Thursday, June 28, 2012

The elusive argument of what the Fed should do

After reading in two separate posts that there are 'many actions' the Fed could take to help employment in this country, I decided to search for a listing of these actions. I'm surprised that I had to search, because one of the first tenets of argumentation is that you support your assertions. So when someone asserts that the Fed could help employment, in the next sentence or paragraph, they should explain how. Simple, right? Not too much to expect, I would have thought.

Well, the arguments for what the Fed could do were largely attributed to Paul Krugman, a Nobel laureate in economics, so it wasn't too hard to find. Nor is it too hard to understand Krugman's suggestions:
  1. First of all, be bold and try actions other than the usual limited set of raising or lowering the Fed fund interest rates.
  2. Buy longer term government bonds and government-backed mortgage securities. (Krugman reports that the Fed is currently doing this.)
  3. Change the inflation target from 2% to 4%, signally that the Fed will continue pumping money until there's enough growth to start having significant inflation pressure.
Once the suggestions are enumerated, it becomes clear that there aren't 'many' actions. #1 isn't a specific action. #2 is already being done. So that leaves a single action--changing the inflation target.

With only one additional action being suggested, I would think our society or pundits could have a substantial debate. So what are the pros and cons, the risks of pursuing this course or not pursuing it?
  • Pro, from Krugman: "If the Fed were to raise its target for would help persuade investors and businesses alike that sitting on cash is a bad idea.
  • Con, from the American Enterprise Institute: Inflation lowers the purchasing power of dollars, which mean higher prices for commodities like oil.
I believe the con argument, but the pro argument is less probable. I don't know if the investors who got so badly burned in 2008 will unleash their cash out of fear of inflation that hasn't appeared yet.

What I find strange is the lack of more discussion. Is this all there is? No more ideas for what the Fed could do? It's no wonder that the economy is rebounding so slowly. The Fed can't really do much more, the Congress and president can't agree on what to do, the rest of the world either has its own problems or they aren't looking to pump us up. So, no quick fix. How unAmerican!

Inflate your way to riches.


Economist article with comments
St. Louis Fed comments
Background comments by Bernanke
Related argument on quantitative easy from AEI: The low interest rates force investors into riskier investments, like commodity speculation. Lovely.
Four specific suggestions with rationales from an economist. Many times better than Krugman, but more work to read.


A Political Junkie said...

From what I have read, even some of the Federal Reserve Bank Presidents are unsure of the results of QE and low interest rates, suggesting that this prolonged period of ultra-low rates could well lead to a Japanese-style lost decade.

It was interesting to read a statement from the U.K. that stated that low interest rates had removed tens of billions of dollars from the economy, a critical factor in a consumer driven world that we currently live in.

ModeratePoli said...

I've read your posts on the negative effects of ultra-low interest rates on pensioners and somewhere else (or maybe your blog) on the effect on pension plans.

It's certainly an important topic, but I wish I could get a sense of more of the issues involved. How do higher interest rates hurt (or help) businesses? Will it hurt government budgets a lot, or just marginally?

Where would interest rates be if the Fed wasn't buying so much debt? I wish I had the information about this so I could make an informed decision.

Couves said...

Good post MP. Monetary policy is one of my personal jihads right now.

The alternative to the Keynesian approach is to end all monetary stimulus, a policy which is pushed most forcefully by the Austrian School. Peter Schiff is probably the best known popularizer of the school (he has lots of stuff on youtube).

Agreed on inflation - it's essentially a regressive tax on the elderly, who don't have the luxury of time needed for volatile investments. And it's exactly those investments that the Fed is trying to boost -- the stock market and real estate. Liberals generally bemoan the necessity of "playing the market" with one's retirement, yet they support the very same monetary policies that make it necessary.

Also agree with Political Junkie -- I get the sense that everyone is just waiting for the next shoe to drop, but they don't know exactly where it will fall. When that's the case, holding cash is not a bad idea, even with higher inflation. There's just too many ways to get screwed right now.

Regarding Krugman: Back in 2005, he wrote an article about the housing bubble being inflated by monetary stimulus. Amazingly, his suggestion wasn't to stop inflating the bubble, but for the Fed to find the next thing to inflate once the current bubble burst!

The solution to a phoney economy that has misallocated resources isn't to keep it going, or to build a new phoney economy. We need to let markets work, find their natural level and build back production according to what people actually want to buy, based on what they can actually afford to pay. That will mean less consumer spending than Krugman, the Fed or Wall Street want, but that's not the problem they think it is. Massive consumer spending is not necessary for a strong and growing economy (We used to be a thrifty nation!). In fact, shifting resources from spending to investment will ultimately make the economy grow even faster.

Liberals have somehow tied themselves to an economic theory based on milking consumers for the benefit of Wall Street. There has to be an alternative - the Austrian School is the closest thing I've found.

ModeratePoli said...

@Couves, I learned thrift growing up, and I follow it now. Maybe that's why I'm not freaked out by the thought that we're not going back to one bubble after another, but maybe we'll have a slower growth cycle that's more solid than we've had for decades.

Sometime, the population of the world will stabilize, and we'll need a model that isn't so dependent on growth. I can see it in my head--everyone gets a modest return on their labor, and we all have enough and even have money for some leisure and some charity. I can't believe that's not possible because I think it worked that way for ages (like maybe the Middle Ages).

Concerning the Austrian school, I'm not a fan, particularly of the gold standard stuff. I read something recently where an Austrian adherent is against any fractional lending, and I find that ridiculous. Tell that to my well-managed small bank.

I haven't found a theory where the Austrian school is right, at least not yet. If you want to give me links to written material, I'd appreciate it.

I'm not interested in youtube --it's too frustrating for the kind of analysis I do. I want to be able to trace the logical steps, so video isn't a good medium. I'm glad Krugman wasn't on youtube. For example, Krugman can write "None of this [unemployment] need be happening" and I can pull out that quote and that sentiment and give it a barrage of questions. I can't do that with a video. (Hope this isn't TMI.)

Couves said...

MP - My understanding of macro policy is based on what I've learned from the Austrian School over the last few years. Yes, some ‘Austrians’ support the Gold Standard, or even oppose fractional reserve banking (!), but those aren't essential parts of "Austrian" thinking. Nor are the laissez faire fiscal policies many of them subscribe to (While Rothbard was an anarchist, Hayek was an unapologetic supporter of the welfare state.).

As for them not being right about anything… they were completely right about the housing bubble, which is what has brought them a lot of attention lately.

If I have a chance, I’ll look for some articles for you.

ModeratePoli said...

@Couves, Recognizing the housing bubble was not a feat of great insight, but one of honesty and/or courage, which unfortunately are in seriously short supply among elected officials.

I recognized the housing bubble, and the tech bubble before that. It doesn't make me a brilliant economist. What I wish is that the brilliant economists could figure out what laws we need to stop these Wall Street gamblers from collapsing the economy. Ron Paul and Rand Paul haven't been much help in that. (And yes, the Fed deserves its share of blame too, just not all the blame.)

Couves said...

MP - True, you don't need to be an economist to spot a bubble, although most either missed it or (like Krugman) simply shrugged it off. Many economists like to think of themselves as practicing something like a hard science, but when they miss something anyone with common sense can observe, you have to wonder… More importantly, the Austrians didn't just observe what was obviously happening, they explained why it was happening, how we should react to it, etc.

The housing bubble is an event that social scientists might call "overdetermined" -- you can point to a number of factors as being key to its development. The Austrian insight, which I think is spot-on, is that maintaining an expansionary monetary policy for too long will inevitably lead to some kind of mischief -- if it's not a real estate bubble, it's a tech bubble, or some other inflationary manifestation. There are certain laws of economics that simply cannot be avoided. It’s kind of an obvious, almost too-simple insight, yet Fed policymakers (and most economists) just don’t buy it, all evidence to the contrary.

ModeratePoli said...

@Couves, You're right that it's not the keen insight of the Austrian school that sets it apart, but an unusual level of honesty.

Greenspan once showed that level of honesty with his "irrational exuberance" statement, and the reaction guaranteed he'd never be that honest in public again.

I'm not impressed with Krugman. He may provide valuable critiques of other economists' mistakes, but he's not a strong critic of his own views, like acknowledging where they're weak.

As for the problem of too much money, that was the subject on one of my first posts.

I'll be writing more about monetary issues, but it will be speculation than analysis.