth (if it is willing to run the very serious risk of inflation). But that will not necessarily stimulate a demand for this money.

Correct me if I am wrong, but if the Fed is trying to boost AD, isn’t an increase in the demand for money the last thing they’d want?  More and more I just scratch my head at what I read.  From the same article:

But deflation and inflation predictions could both be right in a sense, if you aren’t too fussy about strict definitions. In the late 1970s, the last time Americans suffered from manic interventionism from Washington, we had “stagflation,” a combination of minimal economic growth and double-digit inflation. It wasn’t pretty.

Which year in the 1970s did we have deflation?  And this:

Since deflation, in simple monetarist terms, means too little money chasing too many goods, with a consequent fall in prices, the remedy should be easy. Can’t the Federal Reserve create as much money as it wants with just a few key strokes? Well, there are some things money can’t buy. In political circumstances like today’s, one of them is public confidence.

You need “confidence” to create inflation?  How much confidence did people have in Jimmy Carter?  How about the Zimbabwe central bank?  I had thought inflation was more likely to result from a lack of confidence.  I thought you got inflation by “committing to be irresponsible.”

Both of the guys I quoted are very smart–Kocherlakota is obviously far brighter than I am.  I probably agree with them both on most issues.  But money is a specialized field and I just don’t have much confidence that our decision-makers or the media people who shape the discussion are on top of this issue.  We need people who are “fussy” about definitions.  Who understand why monetary policy does seem like “magic” to the uninitiated.  Every single FOMC voter should have not only a PhD in economics but 20 years of research on monetary policy, monetary theory, and monetary history.  Not one, not two, all three areas.  It’s that important.  (For instance, does Kocherlakota know that the Fed tried Rajan’s exact proposal in 1931, they raised rates by 200 basis points when the economy was weak and rates were very low?)

Update:  I just noticed that Nick has a post with a lot of interesting discusssion.  I can see I’ll have to address this issue again tomorrow.

OK, I’m ready to throw in the towel.  I just made the mistake of checking Drudge.  His website is frequently shameless, but you have to admit he often picks up the zeitgeist.  All the news about the economy is dreary.  Then I looked at Bloomberg and here are the latest TIPS spreads:

5 year conventional T-bonds 1.33%,  Indexed bonds 0.08%,  TIPS spread 1.25%

10 year conventional T-bonds 2.50%, Indexed bonds 1.03%, TIPS spread 1.47%

Both have been falling like a stone.  This suggests that a sharp slowdown in NGDP growth is very likely.  Until now I’ve tried to remain an optimist, disappointed in the pace of recovery, but assuming that we were at least muddling forward.  But it is now clear that we are no longer recovering.

So let’s put this fiasco into perspective.  What can we compare it to?  As far as I know, there are four great recessions/depressions with near zero rates:

1.  The 1929-33 contraction

2.  The 1937-38 contraction

3.  Japan since 1994.

4.  The US since 2008.

The real economy did grow after 1938, but mild deflation continued.  A serious recovery only began with WWII intensifying in mid-1940.  Japan never really had a satisfactory recovery, although there were some reasonably good years such as 2003-07.  And of course the recovery from 1929-33 only began when the dollar was sharply devalued.  The bottom line is that zero interest rate malaises don’t seem to end like ordinary recessions; short of some sort of dramatic shock like dollar devaluation or World War, they seem to linger.  What can we learn from that?

Before explaining my analogy (actually Nick Rowe’s analogy) considering the following paradox:

1.  Near-zero nominal rates are always associated with economic malaise: a weak economy with deflation or disinflation.  So we don’t want near-zero rates.

2.  Lowering nominal rates below zero is impossible.

3.  Directly raising nominal rates through monetary policy is contractionary, and will make the recession/deflation worse.

So what do we do?  As you know I think there is a simple answer.  Indeed I think there are lots of simple answers (massive QE, negative IOR, explicit NGDP targeting, etc.)  But I think we need to face the fact that for some reason our monetary authorities don’t see it this way.  They view all these ideas as exceedingly risky, as exceedingly reckless, as exceedingly expansionary.

Go back and review the history.  Short of World War, the only escape from zero rate deflation was in 1933, with dollar devaluation.  Your history books never gave you any idea how controversial that was.  Think about this.  FDR basically had the Federal government take over the economy through programs like the NIRA and AAA.  They controlled almost everything.  And yet there was little objection from Wall Street.  People just went along.  But dollar devaluation was different.  It wasn’t just the conservatives who were apoplectic.  The unions were opposed.  FDR saw one top economic advisor after another resign in protest.  And these were his supporters.  The program was highly successful in raising prices (and output until the NIRA raised wages 20%), but nevertheless was the most controversial thing FDR ever did.  Even more than the Court packing.

Milton Friedman once noted that ordinary people were shocked when told that unelected Fed officials were free to simple double the money supply anytime they wished.  I think the same thing is true of changing the value of the dollar, as when FDR arbitrarily decided each dollar would be worth 60 cents (in gold terms.)  People seem OK with interest rate targeting, but anything else seems radical.  But interest rate targeting doesn’t work anymore.  So we are stuck.

Nick Rowe uses the analogy of balancing a long pole in your hand.  If you want the top to go left, you move your hand right.  By analogy, if the Fed wants inflation/growth (and long term rates) to go up, they lower the fed funds rate.  But if you bump up against a tall wall, then you may not be able to move your hand in the direction required to move the pole in the other direction.  You are stuck.  The only solution is to rely on some other method–such as directly grabbing the top of the pole.

The Fed needs to raise NGDP growth by some method other than lowering nominal rates.  It is up against the wall.  That means they need some other policy tool.  It might be the printing press (QE), negative IOR, price level or NGDP targets, dollar devaluation, etc.  But it can’t be done by manipulating the fed funds rate.  And for some reason the Fed seems paralyzed.

I guess because I have spent my whole life studying unconventional policy tools, and because I never favored interest rate targeting in the first place, these alternatives don’t seem at all scary to me.  FDR created inflation when he raised the price of gold.  And the inflation basically stopped when he stopped raising the price of gold.  Excluding WWII, no one has ever overshot toward high inflation coming out of a zero rate trap.  That’s why Krugman and I can have such serene confidence that the inflation scare-mongers will be proved wrong.  I’ve seen this movie already.  Several times.

Because deflation make rates low, and leads to cash and reserve hoarding, it makes money seem really loose when it is actually very tight.  Fed officials currently argue that money is very loose.  They are wrong, but that’s what they think.  Now we need to convince conservative central bankers, who are devoted to price stability, to take what seems like ultra-loose monetary policy, and make it far looser.  The thought makes me despair.  That’s why it is so tragic that Milton Friedman died in late 2006.  He was a voice that central bankers would listen to.  He was a respected conservative.  An inflation hawk.  Regarding the Japanese malaise, he 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 U.S. 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.

That’s right Dr. Friedman, it’s just too counter-intuitive for people to accept.  And that’s precisely why we are fated to suffer through the Great Recession.  It’s a real pity.

PS.  Nick’s analogy is in the comment section of the link.

PPS.  Andy Harless has a post showing a Fed president stumbling over the interest rate paradox discussed above.

I was reading the comment section of Will Wilkinson’s blog, and came across this assertion:

The libertarian effort to convert liberals will be about as successful as the libertarian effort to convert conservatives. Liberals would at base have to share some common ideology with libertarians for that to work, but since they don’t, it won’t.

I couldn’t disagree more strongly.  Liberaltarianism is basically libertarians attempting to knock some sense into liberals on economic issues.  As you may know, I think both left and right wing liberals have basically the same (quasi-utilitarian) values, but different worldviews.  And as you know, I think the right wing worldview is more accurate on most economic issues (although now I guess I have to exclude monetary policy.)

Let’s review what liberals used to believe, before libertarians knocked some sense into them:

1.  In the US, they believed the prices of goods and services should be set by the government.  Ditto for wages.  This took the form of the NIRA in the 1930s.  It took the form of multiple industry regulatory agencies like the ICC and CAB.  By the late 1960s and early 1970s they favored “incomes policies” which were essentially across the board wage and price controls.  Today they generally favor letting the market set wages and prices.  Very liberal Massachusetts recently abolished all rent controls.

2.  In the US, they believed the government should control entry to new industries.  They have abandoned that belief in many industries, and based on recent posts by people like Matt Yglesias, are becoming increasingly disillusioned with remaining occupational restrictions.

3.  They favored 90% tax rates on the rich.  Today they favor rates closer to 50% on the rich.

4.  In most countries liberals thought government should own large corporations.  Today most liberals around the world think large enterprises should be privatized.  Over the next few decades there will be trillions of dollars in new privatizations, and very few nationalizations.

Sure the recent crisis has created setbacks, such as the government takeover of GM.  But the long run trend around the world has been strongly liberaltarian, and will almost certainly remain so for the foreseeable future.  Just the other day Denmark decided to cut unemployment benefit eligibility from 4 years to 2 years.  Think about what that means.  Two French researchers (Algan and Cahuc) found that Danes had the most liberal/civic-minded attitudes on Earth.  They argued that Denmark was the country most suited to have social insurance programs, because the non-deserving would be less likely to abuse the programs in Denmark than in any other country.  Yet even in ultra-honest Denmark it was found that a large number of workers mysteriously found jobs immediately after their unemployment benefits ran out.  So they are cutting back.  Denmark already has the freest markets in the world, and now they are shrinking their welfare state.  No wonder the Danes are so happy, despite dreary weather.

I see people like Brink Lindsey as trying to make pragmatic libertarians better understand their role in the ongoing policy debate.  We are not engaged in some sort of Manichean struggle between good and evil.  We are trying to convince well-meaning policy wonks like Matt Yglesias of the virtues of free markets.  Whether success on that front would actually change public policy depends on how civic-minded (or “liberal” in the original sense of idealistic) the society is.  In very civic-minded societies liberaltarian ideas are accepted much more easily that in less civic-minded societies, where rent-seeking may be endemic.  In the long run, the only hope for those societies is a change in attitudes.  I believe that occurs through the narrative arts.  Progress seems slow, because the problems seem so overwhelming.  But taking the long view, the progress we have already achieved has been mind-boggling.

Good luck to Brink and Will in their new jobs.

Last night JimP sent me a chilling but persuasive article written by the WSJ’s Jon Hilsenrath.  He clearly has good sources:

WASHINGTON””The Aug. 10 meeting of top Federal Reserve officials was among the most contentious in Ben Bernanke’s four-and-a-half year tenure as central bank chairman.

With the economic outlook unexpectedly darkening, the issue was a seemingly technical one: whether to alter the way the Fed manages its huge portfolio of securities.

But it had big implications: Doing so would plunge the Fed back into the markets and might be a prelude to a future easing of monetary policy, moves that divided the men and women atop the central bank.

At least seven of the 17 Fed officials gathered around the massive oval boardroom table, made of Honduran mahogany and granite, spoke against the proposal or expressed reservations. At the end of an extended debate, Mr. Bernanke settled the issue by pushing successfully to proceed with the move.

So it’s not just three, there are no less than seven hawks among the regional Fed Presidents/Board of Governors.  Read the entire piece, it’s scary.  Lots of our most important policymakers don’t understand what the market clearly understands–we have a major AD problem.  Let’s review the facts:

1.  Between 2008:2 and 2009:2 NGDP falls by more than 8% relative to trend.

2.  Since 2009:2 NGDP has grown about 4%, which is still below trend.

3.  All signs point to a recent slowdown from the already anemic 4% rate.

4.  Unemployment is near post-war records, and is not expected to fall.

5.  Core inflation and inflation expectations are well below the Fed’s implicit 2% target, and even farther below the actual average inflation rate over recent decades, which is over 2%.

This isn’t rocket science.  When the AD curve shifts to the left then NGDP falls (relative to trend, as in the excellent Cowen/Taborrok textbook.)  That’s an adverse demand shock.  We have seven members of the Fed who don’t even seem to understand the basics of AS/AD theory.  Who have concocted all sorts of bizarre structural theories to explain away their failure to boost NGDP enough for a robust recovery.  This is EXACTLY what happened at the Fed in the Great Depression.

Some Fed members worry about keeping rates near zero because near-zero rates are often associated with deflation.  Well yes, but raising the short term policy rate doesn’t solve that problem, the Fed tried that in 1931.  They seem unaware that monetary policymakers must have two tools.  If all you have is the fed funds rate, then the price level is intermediate indeterminate.  You also need some sort of nominal target, or a Taylor-rule like reaction function.  If you want higher rates because you’ve noticed that low rates are associated with deflation (which is a reasonable thing to want), then you don’t raise the short term policy rate, you raise your nominal target.  Nick Rowe has done a lot of excellent posts on this subject.  Again, it isn’t rocket science, these principles are well understood.  But when you read comments from some Fed officials, you’d think you are listening to undergraduates trying to grasp these concepts for the first time.  And they are screwing up the entire economy!!!

When I went to bed last night I thought to myself; “Maybe it’s not this bad.  Maybe I shouldn’t freak out over a single article.  After all, I pride myself in taking my marching orders from the markets.  Let’s see how they reacted to the Wall Street Journal story.”

When I woke up this morning I noticed the markets were down sharply.  Then I saw a Yahoo.com story entitled:

Traders Freaking Out Over WSJ Report On The Fed: Here’s Why

Last night, WSJ’s John Hilsenrath reported that at the last FOMC meeting, several of the Fed governors expressed reservations about the plan to maintain the size of the balance sheet, and roll over MBS into Treasuries.

There are a lot of moving parts to the story because there are different reasons for the objections. Some of the Fed governors are hawkish (like Hoenig). Some are more dovish (like Bullard). And some think that the Fed can’t really do anything because our problems are more structural (Kocherlakota).

But here’s what folks are taking away from the article: The Fed is still way behind the curve in terms of how bad the economy is. It’s paralyzed.

It’s funny, because this is the exact opposite of what some people initially thought — there was this fear that the Fed knew something about bad news coming down the pike that the public hadn’t heard yet. In fact, as we now know, the Fed isn’t seeing what everyone else is.

Anyway, this is the talk of the morning, and it’s helping send stocks down again.

I know there will be some saying; “Sure, the stock market likes easy money, stocks are a hedge against inflation.”  Actually no.  The market did horribly in the high inflation period of 1966-81.  Here’s how I look at it:

1.  The market hated inflation in the 1970s.

2.  The market is begging for easier money today.

3.  Put 1 and 2 together–what does that tell you?

This is the last nail in the coffin of the Krugman “depression economics” theory.  Recall that that theory is based on the assumption that everything changes when rates hit zero.  Since monetary policy is (supposedly) completely ineffective, suddenly all he old Keynesian myths come true.  A fiscal multiplier.  Imports are bad.  Saving too much causes recessions.  All the prejudices of the man on the street.

Is monetary policy really ineffective at zero rates?  Try telling that to Wall Street.

PS.  For those who like black comedy, check out this Kevin Warsh statement:

An abrupt change in stance, he argued, could lead the public to believe the Fed was more worried about the economy than it really was.

Update:  I guess I am so freaked out that I have become a bit sloppy with recent posts.  I apologize.  Commenter 123 asked for an example of the interest rate fallacy cite above.  I.e., the idea that since low rates are associated with deflation, raising the short term policy rate can cure deflation.  I suppose this Kocherlakota excerpt is what I had in mind:

Long-run monetary neutrality is an uncontroversial, simple, but nonetheless profound proposition. In particular, it implies that if the FOMC maintains the fed funds rate at its current level of 0-25 basis points for too long, both anticipated and actual inflation have to become negative. Why? It’s simple arithmetic. Let’s say that the real rate of return on safe investments is 1 percent and we need to add an amount of anticipated inflation that will result in a fed funds rate of 0.25 percent. The only way to get that is to add a negative number””in this case, -0.75 percent.

To sum up, over the long run, a low fed funds rate must lead to consistent””but low””levels of deflation. The good news is that it is certainly possible to eliminate this eventuality through smart policy choices. Right now, the real safe return on short-term investments is negative because of various headwinds in the real economy. Again, using our simple arithmetic, this negative real return combined with the near-zero fed funds rate means that inflation must be positive. Eventually, the real economy will improve sufficiently that the real return to safe short-term investments will normalize at its more typical positive level. The FOMC has to be ready to increase its target rate soon thereafter.

That sounds easy””but it’s not. When real returns are normalized, inflationary expectations could well be negative, and there may still be a considerable amount of structural unemployment. If the FOMC hews too closely to conventional thinking, it might be inclined to keep its target rate low. That kind of reaction would simply re-enforce the deflationary expectations and lead to many years of deflation.

I suppose there are different ways of reading this passage, but I find the last two sentences to be very disturbing.  What do you think?  I’d rather stick with “conventional thinking.”

Update:  Andy Harless has a nice post on this quotation.