Is The Fed "Pretending"?

by: Brad DeLong

Over at Equitable Growth: Ted Rivelle is clearly saying things that make sense to him. But I don't think what he says makes sense to the world, and it certainly does not make sense to me:

Ted Rivelle:

- Fed's game of pretend must end soon:

"Artificially low rates mean that improperly qualified borrowers…

…obtain loans and then bid resources away from those who might employ them more productively. Along the way leverage accumulates, increasing financial risk and market volatility… The Fed's reluctance to pull the plug on zero interest rates is understandable. Since low rates have enabled activities that would not survive a rate rise, a renormalisation will be painful… So why do it? Because 'kicking the can' means the inevitable deleveraging will be more painful. Sustainable growth comes from improvements to work process and product. Merely adding leverage to a business does not improve its efficiency; higher home prices do not increase the wages of those in the home… The game of pretend ultimately has to end. For investors, the question that matters is when and how. When the end game comes, leverage will be forced out of the system and asset prices will fall. If the Fed is willing to recognise that ultimately its policies cannot dictate economic realities, rate rises should begin soon, presumably in 2015…

"Artificially low interest rates" - Knut Wicksell would say that the "natural" interest rate is one at which the planned supply of savings at full or normal employment is equal to desired business borrowing to finance investment at that interest rate plus the required financing for the government debt. When the market interest rate is below that Wicksellian natural rate - "artificially low", one might say - then you will have demands for financing resources outrunning the full-employment planne savings supply, the economy attempting to leverage up and reduce its net holdings of cash reserves in an unsustainable manner, unexpected inflation, and an unsustainable boom. When the market interest rate is above that Wicksellian natural rate - "artificially high", one might say - then you will have the planned savings supply of financing resources outrunning demand, the economy attempting to leverage down and increase its net holdings of cash reserves in an unsustainable manner, unexpected deflationary pressures, and a slump.

In short, interest rates are "artificially" low when the market rate of interest is less than the natural rate of interest, at which the quality of planned savings supplied at full employment balances investment plus government demand for finance. If interest rates are low but if planned savings at full employment exceed investment, then interest rates are not "artificially low": they are naturally low. If they are "artificially" anything, they are artificially high.

That Ted Rivelle has not grasped this distinction between interest rates that are merely low and interest rates that are "artificially" low is revealed by claims like:

improperly qualified borrowers [are now] obtain[ing] loans and then bid[ding] resources away from those who might employ them more productively…

We know when real productive resources are being bid for by the feckless bubble masters in a way in the way that snatches them out of the hands of those who might employ the more productively. We know because the snatching is done by bidding up the prices of the real resources. It is done by higher prices convincing those who might employ them truly productively that their project is no longer profitable.

What real investment projects now are being canceled because of unexpectedly and surprisingly high costs of real resources?

None.

The most we get is claims that:

Paul Singer:

- Fake Growth, Fake Money, Fake Jobs, Fake Stability, Fake Inflation Numbers:

"From the notion that there is 'core' and 'non-core' inflation…

…to ignoring house prices and using 'rental equivalence'; to 'hedonic adjustments' according to which, if your computer is 'better' than last year's, then you should subtract an amount from the actual price every year to reflect that improvement even though it is subjective and not really quantifiable; to a handful of other nonsensical adjustments, inflation is understated.

Inflation is also distorted by the increasing gap between the spending basket of the well-off and that of the middle class (check out London, Manhattan, Aspen and East Hampton real estate prices, as well as high-end art prices, to see what the leading edge of hyperinflation could look like).

Said differently, inflation is the degradation of the value of money. Money has no meaning beyond the value of the real things for which it can be exchanged. The inventions and tools of modern finance have made things look really complicated, but stripping inflation to its essence is critical to understanding what is real and what is false. The inflation that has infected asset prices is not to be ignored just because the middle-class spending bucket is not rising in price at the same rates as high-end real estate, stocks, bonds, art and other things…

This will not do at all.

The argument that economic growth is being hobbled because high-end art, Kensington town houses, Manhattan apartments, Aspen condos, and East Hampton beach houses are being "bid… away from those who might employ them more productively" by "improperly qualified borrowers" is rich. Yes, the knock-on effects of what I am going to have to start calling the Greatest Crash of 2008-09 was to greatly reduce the natural rate of interest and so greatly increase the wealth of those today who own cash flows in the future relative to the wealth of those today with flows of cash to reply as new savings. Yes, the Federal Reserve did not mask this huge shift in wealth by keeping market interest rates constant and so driving an even extra-larger positive deflationary wedge between natural and market interest rates. Yes, the effect is that Paul Singer - and, I guess, Ted Rivelle - have lost relative wealth and status with respect to their peers who were not raving inflation-predictors. Yes, the magnitude and persistence of the fall in the natural rate of interest since 2008 is distressing and terrifying. But none of this means that the Federal Reserve by keeping interest rates artificially low is allowing unworthy unqualified borrowers to snatch control of resources out of the hands of those who could use them more productively.

In fact, if the Federal Reserve were to raise interest rates, we would find that resources would be used even less productively - the pool of unemployed resources that are not being used at all would increase.

And yet the feeling that there is something wrong with having interest rates so low - even though Knut Wicksell would tell us that it is natural for them to be so - is widespread. Ben Bernanke says that there is a:

risk… that rates will remain low… [For] in an environment of persistently low returns, incentives may grow for some investors to engage in an unsafe 'reach for yield'… [The alternative risk that] rates will rise sharply… The two risks may very well be mutually reinforcing…

And Larry Summers will say that if the problem is the collapse of the credit channel - the inability of a market in which participants have impaired balance sheets to properly mobilize the risk-bearing capacity of society in order to finance enterprise - the first-best answer cannot be pushing down the long-run rate of interest and so providing extraordinary incentives to invest in long-duration projects. That would produce an economy with (a) too-few risky short- and medium-term enterprises, (b) a too-high duration capital stock, and (c) too-much near-rational Ponzi finance. Much better to either (a) fix the balance sheet problems and restore the risk-bearing capacity mobilizing power of the credit channel, or (b) failing that using the government as a financial intermediary to mobilize the taxpayers' risk-bearing capacity when private finance cannot mobilize investors'.

The question, of course, is how important are these defects? And if - for reasons of policy failures of the government to get its fiscal act together or of banking and housing finance regulators to do their proper work to restore the credit channel - the first best is unavailable, with how much easy monetary policy should the central bank compensate?

It seems to be very clear that prudential regulation rather than interest-rate manipulation is overwhelmingly the proper tool to deal with Ponzi finance, irrational or near-rational, and with systemic risk created by too much "reaching for yield". And often lost in this discussion is the fact that some "reaching for yield" is the point of easier monetary policy. As Hiroshi Nakaso puts it in The Potential Impact of Large-Scale Monetary Accommodation, the point of the policy is:

to achieve the price stability target of 2 percent at the earliest possible time… to dispel a view that… prices would not rise… to raise inflation expectations… to exert downward pressure across the entire yield curve through massive purchases of government bonds…. I would like to address a frequently cited remark that unconventional monetary stimulus could destabilize financial markets and the economy at large by encouraging 'search for yield' activities… A rise in asset prices and a decline in volatility are intended effects…

So far I have seen no signs anywhere that "reach for yield" is creating any systemic risk. If other people do see such signs, could they please point them out as soon as possible? And the shortfall of aggregate demand from potential output creates an Okun Gap. A capital stock that is too long in duration and too light on short- and medium-term risky projects is a Harberger triangle. It takes a heap of Harberger triangles to fill an Okun Gap.