There are those, like Peter Schiff, that argue that the Government (including the Fed) shouldn't 'meddle' with the economy, that is, all the different efforts at stimulus are misguided and misdirected. It prevents a cleansing of the economy. Implicit in this is a view of the economy as a self-stabilizing mechanism that is simply not supported by data.
Here are a few quotes from Peter Schiff's article:
The recession the Fed is trying so desperately to prevent must be allowed to run its course so that the economy that we have developed over the last decade, the one that is overly reliant on low interest rates, borrowing and consumer spending, can finally restructure itself into something healthier.
Holding rates of interest far below market levels (which is the goal of stimulus) alters patterns of consumption, savings, and investment.
There are three particularly worrying thoughts at work here which we will pose as questions:
- Are interest rates 'artificially' low?
- Must the recession be allowed to run its course so that the economy can restructure into something 'healthier?'
- Is the economy self-stabilizing?
Are interest rates artificially low?
Well, yes and no. Yes, one could argue that short-term rates are 'artificially' low, as these are the result of Fed policy. But isn't the Fed supposed to lower these rates when the economy falters? That is their mandate, as it happens.
The Fed is supposed to increase rates when the economy starts to overheat and inflation becomes a danger, and do the opposite when inflation isn't a danger and growth falters. Since the latter is happening, and inflation isn't a problem, interest rates should certainly be low. How low is 'artificially' low?
More importantly, short-term rates do not matter much for the process of resource allocation. Capital formation by business invariably has a long-term horizon, greatly exceeding those of the short-term interest rates. Now, long-term rates are also very low, but these are market rates that are much less under control of the Fed.
In fact, long-term rates are low because of the deleveraging by the private sector and banks. Households who saw 40% of their wealth wiped off because of the housing implosion are paying off debt and borrowing and spending less. Businesses invest less as the subdued demand provides little incentive to expand capacity.
This simply means that the private sector as a whole (households and firms) has moved into a huge surplus. Savings greatly exceed investment.
So equilibrium interest rates, those which would equate the supply and demand for loanable funds, are probably below zero. Indeed, Richard Koo from Nomura has argued that if the central bank cuts interest rates to zero and nothing happens you're not in an ordinary world. This world is known as a liquidity trap.
For those who are familiar with the mechanics of a liquidity trap and the workings of deleveraging during a balance sheet recession, this absence of high bond yields in the face of very large public deficits and the absence of accelerating inflation hasn't been difficult to explain, even predict. Nor would public borrowing 'crowd out' private borrowing.
This simple diagnosis enabled the likes of Krugman as long as three years ago to rubbish those (like Niall Ferguson) who argued that all that public sector borrowing would lead to escalating bond yields. For exactly the same reasons those predicting accelerating inflation could also be rubbished.
This diagnosis has withstood the test of time rather well. So, long-term rates are not low because of any Fed policy, but because of the economic conditions produce excess savings in the private sector. As further evidence, bond buying (quantitative easing or QE) by the Fed has made very little difference. Announcing, starting, nor ending QE has made much of an impact on long-term rates.
The economy is simply going through a process of deleveraging, producing excess savings in the private sector, and this process itself is producing record low (long-term) interest rates. But record short-term, nor long-term interest rates do much to alter this process. Even at zero rates, there is little demand for credit as long as this deleveraging process continues.
All that central bank money just sits there in bank reserves, without making it into the real economy, even at zero interest rates:
So no, we largely think that interest rates aren't 'artificially' low. They are low by historic standards, but that is produced by the economic conditions. Even the record low interest rates still produce a surplus of savings over investment, a sure sign that these rates aren't 'artificially' low.
Must the recession run its course?
We think that is a dangerous statement on several levels. First, if enacted, it would amount to sacrificing the livelihoods of millions for the sake of some abstract ideal, one writer's assessment of what a 'healthier' foundation of the economy would be.
We are from Europe, and that's a continent with a particularly unfortunate history where it comes to sacrificing people for the sake of abstract ideals, so we might be a bit sensitive to this.
But what would a recession achieve? What is a 'healthier' footing of the economy exactly? Here is Schiff again:
Because the Fed has kept interest rates too low for too long, Americans have saved too little and borrowed too much; consumed too much and produced too little; and imported too much and exported too little. Too much of our labor is devoted to the service sectors and not enough to goods production. Too much capital goes to Wall Street speculators and not enough to Main Street entrepreneurs. We built too many homes but not enough factories. We have developed too many shopping centers, and not enough natural resources. The list of Fed induced misallocations goes on.
Wow! Schiff basically blames everything that has gone wrong with the US economy in the last couple of decades on those 'artificially' low interest rates by the Fed. While Seeking Alpha isn't the American Economic Review, it would have been nice if he could have substantiated at least some of these claims. Yes, at times, short-term interest rates have been too low for too long. But this is mostly with hindsight. It's the Fed's job to keep inflation in check, and this is what they've been doing.
The case for higher rates would have had to be based on asset prices. Greenspan himself noted 'irrational exuberance' in 1996, but did little about it. The (arguably much) bigger mistake actually lies with the past decade's housing boom, which Greenspan denied until the end. So Schiff's gripe with the Fed amounts to a call for the Fed to target asset prices. But isn't that interfering in the 'price discovery' process of markets?
What's more, Fed policy isn't all powerful, not even outside the present conditions in which its effectiveness is particularly low because of deleveraging. Long-term market rates matter more for the economy and aren't under direct Fed control. These rates are basically ruled by inflationary expectations, so the more credible the Fed is, the lower long-term rates will actually be.
So while Schiff might not have been happy with the Fed at all, the markets had great faith in the institution, and Greenspan in particular, as long as inflation remained low.
Another question that Schiff needs to answer is whether easy credit by the Fed led to a generalized, economy wide investment boom. Hardly:
Since 1980, U.S. investment as a percentage of GDP was sliced in half, from nearly 24 percent to 12 percent, leaving the United States 174th in the world. The result was a dearth of real value added products and productivity. [Moneynews]
As an aside, one might want to check what Fed rates were in 1980s to get the right perspective on this. Higher rates would have led to even lower investment, and more problems. This isn't exactly a sign of an economy that ran amok because of low interest rates. Other evidence that belies this picture comes from corporate profitability. Apparently few marginal investment projects were induced by Schiff's 'artificially' low rates, how else can corporate profitability have been so good?
Yes, there were problems in specific sectors, like finance and housing. But these problems have been created by deregulation, not by 'artificially' low rates by the Fed. The latter would have produced a generalized, economy wide investment boom, not one contained in a few sectors. And what's more, the sector specific bubbles are much more difficult to defuse by across the board rate rises by the Fed.
How about those households going on a borrowing and spending binge? Well, as we explained in greater detail earlier on SA, rising inequality and the rising wedge between labor productivity and wages might have something to do with that. In the rich world, the US is unique in terms of wage stagnation since the mid 1970s, and the borrowing and spending could simply have been ways to keep up with the increased wealth and consumption around.
If this assessment is right, it's also pretty unlikely that getting the Fed out of the game of setting interest rates way below those mythical market equilibrium rates will do much to solve the problem. In fact, doing that would likely have choked the economy. Borrowing and spending by households would have been less, and investment by business would have been affected both by higher rates and less consumer spending.
Is the economy inherently stable?
Schiff wants to let the recession "run its cause," as he expects that the economy will automatically return to equilibrium, one on a sounder footing even. Is this what would happen? One can have grave doubts about that. This is no ordinary business cycle recession but quite another beast.
It's a balance sheet recession, where the private sector cuts back borrowing and spending in order to repay debt and repair balance sheets. One problem with balance sheet recessions is that normal monetary policy, the tool to soften garden variety business cycles, doesn't work. Indeed, rates have been cut to zero without much happening.
A much bigger problem is that balance sheet recessions can easily feed on themselves. Rather than self-healing, the economy would self-destruct. Irving Fisher realized that in the 1930s. One feedback loop is through the reduction in private sector spending. This reduces output, it puts the economy in a recession and creates unemployment which cuts spending further, etc.
More dangerously is the asset price implosion that precipitated the balance sheet recession. Self-reinforcing feedback loops here run from lower asset prices producing forced asset sales, producing even lower asset prices and even worse balance sheets for households and banks, and all of this depressing incomes and the economy more.
Debt is then supported by ever lower income and assets, the famous Fisherian debt-deflationary spiral. This could be even worse if, like in Japan, prices start to fall which increases the real value of the debt. Throw in a few financial institutions collapsing and you're in really serious trouble.
The aftermath of an asset price implosion is about the most inappropriate and dangerous time to put the theory of self-restoring equilibrium to the test. We know that GDP, employment, world-trade, and stock markets were all falling as fast, or faster in 2008-9 compared to 1929-30. It's the rapid policy interventions that have made the difference this time around and stopped this from turning into another 1930s style depression.
With monetary policy impotent, it's only fiscal policy that can make a difference. We know in similar circumstances what happens when the foot is taken off the gas. What happened in 1937 in the US is very similar as to what happened in Japan in 1997 in the aftermath of the Japanese asset implosion in the early 1990s. In both cases, premature fiscal consolidation rapidly led to the return of the recession.
Today we have a mild form of that in the US, fiscal policy is already a drag on the economy. With the deleveraging of households incomplete, it's no wonder that the recovery has been so sluggish.
The only saving grace is that the big public sector deficits of the past four years have enabled the deleveraging process not to cause more economic damage.
But now is not the time to put sacrifice the livelihood of millions in the name of the abstract ideal of self-restoring equilibrium forces. Although the deleveraging process is already quite advanced, the economy could still be overwhelmed by the Fisherian self-reinforcing feedback loops described above.