Why Fed chairs need to take EC101

One of the ideas we drill into students very early on is that economists use the term “investment” in a very different way from how it is used in everyday speech.  Thus average people may talk about “investing” in stocks or bonds, but economists consider that sort of activity to be saving (if the alternative is consumption–not if money is just moved from a bank account into stocks.)  Economists consider “investment” to be the construction of new capital goods.  That activity is financed through saving, and indeed it’s a tautology that aggregate saving equals aggregate investment, because saving is defined as the resources that go into investment.

Thus it makes absolutely no sense to talk about financial and physical investment as alternatives, as two types of “investment”.  Unless you are Kevin Warsh:

We believe that QE has redirected capital from the real domestic economy to financial assets at home and abroad. In this environment, it is hard to criticize companies that choose “shareholder friendly” share buybacks over investment in a new factory. But public policy shouldn’t bias investments to paper assets over investments in the real economy.

How has monetary policy created such a divergence between real and financial assets?

This is from a 2015 WSJ article where Warsh claims that expansionary monetary policy has reduced real business investment by encouraging business to buy financial assets rather than build physical assets.  If a business buys a financial asset, then someone else sells that asset.  There’s no first order net effect on saving or investment.  In contrast, if a business creates a new financial asset like a stock or bond and uses it to fund new investment, then aggregate saving and investment may rise (assuming no crowding out.)  At the individual level, the decision to “invest” in financial assets is simply unrelated to the question of aggregate physical investment.  It’s a non-sequitor.  And at the aggregate level, to the extent that financial investment is a form of saving then more financial investment implies more physical investment.  (And no, the paradox of thrift has no bearing on the points I’m making here, even if it were true.)

Warsh realizes that his ideas are at variance with basic textbook economics, but doesn’t seem to care:

On his recent book tour, former Federal Reserve Chairman Ben Bernanke stated that low long-term interest rates are not the Fed’s doing. Low rates result from a shortage of good capital projects. If there were good investment projects, he explained, capital would flow and interest rates would rise. Mr. Bernanke insists that the absence of compelling investment opportunities in the real economy justifies continued, highly accommodative monetary policy.

That may well be true according to economic textbooks. But textbooks presume the normal conduct of policy and that the prices of financial assets like stocks and bonds are broadly consistent with expectations for the real economy. Nothing could be further from the truth in the current recovery.

His disdain for EC101 economics makes him a perfect choice for Trump.

PS.  Actually, textbooks do not “presume the normal conduct of policy.”  That’s simply false.

PPS.  Warsh offers zero evidence that easy money reduced business investment, and zero evidence that asset prices are out of line with fundamentals.  Even if he is correct on both points, it’s “broken clock twice a day” correct; he doesn’t seem to understand basic macroeconomic concepts.

HT:  Karl Smith



10 Responses to “Why Fed chairs need to take EC101”

  1. Gravatar of Effem Effem
    5. October 2017 at 11:04

    Agree there is a large disconnect between economic lingo and mainstream business lingo.

    I think what many like Warsh are trying to say is: the Fed largely relies on a wealth effect to stimulate aggregate demand. And it appears to be problematic that such a large wealth effect is required to bring AD growth to it’s desired level. And this is may be unstable because 1)a highly leveraged system is not well structured to handle a fall in wealth if it becomes necessary, 2) wealth inequality seems to be partially driving political volatility (which at an extreme could jeopardize the Fed itself).

  2. Gravatar of ssumner ssumner
    5. October 2017 at 11:45

    Effem, I agree that that is what he means, but of course it’s wrong. Easy money is not driving up asset prices because money is not easy.

  3. Gravatar of Effem Effem
    5. October 2017 at 12:15

    If money were tight how could credit spreads be so narrow? European corporate junk bonds now yield less than treasuries of a similar duration, as one example. Tight spreads=near-zero defaults=market pricing in perhaps a decade of uninterrupted growth.

  4. Gravatar of Effem Effem
    5. October 2017 at 12:44

    Another question on Fed impact on assets:

    Let’s say the Fed still targeted 2% inflation but did so by giving cash to each American citizen equally. Do you honestly think all financial assets would look the same as they do now?

    (i know this creates a tightening-mechanism problem…maybe the actual mechanism is to raise or lower the tax bill of each citizen equally…but irrelevant for the hypothetical).

  5. Gravatar of Matthew Waters Matthew Waters
    5. October 2017 at 15:30


    I presume the European bonds are in Euros. With lower inflation expectations, European bonds yield less to begin with. Though yeah, I wouldn’t put my money in European junk bond at 2%. I’d rather pay the small negative but risk-free rates charged by ECB.

    But many asset bubbles happen during “normal” policy. It’s widely considered that housing, dot-com and 1929 stock market were bubbles.

    True, people have found ways to blame the Fed for these bubbles still. It’s very common to blame the Fed for mid-2000’s housing orices, just with Fed funds rate targets.

    Generally, it’s an absurd argument. It’s up to the investor, and the investor alone, to not overpay for assets. If an investor invests wrongly and loses money, that’s just not a concern of monetary policy. It could be a concern of overall financial policy and regulation, if the investors are unsophisticated or have government backing. But it’s not a concern of monetary policy.

  6. Gravatar of Matthew Waters Matthew Waters
    5. October 2017 at 15:46

    Reading your comments again, you may not be making an argument that the European junk bonds are overpriced. With apologies to the EMH, I actually think they are overpriced at first glance.

    Giving cash to every American has fundamental wealth effects, so it would be different. Open market purchases mean somebody had to have Treasuries worth what they’re getting back in cash. The only way Treasury holders become richer is if the purchases themselves reduce yields and increase prices.

    In practice, the evidence is either inconclusive on QE itself lowering rates, or the announcement of QE increases rates. Comparing the Fed and the ECB shows higher rates from looser policy, including asset purchases.

  7. Gravatar of Benjamin Cole Benjamin Cole
    5. October 2017 at 16:09

    Kevin Warsh is in that tribe that contends, “Money, always and everywhere, should be tighter.”

  8. Gravatar of bill bill
    5. October 2017 at 17:54

    I guess I’m getting old. At least back in 2000 people could say that an 85% rise in the NASDAQ was unsettling. But now we’re hearing bubble talk because the market is up over 50% in Ten years.
    Starting with conclusions and flailing around for justifications much?

  9. Gravatar of Benjamin Cole Benjamin Cole
    5. October 2017 at 18:12

    Why a perpetually tight monetary policy?

    Harry Johnson was a legendary figure in right-wing economic circles, not so long ago. You don’t see him touted about much anymore, I don’t know why.

    Why do the Warshes of the world always want tight monetary policy?


    “From one important point of view, indeed, the avoidance of inflation and the maintenance of full employment can be most usefully regarded as conflicting class interests of the bourgeoisie and the proletariat, respectively, the conflict being resolvable only by the test of relative political power in the society and its resolution involving no reference to an overriding concept of the social welfare.”

    Hey, Johnson said it, not me.

  10. Gravatar of Doug M Doug M
    6. October 2017 at 08:53


    Tight money is associated with a flat yield curve (high fed funds rates relative to all other rates) and a narrow credit spreads.

    Easy money is a steep curve (low fed funds rates to all other rates) and wide credit spreads.

    If the market paying you to take on more risk then money is easy.

    If it isn’t then money is tight.

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