DRI-201 for week of 1-12-14: No Bravos for Bernanke

An Access Advertising EconBrief:

No Bravos for Bernanke

Last weekend’s Wall Street Journal featured an op-ed by the former Chairman of President Obama’s Council of Economic Advisors, Austan Goolsbee. Goolsbee’s tenure obviously familiarized him with the chief requirement for policymaking success in a Democrat regime; namely, the ability to define success down. His op-ed, “Brave for Bernanke and the QE Era,” is a spectacular example of the art.

Goolsbee contrasts the enthusiastic reception given to Federal Reserve Chairman Bernanke’s farewell address to the American Economic Association convention with the wide-ranging criticism directed at Bernanke from across the political spectrum. He briefly summarizes the Fed’s policies under Bernanke, confining himself to the last 3 ½ years of the so-called QE (quantitative easing) Era. Bernanke’s imminent departure and the start of the “exit-strategy countdown” signaled by QE tapering mean that “it is time to take stock of the QE Era – and time for the critics to admit they were wrong.”

Partisan divisions being what they are, it is a foregone conclusion that Goolsbee’s call will not resonate with many on both sides of the political spectrum. But it is not necessary to invoke partisan politics to criticize it. Bernanke’s policies – and Goolsbee’s – are anathema to free-market economists. But one need not espouse laissez faire in order to gaze askance at Goolsbee’s case for Bernanke’s actions. Bernanke’s tenure should be viewed as a disaster regardless of one’s political preference or economic philosophy.

Indeed, the propriety of Bernanke’s policy choices is not up for debate at this point. They are what economists would call a sunk cost; their costs have been incurred (or are unavoidable) and can’t be changed or escaped. No doubt Bernanke should have chosen differently and we would be better off if he had done so. But the question before the house is: What were the actual results of his choices? Goolsbee finds those results to be very good and purports to explain why. We can and should quarrel with his verdict and his explanations.

Bernanke and Stimulus

“…Looking back…it is clear that the Fed was right to try to help improve the [economy] and the critics were wrong [about inflation].” Goolsbee assigns Bernanke’s policies a grade of A for activism.  The implication is that it is better for a Federal Reserve Chairman to do something rather than nothing, even if activism requires a program of unprecedented scope and unknown impact.

“Think back to the days before the 2008 crisis or recession. If confronted with the scenario that would follow – five years of GDP growth of only around 2% a year, five years of unemployment rates around or above 7%, core inflation consistently below 2% – the near-universal response of economists would have been for the Fed to cut interest rates.” But would economists have reacted that way knowing that all of these effects accompanied a policy of zero interest rates? It’s one thing to say “we should have cut interest rates and all these bad things wouldn’t have happened,” but quite another to say “all these bad things happened anyway in spite of our interest rate cuts.” An objective observer would have to consider the possibility that the interest rate cuts were the wrong medicine. Of course, Goolsbee pretends that this is unthinkable; that the only possible action in the face of adversity is cutting rates. But if that were really true, his review of Bernanke’s reign is a mere formality; Bernanke’s decisions were right by definition, regardless of result. In reality, of course, the zero-interest-rate policy was not a foregone conclusion but rather an evaluative action subject to serious question. And its results do not constitute a ringing endorsement.

To appreciate the truth of this, ponder the wildly varying conclusions reached by Keynesian economists who are not ideologically hostile to Bernanke and Goolsbee. Larry Summers considers macroeconomic policy under Obama a failure because the U.S. suffers from “secular stagnation.” He prescribes a cure of massive public spending to replace the structural collapse of private investment and private over-saving. While Bernanke cannot take the blame for the failings of fiscal policy, Summers criticizes him for not doing more to provide liquidity and increase (!) inflation. Summers’ colleague Paul Krugman is even more emphatic. Bernanke should crank up the printing press to create bubbles because wasteful spending by government and the private sector is necessary to create employment. Without waste and profligacy, unemployment will persist or even rise. Alan Blinder has the temerity to point out what free-market economists noticed years ago – that the money created by Bernanke was mostly sitting idle in excess bank reserves because the Fed had chosen to pay interest on excess reserves. But Blinder is too gentlemanly to ask the obvious question: If the money creation is supposed to be “economic stimulus,” why has Bernanke prevented the money from actually stimulating?

These Keynesian economists are the farthest thing from free-market, laissez faire doctrinaires. But they are not about to give Ben Bernanke a passing grade merely for showing up, trying hard and looking very busy.

To be sure, Goolsbee does make a case that Bernanke actually succeeded in stimulating the U.S. economy. He names two of his colleagues, fellow attendees at the AEA convention, whose “research indicates that [Bernanke’s] Fed policies have helped the economy, albeit modestly… they lowered long-term Treasury rates by about 30 basis points and a bit more for mortgage spreads and corporate bond yields…Americans were able to refinance their homes at more affordable rates, and the drop led to an increase in consumer spending on automobiles and other durables.” Fifty years ago, John Maynard Keynes’ picture appeared on the cover of Time Magazine as an avatar of the end of the business cycle. Now, our Fed prosecutes a policy characterized by a leading English central banker as “the greatest government-bond bubble in history,” and economists have to do research in order to dig up “modest benefits” of the policy that would otherwise go unnoticed. And Goolsbee offers them up with a straight face as the blessings that justify our gratitude to Ben Bernanke.

Bernanke and Inflation

“The QE Era did not create inflation. Not even close. The people who said it would were looking only at the growth in the monetary base… the people arguing that QE means simply printing money (it doesn’t, really) didn’t recognize that the policy was simply offsetting the reverse printing of money resulting from the tight credit channels in the damaged financial system.” Milton Friedman devoted the bulk of his career to refuting the claims of this type of thinking; it would require a lengthy article to review his insights and a book-length analysis to review the economics issues raised by Goolsbee’s nonchalant assertions. But one sentiment popularized by Friedman suffices to convey the concern of “the people” Goolsbee dismisses so condescendingly: “Inflation is always and everywhere a monetary phenomenon.”

At no point in human history has a monetary expansion like Bernanke’s occurred without leading to hyperinflation. So Bernanke’s critics are not a gaggle of tinfoil-hat-sporting, tennis-shoe-wearing conspiracy theorists. They have history on their side. Goolsbee’s confident assurance that Bernanke leaves office with inflation under control is based on a planted axiom the size of an iceberg; namely, that Bernanke’s successor(s) can somehow corral the several trillion dollars of excess reserves still loitering around the financial system before they emerge into circulation in the form of expenditures chasing a limited stock of goods and services. But that’s only the beginning; the Fed must also conduct this money wrangling in such a way as to keep interest rates from rising too greatly and thereby dealing the economy a one-two death blow of overwhelming government debt service and private-sector constriction of economic activity. It is not immediately obvious how this might be accomplished.

Friedman made a case that the Great Depression began in the early 1930s with bank failures that had a multiple contractionary effect on the U.S. money supply. Like generals always fighting the last war, the Fed has since been grimly determined not to be hung for monetary tightness. As F.A. Hayek pointed out, a central bank that always errs on the side of loose money and inflation and never on the side of tight money or deflation will inevitably bias its policy toward inflation. That is the status quo today. Japan’s longtime low inflation is miscalled “deflation,” thereby providing a rhetorical justification for revving up the inflationary printing press. A similar boomlet is building here in the U.S.

Presumably, this explains Goolsbee’s reference to QE credit creation as an offset to credit destruction. But whether you accept Friedman’s analysis or not, Goolsbee’s rationale doesn’t hold water. The bank bailouts of 2008-09 – which were forced on sound banks and shaky ones alike by the Fed and the Treasury – were explicitly sold as a means of guaranteeing financial liquidity. QE did not come along until mid-2010. By then, banks had already repaid or were repaying TARP loans. Thus, Goolsbee cannot sell the QE Era as the solution to a problem that had already been solved. Instead, the evidence favors QE as the palliative for the financial problems of the U.S. Treasury and the spending addiction of the U.S. Congress – matters that Goolsbee delicately overlooks.

Bernanke and Greenspan: The Perils of Premature Congratulation

When Alan Greenspan left office, he had presided over nearly two decades of economic prosperity. The news media had dubbed him “The Maestro.” It is not hard to understand why he was showered with accolades upon retirement. Yet within a few short years his reputation was in tatters. Bernanke gave us an industrial-strength version of Greenspan loose-money policies. But the economy spent most of Bernanke’s tenure in the tank. And Bernanke leaves office having bequeathed us a monetary sword of Damocles whose swing leaves our hair blowing in its breeze.

With the example of Greenspan still fresh in mind, we can justifiably withhold judgment on Bernanke without being accused of rank political prejudice.

Bernanke as Savior

“…We should all be able to agree that fashion standards during a polar vortex shouldn’t be the same as in normal times.” Goolsbee is suggesting that Bernanke has adopted the stern measures called for by the hard times thrust upon him. This is indeed the leitmotiv for economic policy throughout the Obama Administration, not merely monetary policy – hey, just imagine how much worse things could have been, would have been, had we not done what we did. In order for this alibi to stand up, there must be general agreement about the nature and size of the problem(s) and the remedy(ies). Without that agreement, we cannot be sure that Bernanke hasn’t worsened the situation rather than helping it – by addressing non-existent problems and/or applying inappropriate solutions.

In this case, we have had only the word of Chairman Bernanke and Treasury Secretary O’Neill (under President Bush) that economic collapse was threatened in 2008. Despite the wild talk of imminent “meltdown,” none occurred. Indeed, there is no theoretical event or sequence that would meet that description in economics. General economic activity worsened markedly – after the bailout measures were authorized by Congress. The emergency stimulus program did not affect this worsening, nor did it effect the official recovery in June 2009; stimulus funds were so slow to reach the economy that the recovery was well underway by the time they arrived.

The QE program itself has been advertised as “economic stimulus” but is notable for not living up to this billing. (To be sure, this is misleading advertising for the reasons cited above.) If anybody feels grateful to Bernanke for launching it, it is presumably officials of the Treasury and Congress – the former because QE prevented interest rates from rising to normal levels that would have swamped the federal budget in a debt-service tsunami, the latter because the precious spending programs beloved of both parties were spared. But Goolsbee comes nowhere within sight or shouting distance of these financial truths.

It makes sense to hail a savior only when you have reached safety. We haven’t even crossed the icy waters yet, because we’ve had the benefits – tenuous though they’ve been – of QE without having to bear the costs. In other words, the worst is yet to come. Bernanke has made all of us protagonists in an old joke. A man jumps out of a skyscraper. As he falls toward earth, the inhabitants of the building on each successive lower floor hear him mutter, “Well – so far, so good.”

The Politicization of Economics

Why make so much of Austan Goolsbee’s valedictory salute to Ben Bernanke? If the quality of Bernanke’s economic policy is a sunk cost at this point, doesn’t that also moot our assessment of his job performance? If Austan Goolsbee has badly misjudged that performance, that doesn’t say much for Goolsbee, but why should we care? After all, Goolsbee is no longer employed by the Obama Administration; he is now safety ensconced back in academia.

Goolsbee’s judgments matter because they are clearly motivated by politics. They are part of a disturbing pattern in which liberal economists provide a thin veneer of economics – or sometimes no economics at all – to cover their espousal of left-wing causes. Goolsbee pooh-poohs the claim that QE was both dangerous and unnecessary, claiming that the rise in the stock market is not a bubble because it has “tracked increases in corporate earnings.” But earlier in the same article, Goolsbee claimed that QE lowered long-term interest rates on Treasuries and corporate bonds (thus reducing costs of corporate finance) and increased spending on consumer durables. So QE induced increases in corporate earnings that wouldn’t otherwise have occurred, causing increased stock prices – but is absolved from charges of creating a stock bubble because the stock prices were caused by autonomous increases in corporate earnings? Goolsbee claims credit for QE on Bernanke’s behalf at one stage, and then disclaims QE’s influence on exactly the same point at another. This is the type of circular contradiction masquerading as economics that Goolsbee and other Keynesians use to sell their politics.

“Forgoing the Fed’s unconventional monetary policies – inviting real and quantifiable damage to the economy – just to prevent the possibility of a potentially dangerous bubble forming somewhere in the economy would have been cruel and unnecessary,” Goolsbee concludes. Foregoing the “modest benefits” that Goolsbee’s pals managed to dig up merely because the Fed had to create “the greatest government-bond bubble in history” in order to generate them would have been “cruel and unnecessary.” Oh, wait – what about the loss of interest income suffered by hundreds of millions of Americans – many of them retirees, the disabled and other fixed-income investors – thanks to the zero-interest-rate policy ushered in by the QE Era? Was this cruel and/or unnecessary? Goolsbee delicately avoids the subject.

But Goolsbee’s fellow Keynesian, Paul Krugman, is not so circumspect. Krugman comes right out and says that nobody has the right to expect a positive interest return on safe assets while the economy was in a depression; they can either make do with an infinitesimal interest return or lose the value of their money to inflation. (In the same blog post, Krugman had previously accused his critics of callous indifference to the pain caused by business liquidations in a depression.)

This is not economics. It is half-baked value judgment hiding behind the mask of social science. Similarly, Austan Goolsbee’s evaluation of Ben Bernanke’s term as Federal Reserve Chairman may have the imprimatur of economics, but it lacks any of the substance.

DRI-332 for week of 6-16-13: What Lies Ahead for Us?

An Access Advertising EconBrief:

What Lies Ahead for Us?

Last month, Federal Reserve Chairman Ben Bernanke announced that the Fed Open Market Committee is contemplating an end to the $85 billion program of bond purchases that has been dubbed “Quantitative Easing (QE).” The announcement was hedged over with assurances that the denouement would come only gradually, when the Fed was satisfied that general economic conditions had improved sufficiently to make QE unnecessary. Nonetheless, the announcement produced a flurry of speculation about the eventual date and timing of the Fed’s exit.

The Fed’s monetary policy since the financial crisis of 2008 and the stimulus package of 2009 is unique in U.S. economic history. Indeed, its repercussions have resounded throughout the world. Its motives and means are both poorly understood and hotly debated. Shedding light on these matters will help us face the future. A question-and-answer format seems appropriate to reflect the mood of uncertainty, anxiety and fear that pervades today’s climate.

What was the motivation for QE, anyway?

The stated motivation was to provide economic stimulus. The nature of the stimulus was ambiguously defined. Sometimes it was to increase the rate of inflation, which was supposedly too low. Sometimes it was to stimulate investment by holding interest rates low. The idea here was that, since the Fed was buying bonds issued by the Treasury, the Fed could take advantage of the inverse relationship between a bond’s price and its yield to maturity by bidding up T-bond prices, which automatically has the effect of bidding down their yields. Because $85 billion worth of Treasury bonds comprise such a large quarterly chunk of the overall bond market, this will depress bond yields for quite a while after the T-bond auction. Finally, the last stimulative feature of the policy was ostensibly to indirectly stimulate purchase of stocks by driving down the yields on fixed-income assets like bonds. With nowhere to go except stocks, investors would bid up stock prices, thus increasing the net worth of equity investors, who comprise some 40-50% of the population.

How was driving up stock prices supposed to stimulate the economy?

The ostensible idea was to make a large segment of Americans feel wealthier. This should cause them to spend more money. This sizable increase in overall expenditures should cause secondary increases in income and employment through the economic process known as the “multiplier effect.” This would end the recession by reducing unemployment and luring Americans back into the labor force.

How did the plan work out?

Inflation didn’t increase much, if at all. Neither did investment, particularly when viewed in net terms that exclude investments to replace deteriorated capital stock. Stock prices certainly rose, although the consumption increases that followed have remained modest.

So the plan was a failure?

That would be a reasonable assessment if, and only if, the stated goal(s) of QE was (were) the real goal(s). But that wasn’t true; the real goal QE was to reinforce and magnify the Fed’s overall “zero interest-rate policy,” called ZIRP for short. As long as it accomplished that goal, any economic stimulus produced was a bonus. And on that score, QE succeeded very well indeed. That is why it was extended and why the Fed is stretching it out as long as it can.

Wait a minute – I thought you just said that even though interest rates have remained low, investment has not increased. Why, then, is the Fed so hot to keep interest rates low? I always heard that the whole idea behind Fed policies to peg interest rates at low levels was to stimulate investment. Why is the Fed busting our chops to follow this policy when it isn’t working?

You heard right. That was, and still is, the simple Keynesian model taught to freshman and sophomore economics students in college. The problem is that it never did work particularly well and now works worse than ever. In fact, that policy is actually the proximate cause of the business cycle as we have traditionally known it.

But even though the Fed gives lip service to this outdated textbook concept, the real reason it wants to keep interest rates low is financial. If the Fed allowed interest rates to rise – as they would certainly do if allowed to find their own level in a free capital market – the rise in market interest rates would force the federal government to finance its gargantuan current and future budget deficits by selling bonds that paid much higher interest rates to bondholders. And that would drive the percentage of the federal government budget devoted to interest payments through the roof. Little would be left for the other spending that funds big government as we know it – the many cabinet departments and myriad regulatory and welfare agencies.

Even if you don’t find this argument compelling – and you can bet it compels anybody who gets a paycheck from the federal government – it should be obvious to everybody that the Fed isn’t really trying that hard to apply traditional stimulative monetary policy. After all, stimulative monetary policy works by putting money in public hands – allowing banks to make loans and consumer spending to magnify the multiplier effects of the loan expenditures. But Bernanke lobbied for a change in the law that allowed the Fed to pay interest to banks on their excess reserves.  When the Fed enforces ZIRP by buying bonds in the secondary market, it pays banks for them by crediting the banks’ reserve accounts at the Fed. The interest payments mean that the banks don’t have to risk making loans with that money; they can just hold it in excess reserves and earn easy profits. This is the reason why the Fed’s money creation has not caused runaway inflation, as government money creation always did in the past. You can’t have all or most prices rising at once unless the newly created money is actually chasing goods and services, which is not happening here.

But the mere fact that hyperinflation hasn’t struck doesn’t mean that the all-clear has been sounded. And it doesn’t mean that we’re not being gored by the horns of a debt dilemma. We certainly are.

Being gored in the bowels of a storm cellar is a pretty uncomfortable metaphor. You make it sound as though we have reached a critical economic crisis point.

We have. Every well-known civilizational collapse and revolution, from ancient Rome to the present day, has experienced a financial crisis resembling ours. The formula is familiar. The government has overspent and resorted to money creation as a desperate expedient to finance itself. This has papered over the problem but ended up making things even worse. For example, the French support for the American colonies against Great Britain was the straw that broke the bank of their monarchy, fomenting the French Revolution. The Romanovs downfall occurred despite Russia’s increasing rate of economic growth in the late 1800s and because of financial profligacy and war – two causes that should be familiar to us.

It sounds as though government can no longer use the tools of fiscal and monetary policy to stimulate the economy.

It never could. After all, the advent of Keynesian economics after 1950 did not usher in unprecedented, uninterrupted world prosperity. We had recessions and depressions before Keynes wrote his General Theory in 1936 and have had them since then, too. And Keynes’s conclusions were anticipated by other economists, such as the American economists Foster and Catchings in the late 1920s. F.A. Hayek wrote a lengthy article refuting their arguments in 1927 and he later opposed Keynes throughout the 1930s and thereafter. The principles of his business-cycle theory were never better illustrated than by real-world events during the run-up to the recession and financial crisis in 2007-2008 and the later stimulus, ZIRP and QE.

It seems amazing, but Keynesian economists today justify government policies by claiming that the alternative would have been worse and by claiming responsibility for anything good that happens. Actually, the real force at work was described by the Chairman of Great Britain’s Bank of England, Mervyn King, in the central bank’s February Inflation Report:

“We must recognize [sic], however, that there are limits to what can be achieved via general monetary stimulus – in any form – on its own. Monetary policy works, at least in part, by providing incentives to households and businesses to bring forward spending from the future to the present. But that reduces spending plans tomorrow. And when tomorrow arrives, an even larger stimulus is required to bring forward yet more spending from the future. As time passes, larger and larger doses of stimulus are required.”

King’s characterization of transferring spending or borrowing from the future accurately describes the effects of textbook Keynesian economics and the new variant spawned by the Bernanke Fed. Keynesians themselves advertised the advantage of fiscal policy as the fact that government spending spends 100% of every available dollar, while private consumers allow part of the same dollar to leak into savings. This dovetails exactly with King’s account. The artificially low interest rates created by monetary policy have the same effect of turning saving into current consumption.

Today, we are experiencing a grotesque, nightmarish version of Keynesian economics. Ordinarily, artificially low interest rates would stimulate excessive investment – or rather, would drive investment capital into longer-maturing projects that later prove unprofitable, like the flood of money directed toward housing and real-estate investment in the first decade of this century. But our current interest rates are so absurdly low, so palpably phony, that businesses are not about to be suckered by them. After all, nobody can predict when rates might shoot up and squelch the profitability of their investment. So corporations have pulled up their financial drawbridges behind balance sheets heavy with cash. Consumers have pulled consumption forward from the future, since that is the only attractive alternative to the stock investments that only recently wrecked their net worth. This, too, validates King’s conclusions. Whether “successful” or not, Keynesian economics cannot last because the policy of borrowing from the future is self-limiting and self-defeating.

Didn’t I just read that our budget deficit is headed lower? Doesn’t this mean that we’ve turned the corner of both our budget crisis and our flagging recovery?

If you read carefully, you discovered that the improvement in the federal government’s fiscal posture is temporary, mostly an accounting artifact that occurs every April. Another contributing factor is the income corporations distributed at year-end 2012 to avoid taxation at this year’s higher rates, which is now being taxed at the individual level. Most of this constitutes a one-time increase in revenue that will not carry over into subsequent quarters. Even though the real economic benefits of this are illusory, it does serve to explain why Fed Chairman Bernanke has picked this moment to announce an impending “tapering off” of the QE program of Fed bond purchases.

How so?

The fact that federal deficits will be temporarily lower means that the federal government will be selling fewer bonds to finance its deficit. This, in turn, means that the Fed will perforce be buying fewer bonds whether it wants to or not. Even if there might technically be enough bonds sold for the Fed to continue buying at its current $85 billion level, it would be inadvisable for the federal government to buy all, or virtually all, of an entire issue while leaving nothing for private investors. After all, U.S. government bonds are still the world’s leading fixed-income financial instrument.

Since the Fed is going to be forced to reduce QE anyway, this gives Bernanke and company the chance to gauge public reaction to their announcement and to the actual reduction. Eventually, the Fed is going to have to end QE, and the more accurately they can predict the reaction to this, the better they can judge when to do that. So the Fed is simply making a virtue out of necessity.

You said something awhile back that I can’t forget. You referred to the Keynesian policy of artificially lowering interest rates to stimulate investment as the “proximate” cause of the business cycle. Why is that true and what is the qualifier doing there?

To illustrate the meaning, consider the Great Recession that began in 2007. There were many “causes,” if one defines a cause as an event or sequence of events that initiated, reinforced or accelerated the course of the recession. The housing bubble and ensuing collapse in housing prices was prominent among these. That bubble itself had various causes, including the adoption of restrictive land-use policies by many state and local jurisdictions across America, imprudent federal-government policies promoting home-ownership by relaxing credit standards, bank-regulation standards that positioned mortgage-related securities as essentially riskless and the creation and subsidy of government-sponsored agencies like Fannie Mae and Freddie Mac that implemented unwise policies and distorted longstanding principles of home purchase and finance. Another contributor to recession was the decline in the exchange-value of the U.S. dollar that led to a sharp upward spike in (dollar-denominated) crude oil prices.

But the reign of artificially low interest rates that allowed widespread access to housing-related capital and distorted investment incentives on both the demand and production side of the market were the proximate cause of both the housing bubble and the recession. The interest rates were the most closely linked causal agent to the bubble and the recession would not have happened without the bubble. Not only that, the artificially low interest rates would have triggered a recession even without the other independent influences – albeit a much milder one. Another way to characterize the link between interest rates and the recession would be to say that the artificially low interest rates were both necessary and sufficient to produce the recession. The question is: Why?

For several centuries, an artificial lowering of interest rates accompanied an increase in the supply of money and/or credit. Prior to the 20th century, this was usually owing to increases in stocks of mined gold and/or silver, coupled with the metallic monetary standards then in use. Modern central banks have created credit while severing its linkage with government holdings of stocks of precious metals, thus imposing a regime of fiat money operating under the principles of fractional-reserve banking.

In both these institutional settings, the immediate reaction to the monetary change was lower interest rates. The effect was the same as if consumers had decided to save more money in order to consume less today and more in the future. The lower interest rates had complex effects on the total volume of investment because they affect investment through three different channels. The lower rate of discount and increased value of future investment flows greatly increase the attractiveness of some investments – namely, those in long-lived production processes where cash flows are realized in the relatively distant future. Housing is a classic example of one such process. Thus, a boom is created in the sector(s) to which resources are drawn by the low interest rates, like the one the U.S. enjoyed in the early 2000s.

The increase in employment and income in those sectors causes an increase in the demand for current consumption goods. This bids up prices of labor and raw materials, provided either that full employment has been reached or that those resources are specialized to their particular sectors. This tends to reduce investment in shorter-term production processes, including those that produce goods and services for current consumption. Moreover, the original investments are starting to run into trouble for three reasons: first, because their costs are unexpectedly increasing; second, because the consumer demand that would ordinarily have accompanied an increase in saving is absent because it was monetary expansion, not saving, that produced the fall in interest rates; and third, because interest rates return to their (higher) natural level, making it difficult to complete or support the original investments.

Only an increase in the rate of monetary expansion will allow original investments to be refinanced or validated by an artificial shot of consumer demand. That is what often happened throughout the 20th century – central banks frantically doubled down on their original monetary policy when its results started to go sour. Of course, this merely repeated the whole process over again and increased the size and number of failed investments. The eventual outcome was widespread unemployment and recession. That is the story of the recent housing bubble. This mushrooming disaster couldn’t happen without central banking, which explains why 19th century business cycles were less severe than many modern ones.

I don’t recall reading this rather complicated explanation before or hearing it discussed on television or radio. Why not?

The preceding theory of business cycles was developed by F. A. Hayek in the late 1920s, based on monetary theory developed by his mentor, Ludwig von Mises, and the interest-rate theory of the Swedish economist, Knut Wicksell. Hayek used it to predict the onset of what became the Great Depression in 1929. (Von Mises was even more emphatic, foreseeing a “great crash” in a letter to his wife and refusing a prestigious appointment in his native Vienna to avoid being tarred by exposure to events.) Hayek’s theory earned him an appointment to the London School of Economics in 1931. It was cited by the Nobel committee that awarded him the prize for economic science in 1974.

But after 1931, Hayek engaged several theoretical controversies with his fellow economists. The most famous of these was his long-running debate with John Maynard Keynes. One long-term consequence of that debate was the economics profession’s exile of capital theory from macroeconomics. They refused to contemplate the distinction between long-term and short-term production processes and capital goods. They treated capital as a homogeneous lump or mass rather than a delicate fabric of heterogeneous goods valued by an intricate structure of interest rates.

That is why Keynesian macroeconomics textbooks pretend that government can increase investment by creating money that lowers “the” interest rate. If government could really do this, of course, our lives would all be radically different than they actually are. We would not experience recessions and depressions.

Public-service radio and television advertisements warn consumers to beware of investment scams that promise returns that are “too good to be true.” “If it sounds too good to be true,” the ad declares sententiously, “it probably is.” What we really need is a commercial warning us to apply this principle to the claims of government and government policymakers – and, for that matter, university professors who are dependent upon government for their livelihood.

It turns out to be surprisingly difficult to refute the claims of Keynesian economics without resorting to the annoyingly complicated precepts of capital theory. Ten years before Keynes published his theory, the American economists Foster and Catchings developed a theory of government intervention that embodied most of Keynes’ ideas. They published their ideas in two books and challenged the world to refute them, even offering a sizable cash prize to any successful challenger. Many prominent economists tried and failed to win the prize. What is more, as Hayek himself acknowledged, their failure was deserved, for their analysis did not reveal the fallacies inherent in the authors’ work.

Hayek wrote a lengthy refutation that was later published under the title of “The ‘Paradox’ of Saving.” Today, over 80 years later, it remains probably the most meticulous explanation of why government cannot artificially create and preserve prosperity merely by manipulating monetary variables like the quantity of money and interest rates.

There is nothing wrong with Hayek’s analysis. The main problem with his work is that it is not fashionable. The public has been lied to so long and so convincingly that it can hardly grasp the truth. The idea that government can and should create wealth out of thin air is so alluring and so reassuring – and the idea of its impossibility so painful and troubling – that fantasy seems preferable to reality. Besides, large numbers of people now make their living by pretending that government can do the impossible. Nothing short of social collapse will force them to believe otherwise.

The economics profession obsessively studied and research Keynesian economics for over 40 years, so it has less excuse for its behavior nowadays. Keynes’ main contentions were refuted. Keynesianism was rejected by macroeconomists throughout the world. Even the head of the British Labor Party, James Callaghan, bitter denounced it in a famous speech in 1976. The Labor Party had used Keynesian economics as its key economic-policy tool during its installation of post-World War II socialism and nationalization in Great Britain, so Callaghan’s words should have driven a stake through Keynes’ heart forevermore.

Yet economists still found excuses to keep his doctrines alive. Instead of embracing Hayek, they developed “New Keynesian Economics” – which has nothing to do with the policies of Bernanke and Obama today. The advent of the financial crisis and the Great Recession brought the “return of the Master” (e.g., Keynes). This was apparently a default response by the economics profession. The Recession was not caused by free markets nor was it solved by Keynesian economics. Keynesian economics hadn’t got any better or wiser since its demise. so there was no reason for it to reemerge like a zombie in a George Romero movie. Apparently, economists were reacting viscerally in “we can’t just sit here doing nothing” mode – even though that’s exactly what they should have done.

If QE and ZIRP are not the answer to our current economic malaise, what is?

In order to solve a problem, you first have to stop making it worse. That means ending the monetary madness embodied in QE and ZIRP. Don’t try to keep interest rates as low as possible; let them find their natural level. This means allowing interest rates to be determined by the savings supplied by the private sector and the investment demand generated by private businesses.

In turn, this means that housing prices will be determined by markets, not by the artificial actions of the Fed. This will undoubtedly reverse recent price increases recorded in some markets. As the example of Japan shows only too well, there is no substitute for free-market prices in housing. Keeping a massive economy in a state of suspended animation for two decades is no substitute for a functioning price system.

The course taken by U.S. economic history in the 20th century shows that there is no living with a central bank. Sooner or later, even a central bank that starts out small and innocuous turns into a raging tiger with taxpayers riding its back and looking for a way to get off. (The Wall Street Journal‘s recent editorial “Bernanke Rides the Bull” seems to have misdirected the metaphor, since we are the ones riding the bull.) Instead of a Fed, we need free-market banks incapable of wangling bailouts from the government and a free market for money in which there are no compulsory requirements to accept government money and no barriers to entry by private firms anxious to supply reliable forms of money. Bit Coin is a promising development in this area.

What does all the talk about the Fed “unwinding” its actions refer to?

It refers to undoing previous actions; more specifically, to sales that cancel out previous purchases of U.S. Treasury bonds. The Fed has been buying government bonds in both primary and secondary bond markets pursuant to their QE and ZIRP policies, respectively. It now has massive quantities of those bonds on its balance sheet. Technically, that makes the Fed the world’s largest creditor of the U.S. government. (Since the Fed is owned by its member banks, the banks are really the owner/creditors.) That means that the Federal Reserve has monetized vast quantities of U.S. government debt.

There are two courses open to the Fed. One of them is hyperinflation, which is what will happen when the Fed stops buying, interest rates rise to normal levels and banks have no alternative but to use their reserves for normal, profit-oriented purposes that put money into circulation for spending. This has never before happened in peacetime in the U.S. The other is for the Fed to sell the bonds to the public, which will consist mostly of commercial banks. This will withdraw the money from circulation and end the threat of hyperinflation (assuming the Fed sterilizes it). But it will also drive bond prices into the ground, which means that interest rates will shoot skyward. This will create the aforementioned government budget/debt crisis of industrial strength – and the high interest rates won’t do much for the general business climate for awhile, either.

Since it is considered a public-relations sin for government to do anything that makes the general public uncomfortable and which can be directly traced to it, it is easy to see why the Fed doesn’t want to take any action at all. But doing nothing is not an option, either. Eventually, one of the two aforementioned scenarios will unfold, anyway, in spite of efforts to forestall them.

Uhhhh… That doesn’t sound good.

No spit, Spurlock. Yet, paradoxical as it might seem at first, either of these two scenarios will probably make people more receptive to solutions like free banking and free-market money – solutions that most people consider much too radical right now. There are times in life when things have to get worse before they can get better. Regrettably, this looks like one of those times.

DRI-397 for week of 9-16-12: “QE3: Flying Blind”

An Access Advertising EconBrief: 

“QE3: Flying Blind”

Recently, Federal Reserve Chairman Ben Bernanke announced that the Federal Reserve would embark on still another venture in stimulative monetary policy – QE3. Bernanke characterized this sequel as intended to “help Main Street” by fighting unemployment, which “has remained stubbornly high.”

“QE” stands for “quantitative easing.” The meaning of this phrase will seem obscure to all but insiders; it implies that the focus of monetary policy is entirely on the quantity of money rather than something else. Economic textbooks of a half-century ago defined monetary policy according to the tenets of Keynesian economics – the manipulation of interest rates (usually downward) through changes in the quantity of money.

When interest rates are at or near zero, there is little further scope for employing this tool – at least in the orthodox manner. The idea behind quantitative easing is that further increases in the quantity of money may still have stimulative impact when selectively employed. Meanwhile, the increases have the effect of maintaining the Fed’s zero-interest-rate policy (ZIRP).

The third edition of the QE series both conforms to and differs from the first two. The additional money will come from monthly purchases of mortgage-backed securities by the Fed, in the amount of $40 billion. This is both a similarity and a difference. The .Fed has been trying since 2009 to raise home prices by buying mortgage-backed securities – without much success. Prior to QE3, however, this program was segregated from monetary policy as such and marketed as a kind of disaster relief for the housing industry.

The other element of QE3 is a continuation of “Operation Twist,” the revival of a little-remembered 1960s policy aimed at changing the maturity structure of federal-government debt. By buying and retiring long-term government bonds and selling short-term government debt instruments, the Fed has significantly shortened the average maturity of federal debt. Since short-term interest rates are being held artificially low, this has allowed the government to reduce its interest payments on the debt.

The Political Reactions to the QE Series

Technically, the Federal Reserve is an independent institution, neither completely governmental nor strictly private. Its actions are ostensibly motivated by non-partisan considerations and as such should be above politics. In practice, the Fed has become a sizzling hot potato on the election-year grill.

Most defenders of the administration – not all of them Democrats, surprising as that may seem – insist that the Fed’s actions since 2007 have been emergency actions aimed at rescuing us from the abyss of worldwide great depression, a la the 1930s. Since reported U.S. unemployment has not risen to 25% and GDP has not fallen precipitously, the Fed’s actions must have been successful.

Criticism of the Fed has been purely political, its defenders maintain, since its actions have been taken right out of the textbook – or perhaps “script” would be a more precise analogy – of measures designed to combat financial crisis, market crash and incipient depression. Since quantitative easing has been used only in Japan over the last dozen years or so and has been mostly deemed a failure, it is not clear why the Fed has called this play or why armchair quarterbacks tout this playbook so confidently.

Fed critics are aghast at the Fed’s actions and its rationale for them. Massive injections of liquidity and a long-term “zero-interest-rate-policy” (ZIRP) are draconian, unprecedented actions. Their justification can only be an emergency of life-threatening dimensions – to import an analogy from medical crisis management. But unlike the Great Depression that began in 1929, this emergency was never realized, only putative. There were no massive bank failures, no bread lines, no riots, no widespread unemployment. There was the popping of the government-policy-created housing bubble and an ensuing recession – the thirty-third if you believe the long line of U.S. recessions began in 1854, as the National Bureau of Economic Research does. But another decade-long depression was not inevitably in the cards.

Even more telling have been the Fed’s incoherent explanations for its actions. Bernanke says that this QE is supposed to fight unemployment. But each previous QE had the same rationale. Yet results were anemic at best – unemployment fell from almost 10% down to its present 8.1% mostly because the size of the labor force shrunk to a shocking, seldom-seen extent. Actual employment is still less than in 2007, prior to the onset of the recession.

The political camps are miles apart, but even Bernanke’s supporters should acknowledge, as he himself does, that legitimate doubts plague public acceptance of the QE series. Two nagging questions lead the list. First, why should this QE succeed where the first two largely failed? Surely not because the technical details are different; purchases of mortgage-backed securities have scarcely budged home prices previously, so why should they lift the entire economy now? Without saying it in so many words, Bernanke is implying that his intentions are what determine the results of the policy. Previously, the policy now labeled as QE3 was not intended to be stimulative, so it should not be criticized for its lack of punch. But now, less than two months before the Presidential election that will determine whether he is reappointed as Fed Chairman, Bernanke has recognized that need to fight unemployment. So we should expect that the same policies that didn’t work before will work now.

Second, the phrasing of Bernanke’s remarks clearly suggests that previous QEs had a different purpose. What was it and why did Bernanke fail to disclose it then and now? After all, it’s not as if he can be excused for holding political cards close to his vest. The Fed is supposed to be independent of politics and government policy.

And while we’re posing questions, let’s not forget an even more obvious one: How do we know that the QE cure is not worse than the disease it is supposed to fight?

The Curious Rationale for the QE Series

This space has previously addressed what seems to be the true rationale for the QE series; namely, the desire to prop up the banking system by subsidizing banks. Because banks and Wall Street are in bad odor with the public, the subsidies have to be undercover. The QE series has involved purchases of securities by the Fed from commercial banks and payment in the form of deposits credited to bank reserves by the Fed. In order to induce the banks to hold this money as excess reserves instead of lending it out, the Fed began paying interest to banks on their excess reserves in 2010. By restraining bank lending rather than encouraging it, the Fed has itself prevented its policies from stimulating the economy. Indeed, for the last year or so the Fed has even “sterilized” the increases in bank reserves with asset sales so as to hold the supply of base money roughly constant.

We cannot know the reasons for this policy because Bernanke has not even acknowledged it, let alone explained it. Presumably, the Fed believes that too many U.S. commercial banks are at or near the point of insolvency. Normally, the Fed handles insolvent commercial banks by merging them with sound banks, but this is clearly infeasible when a sizable fraction of banks are unsound. Absent its standard form of treatment, the Fed may be putting the banking system in a therapeutic coma until conditions improve. In other words, the Fed may be allowing bank balance sheets to fatten on safe interest payments earned on excess reserves while buying time for housing prices to rise. Housing price increases would increase the value of the mortgage-backed securities that form the bulk of commercial-bank assets.

This is consistent with the form taken by QE3, in which Fed purchases of mortgage-backed securities are the backbone of stimulative policy. This unprecedented policy change reverses age-old Federal Reserve precedent of purchasing and selling only government securities, in order not to favor or harm particular industries or firms in the private economy.

There is an alternative explanation for the QE series and ZIRP. The state of the federal budget is so parlous that by 2020, interest on debt threatens to overwhelm it and comprise almost all the projected total. This would crowd out almost all social spending directly and indirectly crowd out private investment spending by forcing an increase in market interest rates in order to attract the bond investment necessary to finance the projected budget deficits. ZIRP can be viewed as a delaying action designed to hold down federal-government interest payments as long as possible and buy time for Congress and the President to deal with the nation’s fiscal problems.

We should note, first, that these two alternative explanations for the QE Series are not mutually exclusive. Indeed, there reinforce each other. But they are both thoroughly dishonest because, if either or both are true, they mean that Bernanke has been lying through his teeth for years. They also signal the end of Federal Reserve independence from politics. Both involve Fed implementation of fiscal policy as well as monetary policy, even though fiscal policy is supposedly the sole preserve of the Treasury and the political administration in power.

Why Is the Cure Worse Than the Disease?

Judging from the actions of the Federal Reserve since 2008, one might think that the only function served by interest rates is to serve as levers by which the Fed speeds up or slows down the pace of economic activity. This is miles away from the truth. The true function of interest is outlined in economic textbooks and reference books.

In The Fortune Encyclopedia of Economics, Paul Heyne informs us that “interest is the price people pay to have resources now rather than later.” At a consumer-loan rate of 11%, we can borrow $900 for one year and repay $1,000 in one year’s time. Obviously, since we have the wherewithal to repay the $1,000 loan in one year, we could have simply waited one year and enjoyed $1,000 worth of consumption goods. But we chose instead to consume $900 today, and the 11% ($100) premium we paid is the price for our anxiety to consume in the present. It reflects the degree of our time preference, a term suggesting that an inherent human tendency to prefer consumption sooner rather than later is what accounts for a positive interest rate. And it is the ability to utilize capital goods productively that allows us to finance them with borrowed money and use their product to repay both cost and interest on the loan.

This implies that interest is not purely a monetary phenomenon. “The fact that loans are usually made in money leads to the mistaken belief that interest is the ‘price paid for the use of money'” and can be lowered mechanically be by increasing the amount of money in circulation. “But interest would also exist in a pure barter economy where money was not used.”

This is not merely conjectural. In wartime prisoner-of-war camps, prisoners made loans to each other from their limited stocks of ration goods, demanding repayment of a larger quantity of the good. When cigarettes later became the medium of exchange in the camps, these constituted both principal and interest for the loans. The medieval church condemned the collection of interest as sinful, but it purchased annuities to the proceeds of land rents at less than their face value; e.g., it charged interest to sellers.

The fact that goods and money are valued differently at different points in time means that interest rates are key tools of human valuation. “The interest rate enters at least implicitly into all economic decisions, because economic decisions are made by comparing expected future benefits to costs.” The farther into the future a prospective benefit is deferred, the lower its current value. That current or present value is calculated numerically by discounting the benefit using a relevant interest rate.

Every sort of investment decision requires this kind of discounting calculation or its obverse, the future value calculation – both of which require the use of an interest rate. People who want to save for their retirement must do these calculations and supply relevant interest rates for their own use. Businesses pondering fixed investment will probably wish to calculate a “hurdle rate” or interest rate of return for comparison purposes. To do it they will need market rates of return to serve as benchmarks.

The Soviet Attempt to Control the Interest Rate

Soviet Russia virtually eliminated private property and capital markets from the Russian landscape beginning in 1917. In principle, this eliminated both the opportunity and the need for nominal interest rates. But economics predicts that the phenomenon of interest is necessary for people to behave rationally. Sure enough, Communist economic planners eventually tried to invent an interest rate to improve the effectiveness of their own planning. (They couldn’t call it an interest rate, for fear of being shot – they called it the “efficiency index.”)

The Soviet government had the advantage of being able to observe Western financial markets and interest rates in constructing their artificial interest rate. Even so, their attempt failed miserably. Although few realized it at the time, subsequent research and archival disclosures revealed that their economy declined more or less continuously

when its private features were suppressed. Ultimately it collapsed completely, beginning in 1989. One important cause of the collapse was the utter inability to tailor investment to meet consumer wants and needs.

The U.S. Economy Under ZIRP

How would we expect a free-market economy to react when the price signals that customary guide production and consumption decisions are disrupted, garbled and stopped entirely? We would expect confusion and indecision to result. We would expect the pace of economic activity to slow as people groped for substitute decision variables on which to base their actions. We would expect to find extreme reluctance in committing large amounts of resources and money to future endeavors, whether in hiring or investment. In short, we would expect to see an economy very much like the economy we observe all around us today.

The effects of ZIRP are even more pernicious than they might seem at first glance. Although the interest rates most directly (and indirectly) affected by ZIRP are short-term rates, long-term interest rates under ZIRP are also not unhampered free-market rates. Just as with the prices of goods and services, interest rates act through their relative relationship to each other rather than through their absolute magnitude alone. That is, the relationship of (say) six-month to one-year rates is just as important as either rate by itself. Even though the effect of ZIRP on interest rates becomes progressively smaller as the term structure of the rates lengthens, the relative relationship between long rates and shorter rates is still affected by distortions in the latter. These distortions cause changes in the supply of and demand for savings and investment that, in turn, affect long-term rates as well. This is not only acknowledged but welcomed by the Fed – Bernanke expressly claimed lower long-term rates as an intended effect of QE3.

The 1970s Inflation – Comparing Distortions

The last time that widespread distortions in relative interest rates occurred in the U.S. was the late 1970s. They were due to the high inflation that had accelerated thanks to Federal Reserve policies throughout that decade. Although all interest rates came to include an “inflation premium” intended to compensate asset holders for the loss of purchasing power of fixed-income interest payments, this market-imposed version of financial inflation indexing was an inexact science. In practice, the relative relationship of interest rates of differing terms was also distorted by inflation, if only because few if any asset holders had exactly the same consumption patterns. Consequently, inflation had a different effect on the real value of a given interest return for each investor.

An even greater degree of distortion was experienced in 1970s’ consumer goods markets, where rapidly rising prices did not all rise at the same rate. Consequently, relative prices changed dramatically compared to their pre-inflation levels. Consumers’ money incomes also did not rise pari passu with inflation, causing marked shifts in real income away from those on fixed incomes and dependent on fixed-income investments.

Today, the greater distortion is experienced in financial and investment markets. Interest rates are to the future what a plane’s instrument panel is to a pilot. When the instruments are broken or unreliable, the pilot’s navigational horizon is limited to what he can see. ZIRP gives us interest rates that are unreal, phony, untrustworthy. This limits our planning horizon severely, making us unwilling to look very far ahead, hire employees or commit substantial funds to the future. And it even distorts the choices we make in the present.

Flying Blind Under ZIRP

Lower interest rates cause producers to become more future-oriented, shifting production to good with longer production processes using more capital-intensive methods. Under normal circumstances, when lower interest rates are the result of an increase in saving by the public, this is appropriate. The public’s increase in saving is a signal that it wants more consumption in the future and less now. This insures an adequate volume of purchasing power to buy the volume of future goods produced, while changes in the prices of goods and services insure that the right amounts of particular goods and services are produced.

But when the low interest rates are contrived artificially by the Fed instead of organically by private saving, there is no assurance that the future volume of consumption spending that consumers have planned will be adequate to purchase the goods produced by producers. Producers of slower-gestating goods will suffer losses because their prices will have to fall to unremunerative levels to clear the market. This will lead to business failures, layoffs and unemployment. Ordinarily this cycle would be reversed by changes in interest rates – unless interest rates cannot rise to cut it short. Then producers are in a quandary. The market signals they have come to rely on are now telling them to do things that have just failed. On the other hand, government regulators are telling them they can’t do many of the things they want to do. So they do nothing, or as little as possible.

Free markets have evolved a delicate and complex system of price signals to guide producers and consumers. Prices of goods and services guide us in our purchases from day to day and over very short time horizons. Interest rates guide our planning decisions over significant lengths of time; they are the instrument panel that helps us to navigate a cloudy and uncertain future. But when this system of prices fails or is hamstrung by government, as happened in the Soviet Union and in 1970s America and now under ZIRP, we find ourselves flying blind.

QE3: The Substitution of Politics for Markets

Fed Chairman Bernanke’s justification for QE3 is impossible to take at face value and difficult to rationalize in any favorable way. Evaluated as economic policy, it further accelerates the trend first kicked into overdrive in 2008; namely, the substitution of bureaucratic and political criteria for those of markets. The verbal cosmetics applied to beautify these actions do not mask their flaws. And the emergency rationale invoked to justify them cannot overturn the verdict of history and logic.