How (Falsely) Low Interest Rates Screw Up the Economy
I just made a fairly long and technical post, which I’m sure half of my readers will skip. Let me say it in plainer English:
Loosely speaking, the market interest rate allocates the available financial capital among various possible investment projects. The equilibrium interest rate is j-u-u-s-t right so that people save exactly the amount of money that other people want to borrow.
Although we think of it in terms of money, there is a corresponding physical reality to all this, too. If entrepreneurs see hot new investment projects and want to start hiring workers and buying raw materials to get started, those workers and resources have to be redirected away from other things.
Ideally, if everyone in the community wanted to cut back on eating out once a month, in order to save up for a summer cruise in 3 years, what would happen is that their spending and saving decisions would (a) cause layoffs in the restaurant industry, and (b) lower interest rates enough to make it profitable for the people in the cruise industry to borrow money to start building more ships and training more crew members. Obviously in the real world things would be messier, but the point is that market prices–especially interest rates of various maturities–would help with this transition.
Now what happens if the government comes in, prints up a bunch of $100 bills, and starts lending them out to borrowers at lower rates than what the original market interest rate was? Obviously that will totally screw things up.
Even if people are fully aware that there’s a guy throwing funny money into the works, they can’t not borrow at the lower rates. That would only work if they could trust every single person in the whole economy to not take the crisp new $100 bills from the Fed official, even though he was offering to lend them at lower terms than the other people offering equally-legal $100 bills.
The point is that it can’t be the case that this handing out of new money is benign. People end up borrowing more money than they otherwise would have been able to get. Even a particular entrepreneur who knows there is a bubble, and knows interest rates will eventually shoot up, and who gets out in time, has still screwed things up. In other words the damage caused by the Fed guy handing out $100 bills is not simply the borrowers who get caught with their pants down when rates shoot up earlier than they thought.
No, from DAY ONE, when people borrow more money at the artificially low interest rate than they should have been able to borrow, the structure of the market starts diverging from what it should have been. If you think “rational expectations” should allow people to offset everything, then you are really saying the market interest rate serves no function.
If you admit the market interest rate means something–that a businessperson needs to know, for example, whether the one-year rate is 3 percent versus 2 percent–then you have to admit that it screws things up if the government pushes down the original 3 percent rate to 2 percent.
How (Falsely!) Low Interest Rates Contributed to the Housing Boom
In my battles with Greenspan defenders, things often come down to examination of what the Federal Reserve did with the money supply (however defined) after the dot-com crash. The idea is that interest rates per se are irrelevant, since the (typical) way the Fed moves interest rates is by shrinking or enlarging the total amount of bank reserves through open market operations.
The reason we are supposed to focus on money, not nominal interest rates, is that the market interest rate could be changing for “fundamental” reasons. For example, if the free market interest rate should be rising, then the mere fact that the Fed raises its target rate too doesn’t prove that the Fed is “tightening.” Indeed, if the Fed’s hikes lag behind the increase in what the free-market interest rate would be (however we define it), then arguably the situation would represent one of “easier money.”
This is a very important point, and failure to heed it led certain Keynesians astray when they thought the German central bank in the Weimar Republic was engaged in tight money because nominal interest rates were so much higher than normal. (!!) This despite the wheelbarrows of cash.
Notwithstanding all of the above, I think there is a similar danger in throwing nominal interest rates out the window. For example, I have a gut feeling that interest rates are too low right now, simply because…I can’t believe free market interest rates would ever be virtually zero–let alone negative for brief periods!–in a modern economy not threatened by roving marauders. (Even if Geithner et al. are marauders, they are not roving. They are here for at least another three years, so suck it up.)
When it comes to the housing boom, suppose (for whatever reason) that interest rates in the early 2000s responded very strongly to modest injections of money from the Fed. In other words, nobody has ever shown me that, say, a 1% increase in the growth of some monetary aggregate could only cause a proportionally small distortion in market interest rates. And because interest rates are prices that mean something about intertemporal tradeoffs, that can in theory really screw up the whole economy.
To reiterate a basic point that even many free market economists overlook: INTEREST AND MONEY ARE NOT THE SAME THING. The problem with government intervention in the banking system is not merely that “it will eventually lead to price inflation.” No, when the government distorts the interest rate, it messes up the intertemporal coordination of the economy. People’s long-term plans don’t mesh as well as they would in the absence of a central bank.
With the above as background, I was very pleased to read this post by David Beckworth (HT2 Arnold Kling). He quotes from various academic papers and blog posts showing plausible ways that low nominal interest rates could have fueled the housing boom. Here’s a good excerpt, and note that the first paragraph is from Beckworth, while the remainder is his quoting in turn of Barry Ritholtz:
Both papers above empirically show the low federal funds rates were very important to the excessive leverage and big bets made by financial institutions during this time. Barry Ritholtz provides a nice summary of this channel in a recent post:
What Bernanake seems to be overlooking in his exoneration of ultra-low rates was the impact they had on the world’s Bond managers — especially pension funds, large trusts and foundations. Subsequently, there was an enormous cascading effect of 1% Fed Funds rate on the demand for higher yielding instruments, like securitized mortgages…
An honest assessment of the crisis’ causation (and timeline) would look something like the following:
1. Ultra low interest rates led to a scramble for yield by fund managers;
2. Not coincidentally, there was a massive push into subprime lending by unregulated NONBANKS who existed solely to sell these mortgages to securitizers;
3. Since they were writing mortgages for resale (and held them only briefly) these non-bank lenders collapsed their lending standards; this allowed them to write many more mortgages;
4. These poorly underwritten loans — essentially junk paper — was sold to Wall Street for securitization in huge numbers….
And then the list goes on to describe the events we all know.
Let me add one point here: Tyler Cowen (I think?) had a post a while back ridiculing or at least seriously questioning this line of argument. He said something like (and this is a paraphrase), “Suppose the government started paying people to store bananas on their roofs. After a while, if a bunch of roofs started caving in, would that be a sign of irrational homeowners or bad government policies? Surely the people who believe in the free market should be troubled that homeowners would respond so stupidly to a government incentive that they had the option of refusing.”
With that skepticism in mind, I imagine someone could dismiss the excerpt I’ve placed above by saying, “Well gee whiz, suppose that the Fed didn’t exist, and that the analogous free market interest rate fell to 1% from 2003 – 2004. Are you saying that the dumb investment banks would have blown up a few years later because of their insatiable need for higher yields?”
But hang on: If I’m right that it was Greenspan (and other central bankers) who pushed down nominal interest rates well below what they should have been, in an attempt to have a “soft landing” after the dot-com crash, then it’s not true that the free market interest rate would have been anywhere near those low levels. Things like investors’ preferences regarding risk and yield help determine what the structure of free market interest rates would be.
In that respect, I think Cowen’s banana analogy (if I have correctly represented it above, which I may not have) would be similar to someone saying, “What’s the big deal with setting Manhattan rents at $400 a month? Suppose there were a new invention that made building apartments easier, and the supply curve shifted way out so that the market price was $400. Do the free marketeers think this would all of a sudden cause a massive shortage of apartments? Of course not. So why do they get their undies in a bunch when I suggest that the government set a price cap at $400?”
Bob Murphy, Neo-Confederate?
Steve Landsburg has the distinction of (possibly) being a more narcissistic economics blogger than me. (As Vader would say, “Impressive.”) Not only did Steve decide his readers should see his personal list of heroes, but he broke it up over three posts, making them guess at the identity of the people who were pictured.
Anyway, one of the people on Landsburg’s list was Abraham Lincoln. (Everyone identified that portrait in round one.) During the post-game show, one of the commenters was horrified at the inclusion of “The Great Murderer” but I tried a friendlier approach:
Steve,
If you’re still reading, I would love to hear your reasons for including Lincoln. I have the same misgivings as the other commenter above, though I was going to introduce them with levity. (E.g. “I know you like math, Steve, so is that why you included the guy who maximized the wartime deaths of Americans?”)
Don’t get me wrong, I grew up thinking Lincoln was great, just as I thought FDR was great. But when I actually started thinking about things (a la your bathtub drain), I realized: “Wait a second, doesn’t ‘he saved the Union’ describe the same behavior that King George engaged in when the colonists decided to split?”
I’m being dead serious here. If you’re new to my blog, and had never really thought much about it, I’m curious to know: Do you think Abraham Lincoln is great, and if so, why? Isn’t the whole point of our “way of life” that we allow people to choose their own forms of government?
Let me deal with the obvious rejoinder: The U.S. colonies had slavery when they seceded from Great Britain. If King George had promised to free the American slaves, would you have rooted for the colonists to lose the American Revolution?
Ludwig von Mises On the Health Insurance Bill
[UPDATE below.]
Ever since I finished the Study Guide to Mises’ magnus opus, he has been communicating with me from beyond the grave. I asked him what he thought of the pending health insurance legislation, and he reminded me of his general principles of the dynamics of interventionism. Once the government interferes with one aspect of the market, it can’t stop there. Things would be even worse than before the initial intervention. So the government has to do a second, third, fourth…interventions, until you either stop–amidst a completely muddled system that everyone recognizes is awful–or go full-bore until you hit socialism.
I understood the general principle, but I asked Dr. Mises to apply it to this particular case. So he said:
Start with the proposition that we don’t want our fellow citizens denied coverage because of preexisting conditions — which is a very popular position, so much so that even conservatives generally share it, or at least pretend to.
So why not just impose community rating — no discrimination based on medical history?
Well, the answer, backed up by lots of real-world experience, is that this leads to an adverse-selection death spiral: healthy people choose to go uninsured until they get sick, leading to a poor risk pool, leading to high premiums, leading even more healthy people dropping out.
So you have to back community rating up with an individual mandate: people must be required to purchase insurance even if they don’t currently think they need it.
But what if they can’t afford insurance? Well, you have to have subsidies that cover part of premiums for lower-income Americans.
In short, you end up with the health care bill that’s about to get enacted. There’s hardly anything arbitrary about the structure: once the decision was made to rely on private insurers rather than a single-payer system — and look, single-payer wasn’t going to happen — it had to be more or less what we’re getting. It wasn’t about ideology, or greediness, it was about making the thing work.
I see that in the afterlife Mises is following Hayek’s example and trying to convert socialists.
UPDATE: Lew Rockwell emails with an actual quote from Mises’ Socialism:
“To the intellectual champions of social insurance, and to the politicians and statesmen who enacted it, illness and health appeared as two conditions of the human body sharply separated from each other and always recognizable without difficulty or doubt. Any doctor could diagnose the characteristics of ‘health.’ ‘Illness’ was a bodily phenomenon which showed itself independently of human will, and was not susceptible to influence by will. There were people who for some reason or other simulated illness, but a doctor could expose the pretense. Only the healthy person was fully efficient. The efficiency of the sick person was lowered according to the gravity and nature of his illness, and the doctor was able, by means of objectively ascertainable physiological tests, to indicate the degree of the reduction of efficiency.
“Now every statement in this theory is false. There is no clearly defined frontier between health and illness. Being ill is not a phenomenon independent of conscious will and of psychic forces working in the subconscious. A man’s efficiency is not merely the result of his physical condition; it depends largely on his mind and will. Thus the whole idea of being able to separate, by medical examination, the unfit from the fit and from the malingerers, and those able to work from those unable to work, proves to be untenable. Those who believed that accident and medical insurance could be based on completely effective means of ascertaining illnesses and injuries and their consequences were very much mistaken. The destructionist aspect of accident and health insurance lies above all in the fact that such institutions promote accidents and illness, hinder recovery, and very often create, or at any rate intensify and lengthen, the functional disorders which follow illness or accident.
“Feeling healthy is quite different from being healthy in the medical sense, and a man’s ability to work is largely independent of the physiologically ascertainable and measurable performances of his individual organs. The man who does not want to be healthy is not merely a malingerer. He is a sick person. If the will to be well and efficient is weakened, illness and inability to work is caused. By weakening or completely destroying the will to be well and able to work, social insurance creates illness and inability to work; it produces the habit of complaining – which is in itself a neurosis – and neuroses of other kinds. In short, it is an institution which tends to encourage disease, not to say accidents, and to intensify considerably the physical and psychic results of accidents and illnesses. As a social institution it makes a people sick bodily and mentally or at least helps to multiply, lengthen, and intensify disease.”
I’m going to go out on a limb and say that Mises would not endorse the present bill.
For Road Trips of Moderate Length…
…why not listen to a guy with a sweet English accent read my Chaos Theory? Intro here, audio recording here.
The Connection Between Drug Prohibition and Violence
If you read a standard economic treatment of drug prohibition, it will probably say that drug dealers become more violent since they can’t use the police and courts to protect their property.
At first that sounds fine, but if you are suspicious of government “services” then you start to wonder. In fact, I think the argument is totally wrong. There are all sorts of commercial transactions that aren’t really backed up by the government; people spend lots of money every day buying things on eBay or Amazon from perfect strangers who live on the other side of the country. In principle you could sue them if they didn’t ship you the jewelry or the rare book or the signed photo of Paul Reubens, but in practice these transactions rely on reputation and the private-sector hosts’ incentives to make sure their customers have enjoyable experiences.
So anyway I’m working on a project for high school kids, and I’m making this general point. A new aspect of this occurred to me and I put it in a footnote, but only Free Advice readers can see it. The rest of the riffraff out there will have to wait until the summer when the book comes out.
Here’s the footnote:
Indeed, if drug dealers could conduct major transactions using electronic payments routed through a universally respected third party, the number of violent drug deals “gone bad” would plummet. Rather than bringing suitcases of cash (along with heavily armed bodyguards) to parking garages in the dead of night, a cocaine retailer could deposit $1 million with a reputable financial institution, which would agree to transfer the funds to a Colombian wholesaler once the retailer had received his goods. (The process could unfold in stages if the Colombians wanted to make sure they weren’t double-crossed.) The reason drug dealers currently can’t operate in this fashion isn’t that they fear a bank will steal their money and then the drug dealers won’t be able to call the police. The first time that happened, nobody—even people unconnected with the drug trade—would use that bank again. In reality drug dealers can’t use the simple mechanism we’ve described because of the risk that the government would seize their funds as “drug money.” So we see that it is not government neglect, but government enforcement of drug laws, that makes violence more appealing in the drug trade.
Glenn Greenwald Explains: "Why Do They Hate Us?"
Sometimes I just have to marvel at how succinctly Glenn Greenwald crystallizes things that have been bothering me. He has the extra benefit of actually being knowledgeable on issues of terrorism and the law, which is nice. Here’s a great passage from today, but you should read the whole post:
[I]t’s impossible to grow accustomed to the extreme fantasy atmosphere and self-absorbed blindness that pervades American discussions over Terrorism, especially in the wake of a new scare. The Right, seeking as always to exploit Terrorism fears, falsely accuses Obama of not displaying “war” language and a “war” mentality, in response to which he and his aides step forward to affirm — yet again — that WE ARE AT WAR!, and to point to all of the times Obama decreed this to be so and all of the war actions he has ordered. So we’ve spent the last decade screaming to the world that WE ARE AT WAR!, that we’re a War Nation, that we’re led by a War President. That we are “at war”…is an absolute bipartisan orthodoxy that must be affirmed by all Serious people. And we are currently waging some form of actual war in no fewer than five predominantly Muslim countries (Afghanistan, Pakistan, Iraq, Yemen and Somalia); are threatening Iran with “crippling” sanctions and — from our more deranged quarters — war; and continuing our unbroken devotion to Israel’s causes.
Yet even in the face of all of that, it is bewilderment and confusion that reign when our media stars and political figures talk about attempts to attack Americans. Why would they possibly want to do this? They must be crazy, or drunk with religious fervor, or consumed by blinding, inhumane hatred. Much of that is probably true for individuals willing to blow themselves up in order to slaughter as many innocent civilians as possible. But it’s equally irrational to think that you’re going to spend a full decade bellowing WE ARE AT WAR! to the world, send bombs and troops and all forms of death to multiple Muslim countries (both directly and through Israel), and not have that directed back at us. That’s what happens when a country is “at war” — it doesn’t just get to blow up things and people in other countries, but its own things and people sometimes get blown up as well. That’s how “war” works.
It’s truly astounding to watch us — for a full decade — send fighter jets and drones and bombs and invading forces and teams of torturers and kidnappers to that part of the world, or, as we were doing long before 9/11, to overthrow their governments, prop up their dictators, occupy what they perceive as holy land with our foreign troops, and arm Israel to the teeth, and then act surprised and confused when some of them want to attack us. In general, the U.S. only attacks countries with no capabilities to attack us back in the “homeland” — at least not with conventional forces. As a result, we have come to believe that any forms of violence we perpetrate on them over there is justifiable and natural, but the Laws of Humanity are instantly breached in the most egregious ways whenever they bring violence back to the U.S., aimed at Americans. It’s just impossible to listen to discussions grounded in this warped mentality without being astounded at how irrational it is. What do Americans think is going to happen if we continue to engage in this conduct, in this always-widening “war”?
Economic Blogger Ranking, By Scholarly Impact
Check out this article (HT2 Greg Mankiw). It has a table ranking econ bloggers by scholarly impact. I don’t mind being beaten by Paul Samuelson, or Nouriel Roubini, or even Tyler Cowen or Bryan Caplan for that matter. But Stephan Kinsella?! What the heck?! (Incidentally we have surpassed our weekly quota of I-hate-GMU / no-I-hate-Auburn so please let’s not start it up on this post too.)
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