A Plea to My Fellow Free Marketers

As a free-market loving individual, it pains me to see so many of my fellow travelers claim the Fed has artificially suppressed interest rates since the onset of the crisis. Recently, I was disappointed to see George Will and Bill Gross repeat these claims. They have made these claims before, but I was hoping after all these years they would begin to question the premise of their views. But alas, it did not happen. Here is George Will's latest volley on this issue :

[S]even years of ZIRP — zero interest-rate policy — have not restored the economic dynamism essential for social mobility but have had the intended effect of driving liquidity into equities in search of high yields, thereby enriching the 10 percent of Americans who own approximately 80 percent of the directly owned stocks. Also, by making big government inexpensive, low interest rates exacerbate the political class’s perennial disposition toward deficit spending. And little of the 2016 federal budget’s $283 billion for debt service will flow to individuals earning less than the median income.

And here is Bill Gross in his latest newsletter:

So the Fed has chosen to hold off on their goal of normalizing interest rates and... and the investment community wonders how long can this keep goin’ on. For a long time I suppose, as evidenced by history at least. Ken Rogoff and Carmen Reinhart have meticulously documented periods of “financial repression”[.]

There is no doubt the low interest rates over the past seven years have caused many problems: they have harmed individuals living on fixed income, incentivized unusual reaching for yield by investors, and made it easier to run large budget deficits. But are the low rates behind these developments really the Fed's doing?

What I wish George Will, Bill Gross, and other free market advocates would consider is the possibility that the Fed itself is not the source of the low rates, but simply is a follower of where market forces have pushed interest rates. That is, the Great Recession and the prolonged slump that followed  caused interest rates to be depressed and the Fed did its best to keep short-term interest rates near this low market-clearing level.

But there is more to this story. The crisis was so severe that the market-clearing level of short-term interest rates was pulled down well below 0%. That is a natural consequence of the sharp collapse in business and household spending. The Fed,  however, cannot push short-term nominal interest rates very far past 0% because people would start hoarding cash rather than earn negative interest. So instead it was forced to keep short-term interest rates near the zero lower bound (ZLB) while the actual market clearing interest rate level slowly worked its way back up toward zero as the economy healed.

The irony of this is that the free marketers of the world, like George Will and Bill Gross, should be sympathetic to this story. They believe in the power of prices to clear markets so they should be open to the possibility that sometimes--in severe crises like the Great Depression or Great Recessions--interest rates may need to go negative in order to clear output markets. If so, it is incorrect for them to ascribe the low interest rates to Fed policy since it was simply chasing after a falling market-clearing interest rate level. 

They should also be aghast at the ZLB. For it serves as price floor on interest rates that keeps markets from clearing. Any good capitalist worth his or her salt should be in favor of abolishing this price floor and allowing prices to work. It therefore really pained me to see Senator Rand Paul make this statement about Bernanke in a CNBC interview:

If you ask Ben Bernanke or any of the other so-called free-market economists whether or not they're for price controls of eggs or potatoes or bacon, they'll say, "Oh no, price controls cause a distortion. They lead to shortages or abundance or food rotting on the shelves." But then you ask them about money and they're like, "Oh no, we should control the price of money." It's a fallacy in their argument. If price controls are bad for the market, they're also bad for the money. 

But it is not the Fed! It is the ZLB that is the distortion here. It is preventing capitalism from working. This is why folks like Miles Kimball want to introduce ways to eliminate the ZLB and let markets do their magic.

I am not saying Fed policy has been great over the past seven years. Far from it. It has been incredibly ad-hoc and was done in such a way as to prevent a rapid recovery in spending. What I am saying is that we free marketers need a more nuanced understanding of what has kept interest rates so low and what can be done about them. Here is one practical solution from the conservative National Review magazine.

I really wish folks like George Will, Bill Gross, and Rand Paul would reconsider their views on this matter. They would be better capitalists for doing so.