Wednesday, August 7, 2013

It is time to think the unthinkable and raise interest rates

Allister Heath triggered an epic twitter debate when he called for the Bank of England to do the unthinkable and raise interest rates.

On the one side, represented by former Monetary Policy Committee member Danny Blanchflower, were those who argued that we continue to need near zero interest rates until such time as the economy recovers and unemployment drops close to pre-financial crisis levels.

On the other side, represented by Ros Altmann, an economist who focuses on retirement issues, were those who argued that zero interest rate policies hurt the real economy by stifling demand.

Regular readers won't be surprised that your humble blogger (tweeting @tyillc) joined in the debate.

Before going further, let me remind readers that unlike Ms. Altmann and Mr. Blanchflower, I do not have a PhD in Economics.  As a result, like Walter Bagehot, the Economist Magazine editor who invented the modern central bank, I focus on what is actually happening and providing a framework for understanding what it will take to end our current financial crisis and prevent future financial crises.

To his credit, Mr. Blanchflower presents an energetic defense of the indefensible.  He argues that given the current level of unemployment there is no empirical support in a peer reviewed economic article that supports the notion that interest rates should be raised.  The economic literature calls for aggressive monetary stimulus. this the same peer group of economists that failed to predict the financial crisis? this the same peer group that is making economic forecasts at both the Bank of England and Fed and since the beginning of the financial crisis has routinely predicted better economic performance than has occurred?

I called Mr. Blanchflower's position indefensible because the peer reviewed economic literature never considers that there might be an inflection point where the strong relationship between lower interest rates and lower unemployment no longer holds.

Regular readers know exactly where this inflection point is:  it is Walter Bagehot's 2% lower bound.  He observed in the 1870s that economic behavior changes when interest rates drop below 2% and as a result said interest rates must be kept above this level.

Once one realizes there is an inflection point, it is easy to explain why the Bank of England and the Fed are predicting better economic performance than has occurred.  Below the inflection point, economic behavior changed and this change in behavior is not incorporated into the models used by the Bank of England and the Fed.

On the other side of the debate, Ms. Altmann supported Mr. Heath's observation on the impact of the zero interest rate and quantitative easing policies.
Keeping rates artificially low for extended periods of time inevitably distorts economies and misallocates resources. 
It allows unsustainable projects to survive, pushes bond, equity and property prices too high, depresses the value of sterling without, in a modern economy, boosting exports, messes up the pensions market, and incentivises consumption over saving – and all of that even before inflation begins to rear its ugly head.
Ms. Altmann puts forth the arguments the regular readers are familiar with under the Retirement Plan Death Spiral.  Current consumption is reduced as savers, both individuals and corporations, offset the loss of earnings on their retirement plans by saving more money.

As you can imagine, the debate became show me the empirical proof versus here is the anecdotal evidence.

To see if Mr. Blanchflower might acknowledge that maybe zero interest rates and quantitative easing are not the appropriate policy response to a bank solvency led financial crisis, I introduced the WSJ interview of Anna Schwartz.

Ms. Schwartz observed that these policies were wrong, wrong, wrong.

Mr. Blanchflower asked if this was the best I could do.

Naturally, I responded with a yes.  After all, Ms. Schwartz was an expert on the Great Depression and co-authored THE book on monetary policy.

To see if there were a position of compromise, I introduced the simple fact that back when I was working at the Fed and the Fed was taming inflation the economy was not particularly sensitive to changes in interest rates of less than 1%.

Despite Alan Greenspan cutting rates by a quarter of 1% at a time, there is no reason to believe the real economy has gotten to be more responsive to changes in interest rates.  Does anyone really think a company doesn't move ahead with a project because the cost of debt goes up by 0.25%?  Does anyone really think people don't buy a house because the cost of debt goes up by 0.25% (hint: they buy a smaller house)?

Faced with this fact, Mr. Blanchflower offered the real reason that central bankers will never be able to allow interest rates to increase.
tyillc because mortgage holders have had falling real wages compensated for by low mtg payments so if rise disaster
Translation: central bank policy is held hostage by excess public and private debt in the financial system and the need to protect bank book capital levels and banker bonuses.

I would like to thank Mr. Blanchflower for a) his willingness to engage in the discussion and b) his insights.

I would be remiss to not share one other insight.  As Mr. Blanchflower observed, he and I can debate what the policy should be, but the policymakers need to get it right.

In two days, it will be six years since the beginning of the financial crisis and the policymakers have not gotten right.  As documented by the Dallas Fed, the cost of the financial crisis has now grown to well in excess of $12 trillion with no end in sight.

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