Sorry for the title in advance. Very bad joke. But it’s true – Ben Bernanke is going to be writing a blog regularly. You can find his first entry here. It’s a nice summary of many of his primary views and since I’ve spent much of my time disagreeing with many of his primary views I figure I should maintain ramming speed and take this opportunity to welcome him to the blogosphere properly. Let the ramming begin!
1) The Economy Determines Interest Rates. The primary point of his post is about interest rates, why they’re low and how interest rates are set. Bernanke makes it clear that the economy determines the structure of interest rates even though the Federal Reserve can influence interest rates. This is a point I’ve made on many occasions, but our views part ways from here. The reason we disagree on so much else is because we have rather differing ideas on the underlying operational and theoretical workings of the monetary system. I would argue that I work from a largely operational view of the system whereas someone like Bernanke tends to argue from a textbook sort of view. The textbooks are useful, but only to the extent that they reflect our actual world.
2) The Mythical Natural Rate of Interest. Economists have long theorized that the economy has a single price, or interest rate, which would be consistent with full employment. In his blog post Bernanke says:
“The Fed’s ability to affect real rates of return, especially longer-term real rates, is transitory and limited. Except in the short run, real interest rates are determined by a wide range of economic factors, including prospects for economic growth—not by the Fed.
To understand why this is so, it helps to introduce the concept of the equilibrium real interest rate (sometimes called the Wicksellian interest rate, after the late-nineteenth- and early twentieth-century Swedish economist Knut Wicksell). The equilibrium interest rate is the real interest rate consistent with full employment of labor and capital resources”
This is almost precisely what Paul Krugman would say. The underlying theoretical framework is Wicksellian in origin and exposes a serious difference in views between many mainstream economists and heterodox Keynesians. Most interesting, Bernanke is a Monetarist by background yet he agrees almost entirely with a key point that Paul Krugman, a Keynesian, has been making for years. The problem is, there is not a single ounce of evidence that this natural rate of interest exists or that it can be maintained. Further, there is no reason to believe that there is a single price that the Central Bank can help the economy hit. Rather, the economy is made up of many different interest rates so it would have to hold that there are probably millions of different natural rates of interest. The assumption that this rate exists is flimsy. The assumption that the Central Bank can help the economy achieve this rate is something more than flimsy.
But bad ideas die hard in economics. After all, this bad idea was thrown out by the master almost 100 years ago:
“I am now no longer of the opinion that [Wicksell’s] concept of a ‘natural’ rate of interest, which previously seemed to me a most promising idea, has anything very useful or significant to contribute to our analysis. It is merely the rate of interest which will preserve the status quo; and, in general, we have no predominant interest in the status quo as such.” – JM Keynes, the General Theory, Ch 17
The problem, of course, is that when we assert a certain degree of power to the Central Bank we automatically assume that it has the policy tools to achieve certain ends that might not actually be attainable. But the political discussion of the last 6 years has centered almost entirely around the powers of the Central Bank. That’s a result of this sort of thinking where the theories say the Central Bank can help where it is actually far less powerful than those theories conclude. And so we sit around twiddling our thumbs watching ever expanding QE have limited impacts while unemployment remains unusually high and the economy muddles through a balance sheet recession. All the while, economists glare into their textbooks and conclude, “we simply aren’t trying hard enough!”
3) Bernanke Still Believes in Crowding Out. This takes us to another important piece of Ben Bernanke’s theoretical framework. He says:
“Government spending and taxation policies also affect the equilibrium real rate: Large deficits will tend to increase the equilibrium real rate (again, all else equal), because government borrowing diverts savings away from private investment.”
This is not consistent with an endogenous money system (a system in which the money supply is determined primarily by demand for new loans and not Central Bank’s “money multiplier”). This is consistent with a barter economy or a loanable funds view. And again, there is no evidence that this view is correct. In fact, rising deficits seem to correlate with falling interest rates as anyone paying attention over the last 40 years would conclude.
But the idea of interest rate crowding out is based on a more basic misunderstanding. Many mainstream economists view the real interest rate as the price which maintains equilibrium. In essence, high interest rates encourage saving by increasing the opportunity cost of current consumption. Investment falls because the cost of investment rises. So the theory says that if the government competes with the supply of available savings then that diverts potential saving away from the private sector which causes other private actors to bid up interest rates as they compete for that fixed amount of saving. Of course, this is a neat textbook view of the world that doesn’t at all apply to a world where the money supply expands endogenously and is not fixed. And when you understand that you learn to stop fearing the myth that the government necessarily competes for some fixed supply of funds and could necessarily cause rising interest rates. You’d think that 40 years of falling interest rates and rising government debt levels would slay this myth, but that’s clearly not the case.
Now, this doesn’t mean the government never competes for resources (it most certainly does), but the concept of interest rate crowding out is still a flawed perspective of the monetary system and is no excuse to argue against government spending and tax cuts during periods of sub-optimal economic growth. But that’s precisely what we’ve seen time and time again over the last 6 years. And yet interest rates continue to decline on a near daily basis.
These might seem like wonky “textbook-y” (in Bernanke’s words) arguments. They are anything but. The beliefs outlined above have directly hurt the performance of the US economy over the last 6 years as they have been cornerstones for the arguments in favor of more and more Central Bank intervention. And all of this focus on the Central Bank and QE has undermined the use of fiscal policy, specifically tax cuts and spending. And while Ben Bernanke should be lauded for much of what he has done over the last 6 years I don’t think we should be too quick to celebrate the fact that the US economy is as weak today as it is. And we have his sort of “textbook-y” theoretical thinking to thank for that.