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.
Great post David. I could not agree more. People who think the Fed is "artificially holding prices low" should ask themselves, what happens when a price authority sets the price too low? Answer: your inventory sells out. The bacon flies off the shelves at the below-market price until there is none left. So, is this happening with money? Are private parties pigging out on this "below-market-price" money? No, not at all. The money is just sitting on the store shelves (bank reserves). It should be obvious to anyone with even the most basic understanding of markets that the price of money is currently too high, not too low. Arguably, that's partly the Fed's doing, in setting IOR at 0.25% instead of -0.25%, but that would be a sophisticated argument, unlike the nonsense arguments from George Will, Bill Gross, Rand Paul, and many, many others.ReplyDelete
Menlo Park, CA
David, it looks like Kenneth here even caught John Cochrane wandering into those weeds, but John at least, acknowledged that he should have been more careful about what he was writing:Delete
Interesting catch Tom and great comment Kenneth! Yes, John Cochrane understands this point, probably better than me. And I would definitely count him as a fellow freemarketer.Delete
Actually, the right Cochrane cite is this oneDelete
Here I agree entirely with David that the Fed is not "holding rates down." A bank that is holding rates down is lending a lot at low rates, not one that is taking in trillions.
"But are the low rates behind these developments really the Fed's doing?"ReplyDelete
Yes because of the tools the fed employs such as OMO's and QE stimulate bank intermediation, portfolio flows and debt more than other more efficient tools. As a result of these tools financialization is prevalent which is undermining RGDP, causing greater instability and suppressing interest rates.
To avoid generating excessive financialization the fed can stimulate by dropping money into accounts held at the fed.
Excellent post. Although, in a way, Fed actually is responsible for these low rates. Had it loosened its policy when it was supposed to, markets would have pushed interest rates up by now.ReplyDelete
tkojejohngalt, yes, that is a good point. The Fed is indirectly responsible for the low rates by allowing this weak economic environment to emerge in the first place and then failing to respond appropriately. I've mentioned that elsewhere, but didn't want to far off track my main point here.Delete
Paul Krugman responded to you here, David.ReplyDelete
"My take is that someone like Beckworth is trying to take the monetarist, Milton Friedman position, which is basically one of trusting markets to get it right except when it comes to the business cycle, where it becomes necessary to have expansionary monetary policies in slumps. This is a slightly problematic position on logical grounds: you need some kind of market failure to give monetary policy large real effects, and in that case why imagine that this is the only important failure? But more important, at this point, is the fact that this position turns out to be politically unsustainable. “Government is always the problem, not the solution, except when it comes to monetary policy” just doesn’t cut it for modern conservatives."
This doesn't seem right. Government is the problem when it comes to monetary policy because it refuses to do anything to alter the nature of 0% yielding cash, and thereby offers investors a distortionary above-market return. In a free market, no banker would offer a superior 0% return when the market clearing return is -2%.
Glad to see the plug from Krugman, but yes I agree this problem can be easily viewed as a government failure on many levels from allowing the crisis to emerge to not addressing ZLB constraint.Delete
David, I'm going to do my best impression of a low-information "Free Marketeer" responding to you:ReplyDelete
"Why do you hate freedom?"
thats right. it aint the fed. no fingerprints there. totally innocent.ReplyDelete
marcusbalbus, take a look at my newest post. Hopefully, you will find it sheds more light on this topic. http://macromarketmusings.blogspot.com/2015/10/no-fed-did-not-enable-large-budget.htmlDelete
Very good. It's not about ideology but correct economics.ReplyDelete
Very good post. I don't believe it will help George Will, Bill Gross or Rand Paul to reconsider their views though, as I suspect for them it's never been about free market, but rather about top-down class-warfare. I don't know them personally (of course), so I might be wrong.ReplyDelete
I don't think it's top-down class warfare on George Will's or Rand Paul's part. I don't know much about Gross. I think it's just intellectual laziness. They're so used to a certain way of thinking about interest rates and a certain range of interest rates. They just haven't thought through this.Delete
What CAUSED the market clearing interest rate to end up below zero?ReplyDelete
David, what do you think of this post:ReplyDelete
I am curious if you have ever talked to Rand Paul about monetary policy? He is from Bowling Green and I know he is involved with Cato. I actually think he is very open minded. Assuming he gets reelected to the Senate, I think it would be worth explaining how money and banking work to him. I think he is very capable of being a good spokesman for market monetarism within the Republican Party.ReplyDelete
Will is a stopped clock Austrian, and Gross endlessly talks his book (short Treasuries). Now he's sucking wind.ReplyDelete