Is the Fed Hampering the Recovery?
In his blog post on “Calvinist Monetary Economics,” Paul Krugman claims that a recent Wall Street Journal op-ed by John Taylor on why he believes the Fed is hampering the recovery by keeping interest rates low falls into the “Calvinball” category. Writes Krugman:
For those who don’t read the classics, Calvinball is a sport in which you change the rules whenever you feel like it, very much including in the middle of games.
Back then the tight-money types were inventing new and peculiar principles of monetary policy on the fly; it was obvious that they were looking for some reason, any reason, to justify a rise in rates, because, well, because.
Krugman goes on:
Now Taylor is doing the same thing. He claims that he can show that the Fed’s low-rate policy is actually contractionary, using “basic microeconomic analysis”. Actually, as Miles Kimball points out, he’s committing a basic microeconomic fallacy — a fallacy you usually identify with Econ 101 freshmen early in the semester (and as it happens the same fallacy committed by Rajan).
For Taylor argues that low rates engineered by the Fed are just like a price ceiling that reduces the supply of loans, and therefore reduces overall lending.
Wow. No, the Fed’s interest rate target isn’t a price control; there is no legal or other restraint on the rates lenders can charge. The Fed is driving down interest rates, or equivalently driving up the price of bonds, by buying bonds; I can’t think of any kind of economic analysis in which that would reduce the quantity of bonds sellers end up issuing, that is, the amount of borrowing (and lending) in the economy.
I’ll put all of this controversy in the simplest of terms: Keynesian orthodoxy claims that lower interest rates will always have a positive effect upon the economy because the low rates encourage more borrowing, ceteris paribus, even in a so-called liquidity trap. The issue of the “liquidity trap,” according to Keynesians, is that other factors are holding back “aggregate demand” so that lowering rates by themselves cannot create enough aggregate demand to lift the economy out of a downturn.
That is where fiscal policy comes in, and that is what Krugman has been saying. Thus, anyone who might claim that attempts by the Fed to push down interest rates might have an opposite effect of what is intended is playing “Calvinball.”
The Keynesian approach is pretty straightforward, maybe even crude. All economic activity of an economy, all of the relative prices, all of the relations of production, the products creates, everything, can be put into two functions, aggregate demand and aggregate supply. Push aggregate demand to the right, and as long as the AS curve in not in its steep region, economic growth will occur without too much inflation.
Should the economy be in a “liquidity trap,” then the only way to get the AD curve to move to the right is for government to engage in lots and lots of spending. The positive results from the spending then will trickle down to everyone else, provided government spends “enough.” However, as Bob Murphy has noted, it seems that Krugman is playing some “Calvinball” of his own:
Here is my observation: Paul Krugman will say that government spending has surged under Obama (and Bernanke has engaged in monetary stimulus) when he wants to blow up right-wingers for their failed predictions, yet referring to the same period of time he will say that government spending has actually been either normal or even contractionary, when explaining why his Keynesian solutions haven’t fixed the economy.
Certainly, Krugman is not above using the “Heads I win, tails you lose,” method of arguing. However, I’d like to address a larger question: Can the Fed’s “expansionary policies” actually have a contractionary effect upon the economy?
I’d like to take a different approach than has Taylor and point out that the Fed’s purchases of securities of all types — government, mortgage securities, private assets — is done in order to keep the asset prices high and send false signals to the markets that these securities are worth more than they really are. (The only word for it is fraud and I should point out that when someone in private business, as opposed to Ben Bernanke, tries to artificially jack up the price of securities, he is likely to be prosecuted.)
The Fed wants to drive money toward those assets by keeping their prices artificially high, and I would argue this has two problems that do hamper the economy:
- First, it prevents the needed liquidation of those assets which cannot be supported by market activity so that investors and entrepreneurs can follow real price signals to see where lines of sustainable investments are located. By throwing in what essentially are false prices, the Fed is making it harder for entrepreneurs to find the suitable production lines;
- Second, the Fed’s policies discourage savings (which makes Keynesians very happy, given their vaunted “multiplier” is 1 over the savings rate, so the less we save, the greater the “multiplier”), as real savings provide the liquid capital for long-term investments.
Given Krugman’s mechanistic views of the economy and his overt hostility toward economic activity that is not created by government fiat, I doubt what I have said would convince Keynesians of anything. To them, the economy is a simple thing controlled by levers of spending with the Really Smart People in Washington and at Princeton knowing at all times when to “step on the gas” and “when to apply the brakes.”
Nonetheless, I also would argue that the Fed is holding back the recovery, even as it acts in the name of “aggregate demand.” This isn’t “Calvinball.” It is economics.
William L. Anderson is an author and an associate professor of economics at Frostburg State University in Maryland. He is also an adjunct scholar with the Mackinac Center for Public Policy as well as for the Ludwig von Mises Institute in Alabama.
Read more at “Krugman-in-Wonderland”