Monday, October 1, 2012

Ben Bernanke cites Milton Friedman in justifying knowingly hurting savers

In defending his monetary policies and the fact that the Fed is aware these policies hurt savers, Ben Bernanke cited Milton Friedman.

According to a Business Insider article,
[Ben Bernanke] pointed out that Friedman advocated QE for Japan during its struggle against deflation and weak growth. He also recalled one of  Friedman's most important lessons, that low interest rates are not the same as loose policy.
Support for Friedman's advocacy of QE comes from a Q&A in 2000 between David Laidler and Mr. Friedman.
David Laidler: Many commentators are claiming that, in Japan, with short interest rates essentially at zero,  monetary policy is as expansionary as it can get, but has had no stimulative effect on the economy. Do you have a view on this issue? 
Milton Friedman: Yes, indeed. As far as Japan is concerned, the situation is very clear. And it’s a good example. I’m glad you brought it up, because it shows how unreliable interest rates can be as an indicator of appropriate monetary policy. 
During the 1970s, you had the bubble period. Monetary growth was very high. There was a so-called speculative bubble in the stock market. In 1989, the Bank of Japan stepped on the brakes very hard and brought money supply down to negative rates for a while. The stock market broke. The economy went into a recession, and it’s been in a state of quasi recession ever since. 
Monetary growth has been too low. Now, the Bank of Japan’s argument is, “Oh well, we’ve got the interest rate down to zero; what more can we do?” It’s very simple. They can buy long-term government securities, and they can keep buying them and providing high-powered money until the high powered money starts getting the economy in an expansion. What Japan needs is a more expansive domestic monetary policy.
Regular readers know that Japan's central bank subsequently engaged in massive amounts of purchases of long-term government securities (they have been pursuing QE for over a decade).

Has this ended the state of quasi recession in Japan?


The question becomes, were Mr. Friedman still alive today, would he offer the same advice given a) Japan's experience with quantitative easing and zero interest rate policies and b) the global financial crisis?

While Mr. Friedman is not alive, prior to her death, his colleague Anna Schwartz in a Wall Street Journal interview weighed in:
Ms. Schwartz thinks that our central bankers and our Treasury Department are getting it wrong again. 
To understand why, one first has to understand the nature of the current "credit market disturbance," as Ms. Schwartz delicately calls it.  
We now hear almost every day that banks will not lend to each other, or will do so only at punitive interest rates. Credit spreads -- the difference between what it costs the government to borrow and what private-sector borrowers must pay -- are at historic highs. 
This is not due to a lack of money available to lend, Ms. Schwartz says, but to a lack of faith in the ability of borrowers to repay their debts. 
"The Fed," she argues, "has gone about as if the problem is a shortage of liquidity. That is not the basic problem. The basic problem for the markets is that [uncertainty] that the balance sheets of financial firms are credible."
A problem that your humble blogger has been saying since the start of the financial crisis can only be solved by bringing transparency to all the opaque corners of the financial system.

For banks, this means requiring them to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.  This allows investors to independently assess the risk of each bank.

For structured finance securities, this means requiring them to provide observable event based reporting so that all activities like payments or defaults on the underlying collateral are reported before the beginning of the next business day.  This allows investors to know what they own.
So even though the Fed has flooded the credit markets with cash, spreads haven't budged because banks don't know who is still solvent and who is not. This uncertainty, says Ms. Schwartz, is "the basic problem in the credit market. Lending freezes up when lenders are uncertain that would-be borrowers have the resources to repay them. So to assume that the whole problem is inadequate liquidity bypasses the real issue."
First, thank you Ms. Schwartz for defining what the real issue is, the lack of transparency that makes it impossible for lenders to know who can repay them or not.  A problem that still has not been fixed 5 years after the start of the financial crisis.

Second, based on Ms. Schwartz's analysis and her multi-decade collaboration with Mr. Friedman, the probabilities suggest that it is highly unlikely that Mr. Friedman would be supporting the policies pursued by Mr. Bernanke.

The section in Mr. Bernanke's speech discussing the impact on savers.

How Does the Fed's Monetary Policy Affect Savers and Investors? 
The concern about possible inflation is a concern about the future. One concern in the here and now is about the effect of low interest rates on savers and investors. My colleagues and I know that people who rely on investments that pay a fixed interest rate, such as certificates of deposit, are receiving very low returns, a situation that has involved significant hardship for some.
Hardship that is the direct result of pursuing policies that Ms. Schwartz would say do not impact the underlying cause of the financial crisis or why the capital markets are not working today.
However, I would encourage you to remember that the current low levels of interest rates, while in the first instance a reflection of the Federal Reserve's monetary policy, are in a larger sense the result of the recent financial crisis, the worst shock to this nation's financial system since the 1930s. Interest rates are low throughout the developed world, except in countries experiencing fiscal crises, as central banks and other policymakers try to cope with continuing financial strains and weak economic conditions.
Actually, low interest rates are a reflection solely of central bank monetary policy.  Think Operation Twist to lower yields on long term treasuries.

Central banks around the world (EU, Japan, UK and US) are pursuing low interest rate and quantitative easing policies.  So it is no surprise that interest rates are low throughout the developed world.

To say that interest rates are low largely as a result of the financial crisis is simply being intellectually dishonest.
A second observation is that savers often wear many economic hats. Many savers are also homeowners; indeed, a family's home may be its most important financial asset. Many savers are working, or would like to be. Some savers own businesses, and - through pension funds and 401(k) accounts - they often own stocks and other assets. 
It has already been thoroughly documented in the UK that the value of these other assets for retirees has not increased enough to offset the decline caused by central bank zero interest rate policies.
The crisis and recession have led to very low interest rates, it is true, but these events have also destroyed jobs, hamstrung economic growth, and led to sharp declines in the values of many homes and businesses. 
What can be done to address all of these concerns simultaneously? 
The best and most comprehensive solution is to find ways to a stronger economy. Only a strong economy can create higher asset values and sustainably good returns for savers. And only a strong economy will allow people who need jobs to find them. Without a job, it is difficult to save for retirement or to buy a home or to pay for an education, irrespective of the current level of interest rates. 
The way for the Fed to support a return to a strong economy is by maintaining monetary accommodation, which requires low interest rates for a time. If, in contrast, the Fed were to raise rates now, before the economic recovery is fully entrenched, house prices might resume declines, the values of businesses large and small would drop, and, critically, unemployment would likely start to rise again. Such outcomes would ultimately not be good for savers or anyone else.
This blog has already documented that most of what Mr. Bernanke claims to be statements of fact in the last paragraph are in fact myths.

Based on what Walter Bagehot, the father of modern central banking, said in the 1870s, raising interest rates is likely to lead to an economic recovery.  Retirees and savers would have more money to spend.

House prices might not change at all given that the spread between what banks pay for funds and what borrowers pay for a mortgage is at an all time high.  Raising rates would simply squeeze this spread back to historic norms.

The value of businesses large and small is likely to increase as the value of a business reflects the demand for the goods or services provided by the business.  An increase in demand increases the value of the business.

When businesses see increased demand, they hire.  An increase in employment is positive because it further increases demand in the economy.

In short, raising rates would be great for savers and everyone else.

Please take the preceding comments with the appropriate grain of salt as your humble blogger does not have a PhD in Economics nor do I have an econometric model that shows zero interest rates are positive for the economy.

On the other hand, I managed to predict the financial crisis and that zero interest rates and quantitative easing would not arrest the downward spiral in the economy.

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