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Productivity bleg

Marcus Nunes directed me to a Project Syndicate post by Ernest Liu, Atif Mian, and Amir Sufi, with a nonsensical headline:

Could Ultra-Low Interest Rates Be Contractionary?

That’s not even a question.  I won’t blame the authors, as headlines are usually written by editors.  But this confused me:

The traditional view holds that when long-term rates fall, the net present value of future cash flows increases, making it more attractive for firms to invest in productivity-enhancing technologies. Low interest rates therefore have an expansionary effect on the economy through stronger productivity growth.

This is a basic EC101 error—reasoning from a price change.  Actually, productivity growth tends to be lower when interest rates fall.

Now some will argue that they obviously meant something different, that lower interest rates caused by a more expansionary monetary policy will tend to boost productivity.  OK, but the article is about recent events, and lower interest rates worldwide are certainly not being caused by a more expansionary monetary policy.  More importantly, I don’t ever recall a “traditional” model of the economy making that claim.  Indeed isn’t this the traditional view:

A view deeply entrenched in mainstream macroeconomics is that trend productivity growth is the outcome of technological and institutional factors and can be treated essentially as an exogenous force, unresponsive to business cycles or monetary policy actions. The workhorse macroeconomic models used by international organizations and central banks are built upon this notion.

So here’s my request.  Please direct me to the “traditional” models that claim low interest rates cause faster productivity growth.  I don’t doubt that heterodox models exist that make that claim, but I’m looking for traditional models that make that claim.  Where are they?

More broadly, the tendency of economists to equate low interest rates and easy money is becoming a major embarrassment for the profession.  We really are going back to the Stone Age.

The “animal spirits” fudge factor

Marcus Nunes directed me to an interesting quotation from Bill Gates:

Too bad economists don’t actually understand macroeconomics,” . . . It’s not like physics where you take certain inputs and you predict certain outputs. Will interest rates ever return to normal, and why aren’t they returning to normal? You won’t get a consensus between economists quite the way that if you dropped a ball out your window and called up physicists and asked, ‘What the hell happened?’ There’s so many factors including what [economist John Maynard] Keynes called ‘animal spirits’ in the economic equation that we don’t have predictability. Even today, people are still arguing about what happened in 2008. So it’s even harder to look forward. [Look at] the role of the bond rating agencies in 2008, which is completely unreformed. Why would that be? Well, there must be a lack of consensus.

I like Bill Gates, but this is an example of how people worth $100 billion get listened to on subjects outside of their area of expertise. The physics analogy is silly, and proves exactly the opposite of what Gates assumes. “Macrophysics” (predicting complex physical systems such as hurricanes and earthquakes) does just as poor a job of prediction as macroeconomics.

Nonetheless, Gates is onto something here. Macroeconomics really does have problems that macrophysics does not, and “animal spirits” lies in the center of the confusion. While we cannot predict earthquakes and hurricanes with any precision, we do understand the forces that cause them. I’d argue that most economists don’t understand what caused the 2008 recession, even a decade later.

In my view, most American business cycles are caused by demand shocks, i.e., changes in current NGDP. And those demand shocks are caused by unstable monetary policy, i.e., changes in expected future NGDP. While most economists agree with my claim that US business cycles are mostly caused by demand shocks, they disagree on the claim that the root problem is unstable monetary policy.

Because most economists don’t know how to recognize unstable monetary policy (due to their “reasoning from price changes”), they follow Keynes in putting an “animal spirits” fudge factor into their models. Their models can’t explain why aggregate spending falls, so they assume that some sort of mysterious pessimism has suddenly developed in the minds of millions of entrepreneurs.

Because of the law of large numbers, aggregate business and consumer psychology doesn’t suddenly change for no reason at all. The real problem is modeling the policymakers. We don’t know exactly how the 12 members of the FOMC will behave. Of course Trump is even more of a wild card, on the “real business cycle” side of things.

When macro policy is relatively sound (as during the Great Moderation), there is less emphasis on fudge factors such as animal spirits. When it is not sound, as in the post 2008 period, then voodoo economics takes over.

PS. Here’s another way to make my point about physics. Physicists insist that the behavior of all particles can be explained by the laws of physics (or else is random.) In that case, any failure to accurately predict any physical system that is not due to quantum uncertainty must be a failure of physics. These comparisons with physics are beyond stupid. It would be like a mathematician who studies basic arithmetic claiming his field was more successful than the study of prime numbers.

PPS. The Fed cut its fed funds target by 1/4% today. Yawn. (Should have cut by 50 basis points.)

Update: I’m no expert on reserve management, but this old George Selgin post is looking increasingly prescient.

Google’s bias in favor of Saudi Arabia

If I google ‘”Saudi Arabia attacks Yemen”, then I get a long list of articles that mostly discuss Yemen attacking Saudi Arabia.

The Saudi attacks on Yemen have resulted in a horrific loss of life, whereas Yemen’s attack on Saudi Arabia didn’t kill anyone. What does this tell us? Does Google prioritize oil or human life?

And what is Google, if not the zeitgeist of the western world?

The ECB cut its IOR to minus 0.5%; it should have been minus 50%

The ECB should stop playing around with negative interest rates and simply put a prohibitive tax on excess reserves (something I proposed in 2009). If a small amount of excess reserves are needed to clear interbank balances, then exempt a modest amount of bank reserves from the negative 50% interest rate (aka 50% tax rate.)  

It’s time to abandon interest rate targeting and move to a monetarist approach to policy. In the short run, this heavy tax would lead banks to convert deposits at the ECB to currency. To some extent, they’ve already been doing so under the minus 0.4% deposit rate:

The interest rate on the ECB deposit facility was lowered to 0% on 11 July 2012. It was then lowered by a further 0.10 percentage point on 11 June 2014, on 10 September 2014 and again on 9 December 2015. These decisions did not have a noticeable impact on the amount of cash held by MFIs (i.e. in their vaults and in cash dispensers, referred to as vault cash) until 16 March 2016, when the Governing Council decided to lower the interest rate on the ECB deposit facility to ‑0.40%. This decision represented a pivotal point for some MFIs, after which they decided to convert part of their liquidity into cash, as illustrated in Chart A. For these MFIs, the costs of cash (i.e. costs associated with cash storage and handling) were obviously less than the losses resulting from the negative yields from the ECB deposit facility and current accounts held at NCBs. An average of €50.1 billion was held as vault cash by MFIs between January 2008 and March 2016. Between March 2016 and December 2017 the amount of vault cash held by MFIs increased by €21.1 billion and reached €76.8 billion, i.e. 6.6% of the total value in circulation. The increase in vault cash was mostly driven by German MFIs (69.4% of the increase) and, to a lesser extent, by Italian, French, Austrian and Spanish MFIs. . . .

This increase in vault cash has, however, remained limited. Logistical constraints such as storage capacities or maximum amounts covered by insurance are the most likely limitations on MFIs holding larger amounts of cash.

This 21 billion euro increase in vault cash is trivial. Less than 2% of bank reserves have been converted, despite the strong incentive to do so. If banks are forced to hold almost all of their vast reserves in cash, then interest rates may fall further. But why stop there? Apply the 50% tax to excessive bank cash holdings as well as reserve deposits at the ECB. This will force the currency out into circulation. Large institutions will now hold more currency, but they also have their limits:

Big institutions and individuals are finding creative places to put their cash and avoid negative rates. Banks including UBS Group AG received some requests, even recently, from big institutional and wealthy private clients to withdraw cash from their accounts and hold it in physical notes in their vaults as a way around negative interest rates. For very big amounts, this has generally not been possible, while for smaller amounts it has been done. Money kept in cash limits the effectiveness of negative rates.

The cash will become a hot potato, and increasingly end up in the hands of many individuals and small businesses. Because interest rates on their bank accounts will be substantially negative (more than 100 basis points negative), European savers will search for alternative investments:

In Switzerland, some individuals are putting cash into real estate, prompting fears of overbuilding. “Holding cash,” said Swiss Bankers Association chief economist Martin Hess, “is simply more expensive than building an empty house.”

The hot potato effect will continue until NGDP starts rising rapidly. At that point, nominal interest rates will rise above zero and the ECB’s main problem will be holding down inflation. In the long run, my plan will give savers higher nominal returns than the current policy regime. Actually, if the ECB were truly serious about this then interest rates would rise even in the short run.

Ultimately, the ECB needs to make a decision on the “socialism or inflation” question. Which do they dislike more, higher inflation of a bloated balance sheet? I can’t answer this question for them—it’s a political decision for the Europeans to make.

PS. Completely off topic, here’s a brain teaser:

At precisely 3pm today, Monday, September 16, 2019, I will be in the second largest city in the third largest country (by area) in the world. This country also has the world’s largest GDP. Where will I be?

The hard part of this question is that there are two correct answers.

You can be in two places at the same time.

More on Trump and trade

This Politico story caught my eye:

President Donald Trump’s top advisers are rushing to find an escape hatch for a series of tariff increases in the coming months, worried about the potential for further economic damage.

Many of the president’s top economic officials are trying to resurrect the terms they previously were negotiating with China, a deal officials said was “90 percent” done before a sudden impasse this summer, according to a person familiar with the discussions.

This reminded me of a post I did six weeks ago:

Stocks fell nearly 2% after the tariff announcement, and that’s the reaction that rational readers should go with. But if anyone is foolish enough to trust my judgment, here’s a more optimistic take.

I suspect that Trump has decided that he wants to do a China deal before getting into the election year. He knows that his negotiating position will be weaker in 2020, as the Chinese would have an incentive to string things out until after the election.  They know that Trump doesn’t want to risk an economic shock right before the election. In addition, Trump wants to run for re-election with a big “win” against China under his belt. . . .

Trump presumably knows that China will agree to a deal based on their best previous offer, which was reported to be more than 90% of a completed deal. Thus Trump knows he can get a deal anytime he wants, if he’s willing to settle for a deal that incorporates China’s best offer in previous negotiations. 

And from the same 6-week old post, how does this look today?

To his credit, Trump correctly understands that the John Bolton’s of the world are foolish warmongers, and Huawei is not a threat to US national security. I suspect that Marco Rubio will be more disappointed by the deal than I will be.

I’m less confident in other aspects of the previous post, such as the claim that an agreement is near, or that the Chinese would still accept the “90 percent” offer (which some sources suggest was rejected by Xi Jinping himself.) But this seems to be what Trump now wants. Any deal would have to wait until after October 1, a very important day in China.

BTW, US stocks recovered once it became clear that Trump was again interested in a trade deal.

You’re welcome.

PS. A few weeks ago we learned that Trump lied in his claim that the Chinese called him to restart trade talks:

Trump flashed signs of optimism this week that the trade war could be resolved, saying he’s received calls from Chinese officials saying they wanted to restart talks. Though Trump and Treasury Secretary Steven Mnuchin insisted there had been “communication,” aides privately conceded the phone calls Trump described didn’t happen they way he said they did.

So now when there’s a disagreement about facts we should trust the Communist Chinese more than our own government? What does that say about the charges that Huawei was engaged in spying?

More recently, Kevin McCarthy sounded like a 1970s-era Soviet spokesman:

Minority Leader Kevin McCarthy said Thursday that the national debt would be his top priority if Republicans succeed in retaking the House in 2020.

“First thing we would do is make sure our debt is taken care of,” McCarthy told reporters at a GOP retreat in Baltimore. “This is continuing to grow. … Every great society has collapsed when they’ve overextended themselves,” the California Republican warned.

Yes, and the two boys who shot up Columbine put out a statement that more needs to be done to improve our educational system.