Maybe it’s my jet lag . . .

and my cold . . . but I just don’t get this Conor Sen Bloomberg article:

Trump Wants the Fed to Roll Back the U.S. Economy

Higher interest rates could revive manufacturing and exports. That will hurt consumers and workers.

I’m only at the subtitle, but already lost.  How do higher interest rates boost manufacturing and exports?  And if they did, why would that hurt workers?

One of the main ways the Fed has won its credibility on inflation has been setting interest rates higher, sometimes much higher, than the inflation rate. This was most extreme in 1984, when short-term interest rates spent much of the year over 10 percent while consumer price inflation (stripping out food and energy) finished the year under 5 percent.  When investors and savers can get a “free lunch” by earning a high inflation-adjusted return in Treasuries, they’re incentivized to do so rather than invest in new production or consuming goods and services, both of which would put upward pressure on inflation.

This is reasoning from a price change.  Real rates were high in the mid-1980s precisely because growth was strong.  And buying Treasuries is not an alternative to producing consumer and investment goods.  That’s mixing up financial investment with physical investment.  For instance, suppose America had a massive corporate investment boom financed by corporate bonds.  Then you’d see lots of bond buying and lots of physical investment at the same time.  They are not alternatives.  A better argument would have been that Reagan’s fiscal deficits crowded out private investment.

But this has broader distortionary effects in the economy. On a global level, if investors can earn a high real interest rate on U.S. assets, they’re going to do so, which all else equal will drive the dollar higher in foreign exchange markets than it otherwise would be. The dollar being artificially higher will make U.S. exports less competitive in global markets, leading to larger trade deficits.

Distortionary?  Artificial?  Sorry, but Volcker and Greenspan were targeting inflation at about 4% from 1982-90.  There was nothing “artificial” about the resulting interest rates, they were simply the result of market forces.  The Fed does not set the real interest rate over an extended period of time.  Again, the fiscal deficits might have played a role (although even that factor was probably less important than widely believed at the time.)

In other words, the Fed established its credibility on inflation over the past few decades by setting real interest rates at a high level, which helped to orient the economy around financial activities, consumption and imports rather than production, labor and exports.

These are not either/or scenarios.  Consumption is not an alternative to production, labor etc.  Consumption is an alternative to investment.  Indeed consumption often booms during periods of high employment, such as the late 1960s and the late 1990s.  The same is true of financial activities.  And production is an alternative to leisure, not an alternative to consumption.  And real interest rates have not in fact been high over the “past few decades”.  They were high in the 1980s and have been low since 2001.

Trump wants a different model. It’s what his tariff threats seek to accomplish: making the U.S. economy more production-oriented rather than consumption-oriented. And he wants monetary policy to help do the same thing. If the Fed stops increasing interest rates over the next few quarters, then we’ll never get those high real interest rates in this economic cycle that we’ve gotten in past cycles. This should put downward pressure on the dollar, making U.S. exports more competitive, but at the cost of cheaper imports for U.S. consumers.

Where to begin?  How does downward pressure on the dollar lead to cheaper imports for U.S. consumers?  How does Trump’s tariff model lead to a more “production-oriented” economy?  Are low tariff countries like Singapore, Switzerland and Germany not production-oriented?  And how can monetary policy make the US more production-oriented? Isn’t money neutral in the long run? Where’s the long run aggregate supply curve in this model?

Update:  Several commenters suggested I misinterpreted the phrase “at the cost of cheaper imports”.  Perhaps it was meant to imply that imports would get more expensive.  I.e., “at the cost of more expensive imports for consumers”.

In the long run, if trade and monetary policy leads the U.S. economy to be somewhat less consumption-oriented and more investment-oriented, that’s something we can handle.

How could monetary policy have any long run impact on the share of GDP going to investment?  Is Sen arguing that monetary policy has a long run impact on real interest rates?

I guess in Bloomberg world, high interest rates lead to more manufacturing and exports, which hurts workers.  Low interest rates lead to more production, which helps workers.  But consumers must pay the “cost” of cheaper imports from the weaker dollar.

Am I missing something?

HT: Ramesh Ponnuru


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12 Responses to “Maybe it’s my jet lag . . .”

  1. Gravatar of Kevin Erdmann Kevin Erdmann
    24. July 2018 at 15:10

    The total expected returns on equity capital are unmeasurable, but that is actually the important measure. Fixed income yields are precisely measurable, but they aren’t that important. The financial sector and the economics field seem to use the measurable and unimportant factor, for lack of a better alternative. That, to me, seems to be the core problem which turns so much analysis into an exercise in reading entrails. It isn’t so much that Sen’s intuition about interest rates here is wrong. It’s that there is no way to form a coherent framework that uses the risk free yields as the causal force in productive development.

    Sorry for the self-promotion, but I have been working on a model where returns on investment start at the top – the expected returns on equity. Risk-free savers earn less than that because it is low risk borrowers who are performing the service here, of accommodating deferred consumption. So, if real yields are 2%, it isn’t the difference between 0% and 2% that is conceptually important. It is the difference between a 7% long term return on at-risk capital and 2% that is important. Risk free savers are paying a 5% premium for the safe-keeping of deferred consumption. To me, this helps to align intuitions on these sorts of issues in a more coherent way.

    Industrial investment is dependent on the unmeasurable equity return. The government and some firms have asset bases that permit them to provide the service of funding deferred consumption, but that market is only tangentially related to the cost of capital for new productive assets.

    One way to look at this is to compare the balance sheets of Ford and Tesla. Ford has lots of debt, because it has a primary business making cars and a side business funding deferred consumption. Tesla is mostly equity funded because it is more specifically engaged in marginal new capital development. Tesla’s business model is not particularly sensitive to long term treasury rates. Ford’s may be, somewhat, but as you point out, they are at least as likely to be growing when interest rates are high as they are when interest rates are low.

    Here is a post on the idea: http://idiosyncraticwhisk.blogspot.com/2018/07/upside-down-capm-part-6-leverage-before.html

    Here is another:
    https://idiosyncraticwhisk.blogspot.com/2018/02/upside-down-capm-part-3-capital-growth.html

  2. Gravatar of Benjamin Cole Benjamin Cole
    24. July 2018 at 17:24

    Conor Sen lost me.

    But here he may be right on lower interest rates:

    This should put downward pressure on the dollar, making U.S. exports more competitive, but at the cost of cheaper imports for U.S. consumers.—Sen

    “Where to begin? How does downward pressure on the dollar lead to cheaper imports for U.S. consumers?”–Scott Sumner.

    There might be a slip up here. I think Sen is saying that a cheaper dollar will result in more-expensive imports. His wording is perhaps ambiguous.

    As to nations that employ VAT taxes or sales taxes on imported goods and services, but not on exports, I think there is room for healthy debate as to whether such tax schemes are in fact export subsidies or simply tariffs.

  3. Gravatar of Ege Erdil Ege Erdil
    24. July 2018 at 17:33

    It’s not your jet lag, it’s just that he makes no sense.

    Ignoring the other things he mentioned, I am often annoyed by people’s tendency to say that a real currency depreciation causes a shift in the trade balance. This is just false; it’s possible for countries to have trade deficits and surpluses in a world with no trade frictions, i.e. a world in which PPP holds exactly, so real exchange rates are always 1. Saying that a real currency depreciation causes the trade balance to shift to surplus makes about as much sense as saying that the heat produced by an object falling while subject to air resistance causes the object to fall. It’s gravity that causes the object to fall, the heat is simply a consequence of the friction present in the environment. If you did the same experiment in a vacuum, there would be no heat whatsoever. Regardless, this mistake is made in public even by economists specializing in international trade, even though they have of course seen models of trade in which PPP holds exactly and yet there can still be trade imbalances.

    As an added note, the phrase “production-oriented economy” is silly enough to make me cringe after reading it.

  4. Gravatar of Willy2 Willy2
    24. July 2018 at 17:47

    – Nonsense. REAL interest rates were (very) high in the early 1980s because inflation collapsed.
    – Volcker and Greenspan didn’t have a clue why inflation collapsed. Inflation was the result of the corporate sector keeping a lid on wage growth.

  5. Gravatar of ssumner ssumner
    24. July 2018 at 20:43

    Kevin, You said:

    “The financial sector and the economics field seem to use the measurable and unimportant factor”

    Please do not assume that Sen’s article reflects “the economics field”. But yes, I agree that the Treasury rate is a poor proxy for the return on capital.

    Ben, You said:

    “As to nations that employ VAT taxes or sales taxes on imported goods and services, but not on exports, I think there is room for healthy debate as to whether such tax schemes are in fact export subsidies or simply tariffs.”

    Yes, along with the healthy debate about whether the moon landing was faked.

    Ege, Good point. In my new book proposal, I have three chapters back to back:

    1. Never reason from a price level change
    2. Never reason from an interest rate change
    3. Never reason from an exchange rate change.

    A stronger currency can be associated with more exports, if an export surge causes the stronger currency (as with an oil discovery), or fewer exports, if tight money causes the stronger currency.

  6. Gravatar of Matthias Goergens Matthias Goergens
    24. July 2018 at 21:18

    I agree with Benjamin that the “at the cost of cheaper imports” bit is probably just ambiguously worded. Otherwise the article makes even less sense.

  7. Gravatar of Benjamin Cole Benjamin Cole
    24. July 2018 at 23:05

    Deep-Space Message from the Fake Moon-Landing and Flat Earth Society: VAT taxes are export subsidies. (Stand-by for translation to Western orthodoxy.)

    Okay it goes like this:

    Say a nation primarily relies on VAT taxes which are applied on all imports, and domestic industries serving servicing domestic markets, but not on exporters, even on exporters that export to nations that do not rely in VAT taxes. (This describes European, Chinese and Singapore exports to the US).

    Okay, in Europe the VAT taxes primarily pay the cost of running government, making for a good place to host a business—the infrastructure, schools, national defense, fire and police, civil courts, etc. Importers help pay the freight, domestic industries help pay the freight, but exporters—they piggyback for free. Exporters who export to the US are subsidized. They pay no taxes to help support the nation in which they operate, nor the one they export to. I do not see how this is refutable.

    Now, of course, there are endless complications and some other taxes. In Singapore, for example, all the land is owned by the government of Singapore. Businesses in Singapore pay rent to the government of Singapore. But suppose Singapore offsets the VAT taxes with cut-rate rents? Who knows?

    In the Singapore case, the VAT taxes (dubbed “7% sales taxes” on imports) look much more like a tariff.

    We do not know to what extent European or Chinese governments effectively offset VAT taxes through other gizmos, through it is certainly easy enough in China and Singapore. Just cut the rent, and offset VAT taxes.

    In sum, to flatly declare VAT taxes are not tariffs, or to insist they are, is probably not possible.

    As I said, macroeconomists are peering at trade through a very thick fog of structural impediments and institutional frictions.

    In theory, the macroeconomists know where they are. No wonder they rely on theory.

    But here on Flat Earth, we wonder.

  8. Gravatar of LK Beland LK Beland
    25. July 2018 at 06:40

    Ben Cole

    “Exporters who export to the US are subsidized. They pay no taxes to help support the nation in which they operate, nor the one they export to. I do not see how this is refutable.”

    It is trivial to refute.

    Suppose that your American state has a 10% sales tax (which is pretty typical). Japan has an 8% VAT.

    The sale of a $100 item brings in $10 to your state coffers if it is sold in your state. This is independent of whether it’s American- or Japanese-made.

    Likewise, the same item will bring in $8 to Japan if it is sold there, independently of whether it’s American-made or Japanese-made.

  9. Gravatar of ssumner ssumner
    25. July 2018 at 07:45

    Ben, You said:

    “As I said, macroeconomists are peering at trade through a very thick fog”

    Someone is certainly peering through a thick fog.

  10. Gravatar of Kevin Erdmann Kevin Erdmann
    25. July 2018 at 09:02

    Scott, I guess I am thinking of the typical description of monetary policy as stimulating economic activity by lowering interest rates.

  11. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    25. July 2018 at 10:25

    I love these kinds of articles in the financial press. How intellectually confused can you be and hold a job as an econ commentator. It all clears up when you realize that, as Milton Friedman taught, interest rates are NOT the price[s] of money. So don’t conduct monetary policy by (attempts at) manipulating them.

  12. Gravatar of ssumner ssumner
    25. July 2018 at 17:11

    Kevin, OK, but that’s a very transitory effect in the standard macro model, whereas he’s talking about persistent changes in interest rates, over decades.

    Patrick, And even if interest rates were somehow meaningful, how does one explain the sub-head of the article?

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