An Access Advertising EconBrief:
The Midnight Ride of the Interest-Rate Alarmists
In every Middlesex village and farm – and these days, the word “Middlesex” carries a decided double meaning – the alarm is being sounded. Interest rates will rise. The only question is when.
For six years, the question has been “if,” not “when.” At first, interest rates were held down by “stimulus” – the combination of fiscal and monetary policy embodied in the multi-billion (or trillion, depending on how one counts) dollar program enacted in the early days of the Obama administration in 2009. Then, when the “zero lower bound” beckoned, the QE series of quantitative expansions in monetary “stimulus” helped enforce a continuing ZIRP (Zero Interest Rate Policy).
Now, we have reached a point at which some middle-school youths have no memory of what a real interest rate looked or felt like. And quite a few adults in financial and policymaking circles have no desire to relive their old memories, either. They have mounted up, a la Paul Revere, to cry “The rate hike is coming! The rate hike is coming!”
In a recent Wall Street Journal op-ed (“Why the Alarms About a Slight Rate Hike?” WSJ, 02/18/2015), author Omid Malekan quotes several of these alarmists. “Charles Evans, president of the Chicago Fed and a voting member of the board that determines rate policy, said last month that raising rates too soon would be a ‘catastrophe.’ Former CEO of General Electric Jack Welch, during a Feb. 4 interview on CNBC, called a possible spring rate hike ‘ludicrous.’ Billionaire investor Warren Buffett told Fox Business Network on the same day that he didn’t think a rate increase this year would be ‘feasible.'”
Malekan’s view of these modern-day midnight riders is droll. “Catastrophe. Ludicrous. Not feasible. Really?” For the previous five decades, Malekan notes, the benchmark overnight Fed funds rate averaged 5.7%, ranging from a high of 19% in the early 1980s down to 1% in the early 2000s. But for most of the five-decade reference period – including the Vietnam War, most of the Cold War, the stagflation of the 1960s and 70s and two serious recessions in the 70s and 80s – that 5.7% figure wasn’t far off the mark. But “since December 2008 the fed-funds rate has been kept close to zero.”
And what would the Fed’s proposed interest-rate hike, anathematized as unthinkable by its critics, do? It “would take the fed-funds rate from near zero to about 0.25%, and no that isn’t a misplaced decimal point. We aren’t talking about 2.5%, which would still be less than half the 1954-2007 average. We are talking about 0.25%, which would mean the Fed’s monetary policy would be rolled back from full pedal-to-the-metal to a fraction above pedal-to-the-metal. On a historical chart of the fed-funds rate, the proposed hike would barely be visible to the naked eye. Does that sound like inviting catastrophe?”
The fact that Malekan can mine humor from ZIRP and QE is testimony to the human capacity for finding fun in the darkest of circumstances. After all, one of the most popular motion-picture comedies of all time poked fun at nuclear war and ended with the destruction of the planet. A rise of one-quarter basis point in interest is hardly that apocalyptic, so a little black humor isn’t out of place. But the underlying issues make this no laughing matter.
Hamlet or Waiting for Godot?
For free-market economists, the last six years have been a living nightmare. Like many nightmares, this one has been murky and hard to follow. It has many features of Shakespearian tragedy. The Fed often seems to be playing the role of Hamlet, as when it cannot make up its mind whether or when to raise interest rates. At other times, economic policy takes on the surrealism of a Samuel Johnson play. The QE sequence and the long wait for the return of normality to monetary policy casts the Open Market Committee as the characters from Waiting For Godot – waiting for someone or something they aren’t sure they know or want.
One of the alarmists cited above is actually an Open Market Committee member and Fed policymaker. This just adds to the atmosphere of surrealism surrounding economic policy. But it jibes with the ambivalent reactions that the Fed itself has displayed to its own rate-hike proposal.
The exasperation of Fed watchers is captured in another Wall Street Journal op-ed (“A Muddle of Mixed Messages From the Fed,” WSJ, 02/19/2015) by two members of the Shadow Open Market Committee, Charles W. Calomiris and Peter Ireland. The SOMC is a group of economic and finance professors whose avocation is criticizing the Fed’s monetary-policy actions.
These two men begin by noting that the conventional index of market expectations is the futures market. Interest-rate futures indicate that markets do not believe the Fed will follow through on its stated intention to raise interest rates discretely over the next two years, beginning in mid-2015. Instead, markets expect rates to rise more slowly beginning later this year. Why does this divergence exist? Because the Fed has been giving mixed signals; Fed leaders say one thing (“rates will rise beginning in June”) but hint otherwise (by implying in various forums that both labor markets in particular and the overall economy in general are still shaky). Market participants believe the hints that Janet Yellen and other Fed officials are dropping, not the official policy statements issuing from the agency.
The Fed is legendary for using language reminiscent of the Delphic Oracle as a means of preserving its policy flexibility. While this is politically and bureaucratically useful to the agency, it is economically harmful. If market participants plan for one type of monetary policy and interest-rate environment but later experience a different one, their plans will be adversely affected. The very essence and purpose of interest rates is to coordinate the plans of savers and investors over time, so this confusion cannot be a good thing.
Without saying it in so many words, the two authors also accuse the Fed of reverting to old-line Keynesian habits. This wouldn’t be surprising in view of Chairwoman Janet Yellen’s left-wing Keynesian ideological slant. The hoary Phillips Curve tradeoff between inflation and unemployment has apparently been resuscitated with the Fed’s pathological fear of deflation, insistence on a 2% annual rate of inflation as a positive goal and Ahab-like pursuit of the ever-receding goal of “full employment.” Calomiris and Ireland insist that falling oil prices are not something to be feared and cannot – in and of themselves – cause a deflationary Depression. Only a sudden and severe decline in the money supply can do that. In effect, they are invoking the spirit of Milton Friedman’s famous dictum, “Inflation is always and everywhere a monetary phenomenon” – only in reverse gear.
The Fed’s problem is that Keynesians like Yellen were trained to believe that the interest-rate hike they are now advertising will torpedo an economic expansion – and the existence of a current expansion is the ostensible justification for the interest-rate hike in the first place. As the two authors point out, “even with a hike beginning in midyear, interest rates would remain very low and still well below the inflation rate, implying a negative real interest rate. Prior rate hikes in similar circumstances in 1994 and 2004 did not throw the economy into recession.
Calomiris and Ireland also resurrect another Friedmanism – his famous reference to the “long and variable lags” with which changes in the monetary policy affect the economy. Since 2011, the broad measure of the money supply, M2, has increased at an annual rate of over 6%. The two men see the excess reserves of banks gradually being absorbed into the economy after long sitting idle on deposit at the Fed. This will eventually – sooner rather than later – ratchet the annual rate of inflation toward and above the Fed’s target rate of 2% and completely offset the downward price momentum created by the decline in oil prices. Why, they complain, doesn’t the Fed own up to this?
Thus, the Fed’s case in favor of its announced policy is vastly stronger than the Fed pretends. The Fed is acting as though it doesn’t believe in its own policy.
The Crowning Irony
As if all this weren’t enough to leave any sensible observer groggy, we are forced to acknowledge that the Fed’s critics – fans of interest-rate hikes who are itching to “get back to a normal monetary policy” – suffer from their own blind spot.
Ironically, Calomiris, Ireland and Malekan are so dumbfounded by the Fed’s progressive march away from monetary reality that they haven’t noticed how far into the swamp that march has taken us. Having marched in, we can’t just turn around and march back out again and expect that the exit will be as smooth as the entry.
Calomiris and Ireland cite the interest-rate hikes of 1994 and 2004 as precedent for the one upcoming in June. But the previous increases did not take place in an economy staggering under the public and private debt load we carry today. Malekan cites the quarter-basis-point increase derisively; who’s afraid of a big, bad quarter point, anyhow, he laughs? Hell, we used to live with real interest rates of 5.4% in the old days. So we did, but then the federal-government debt wasn’t $14 trillion, either. We weren’t forced to finance federal-government debt with short-term debt instruments to hold down the rate. If we had to pay even halfway realistic interest rates on our current debt, the federal-government budget would be eaten alive. Suddenly, the U.S. would become Europe – no, it would become Greece, facing a full-blown fiscal crisis that would instantly become a political crisis.
Oh. Well, then – maybe it’s right to be so cautious, after all. Come to think of it, maybe we shouldn’t increase rates at all. Maybe we’re just stuck. You know, life really isn’t so bad. After all, unemployment has declined to the neighborhood of 5%. The economy is growing – slowly, but it’s growing. Let’s just stay where we are, then. Why is the Fed even talking about increasing rates?
From Op-ed Page to Front Page
Let’s jump from the op-ed page of the Wall Street Journal to the front page. The headline for 02/19/2015 reads: “Borrowers Flock to Subprime Loans.” Uh-oh; déjà vu all over again. “Loans to consumers with low credit scores have reached the highest level since the start of the financial crisis, driven by a boom in car lending and a new crop of companies extending credit. Almost four of every 10 loans to autos, credit cards and personal borrowing in the U.S. went to subprime customers in the first 11 months of 2014,” based on data supplied by Equifax.
In other words, the ultra-low interest rates stage-managed by the Fed have paved the way for a new financial crisis. The lead-in to the article didn’t even mention student loans, probably because the category of “subprime” is not meaningful for that type of loan. The auto-loan, credit-card and personal-finance industries are different from real estate. Banks no longer face the same risk exposures as they did in the early years of this millennium. Various elements of this impending crisis differ from the mortgage-finance-dominated crisis that preceded it. To be sure, history does not repeat itself – but it does rhyme, in the words of one sage observer.
It has now penetrated even the thick skulls of Federal Reserve policymakers, though, that asset bubbles are not born spontaneously. They are generated by bad government policies, with interest-rate manipulation prominent among those. It cannot have escaped notice that fixed investment during the six years of ZIRP and QE has fallen to anemic levels. Apparently, it is not so much low interest rates that promote healthy levels of investment as real, genuine interest rates – that is, interest rates that actually reflect and coordinate the desires of savers and investors.
Savers are people who plan savings today and on an ongoing basis to provide for future consumption. Investors are people who plan investments today and on an ongoing basis to provide the future productive capacity that makes future consumption possible. Interest rates coordinate the activities of these two groups of market participants over differing future time periods. This serves to coordinate intertemporal production and consumption in a manner analogous to the way that the prices of goods and services coordinate production and consumption over short-term time periods. (In this connection, “short-term” refers to time periods too short for interest rates to play the major role.)
When the interest rates prevailing in the market are not real interest rates but the artificial interest rates controlled by a central authority, that means that rates are not performing their vital coordinative function. And that means that future investments fail because investors were responding to a false market signal, one that told them that savers wanted more future goods and services in the future than were actually wanted. Having been burned very badly by this process just a few years ago, investors evidently aren’t about to be suckered again. They’re sitting things out, waiting for markets to normalize so they can invest in a market environment that works instead of one that fails. (The exceptions are situations in which “the fix is in;” when investors can get subsidies from government or are sure they will be bailed out in case of failure.)
If this comes as a surprise, it shouldn’t. Over a 70-year period, the Soviet Union tried to live without functioning capital markets. Any mention of interest rates was verboten in Communist circles, but after a while the need for intertemporal coordination in production was so crying that Soviet planners had to invent the concept of an interest rate. But they couldn’t call their invention an interest rate without risking execution, so they called it an “efficiency index.” Alas, merely calling it that did not actually give it the coordinative properties possessed by genuine market interest rates and the Soviet economy collapsed under the weight of its failures in the late 1980s. Similarly, the Chinese Communist economy got nowhere until, in desperation, Deng Xiaoping liberated market forces sufficiently to allow flexible prices and interest rates to prevail in an independent, competitive sector of the Chinese economy. And it was this sector that thrived and promoted Chinese economic growth, while the official, government-controlled sector stagnated.
More and more, respected commentators and observers across the spectrum are speaking out about the untenable status quo into which the Fed has forced us. The speech usually takes the form of grumbling about the need for return to a “more normal” policy. Of course, the problem is that any sort of normal policy is now impossible given the box we are in, but the point is that recognition of the harm caused by ZIRP and QE is becoming general.
So the Fed can’t just sit tight either, much as it would like to. The pressure to change the status quo has built up and is growing by the day. If the Fed continues to stall, it will be obvious to all and sundry that its so-called political independence is a fiction and that its policy is aimed at saving the government’s skin by preserving deficit finance and stalling off fiscal reform.
Actually, the proper metaphor for our current dilemma is probably that of a man riding a tiger. Once the man is atop the tiger, he faces a pair of impossible, or at least wildly unattractive, options. If he gets off, the tiger will kill and eat him. But if he stays on, he will be scratched, clawed and whipsawed to death eventually. Really, the question he must be asking himself as he tries desperately to hang on is: How in the world did I ever get myself in this position?
That question is purely academic to the man on the tiger but vitally important to us as we contemplate the Fed’s dilemma. How in the world did the Fed every get itself in this no-win situation? What made it seem attractive for the Fed to follow a policy that now seems disastrous? Alternatively, what made it seem necessary?
The Keynesian Link With ZIRP: Keynes’ Embrace of Marx
Close students of John Maynard Keynes know that Keynesian economic theory was mostly the work of Keynes’ followers. Students like Nicholas Kaldor, Piero Sraffa, Joan Robinson, Richard Kahn and John Hicks made numerous contributions to the theory that eventually dominated macroeconomics textbooks for some four decades and still survives today in skeletal form.
Nobel laureate Paul Samuelson once observed that Keynes’ General Theory was a work of genius in spite of its poor organization, confusing theoretical structure and intermittent moments of inspiration. Even more pertinent to our present predicament is that the second half of The General Theory leaves economics behind and takes up the cause of social policy.
Keynes faulted capitalism for its preoccupation with what he called the “fetish of liquidity.” It was the capitalist’s insistence on liquidity that underlay the speculative demand for money, which created idle balances that thwarted the expenditure of money necessary to purchase the short-term full-employment level of output. The payment of interest similarly thwarted the level of investment requisite for long-term full-employment. Capitalism would have to be supplanted with a kind of quasi-socialism in order for the market order to be preserved.
The linchpin of this new, stable market order would be a government-directed investment policy specifically intent on driving the rate of interest to zero by injecting fiat money as necessary.Only then would long-term investment would be maximized because the marginal efficiency of investment would be zero. (Another way of characterizing this outcome would be to say that all possible benefit would be squeezed out of investment.) Reading this second section of the General Theory makes it clear that Keynes was the original impetus behind ZIRP.
Keynes’ antipathy towards capitalism and the charging of interest brought him into general sympathy with Marx. Although they reached their respective conclusions by different routes, they both fervently sought the negation of capital markets and the castration of capitalism. Keynes felt he was preserving the institution of private property while Marx sought to destroy it, but in practice Keynesianism and Marxism have had similar effects on free markets and private property.
Should we be surprised, then, that Keynesians in Japan and the U.S. unveiled ZIRP to the world? Certainly not. ZIRP was the deep-seated secret desire of their hearts, the long-denied, long-awaited desideratum for which the financial crisis finally provided the pretext.
Reconsidering the Financial Rescue
Malekan no doubt echoed the views of most when he blandly observed that “although at the time few could argue with the need for such extraordinary Fed action.” He then went on to insist that things were different now and ZIRP and QE had outlived their usefulness and were no longer needed. But our full analysis suggests something quite different. If the Fed’s actions got us into a box from which there is no escape, then the only answer to the dilemma we face today is: Don’t get ourselves into this situation in the first place.
That means that we shouldn’t have ratcheted up federal-government debt with the Obama stimulus – or, for that matter, the Bush stimulus that preceded it. That conclusion will not resonate with most observers, given the overwhelming consensus that we had to do something to prevent the recurrence of a 1930s-style Depression and that massive government stimulus was the only thing to do. But we certainly aren’t forced to take that consensus verdict at face value now, six years after the fact. Six years ago, we felt under time pressure to do something fast, before it was too late. Now we have the luxury of retrospective review.
Neither stimulus lifted the U.S. economy out of recession. The Obama stimulus had hardly been spent when the U.S. economy officially emerged from recession in June, 2009. The unemployment rate declined with painful slowness in the six years after the stimulus, notwithstanding that academic students of economics are taught that the only theoretical rationale for preferring stimulative policies is that they act faster than waiting for markets to eliminate unemployment on their own. There is compelling evidence that the decline in unemployment resulted mostly from long-term departures from the labor force and elimination of unemployment-benefit extensions rather than from job creation. Malekan remarks that “the fact that there is a debate about a quarter-point rate hike tells us that extraordinarily low interest rates have mostly failed to deliver a robust recovery. That people opposed to even the tiniest increase in rates are resorting to hyperbole tells us that they too know this.” And what did we get for what Malekan calls “modest benefits,” but what we can see are really almost no benefits but a flock of trouble? We are riding a tiger with no way out of the fix that confronts us.
Although the reflex action of critics and commentators was to blame the financial crisis and the Great Recession on the usual suspects – greedy capitalists, Wall Street and deregulation – the passage of time has produced numerous studies decisively refuting this emotive response. The roster of government failures at the local, state and federal level was so lengthy that no single study has comprehensively included them all. That lengthy list is the only bit of evidence implying that things could have been worse than they actually were. Everything else – a priori logic and the long history of recessions since the founding of the republic – leads us to think that if left alone to recover, the U.S. economy would be vastly better off now than it actually is.
James Grant has recently written at book length about the severe U.S. recession of 1920-1921, which lasted no more than eighteen months despite no countercyclical government action at all. This is a template for government (in-) action in the face of impending recession. We have tried every form of preventive, stimulative and recuperative remedy the mind of man can devise and they have all failed. Maybe, if we’re lucky, we will someday have the chance to try the free-market cure.