26 Jul 2013

Yellen for Fed Chief! (Matt O’Brien Is Easy to Impress.)

Federal Reserve, Market Monetarism, Scott Sumner 15 Comments

Check out Matt O’Brien’s case for Janet Yellen over Larry Summers as the next Fed chief (HT2 Scott Sumner):

After serving as a Fed governor from 1994 to 1997, as president of the San Francisco Fed from 2004 to 2010, and as Fed Vice-Chair for the past three years, Yellen has emerged as one of the central bank’s intellectual leaders. She talked Alan Greenspan out of targeting zero percent inflation, because it would have increased the odds of falling into a liquidity trap (like we have now), back in 1996. She was one of the first to warn about the risk of the shadow banking blowup and housing slump setting off a credit crunch back in 2007. And she’s been one of the architects of the Fed’s unconventional policies today.

Now this is faint praise indeed. On the first point, O’Brien is crediting Yellen for talking Greenspan out of doing something that would have landed us right where we are anyway (i.e. in a liquidity trap). That’s like crediting William Jennings Bryan for talking Woodrow Wilson out of risking US entry into World War I.

On the third point, O’Brien is crediting Yellen for designing the very policies that have delivered this toiletbowl economy for the last 5 years. May I have another, sir?

Now the second point at least looks good, prima facie. You’re probably imagining Yellen in a Fed meeting in, oh I don’t know, February of 2007, pounding the table and saying, “We are on the verge of the worst crisis since 1929! For the love of Pete, Benjamin, we need to act now!!”

Or, you could follow the link, and see that it’s a Fed meeting that occurred in December of 2007. Here’s Yellen’s demonstration of why she’s the right woman for the job:

At the time of our last meeting, I held out hope that the financial turmoil would gradually ebb and the economy might escape without serious damage. Subsequent developments have severely shaken that belief. The bad news since our last meeting has grown steadier and louder, as strains in financial markets have resurfaced and intensified and as the economy has shown clear signs of faltering. In addition, the downside threats to growth that then seemed to be tail events now appear to be much closer to the center of the distribution. I found little to console me in the Greenbook. Like the Board staff, I have significantly marked down my growth forecast. The possibilities of a credit crunch developing and of the economy slipping into a recession seem all too real. [Bold added.]

(UPDATE: It just occurred to me, that the recession officially began in December 2007. So Matt O’Brien is proudly linking to a Fed meeting in which Janet Yellen proves that she is able to sense a recession coming only shortly after it already started.)

In contrast, here’s what I said, in an online article that ran a few months earlier (and actually this was taken from a private report I did for a bank in the summer of 2007):

Looking back at the chart above, we can see why the worst may be yet to come. In (price) inflation-adjusted terms, the early-2000s levels of the actual fed funds rate is the lowest since the Carter years. And many readers may recall the severe recessions of 1980 and 1982 that followed that period.

From 2001–2004, the Fed kept (real) rates at the lowest they’ve been since the late 1970s. One of the consequences that has already manifested itself is the housing bubble. But a more severe liquidation seems unavoidable. The recent Fed cut may postpone the day of reckoning, but it will only make the adjustment that much harsher.

(The title of the above article was, “The Worst Recession in 25 Years?” but I don’t remember if I picked that or not.)

Obviously I’m biased, but I’d have to say that my hedged statement was a lot more accurate than Yellen’s hedged statement. (Full disclosure: I foolishly ignored Austrian business cycle theory in a post in January 2007 when I made fun of Peter Schiff’s doomsaying. My bad.)

Now Matt O’Brien would laugh at my recession call, because it’s based on this wacky Austrian notion that interest rates have anything to do with the business cycle. O’Brien quotes the following passage from Larry Summers:

[SUMMERS:] However, one has to wonder how much investment businesses are unwilling to undertake at extraordinarily low interest rates that they would be willing to undertake with rates reduced by yet another 25 or 50 basis points. It is also worth querying the quality of projects that businesses judge unprofitable at a -60 basis point real interest rate but choose to undertake at a still more negative real interest rate. There is also the question of whether extremely low safe real interest rates promote bubbles of various kinds.

Then O’Brien comments:

In other words, he [Summers] thinks the Fed pushing down real interest rates might only push companies to make bad investments they otherwise wouldn’t make. It’s a very Austrian view of things — the idea that pushing interest rates “artificially” low makes businesses make mistakes.

This is not good. Now, there are plenty of people who think QE is going to turn us into Zimbabwe or inflate the mother-of-all-bubbles or just bail out the banks, but none of those people should be running the Fed.

Yes that’s right, Summers thinks that when it comes to the economy, it’s not just how much businesses invest, but also what they invest in. You would think this would be an obvious point, but instead he is mocked for it (by Scott Sumner too).

On the one hand, I can’t believe that it’s dismissed as crankish Austrianism to think that businesses need to invest in the proper channels, to have a sustained recovery. On the other hand, it’s job security.

15 Responses to “Yellen for Fed Chief! (Matt O’Brien Is Easy to Impress.)”

  1. DesolationJones says:

    Summers is being mocked for thinking “low” interest rates will cause bad investment, not for thinking bad investment matters. Low interest rates causing bad investment is not an obvious given point.

    • skylien says:

      Well just like decreeing to make the price of oil 2 Dollars per Barrel wouldn’t be an obvious given point that it will be used then for comparatively wasteful projects… This doesn’t mean that waisting oil isn’t a problem.

    • Matt M. (Dude Where's My Freedom) says:

      Why isn’t that obvious?

      I mean, I guess it depends on your definition of “bad” but it seems pretty dang obvious to me that lowering interest rates will increase the amount of marginal investments that previously were considered not worth the cost. Whether an investment is “good” or “bad” is likely subjective, but lower interest rates will allow lower quality investments to be undertaken.

      • G. King says:

        If that is your claim how do you distinguish between investments incentivised by artificially lowered interest rates and investments incentivised by a lower “natural” rate of interest? Why doesn’t the free market allow lower quality investments to be taken up in a lower interest rate environment and if so why are they not dangerous malinvestments?

        • skylien says:

          There is no such thing as a lower quality investment. The quality of an investment is defined by its return which finally must be greater than the repayment of any loan + interest taken up for this investment. If the current time (and for Keynesians also the liquidity) preference does not allow this then this is a malinvestment.

          You can lower the interest rate artificially by increasing the money supply which will lead to relatively (compared to the situation without increase in the money supply) higher prices in the future. Yet that is not enough because it is only possible to reduce the interest rate if this relative increase in prices is NOT fully anticipated by the market. If the market would perfectly anticipate this relative price increase in the future you could not lower the interest rate artificially.

          Since the market obviously is deceived by this lower interest rate due to an increasing money supply (else it wouldn’t be lower) there will be to the extent of the wrong expectation of future prices malinvestments because those are not able to yield the profit which actually is needed to support them. Those relative higher prices which were not anticipated eat up more profits than expected in the past.

        • skylien says:

          Additionally, is it possible that the market instead of underestimating future prices generally overestimates them? Yes of course that would be hyperinflation then.

          It’s a game of expectations which CBers think they can twist and manipulate so that it is in line with physical realities and preferences of this people (As if they could ever know that…). Yet later on if those expectations hit the brick wall and turn out to be wrong, CBers are quick to deny any responsibility that they might have caused/fueled those wrong expectations.

    • Bob Murphy says:

      Low interest rates causing bad investment is not an obvious given point.

      Suppose the government used subsidies to provide gasoline to motorists at $2/gallon. Would you be OK with me saying there would be more than the optimal amount of driving? Would that be not an obvious given point?

  2. Daniel Kuehn says:

    That is kind of strange. Meh. O’Brien is a journalist and he’s latching on to easy-to-grasp good guy/bad guy dichotomies. Not surprising it comes out with crappy analysis.

    The idea that rates impact the composition and not just the volume of investment is hardly just Austrian. That’s Stiglitz and Weiss (1981). That’s Adam Smith!

    Austrians tie it to the natural rate and Austrians focus on the time structure as the compositional characteristic of greatest interest.

    That raises the real point here – why is O’Brien saying rates are “artificially low”? That’s where I would raise the criticism – not that interest rates don’t have compositional effects – they do (I’m not sure how significant it is, but they do), but that right now rates are above the natural rate, not below it.

    • Matt Tanous says:

      “right now rates are above the natural rate, not below it”

      Tell me how zero can be above a natural rate that must, due to the nature of capital and time-preference, never reach zero.

      “It is not surprising, therefore, that the more abundant capitals are, the lower is the interest.

      Is this saying that it will ever reach zero? No; because, I repeat it, the principle of a remuneration is in the loan. to say that interest will be annihilated, is to say that there will never be any motive for saving, for denying ourselves, in order to form new capitals, nor even to preserve the old ones. In this case, the waste would immediately bring a void, and interest would directly reappear. ” – Frederic Bastiat

      And if we might say that the “real” rate is negative, while the nominal rate is not…. the disparity is an artificial consequence of the money creation at the Fed!

    • DesolationJones says:

      “That raises the real point here – why is O’Brien saying rates are “artificially low”?”

      O’Brien isn’t saying that. It’s what the Austrians are saying. He put that word under quotes for a reason. He doesn’t actually believe that himself.

  3. Blackadder says:

    Re the first point, there is a famous quote by (I think) George Stigler to the effect that if an economist manages to delay the implementation of an unnecessary $100 million government program by two weeks, then he has justified his salary for a lifetime. Ten years is a long time.

    • Bob Murphy says:

      Blackadder wrote:

      there is a famous quote by (I think) George Stigler to the effect that if an economist manages to delay the implementation of an unnecessary $100 million government program by two weeks, then he has justified his salary for a lifetime.

      He must be using at least a 7 percent discount rate. (Or they didn’t pay him much.)

      • Blackadder says:

        I think he said it back in the 1960s. Inflation, Bob, inflation.

        • Ken B says:

          Back when $2 for gasoline wouldn’t lead to too much driving.

  4. Major_Freedom says:

    “On the one hand, I can’t believe that it’s dismissed as crankish Austrianism to think that businesses need to invest in the proper channels, to have a sustained recovery. On the other hand, it’s job security.

    Agree with that one.

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