Thursday, January 26, 2012

Bernanke confirms why economists must disclose three critical assumptions behind their recommendations

Regular readers know that your humble blogger focuses on solutions to the financial crisis.  As a result, I seldom write on monetary or fiscal policy.  However, when I do write on monetary or fiscal policy, the ideas in the posts are typically provocative and subsequently become accepted.

In the last 24 hours, I was asked by a reader (hat/tip Bart E.) to apply my economic paper disclosure requirement to Fed Policy -- Zero Interest Rate Policies and Quantitative Easing -- and I came across an interesting post on NakedCapitalism which asked the simple question "Is QE/ZIRP killing Demand?"  I answered yes to this question over a year ago in a post.  

Regular readers know that I prefer a simple disclosure be attached to all economic papers:
The following are the three most important assumptions on which this paper is based.  If they are not correct, accepting or applying any aspect of this paper, including its recommendations, is likely to cause significant economic damage.
Now, imagine that this was applied to the zero interest rate and quantitative easing policies being pursued by central banks around the world.

What would the critical assumptions look like?  As reported on a Forbes' blog,
In his post-FOMC press conference, Fed Chairman Ben Bernanke recognized his zero-interest rate policy hurts savers.  Clearly Mr. Bernanke realizes that his recommended policy has the capacity for inflicting harm.
But what assumptions is he making that would justify inflicting harm?

Bernanke made it crystal clear that his intention is to make people spend, practically telling savers to get out there and invest [in longer term and riskier assets].
First, he assumes that in the aftermath of a credit bubble monetary policy can actually make people spend or change their investment behavior to accept greater risk.

This is a very interesting assumptions given what happened leading up to the financial crisis in 2008.  Then, investors responded to the Fed's low interest rate policy by chasing yield.  Specifically, they purchased opaque, toxic structured finance products produced by Wall Street.

We know how chasing yield worked out for investors.

Does Mr. Bernanke now assume that these same investors have amnesia and have forgotten how much money they can lose chasing yield?

This assumption is also very interesting in light of the Japanese experience.  Japan also experience a credit bubble bursting that rendered its largest financial institutions insolvent (the market value of their assets was less than the book value of their liabilities).

Japan's central bank rolled out zero interest rate policies and quantitative easing.  

This has been going on now for 2+ decades and savers are trying to save and investors are still shying away from risk.  What has not happened is that savers and investors have not decided because they cannot receive a return on their savings or investments that they should stop saving or investing and instead spend.

Why exactly should US savers and investors behave differently?

The Chairman was put on the spot with several questions regarding the effectiveness of his policies.  Asked about the destruction of savings given ultra-low interest rates, Bernanke admitted he understood savers were getting a real bad deal.  Essentially, Bernanke said the anemic recovery necessitated low interest rates to strengthen.  Low rates are used to stimulate investment, according to Bernanke, and that “has a cost on savers.”
Second, he assumes that ultra low interest rates will stimulate investment.

I have a confession.  I do not have a PhD in economics.  I have a Masters in Management (another way of saying MBA).

In b-school they teach that interest rates factor into the decision by business to invest well after the question of "is there demand" has been answered.  If there is no demand or prospect for demand, no further analysis is needed and no investment takes place.

[In b-school they also teach the idea of discounting cash flows and the rule of 72 - the time it takes to double your money.  This rule is interesting as it gives a sense for the lack of importance low interest rates has in the investment decision.  At 6%, it takes 12 years to double your money.  At 4%, it takes 18 years.  Simply put, low rates do not change a marginal or high risk investment into a good investment or one that should be undertaken.]

So now we know why Mr. Bernanke is pleading with savers to spend.  Without spending, there is no demand and without demand businesses will not invest.

This raises an interesting question?  What will it take to encourage savers to spend again given that Japan has shown that 2+ decades of zero return doesn't do the trick?

A good place to start might be to look at Walter Bagehot's 1870s observation about what rate savers need.
John Bull can stand many things, but he cannot stand two percent.
[For those who do not know who Walter Bagehot is, he was a businessman and editor-in-chief for the Economist magazine who quite literally wrote the book on what modern central bank's should and should not do.]

The economic experience of each country that has pursued zero interest rate policies would appear to confirm that Mr. Bagehot is right.  Below two percent, John Bull cannot stand it and demand declines.
In other words, Bernanke told people to stop saving and start investing.  When the economy is really bad, he explained, returns are going to be low and savers will get meager returns.  
Keeping your money in supposedly safe Treasury bills and CDs won’t help reactivate the economy, according to the Chairman’s view of the economy, and neither will keeping dollars under a mattress.
So apparently Mr. Bernanke assumes that people should behave exactly how his economic model says they should behave or conversely that people are behaving irrationally if their behavior does not conform to the model's prediction.

Instead, people appear to be following Mark Twain's investment advice:  worrying about the return of their money rather than the return on their money.  In following this investment advice, they are not reactivating the economy.

Mr. Bernanke is clearly frustrated that people are following Mark Twain's investment advice and not his economic model [which apparently assumes that retirees will rush out and spend the savings they need to live off of for the rest of their life because interest rates are zero and not instead cut back on consumption to make their savings go as far as possible].

Perhaps the Queen of England and I are the only ones to notice a simple fact: economic models failed leading into the financial crisis and have failed in their predictions since the start of the crisis.

The important point here is that policy is being driven off of assumptions in economic models that do not work.

As they say at Davos, now is time for a Great Transformation.  We need to start setting policy based on what people actually do and not off failed economic models.

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