Much of the discussion surrounding the Reinhart and Rogoff debacle has been focused on the spreadsheet error and the obvious cherry picking within the data. That’s led many to conclude that their model was suddenly flawed and appears to discredit the research in large part. This seems like a big “aha” moment for most people in the mainstream media even though many of us (primarily MMTers and Monetary Realists) said that the research was flawed many years ago. It was clear, from many of the data points, that no clear distinction in types of monetary systems was being made. For instance, in comparing currency issuing nations with currency using nations, the research was hugely flawed from its start.
Since the UMass Amherst paper made waves a few weeks ago, Reinhart and Rogoff have responded in a number of different articles. Their latest is an FT piece which I believe exposes more flaws in their framework. The part that concerns me is this:
Unfortunately, ultra-Keynesians are too dismissive of the risk of a rise in real interest rates. No one fully understands why rates have fallen so far so fast, and therefore no one can be sure for how long their current low level will be sustained. John Maynard Keynes himself wrote How to Pay for the War in 1940 precisely because he was not blasé about large deficits – even in support of a cause as noble as a war of survival. Debt is a slow-moving variable that cannot – and in general should not – be brought down too quickly. But interest rates can change rapidly.
Economists simply have little idea how long it will be until rates begin to rise. If one accepts that maybe, just maybe, a significant rise in interest rates in the next decade might be a possibility, then plans for an unlimited open-ended surge in debt should give one pause.
This reminds me of the Tomas Sargent commercial which goes like this:
Man’s Voice: “Tonight our guest, Thomas Sargent, Nobel Laureate in economics and one of the most cited economists in the world. Professor Sargent, can you tell us where CD rates will be in two years?
Professor Sargent: “No.”
Woman’s Voice: “If he can’t, no one can”.
When that commercial comes on TV, I usually jump out of my seat like a 10 year old in class who knows the right answer to something (well, more likely, I am too busy reading a boring paper about finance to notice, but me jumping up and down is a better visual so let’s go with that). But R&R might be right about one thing – maybe economists really do have “little idea how long it will be until rates begin to rise” because they have no understanding of the market dynamics that drive interest rates. I tried to explain this concept last year:
Long rates are ultimately a function of current economic conditions. The Fed sets short rates based on expectations of future economic conditions and long rates are an extension of short rates. In fact, if the Fed wanted to pin the 10 year t-bond at 0% it would just do it, but that’s a different matter. And bond traders front-run the Fed in trying to outguess the future economic conditions. So, it’s best to think of this whole relationship like a person walking a dog through traffic. The Fed walks the bond market around and the bond market tries to steer the Fed by guessing where traffic is headed. But the Fed can always control the rate and the leash if they want. The dog ultimately knows this and so doesn’t steer too far from its master (though it doesn’t want to be behind its master!). So it’s all a delicate guessing game because there’s no telling when the traffic might become faster or slower than we expect.
Now, we know one thing for certain – the Fed is the monopoly supplier of reserves to the banking system. If it wants to set the short rate at 0%, it simply challenges bond traders to bid against its bottomless pit of bank reserves. Once they’ve bankrupted enough arrogant bond traders, the rest of them tend to get in line with the understanding that you don’t fight the Fed when it wants to set a price in the overnight market. Theoretically, the Fed could do the same thing across the entire curve of government debt. Yes, if it wanted to name the price of the 30 year t-bond and set it at, say, 0%, it could.
The government has other options as well with regards to interest rates. For instance, if the Treasury decided they didn’t want to issue anything over a 5 year note, they’d simply stop issuing all longer durations and then you’d have the Fed setting short rates and the structure of the curve would almost perfectly reflect Fed policy. That’s a slightly different matter, but it shows that interest rates are a much smaller problem for a currency issuing central bank than most people presume.
The point is, R&R’s understanding of the monetary system appears to be largely flawed. Not only does their original paper include apples and oranges comparisons that render it flawed, but their recent comments prove that they don’t really have a full grasp on the importance of having a politically cohesive central bank and Treasury under who act as facilitating currency issuers to the monetary system.
You don’t have to be an “ultra Keynesian” to understand how the monetary system works. You just have to study the actual operational realities. Many of us have been beating this drum for years now, repeatedly stating why Europe’s monetary system was at risk of bond vigilantes and why the USA’s monetary system wasn’t. Many of us have been right about many of these big picture concepts while flawed modelling has clearly led some very smart people astray. In my opinion, understanding the monetary system at its core operational and institutional levels if the key to putting the pieces of this puzzle together. Why we continue to rely on people with obviously failed models is beyond me.