Feed on

At least I admit it.

One thing we have seen in this crisis is the rise from the dead of fears of “debt-deflation.” This is one way through which monetary factors (negative ones) are transmitted to the “real” economy in a negative way. In another post I’ll walk through the idea that “money is neutral.” In other words, simple textbook theory of a world of perfectly adjusting prices and general equilibrium indicates that monetary factors ought not to have any impacts on real GDP.

OK, so what is the deal? If the price level falls, especially in an unanticipated fashion, we know that makes debtors worse off and creditors better off. If Jack loans Jill $100 in 2011 at 5% interest, and Jill promises to pay it back in 2012 then what happens is that Jill sends Jack $5 during the year, and delivers the $100 in full at the end of the year.

However, if the overall price level in the economy falls between now and then, and the contractual loan amount between Jack and Jill is fixed, Jill still needs to come up with $100 at the end of the year. This is a major problem, because $100 one year from now, in a world of declining prices, is worth more than $100 today. The only way Jill can obtain the $10o is to become more productive, to get a wage increase (not likely when prices are falling) or otherwise find some unearned purchasing power. As bad as this is for Jill, it is just as “good” for Jack. He would be gaining dollar for dollar everything Jill is losing.

But this is not just a transfer of resources from debtors to creditors, in which case the monetary shock would still be near neutral. In reality, being forced to pay back more valuable dollars than you borrowed CAN put consumers like Jill into the poorhouse and bankrupt them. In a world of falling prices, trying to sell assets to pay off debts also becomes increasingly difficult. Thus, in this scenario, Jack does NOT get paid. The deflationary cycle will worsen if this occurs.

Now, central banks do not wish for this to happen (ignore the possibility for legal contracts to deal with this problem). So it is in the interest of the central banks to keep nominal interest rates in an economy high enough so that if prices do fall, we still do not get down near this “zero-bound.” But there is also another reason why macroeconomists do not want to get interest rates down near this “zero bound.” It is argued that being at this zero bound puts us in a “liquidity trap” (a future post will explain more) and that by having nominal rates near zero, the central bank will lose the ability to expand the money supply by traditional open market operations. In reality, the central bank can always expand the money supply even without fears of hoarding (it can print dollars with disappearing ink or it can engage in non-traditional asset purchases, but let’s ignore those).

So, here we have two compelling reasons, from macroeconomists, why having low nominal interest rates is undesirable. In a world where we are liquidity constrained and we want to “do something” about a cyclical downturn, economists then reluctantly (most of them at least) that we need to rely on the tools of fiscal policy and deficit spending/stimulus to fix things. Even for hardcore statists, it is widely understood that fiscal policy is inferior to monetary policy tools because of the long lags between enactment and action, and also because of the massive knowledge problem and potential for corruption and waste (and the long term incentives) inherent with rapid expenditures of hundreds of billions of dollars of other people’s money. We don’t generally want to rely on fiscal policy.

Why then does the central bank in the U.S. seem to think that “low interest rates” are so important for U.S. prosperity. Yes we know that low interest rates make it more attractive for firms to borrow, invest and expand. But there are many downsides as well. When rates are low, firms are investing in low value projects. When they are high, they would seem to be more discriminating in what they choose to invest in. In fact, high interest rates would seem to be a signal that the productivity of capital is really high. When rates are low, it means that savings vehicles are less attractive, so lenders will be looking elsewhere for yield, taking larger risks, and perhaps generating “riskless” assets from thin air (think of the AAA tranches of CDOs that came from nowhere because of the demand for yield and safety during the last crisis) and so forth. (i am ignoring real and nominal distinctions for now).

With this in mind, why do we not see more aggressive efforts by central banks to set short-term interest rates much higher, especially during times of expansion (I know, I know, interest is an intermediate target and it is hard to do, so they inflation target). Even if this kind of targeting tightens up money and slows down growth slightly from where it might have been, would this not contribute to more macroeconomic stability? Would this not make debt-deflation less likely (even as real rates adjust)? Would this not make it less likely that we have to rely on the messed-up political process and fiscal policy when times of crisis near?

Seriously, I have no idea what I am talking about, and there are plenty of details left out. But reflecting upon the low-interest rate policy of the Fed in the 2000s and the ensuing arguments in the stimulus debate certainly encourages the line of questioning. For what it’s worth, for those of you out there considering graduate school in economics, choose wisely. In 5 years of study, I learned not a single thing about macro.

4 Responses to “In Which I Illustrate that I Know Nothing About Macroeconomics”

  1. Harry says:

    The trouble is not whether Wintercow knows enough about macro to wield the fiscal and monetary levers of power with the Phillips Curve as his guide. The problem is that the folks in charge think they can.

  2. Harry says:

    I think history has shown that the Fed has little control over long-term interest rates, except to the extent that interest rates will reflect what the fed does with the dollar. Thus buying 500 billion of treasurys to depress the 10- or 30- year yield is an exercise in futility.

    I would like to hear jb’s and wintercow’s take on this.

  3. Harry says:

    This is not an idle question above. Would you, if it were your own money, buy ten-year treasurys yielding 3% given the prospect for inflation?

  4. Michael says:

    When it comes to Keynesian economics, I always just had to remember and do verbatum repeatback; if I tried to think about it logically, I nearly always got it wrong.

Leave a Reply