Macroeconomics: Safety, Savings and Sovereigns

by: Brad DeLong

Raghu Rajan: Money Magic:

[T]he interest rate is a price for the savings that are transferred to spenders. To the extent that the Fed manages to push this price down... it taxes the producers of savings and subsidizes the spenders of savings. Clearly, no government considers pushing down the price of any real good an effective way to stimulate the economy--any gain to consumers is a loss to producers, and the loss typically will outweigh the gain if the market price is a fair one. So why are savings different?...

Ummm... I think we need to stop there.

"The interest rate" is not that low. You can see what I mean if you are a Baa business or a small business out there in the market trying to borrow. You can see that if you look at stock market price-earnings ratios. The expected return to savers is not low. Indeed, it is rather high--it is more expensive than average for firms to get access to capital.

What is low is your expected return if you are a saver who insists on safety. The collapse of confidence in rating agencies and in banks' risk-management departments greatly reduced the supply of safe savings vehicles--places you could park your money and be reasonably sure it would not melt away. The financial crisis and the coming of the Little Depression greatly increased the demand for safe savings vehicles. The net effect was that the price those few actors who could issue safe savings vehicles found themselves having to pay those many actors who wanted to hold safe savings vehicles fell to very low levels.

That does not mean that the Federal Reserve needs to take steps to push the price of savings higher.

At the moment production and employment are depressed. Why? Because if you want to start a profitable business now or expand a business profitably you face a joint production problem: you have to produce both (a) commodities that consumers will want to buy, and (b) savings vehicles that investors will want to hold. Those investment projects that promise enough safety for investors to want to hold them right now do not produce commodities consumers wish to buy at a price that allows for a profit. Those investment projects that produce commodities consumers wish to buy are not safe enough to provide backing and collateral for the safe savings vehicles investors want to hold and allow for a profit.

Raghu may well say that this kind of situation simply should not happen. Real wages, commodity prices, risk premiums, and the intertemporal price structure should be such as to allow for full employment of all factors of production--labor, capital, finance, and entrepreneurship. I might agree with him that they should in the same sense that Galileo might have agreed that the Earth should be the unmoving center of the universe. But it is not.

Given that this is the situation we are in, we have three options:

  1. Tough it out, in the belief that austere virtue will in some way be good for us.
  2. While most organizations cannot expand and produce at a profit, some can--notably the governments of France, Germany, Britain, the U.S., and Japan. Since they can borrow money extraordinarily cheaply and make things, they should do so--and thus restore full employment of factors of production.

  3. The price of safety right now is at outlandish levels because financial markets do a lousy job of mobilizing the global risk-bearing capacity of the world. Central banks and the governments that back them can, however, mobilize that risk-bearing capacity. They should buy up risky assets, distribute the risks across the globe's taxpayers, and issue safe assets until supply and demand have once again pushed the price of safety down to a level at which ordinary companies can make a profit when they jointly produce commodities on the one hand and the quality of savings vehicles that they can issue on the other. This last is quantitative easing--what Raghu calls "easy money", and says the economy does not need.

Raghu favors (1). I favor (2) or (3)--I don't much care which, and preferably both.

Now note that (2) and (3) can only be done by solvent and credible sovereigns. An insolvent and uncredible sovereign cannot issue safe assets. It has no more ability to borrow and produce profitably than any other company. Indeed, its attempts to do so almost surely crowd-out private economic activity that would be more useful. And a government that is insolvent and uncredible cannot promise that it will earmark its future taxes to turn its citizens not already engaged in financial markets into risk-bearers--it has no such future tax capacity free to earmark.

But the U.S. government--and the governments of France, Germany, Britain, and Japan--are certainly solvent, and markets find them very credible (although when I look at the U.S. Republican Party I wonder why). Their interventions in financial markets create a highly-valued commodity--safety backed by tax capacity--that these governments can produce very cheaply. They should do so. That is why savings (or, rather, safety) is different, and why we need more aggressive expansionary policy right now.

Raghu disagrees. Yet when I try to figure out why Raghu disagrees and favors (1), I get nowhere: I can find no coherent argument. The closest thing there is is this declaration that the government should not intervene in any market--for "any gain to consumers is a loss to producers, and the loss typically will outweigh the gain if the market price is a fair one"--and the financial market is a market.

If our principle is that markets are perfect, then of course the Federal Reserve should not do another round of quantitative easing. But that is merely a corollary of the conclusion that the Federal Reserve should never have been created, should not exist, and should be destroyed as soon as possible--for, after all, all it does is interfere in markets. This is the economics of Ron Paul.

Mike Konczal has a somewhat stronger reaction:

Rajan Plays Calvinball on Monetary Policy: A friend pointed out that post-crisis conservative economists talking about monetary policy in general, and QE2 specifically, is like watching a game of Calvinball....

If I read [Rajan] correctly, it’s an argument against monetary policy in general....

Here’s a thought exercise I encourage people to do when they dissect what people think about monetary policy at the zero bound, where we are now. Imagine short-term interest rates were actually at 2% right now. Somebody forgot to actually go ahead and push them down to zero. Whoops. If you looked out at the economy, would you lower interest rates?... Rajan... apparently wouldn’t reduce the short-term rates given the state of the economy. Even worse, he’s gone from creating arguments that the zero-bound encourages too much speculation to a morality play. There’s Ben Bernanke, a WWI general pushing soldiers over the trenches. Inflation taxes producers and subsidizes spenders is the main result. Would the phrase that inflation taxes hoarders, provides incentives to do transactions, relieves the debt burden of the past and balances the relationship between creditors and debtors (and debt and the entire economy) be equally acceptable?... [Monetary policy] is not about rewarding the good people and punishing the wicked, it’s about stabilizing growth, prices and maximum employment without overheating the system or letting it choke to death from a lack of oxygen. And it isn’t clear to me what rules or rough guidelines are motivating the argument here.

Hence, Calvinball.