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Archive for the ‘Federal Reserve’ Category

Having been exposed to scholars from the Austrian school as a graduate student, I have a knee-jerk suspicion that it’s not a good idea to rely on the Federal Reserve for macroeconomic tinkering.

In this interview from yesterday, I specifically warn that easy money can lead to economically harmful asset bubbles.

 

Since I don’t pretend to be an expert on monetary policy, I’ll do an appeal to authority.

Claudio Borio of the Bank for International Settlements is considered to be one of the world’s experts on the issue.

Here are some excerpts from a study he recently wrote along with three other economists. I especially like what they wrote about the risks of looking solely at the price level as a guide to policy.

The pre-crisis experience has shown that, in contrast to common belief, disruptive financial imbalances could build up even alongside low and stable, or even falling, inflation. Granted, anyone who had looked at the historical record would not have been surprised: just think of the banking crises in Japan, the Asian economies and, going further back in time, the US experience in the run-up to the Great Depression. But somehow the lessons had got lost in translation… And post-crisis, the performance of inflation has repeatedly surprised. Inflation…has been puzzlingly low especially more recently, as a number of economies have been reaching or even exceeding previous estimates of full employment. …the recent experience has hammered the point home, raising nagging doubts about a key pillar of monetary policymaking. …Our conclusion is that…amending mandates to explicitly include financial stability concerns may be appropriate in some circumstances.

Here’s a chart showing that financial cycles and business cycles are not the same thing.

The economists also point out that false booms instigated by easy money can do a lot of damage.

Some recent work with colleagues sheds further light on some of the possible mechanisms at work (Borio et al (2016)). Drawing on a sample of over 40 countries spanning over 40 years, we find that credit booms misallocate resources towards lower-productivity growth sectors, notably construction, and that the impact of the misallocations that occur during the boom is twice as large in the wake of a subsequent banking crisis. The reasons are unclear, but may reflect, at least in part, the fact that overindebtedness and a broken banking system make it harder to reallocate resources away from bloated sectors during the bust. This amounts to a neglected form of hysteresis. The impact can be sizeable, equivalent cumulatively to several percentage points of GDP over a number of years.

Here’s a chart quantifying the damage.

And here’s some more evidence.

In recent work with colleagues, we examined deflations using a newly constructed data set that spans more than 140 years (1870–2013), and covers up to 38 economies and includes equity and house prices as well as debt (Borio et al (2015)). We come up with three findings. First, before controlling for the behaviour of asset prices, we find only a weak association between deflation and growth; the Great Depression is the main exception. Second, we find a stronger link with asset price declines, and controlling for them further weakens the link between deflations and growth. In fact, the link disappears even in the Great Depression (Graph 4). Finally, we find no evidence of a damaging interplay between deflation and debt (Fisher’s “debt deflation”; Fisher (1932)). By contrast, we do find evidence of a damaging interplay between private sector debt and property (house) prices, especially in the postwar period. These results are consistent with the prevalence of supply-induced deflations.

I’ll share one final chart from the study because it certainly suggest that the economy suffered less instability when the classical gold standard was in effect before World War I.

I’m not sure we could trust governments to operate such a system today, but it’s worth contemplating.

P.S. I didn’t like easy money when Obama was in the White House and I don’t like it with Trump in the White House. Indeed, I worry the good economic news we’re seeing now could be partly illusory.

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What’s the biggest problem with the Federal Reserve?

The obvious answer is that the Central Bank is susceptible to Keynesian monetary policy, which results in a harmful boom-bust cycle.

For instance, the Fed’s artificially low interest rates last decade played a key role (along with deeply misguided Fannie Mae-Freddie Mac subsidies) is causing the 2008 crisis.

And let’s not forget the Fed’s role in the Great Depression.

Today, though, let’s focus on a narrower topic.

As Norbert Michel explains for the Heritage Foundation, the central bank is trying to expand its power in the financial system.

…one of the “potential actions” the Fed Board is considering is to develop its very own real-time settlement system. This approach makes many private sector actors anxious because no private company wants to compete with the feds. …Since its inception, the Fed has been heavily involved in the U.S. payments system. And one can easily argue that the system has lagged behind precisely because the Fed has been too involved. …The Fed also effectively took over the check-clearing business even though the economic case for such a move was highly suspect. Private firms were doing fine. In fact, there is a long history of the Fed usurping the private market.

Here are some details on the Fed’s most-recent power grab.

…the government is once again angling to take over a function that private firms are already providing. The Clearinghouse, a private association owned by 25 large banks, launched its own system—Real-Time Payments (RTP)—in November 2017. …the private sector is better than the government at providing more goods and services to more people. In the private sector, competitive forces and the need to satisfy customers create constant pressure to innovate and improve. Government entities are wholly insulated from these pressures. The government should not provide a good or service unless there is some sort of clear market failure, where the private sector has failed to provide it. This type of failure clearly does not exist in the payments industry.

Norbert is right. Competition is the way to get better outcomes for consumers.

As such, it’s rather absurd to think a government-operated monopoly will produce good results (look, for instance, at its cronyist behavior during the financial crisis).

Now let’s zoom out and consider the big picture.

Richard Rahn has a column in the Washington Times that raises questions about the Fed’s role in a modern economy.

Is there a need for the Fed? …The Fed has an extensive history of policy mistakes, (too long to even summarize here). The problem has been the assumption that the Fed had better information and tools than it had. At times, it was expected to “lean against the wind” as if it had information not available to the market — or smarter people. In Hayekian terms, it suffered from “the pretense of knowledge.” At this point, it may be beyond fixing. Several very knowledgeable economists who have held high-level positions at the Fed, including regional bank presidents, have begun discussions about setting up a new commission to rethink the whole idea of a Fed and its activities. The structure that now exists is a jerry-built concoction that has been assembled in bits and pieces for more than a century — and increasingly appears to be past its expiration date.

I’ve written about the need to clip the Fed’s wings, but Richard’s column suggests even bolder action is needed.

Larry White and John Stossel also have questioned the role and power of the Federal Reserve.

In any event, one thing that should be clear is that the Fed hasn’t used its existing powers either wisely or effectively.

Thomas Sowell is right. Don’t reward a bureaucracy’s poor performance by giving it even more power.

P.S. Here’s a video I narrated on the Fed and central banking.

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Being a policy wonk in a political town isn’t easy. I care about economic liberty while many other people simply care about political maneuvering. And the gap between policy advocacy and personality politics has become even larger in the Age of Trump.

One result is that people who should be allies periodically are upset with my columns. Never Trumpers scold me one day and Trump fanboys scold me the next day. Fortunately, I have a very simple set of responses.

  • If you would have loudly cheered for a policy under Reagan but oppose a similar policy under Trump, you’re the problem.
  • If you would have loudly condemned a policy under Obama but support a similar policy under Trump, you’re the problem.

Today, we’re going to look at an example of the latter.

The New York Times reported today on Trump’s advocacy of easy-money Keynesianism.

President Trump on Friday called on the Federal Reserve to cut interest rates and take additional steps to stimulate economic growth… On Friday, he escalated his previous critiques of the Fed by pressing for it to resume the type of stimulus campaign it undertook after the recession to jump-start economic growth. That program, known as quantitative easing, resulted in the Fed buying more than $4 trillion worth of Treasury bonds and mortgage-backed securities as a way to increase the supply of money in the financial system.

I criticized these policies under Obama, over and over and over again.

If I suddenly supported this approach under Trump, that would make me a hypocrite or a partisan.

I’m sure I have my share of flaws, but that’s not one of them.

Regardless of whether a politician is a Republican or a Democrat, I don’t like Keynesian fiscal policy and I don’t like Keynesian monetary policy.

Simply stated, the Keynesians are all about artificially boosting consumption, but sustainable growth is only possible with policies that boost production.

There are two additional passages from the article that deserve some commentary.

First, you don’t measure inflation by simply looking at consumer prices. It’s quite possible that easy money will result in asset bubbles instead.

That’s why Trump is flat-out wrong in this excerpt.

“…I personally think the Fed should drop rates,” Mr. Trump said. “I think they really slowed us down. There’s no inflation. I would say in terms of quantitative tightening, it should actually now be quantitative easing. Very little if any inflation. And I think they should drop rates, and they should get rid of quantitative tightening. You would see a rocket ship. Despite that, we’re doing very well.”

To be sure, many senior Democrats were similarly wrong when Obama was in the White House and they wanted to goose the economy.

Which brings me to the second point about some Democrats magically becoming born-again advocates of hard money now that Trump is on the other side.

Democrats denounced Mr. Trump’s comments, saying they showed his disregard for the traditional independence of the Fed and his desire to use its powers to help him win re-election. “There’s no question that President Trump is seeking to undermine the…independence of the Federal Reserve to boost his own re-election prospects,” said Senator Ron Wyden of Oregon, the top Democrat on the Finance Committee.

Notwithstanding what I wrote a few days ago, I agree with Sen. Wyden on this point.

Though I definitely don’t recall him expressing similar concerns when Obama was appointing easy-money supporters to the Federal Reserve.

To close, here’s what I said back in October about Trump’s Keynesian approach to monetary policy.

I also commented on this issue earlier this year. And I definitely recommend these insights from a British central banker.

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Back in January, I spoke with Cheddar about market instability and put much of the blame on the Federal Reserve. Simply stated, I fear we have a bubble thanks to years and years (and years and years) of easy money and artificially low interest rates.

To be sure, I also noted that there are other policies that could be spooking financial markets.

But I do think monetary policy is the big threat. Mistakes by the Fed sooner or later cause recessions (and the false booms that are the leading indicator of future downturns).

Mistakes by Congress, by contrast, “merely” cause slower growth.

In this next clip from the interview, I offer guarded praise to the Fed (not my usual position!) for trying to unwind the easy-money policies from earlier this decade and therefore “normalize” interest rates (i.e., letting rates climb to the market-determined level).

For those interested in the downside risks of easy money, I strongly endorse these cautionary observations from a British central banker.

My modest contribution to the discussion was when I mentioned in the interview that we wouldn’t be in the tough position of having to let interest rates climb if we didn’t make the mistake of keeping them artificially low. Especially for such a long period of time.

My motive for addressing this topic today is that Robert Samuelson used his column in the Washington Post to launch an attack against Steve Moore.

Stephen Moore does not belong on the Federal Reserve Board… Just a decade ago, the U.S. and world economies suffered the worst slumps since World War II. What saved us then were the skilled interventions of the Fed under Chairman Ben S. Bernanke… Do we really want Moore to serve as the last bulkhead against an economic breakdown? …as a matter of prudence, we should assume economic reverses. If so, the Fed chief will become a crisis manager. That person should not be Stephen Moore.

I’ve been friends with Steve for a couple of decades, so I have a personal bias.

That being said, I would be arguing that Samuelson’s column is problematic for two reasons even if I never met Steve.

  • First, he doesn’t acknowledge that the crisis last decade was caused in large part by easy-money policy from the Fed. Call me crazy, but I hardly think we should praise the central bank for dousing a fire that it helped to start.
  • Second, he frets that Steve would be bad in a crisis, which presumably is a time when it might be appropriate for the Fed to be a “lender of last resort.”* But he offers zero evidence that Steve would be opposed to that approach.

For what it’s worth, I actually worry Steve would be too willing to go along with an easy-money approach. Indeed, I look forward to hectoring him in favor of hard money if he gets confirmed.

But this column isn’t about a nomination battle in DC. My role is to educate on public policy.

So let’s close by reviewing some excerpts from a column in the Wall Street Journal highlighting the work of Claudio Borio at the Bank for International Settlements.

In a 2015 paper Mr. Borio and colleagues examined 140 years of data from 38 countries and concluded that consumer-price deflation frequently coincides with healthy economic growth. If he’s right, central banks have spent years fighting disinflation or deflation when they shouldn’t have, and in the process they’ve endangered the economy more than they realize. “By keeping interest rates very, very, very low,” he warns, “you are contributing to the buildup of risks in the financial system through excessive credit growth, through excessive increases in asset prices, that at some point have to correct themselves. So what you have is a financial boom that necessarily at some point will turn into a bust because things have to adjust.” …It’s not that other economists are blind to financial instability. They’re just strangely unconcerned about it. “There are a number of proponents of secular stagnation who acknowledge, very explicitly, that low interest rates create problems for the future because they’re generating all these financial booms and busts,” Mr. Borio says. Yet they still believe central banks must set ultralow short-term rates to support economic growth—and if that destabilizes the financial system, it’s the will of the economic gods.

Amen. I also recommend this column and this column for further information on how central bankers are endangering prosperity.

P.S. For a skeptical history of the Federal Reserve, click here. If you prefer Fed-mocking videos, click here and here.

P.P.S. I fear the European Central Bank has the same misguided policy. To make matters worse, policy makers in Europe have used easy money as an excuse to avoid the reforms that are needed to generate real growth.

P.P.P.S. Samuelson did recognize that defeating inflation was one of Reagan’s great accomplishments.

*For institutions with liquidity problems. Institutions with solvency problems should be shut down using the FDIC-resolution approach.

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In this interview yesterday, I noted that there are “external” risks to the economy, most notably the spillover effect of a potential economic implosion in China or a fiscal crisis in Italy.

But many of the risks are homegrown, such as Trump’s self-destructive protectionism and the Federal Reserve’s easy money.

Regarding trade, Trump is hurting himself as well as the economy. He simply doesn’t understand that trade is good for prosperity and that trade deficits are largely irrelevant.

Regarding monetary policy, I obviously don’t blame Trump for the Fed’s easy money policy during the Obama years, though I wish that he wouldn’t bash the central bank and instead displayed Reagan’s fortitude about accepting the need to unwind such mistakes.

The interview wasn’t that long, but I had a chance to pontificate on additional topics.

The bottom line is that Trump has a very mixed record on the economy. But I fear the good policies are becoming less important and the bad policies are becoming more prominent.

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I periodically explain that you generally don’t get a recession by hiking taxes, adding red tape, or increasing the burden of government spending. Those policies are misguided, to be sure, but they mostly erode the economy’s long-run potential growth.

If you want to assign blame for economic downturns, the first place to look is monetary policy.

When central banks use monetary policy to keep interest rates low (“Keynesian monetary policy,” but also known as “easy money” or “quantitative easing”), that can cause economy-wide distortions, particularly because capital gets misallocated.

And this often leads to a recession when this “malinvestment” gets liquidated.

I’ve made this point in several recent interviews, and I had a chance to make the same point yesterday.

By the way, doesn’t the other guest have amazing wisdom and insight?

But let’s not digress.

Back to the main topic, I’m not the only one who is worried about easy money.

Desmond Lachman of the American Enterprise Institute is similarly concerned.

Never before have the world’s major central banks kept interest rates so low for so long as they have done over the past decade. More importantly yet, never before have these banks increased their balance sheets on anything like the scale that they have done since 2008 by their aggressive bond-buying programmes. Indeed, since 2008, the size of the combined balances sheet of the Federal Reserve, the European Central Bank, the Bank of Japan and the Bank of England has increased by a mind-boggling US$10tn. …in recent years, if anything central bank monetary policy might have been overly aggressive. By causing global asset price inflation as well as the serious mispricing and misallocation of global credit, the seeds might have been sown for another Lehman-style economic and financial market crisis down the road. …the all too likely possibility that, by having overburdened monetary policy with the task of stabilizing output, advanced country governments might very well have set us up for the next global boom-bust economic cycle.

If you want the other side of the issue, the Economist is more sympathetic to monetary intervention.

And if you want a very learned explanation of the downsides of easy money, I shared some very astute observations from a British central banker back in 2015.

The bottom line is that easy money – sooner or later – backfires.

By the way, here’s a clip from earlier in the interview. Other than admitting that economists are lousy forecasters, I also warned that the economy is probably being hurt by Trump’s protectionism and his failure to control the growth of spending.

P.S. The “war on cash” in many nations is partly driven by those who want the option of easy money.

P.P.S. I worry that politicians sometimes choose to forgo good reforms because they hope easy money can at least temporarily goose the economy.

P.P.P.S. Easy money is also a tool for “financial repression,” which occurs when governments surreptitiously confiscate money from savers.

P.P.P.P.S. Maybe it’s time to reconsider central banks?

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During the Obama years, I used data from the Minneapolis Federal Reserve to explain that the economic recovery was rather weak. And when people responded by pointing to a reasonably strong stock market, I expressed concern that easy-money policies might be creating an artificial boom.

Now that Trump’s in the White House, some policies are changing. On the plus side, we got some better-than-expected tax reform. Moreover, the onslaught of red tape from the Obama years has abated, and we’re even seeing some modest moves to reduce regulation.

But there’s also been bad news. Trump’s bad protectionist rhetoric is now turning into bad policy. And his track record on spending is very discouraging.

What’s hard to pin down, though, is the impact of monetary policy. The Federal Reserve apparently is in the process of slowly unwinding the artificially low interest rates that were part of its easy-money approach. Is this too little, too late? Is it just right? What’s the net effect?

Since economists are lousy forecasters, I don’t pretend to know the answer, but I think we should worry about the legacy impact of all the easy money, which is the point I made in this clip from a recent interview.

James Pethokoukis from the American Enterprise Institute has similar concerns.

Here’s some of what he recently wrote on the topic.

…this supposed “boom” looks more like same-old, same-old. First quarter GDP, for instance, was just revised down two ticks to 2% and monthly job growth is a bit weaker than under President Obama’s final few years. …What’s more, pretty much every recession for a century has been accompanied by some magnitude of explicit Fed tightening. And, of course, the Fed is now well into a tightening cycle. …Another complicating factor is the Trump trade policy, which seems to be a market suppressant right now, if not yet a significant economic one.

Those are all good points, though we still don’t know the answer.

I’ll close with two observations.

  • First, our main concern should be boosting the economy’s long-run growth rate, and that’s why we need lower tax rates, less government spending, open trade, and less red tape. As I’ve noted already, Trump has a mixed track record.
  • Second, a short-run concern is whether the Federal Reserve’s easy-money policy in recent years has created a bubble that is poised to burst. If it does, Trump will take the blame simply because he happens to be in the White House.

And that second issue gives me an excuse to re-emphasize that Keynesian monetary policy is just as foolish as Keynesian fiscal policy. You may enjoy a “sugar high” for a period of time, but eventually there’s a painful reckoning.

P.S. For what it’s worth, we’d have more growth and stability if policymakers learned from the “Austrian School” of economics.

P.P.S. Moreover, it’s a good idea to be skeptical about the Federal Reserve.

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