I complain about the state of modern economics a good deal because, as a market practioner and an entrepreneur, I notice that much of the textbook theoretical modeling doesn’t actually reflect anything realistic about the way the world works. While there are many flawed econ and finance concepts such as the Efficient Market Hypothesis, the quantity theory of money, rational expectations, etc, few are more dangerous than the modern economist’s obsession over interest rates.
There was a time before the 1970’s when fiscal policy dominated policy discussions and Central Banks were viewed as relatively secondary players in policy. That all changed in the 1970’s when Milton Friedman and the Monetarists defeated the Keynesians during the stagflation of the decade. The USA shifted dramatically from a focus on fiscal policy to a shift in Central Bank monetary policy. Of course, Friedman and the Monetarists turned out to be fabulously wrong for focusing on the quantity of money utilizing the Central Bank and the policy focus shifted once again as the US Fed moved from targeting the quantity of money to targeting interest rates. Although Friedman and the Monetarists were wrong the policy focus never really shifted from the Central Bank. It just shifted its style.
Today, the obsession over Central Banking is as strong as it’s ever been. And a new research report which was cited in The Economist this weekend shows us that interest rates are a lot less important than economists think. The paper titled “The behaviour of aggregate corporate investment” by S.P. Kothari, Jonathan Lewellen and Jerold Warner confirms what I’ve long believed – that interest rates are a blunt instrument. And no, they’re not a blunt instrument because we’re in a liquidity trap as Paul Krugman and others have (incorrectly) argued. They’re a blunt instrument at all times. That is, interest rates just aren’t that important in the way corporations actually decide to invest. That’s not surprising since the Central Bank sets one interest rate which only loosely impacts the rest of the economy. Therefore, the idea that the Central Bank can steer the economy via this imprecise tool, was always misguided.
Interestingly, as the Fed remains at 0% interest rates and this interest rate targeting proves inept, the policy discussion has shifted yet again. But it hasn’t shifted from Central Banks. It’s just shifted to the way Central Banks can implement policies in alternative manners. Hence the obsession with ideas like QE. Of course, QE doesn’t do nearly half the things most people seem to think so here we have another shift to a policy that just doesn’t do as much as most economists seem to think.
So, where to next before the profession realizes that its focus on interest rates is largely wrong? I don’t know. My guess is we’ll move to targeting other things like an explicit inflation target or a NGDP target. And when those policy ideas fail, and they will, who knows where we’ll go next? But it seems to me that the impact of Milton Friedman and the Monetarists is alive and well. And no matter how badly certain policies fail we seem to keep turning to monetary policy and Central Banks to provide the answer to full employment and high growth. When will we learn that Central Banks don’t have all the answers?
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.