Russ Roberts

David Beckworth on Money, Monetary Policy, and the Great Recession

EconTalk Episode with David Beckworth
Hosted by Russ Roberts
You Gotta Have Standards... Russ Roberts's Federal Reserve...

moneyvhousing.jpg Was the Financial Crisis of 2008 caused by a crisis in the housing market? Or did the Federal Reserve turn a garden-variety recession into the Great Recession? David Beckworth of Western Kentucky University talks with EconTalk host Russ Roberts about the Fed's response to the recession that began in December of 2007 and worsened in 2008. Beckworth argues that the Fed failed to respond adequately to the drop in nominal GDP by keeping interest rates too high for too long. Beckworth describes what he thinks the Fed should have done and the lessons we should learn going forward to reduce the severity of future downturns.

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Readings and Links related to this podcast episode

Related Readings
This week's guest: This week's focus: Additional ideas and people mentioned in this podcast episode: A few more readings and background resources:
  • Financial Crisis of 2008. College Economic Topics. List of EconTalk podcast episodes and other Econlib resources on the Great Recession, organized by proposed cause.
  • Business cycles, some basics:
    • Business Cycles, by Christina D. Romer. Concise Encyclopedia of Economics.
    • Measuring Business Cycles, by Arthur F. Burns and Wesley C. Mitchell. New York: National Bureau of Economic Research, 1946. Housing market and other economic variables correlated with business cycles. Summary volume of three NBER studies conducted by Wesley Clair Mitchell.
    • Bank Runs, by George G. Kaufman. Concise Encyclopedia of Economics.
  • Federal Reserve System, by Richard H. Timberlake. Concise Encyclopedia of Economics.
  • Money Supply, by Anna J. Schwartz. Concise Encyclopedia of Economics.
  • Milton Friedman. Biography. Concise Encyclopedia of Economics.
  • Taylor Rule:
A few more EconTalk podcast episodes:


Podcast Episode Highlights
0:33Intro. [Recording date: May 19, 2016.] Russ: Taping in front of live audience at the Cato Institute.... You've written a lot of provocative things about the Great Recession, the role of the Fed, and trying to understand what happened, so that's going to be our main focus today. I'm sure we'll get into a lot of other related issues. A lot of people blame the collapse of the housing market for the Great Recession and see that--they may disagree about whose fault that is, whether it's the government or the private sector run amok--I always like that phrase. But you don't think that's the central factor. So, first, what is their argument and why do you disagree? Guest: Well, the standard story is that we had a housing boom, a run-up in housing credits; households became over-levered. Another part of the story is maybe government policies helped facilitate that: maybe the Fed kept rates too low for too long. And that generated this [?] of excesses that eventually had to be corrected. So, there had to be, almost be a bust. It was inevitable. On top of that, there's another story that's tied into this, is that a bank run occurred--a financial panic. And while I acknowledge all of those things happened, and some of my co-authors have written with me--we acknowledge these things happened. We don't think those things would have created the Great Recession. We believe there would have been a mild recession, a run of the mill recession. But to get to a Great Recession, you needed to have the Federal Reserve make some policy mistakes in 2008. And we believe it did a series of mistakes. Russ: So, I like your explanation. I'm drawn to it, because I was one of the people who said, as the housing market was expanding a lot, I said, 'Well, that's [not?] something to worry about. It's a small part of the U.S. economy. It can't really wreak the havoc that people are saying. or some people are saying.' Very few, but some people were saying, 'Are you worried about it?' and I'd say, 'No.' So, I was wrong. I think. But you say, actually I was right on the money. It wasn't a housing problem. So, that's a great comfort to me. But, I'm worried that I might actually have been wrong. It's happened many times. So, what's wrong with that argument? It's clearly the case, as you concede, that housing prices went up a lot--a huge amount of construction, expansion of employment in that area; a huge amount of leveraged financial bets made on housing through the securitization market. And a collapse, really, of the so-called shadow banking system. Which should have had, I would have thought, disastrous repercussions--now that I understand something about leverage and the financial system, which I didn't. But what's wrong with that story. Guest: Again, just to repeat: we think there would have been a recession. It's just the severity of it. To answer that, let's go back to 2006. So, in about April 2006, the national average--so there's regional differences, but the national average housing prices begin to fall about that time. If you look at indicators related to housing industry--so, employment, if you look at income, construction, real estate--they are all declining sharply after that point. So, the housing sector and those really close to it are declining for about 2 years before you get to the actual blow[?] of about mid- to late 2008. So, the Federal Reserve and the U.S. economy is doing relatively well for almost 2 years. There's a sectoral recession going on: housing is slowly going down. So, something changed in 2008. Also, the early financial runs: there was panic in 2007, particularly beginning about August 2007, and BNP Paribas I think in France didn't allow people to withdraw funds from an investment fund there. Later, Bear Stearns in early 2008. But all up to that period, all the way to about early 2008, the U.S. economy is doing relatively well. So, if you look at employment outside of construction-related industries and housing industries, employment actually grows up until early to mid-2008. First of all, income growth grows until early to mid-2008. Some kind of catalyst had to step in and make it spread, become a truly systemic event. And you know, as a monetary economist, I naturally think it's got to be related to money somehow. What's the one asset[?] in every market? On every transaction? It's money. If you want to simultaneously mess up an entire economy, somehow effective demand or supply for money. And we believe that happened, or I believe that happened during that time period of the Fed's inactions, and a number of other mistakes.
5:18Russ: So, let's just go back to the timing, which is a little bit tricky. Because it was so long ago. Guest: It is, it is. Russ: It's actually a decade ago, we are talking about. Guest: It's hard to believe. Russ: It's hard to believe, because some of us feel we haven't quite escaped it. But, as you point out--and I went back and looked at the data before this interview--the housing market starts to slow in 2006. The official NBER (National Bureau of Economic Research) start of the recession is December of 2007. The crisis part of it--which they didn't note at the time: in December 2007 nobody said, 'Oh, my gosh, we're in a recession.' This is ex-post dating of the problem. The Crisis begins in March of 2008, you could argue with Bear Stearns; but Fed covers that up, making sure that its creditors are taken care of. I thought that was a mistake, but put that to the side. It's really the Fall of 2008, with the collapse of Lehman Brothers, and instead of other problems--runs on money market funds, etc.--that really create this feeling of so-called panic, that caused Hank Paulson to go to Congress and say the world is going to come to an end. And, as John Taylor and others have pointed out, actually dating it to the Lehman Brothers' collapse is kind of hindsight, because really the economy didn't fall off a cliff. There wasn't real panic. So, what you are arguing--let me try to summarize that and try to say what I think you are saying. You are saying that: Yeah, there was a recession, like many other recessions: housing market led--meaning before it happened. It's not uncommon: in fact, almost every recession of the 20th century began with some kind of housing problem. Whether that's because housing is special or housing is the most important asset on most people's personal balance sheets. That's standard stuff. We would have had a mild recession. Yes, it started December of 2007; but something happened that made 2008, late 2008 going forward, disastrous--the largest downturn in economic activity since the Great Depression. So what was that, if it wasn't the repercussions of the housing market? Guest: Well, let me get back to that in just a minute. I wanted to follow up on-- Russ: Change my timeline? Guest: I love your timeline. It's perfect. But just to mention, to support this timeline you've laid out: Ben Bernanke famously has a video on Youtube where he says, 'Everthing's under control.' And they show that--[?] seen it, and people like to use it to make fun of Ben Bernanke. But to be fair to him, you know, my analysis suggests that up until early 2008, that was the proper thing to say. Things were looking like a manageable, you know, slowdown in activity. As a counterexample, Australia, they had just has much [?] in public debt--I'm sorry, in household debt. They had a housing bubble. All the same problems we had, but they never went through a Great Recession. They went through relatively [?] in fact they haven't had a recession since 1991. And that recession was a mild one, like we had. Their Great Moderation never ended. Russ: That could be because they have kangaroos. Guest: Probably. Russ: No, I mean: causation is very hard to tease out. So, the question would be: Are there other countries, beside Australia, that either had very moderate crises? Canada, I think, for example, had a milder one. Guest: Yeah; I'm not--they may have. I'm not sure about Canada. But Israel, as well. Russ: Correct. Guest: Israel had a relatively mild slowdown. And what they did, in my view, is their central bank acted more aggressively. They took the steps that were needed to curtail the panic and the fear that set in. So, your question is: What did the Fed do wrong? I see three things the Fed did wrong. And George Selgin, who is here, he's written on some of this. But the first thing I think where they went wrong is they did sterilized lending in 2007. So about from September 2007 or so--maybe it's August 2007--up until near the end of 2008 when they began QE (Quantitative Easing). Russ: Quantitative Easing. Guest: Yeah, Quantitative Easing. They did sterilized lending-- Russ: What is that? Guest: They lent money out to certain banks, but for every dollar they lent out, they also sold a Treasury, which pulled money out. So for every dollar they injected, they were also pulling a dollar out. Which meant overall liquidity was staying flat. Now, imagine--again, this is 2007, and again, things were not too bad. But it was still an elevated sense of financial risk. Which means the demand for liquidity had to be up. But all the Fed was doing was targeting specific banks, specific institutions. Russ: Not the economy as a whole. Guest: Not the economy as a whole. And that's what it should have been. That's the first place where it went wrong, in my view. Now, again, I don't think it was as catastrophic, that was the biggest mistake--the biggest mistake. But that was the beginning of a series of mistakes. The bigger one in my view begins in early 2008. The Federal Funds rate had been dropped from about 5.25% to 2.25%--so, I think it's September 2007 to about April 2008, it dropped quite a bit. And I think the Fed was on the right path. But once we get to April, the Fed holds the Federal Funds rate, their target interest rate, at 2% from April all the way through October, the early part of October. And I counted it out: It's 5 months[?] in one week. So for about 5 months they keep it steady. All right? Russ: Having dropped it dramatically. Just as a clarification, the Federal Funds rate is? Guest: It's the overnight rate at which banks lend to each other. It's the rate, at least prior to the Crisis that targeted and intervened in to guide monetary policy. Nowadays, they've got a few other rates they look at. But it was the indicator of the stance of monetary policy. Russ: So, they lowered interest rates in, presumably in, under concern that things were-- Guest: They did-- Russ: not going well. And then they kept them there. What was wrong with that? Guest: Well, they stopped. They were on the right path and then they stopped in April 2008. They were concerned about inflation. Now, I've had a lot of pushback: Well, what's 2%? What's the big deal about 2%? Russ: Meaning, as opposed to 1.5%. Guest: As opposed to zero. Russ: Yeah. Guest: How much more difference would it have made had the Fed gone from 2% to zero? And I think a lot of difference. It's a nonlinear or non-proportional effect. I mean, what's the difference between a sick person getting an antibiotic shot and a healthy person? A big difference. If you have pneumonia, that antibiotic shot may be the difference between life and death. If you are healthy, no big deal. And so I think when it got to that point, it was pivotal that they continue to cut rates. Moreover, it's not just the level of the interest rate. It's where it should be in order to make the economy well again. And we call this the natural interest rate. I like to label it the market-clearing rate: where would rates need to be in order for markets to clear? Russ: [?] markets? Guest: Well, as a whole, the U.S. economy as a whole to clear. So I'm kind of using that term loosely there. But in general what would households need, what would the rate need to be[?] for households and businesses to allocate their spending across time, to bring the economy back to full employment, or to keep it healthy? And when the economy weakens, it pulls that rate, that market-clearing rate, down. Which we call the natural rate. It's the rate based on the fundamentals. Imagine there is no Federal Reserve. Where would market forces push interest rates? They were going down rapidly. Russ: So, you are really talking about the supply and demand for credit. Guest: Yeah. The simple limitable[?] funds model, you can think of that. Savings and investment come together; that magic spot. That was falling quickly; and yet the Fed held rates at 2%.
12:48Russ: So, what's--why does that--the first question would be, let's forget about the sort of complex role monetary policy plays in the economy, because we'll get to that in a minute. But, so the Fed holds their rate, that the banks charge each other, higher than what would be the clearing rate for the economy as a whole. Why is that? What's the consequence of that? Guest: Well, let me add to that--that was the first mistake. Let me answer your question and then follow up with that observation. Not only did they keep it at 2--so that clearing rate was falling--they signaled they were going to increase rates. And that's almost more important than where the current rate is. In fact, probably the way you want to look at monetary policy is: Where is the Fed going to go in the future? And if you look at the Federal Funds rate--a future's contract, so there's a contract you can buy that will lock in a Federal Funds rate and you can, you know, get that, lock that rate in, someone will have to lend you at that particular in the future, so these are particular skin in the game. Or these are rule monies[?] at stake here. That got as high as 3.5% in June 2008. So, not only did they stop at the actual rate of 2, but starting in April, that rate, the forward rate begins to go up. And by June 2008, it hits 3.5%. Russ: Because people are expecting an increase based on the Fed's talk. Guest: They are. Right. And let me be clear--that's one year ahead forecast. So, the market was expecting, a year in advance, that Fed Funds would be 3.5%. Now, why were they expecting this? Because the Fed was really talking up its concerns about inflation. So, there were some commodity price shocks. The price level--inflation was going higher because of a temporary disturbance because of a demand for commodities. And that was driving up prices. And so they were, in my view, too focused on that. And they kind of took their eye off the other part: where the real economy was going. And the key, you go back and read their minutes, even as late as September 2008. If you go read their statement that was released, they state explicitly they were just as concerned about inflation as they were the real economy. They were worried about this. And if you go back and read the transcripts, some of them--in the August meeting, they were predicting the next meeting there would be a rate hike. So, again, things are blowing up around August, September, they are thinking of rate hikes. So, that allowed panic to even grow, to fester. If you think the Fed is going to tighten, and there is a run on the shadow banking system, a run on wholesale lending, mortgages are beginning, you know, to default, all these problems are emerging--it's just, you know, taking that sick patient, not pulling that antibiotic shot away from them.
15:27Russ: So your claim is that by failing--they made some errors of commission-- Guest: Absolutely. Russ: But this is really an error of omission. There's a commission piece to it, right? The omission is it should have been lowering rates further. But, at the same time, the commission part was they were encouraging people to think, in the future, they were going to raise rates. In the near future, they were going to raise rates. And your argument is: effectively tightened money. Guest: Yes. So, again, probably the best way to think about the stance of monetary policy is what is the Fed going to do over the next 6 months, over the next year? We've seen this recently. I mean, the Fed, has, beginning in mid-2014 it talked of interest rates. That it-- Russ: It said, 'Any day now, we're going to get out of this.' Guest: It did. Russ: It said, 'The economy might not be healthy enough. We might be able to raise rates soon.' Guest: And they talked, talked, talked it up. Russ: Then didn't do anything. Guest: And what happened is--well, they didn't, but it had an effect. If you look at the dollar, the dollar rose over 20% between mid-2014 and the end of 2015 when they finally did raise rates. And that sudden increase in the dollar had huge repercussions for the global economy, because a lot of countries are pegged to the dollar or are closely tied in some function to the dollar. So, the Fed simply talking up rates for guidance, all that has an effect today. Because if you think you are going to lose your job in the future, today you are going to make changes in your spending plans and your savings plans. And that's kind of the idea here. Russ: So, Ben Bernanke concedes--which is rare, which is a fantastic thing you have to give him a lot of credit for--he has conceded, maybe he didn't have a choice, but he has conceded that maybe that was a mistake, over that 5-month period. Correct? Guest: Yes. In his book. Which is unusual. Guest: Well, I know he's conceded about the September 2008 FOMC (Federal Open Market Committee). I'm not sure about before then. Russ: Right. But he's conceded that they should have lowered rates and they shouldn't have been worried about inflation. Guest: Right. Russ: And they shouldn't have talked up that they were probably going to raise rates soon. Guest: Correct. Russ: So, he's conceded that. But he would not concede--I'm pretty confident, that that really created the severity of the Crisis. So, what would his argument be? What would he say to you? Would he say, just, 'Well, sure, they should have been a little lower. We shouldn't have encouraged talk that we were going to be raising rates, maybe. But that isn't the real side of the economy. The real side of the economy is that the construction sector is collapsing; banks are still going to have problems. I wouldn't have changed a thing important.' What would you respond to that? Guest: Well, again, I would go back to this idea there is these nonlinear effects: that, yes, we are going to go into moderate recession but to go--to have the gradual decline, you know, almost on a dime go sharply of the intensity--the TED-spread, all these things that indicate that something has fundamentally changed in 2008: Break-evens, which is the difference between what a Treasury bond, a nominal Treasury bond trade, the interest rate on that versus the TIPS (Treasury Inflation-Protected Securities), which is an inflation protected--you look at the difference between those, that is the expected inflation rate that comes from the bond market. In any event, that begins to nose dive in the summer of 2008. So, there's something that happens. And Bernanke would have needed to convince me that his actions, which clearly, time-wise, line up--the Fed's actions line up with this sudden turn for the worse--had contributed something else. It could be that people suddenly panicked and freaked out more. But at the best case story is he can say, 'We didn't stop it.' The best case scenario I would say for Ben Bernanke is, he is a school crossing guard, a child is crossing, the economy is crossing in front of an oncoming car and he stops and doesn't do anything. That's the best case scenario. But I think the timing is a hard one for him to make.
19:17Russ: So, we'll come back later, maybe, to this question of what the Fed should and shouldn't do. But I'm going to ask you a tough question, which is: I didn't hear a lot of people at the time saying that the Fed is making a major mistake here that's going to plunge the economy into the worst recession since the 1930s. So, to me, as an outsider--and you know I've confessed on the air, I love this story, for a lot of reasons, one I mentioned earlier. But also: Wouldn't it be great to have a simple key to have a simple key to the economy, a simple knob or dial that we could turn; and this could be it? So, I think we have a natural inclination to want it to be true. But the question is: Isn't this just an ex-post narrative? Like, the next time this happens, are you now smarter? Did you not know this before? Is this something you figured out after watching this and then, now, the next time before it's about to happen, you'll know? And, to put it in historical perspective, I think it was in 2003 maybe, or 2000, at a monetary conference that Bernanke, with Friedman in the audience, said, 'Professor Friedman, don't worry. We read your book, the Monetary History of the United States. We'll never make this mistake again.' And you are saying he did. And the question I have is: First of all, I'm not sure it's true that he made the mistake. But my second question is: If it is true, how can he make it again, and how could you and others standing to the side of him not pick at the Federal Reserve and say 'You are about to destroy the economy and make the same mistake you said you'd never make'? Guest: Well, to be fair, this is Monday morning quarterbacking; I'll completely confess. Russ: Honest man. Guest: I think I was caught off guard, too. There were some things that really shocked me in late 2008. And I have my blog as evidence: when they imposed, interest on reserves, I thought at the time-- Russ: They did what? Guest: They put interest on reserves. Russ: Yeah. Guest: I thought that was--that was when it really hit me they were going the other direction. In fact, I think one of my first posts, I criticized the Fed for being too easy. So, my view has actually changed. I learned a lot in this Crisis. I'll [?]. But I do think it's important to learn from history, just like Friedman and Schwartz. Their understanding of the Great Depression wasn't the current understanding at the time of the Great Depression, or even a decade after. It takes time to learn from our mistakes. Russ: So, now we have two data points. We're getting the hang of it. Guest: I would say part of the efforts I have made--Scott Sumner, even George Selgin--is we do need a better indicator, a better measure, a better approach to monetary policy. And we can talk about this later. But if they've been looking at things--again, for-looking[?] asset prices, break-evens, but even things like nominal GDP (Gross Domestic Product] targeting, total dollar spending, it was beginning to slow down. Maybe we can save that conversation for later. But I want to be fair: this is Monday morning quarterbacking on my part. But I do think it's important we do this to see where they made these mistakes and hopefully nudge policy in a better direction. Russ: I just want to put a plug in here for bias. When you are biased and you have a pet theory, it does encourage you to go out and find evidence for it. Then you can assess whether--well, is this like the worst case of cherry-picking for all time, or is this like, 'Wow. I never--I hadn't thought to look for that; now that I found the inclination to find it, and I have found it, does that encourage me to take my ideological priors maybe a little more seriously?' And if I don't find it or if it's really hard to find or if the case is kind of farfetched. So the question is--one obvious question at this point is: It's an interesting approach; it hasn't convinced Ben Bernanke. There is a growing number of folks, I think, which is interesting, who are worried about the factors you are talking about. In particular, looking at nominal spending, nominal GDP, as a measure of the health of the economy or as a guide to monetary policy. But you've struggled to convince the skeptics that this is decisive. Is that a fair assessment? Guest: That is fair. And that's why I continue to plod away. But if you look at even Bernanke's own work prior to joining the Fed, he did work on Japan. And he acknowledged--a couple of places he said nominal GDP and inflation are two measures together you should look at. When he got inside the Fed--even if everyone in the Fed, on the Board of Governors, adopted my view, it's a big institution. It takes time to change their views. You can't stop a ship quickly and turn it around. So, I think that the game plan is maybe to educate, to help understand better what's going on. But even in the Fed they had a discussion, in Ben Bernanke's book, about nominal GDP targeting. Some of them liked it but they thought it was too difficult mid-stream to change courses and go onto something like nominal GDP targeting.
23:53Russ: So, at the heart of your story is a puzzle I think for most listeners, which is that interest rates are not the best guide to the tightness or looseness of monetary policy, but rather the relative magnitude of interest rates to a so-called natural rate that would, say, clear the credit market. In real time, almost impossible--well, always impossible to know what that natural rate really is. Is it then the case that this idea is not a very actionable policy guide for the Fed? And in particular it seems like an awfully difficult policy guide. And it raises a related question which is, does the Fed really have control over interest rates? I think they act like they do. Some people believe that they do. A lot of people--you'd be one of them--are skeptical about that. So, why don't you start there. What control, if any, does the Fed have over interest rates? And then, if it does not, which I think you are going to conclude, how is it possible to find that natural rate to avoid these kind of either bubbles being created or bursts based on mistakes? Guest: Okay. So, it is difficult to know what the natural interest rate is in real time. There are attempts, though. There have been people who attempt to measure it. Even the Federal Reserve has their own internal estimates of what that short-term natural rate is. There is also what they call 'medium terms.' And different people have released these measures. But they are all estimates, with wide standard errors. And they all acknowledge. So I do think it's difficult. But given we have central banks that target interest rates it's still useful to have some kind of benchmark. So, Janet Yellen in a recent speech late last year, released a figure that showed some estimate from the Board of Governors that provided like a point estimate of it, with these bands of confidence that are pretty wide. Russ: Better safe than sorry. Guest: Yeah. But even with those, you could see it was negative; and slowly going up. At a minimum it would be nice to have the Fed report those and say, 'Here's where the Federal Funds Rate is; here's where we think the market-clearing natural rate is.' But I agree; there's always going to be a question. Which then leads me back to why I would actually go to something like nominal GDP targeting. Maybe alter the monetary base. Maybe we can save that question for later. But back to your question on: Does the Fed control interest rates? Well, it has some influence in the short term over rates. I mean, I've argued along with George Selgin in a paper recently that we think the Fed did keep rates below the--in the short term for a little bit--below the natural rate in the early-to-mid-2000s, and that added fuel to the fire of the housing crisis. But over the long run I think it has very limited control. If the Federal Reserve cares about inflation, then it's going to have to follow the natural rate. The natural rate is kind of, again, this market-driven, clearing value for interest rates. And if you want to have price stability or aggregate demand, nominal spending stability, then where that goes, the Fed's going to have to implicitly follow that. And I think that's very evident in the last 7 years. So, in the last 7 years since the Crisis, the economy was so weak, there's so much concern, risk aversion, that the natural rate, the market-clearing rate, I believe went negative. It fell down below zero. And people who talk about the Federal Reserve artificially holding rates low: I think they are wrong. I think they are completely wrong. What the Fed did was it followed: so, the market-clearing rate is falling below zero. Well, the Fed can take it as low as zero, because it's zero, if it tries to go below that--and we've seen, there are several banks attempting this--but if you get to zero, at some point below that, people would rather hold cash than earn a negative interest rate at their bank. Now, there's storage costs: it's not going to be quite zero. Maybe -2, -3%. But at some point, it would be better to-- Russ: Holding costs are pretty much offset by the possibility of your house being broken into. It's not a very secure system that you have. Guest: It's not. Russ: They're going to find that book on the shelf that's got your fake pages with your money in it. Guest: It's incredibly inefficient-- Russ: That's what my dad does. He actually uses a real book. Very clever. Guest: Well, not everyone knows. Russ: Yeah, exactly. Don't tell anybody. Guest: But it is incredibly inefficient. But, one way to look at the zero lower bound, what is called the zero lower bound, is: It's a price floor. Right? Any good capitalist worth their salt believes in letting prices reflect fundamentals basically should be against this constraint we have called the zero lower bound. Now, usually we don't get to it. Great Depression, we hit it. Great Recession. Usually it's not a problem. But when it is a problem we see the limits of the Fed's ability to control interest rates. Let me follow up with this observation: So, people have been really critical of the Fed, it's QE (Quantitative Easing) programs. And I was supportive early on. But I've actually grown a little more skeptical of what they actually accomplished. Russ: It seems to me very little. Guest: I think in retrospect not a whole lot. Russ: Creating some really interesting diagrams, charts, with big spikes in them. When I look at the Fed's balance sheet, it's like, 'Wow, they really changed the vertical axis there.' Right? Guest: It does create some graphing challenges. I do think QE put a floor under the economy and it helped keep inflation where the Fed wanted it to be. But I never--I don't believe it could have ever created a robust recovery. But let me get to this observation about the Fed's purchase of Treasuries. So, people were alarmed or worked up, waiting for hyperinflation. But if you look at marketable Treasuries--which is about a little over $13 trillion now--so you often hear about $19 trillion--that's the total public debt, and some of it is held by Social Security, government holdings. But the actual marketable Treasuries that the government is liable to pay, has to pay a real tax burden on, the Fed holds about, right now about 18% of that. And that's how much it held before QE. So what's interesting is during this period I mentioned, they sterilized its balance sheet: it was selling off those Treasuries. And its holdings actually went down quite a bit. So, people who got worked up under QE-2 when the Fed bought up a bunch of Treasuries--well, they should have been equally worked up when they sold off their Treasuries. If that's easy, then in 2007, 2008 there should have been massive tightening. But in any event, the Fed holds now about the same number of Treasuries as it did before. So the large run-up in public debt, this huge run-up in public debt that has people worried, was funded largely by entities other than the Fed. It was funded by foreigners; it was funded by you and me. Our life insurance companies, our banks. We're just as responsible for the low rates that you see on the government debt, and foreigners, as the Fed is.
30:30Russ: So, I'm totally mystified by that. So I'm going to stop you there. Let's go a little deeper into it. So, if you look at the data, the interest rate has fallen steadily, around the world, for a long time. It didn't, like, plunge down and stay low. It's just a slow decline in interest rates--I should more accurately; I hate it when people say 'the interest rate' because there isn't one. But there are a lot of different ones for different risks and different types of assets. But they seem to be falling steadily. You want to attribute that, I assume, to fundamentals. Correct? Guest: Yes. Russ: Market forces. Not the Fed. Not central banks. Guest: Well, mostly market forces. On the margin--you know, the Fed may be tinkering. Russ: Right. Guest: But that's to me the best case scenario. Russ: So how do you understand that? What would drive--and in particular, now, when you suggest, or recently--and you are not alone; a lot of people have argued this--that market rates--the market-clearing rate needed to be negative. What does mean in terms of fundamentals? And how do you understand that in a world where people--where we have all kinds of investment activity going on all the time, with rates of return that are at many times positive, in the United States? What's that mean, that interest rates were close to zero or negative? I really [?]-- Guest: Well, it means that on a personal, practical level that there people out there that are so worried, risk averse, they are willing to give Uncle Sam $100, and pay me back $95 in the future. I'm so worried about preserving capital, preserving the principle amount, that I'm not worried about getting a positive return on it. Russ: That's not enough. What I really need--it's true, I can get a positive return if I take a little bit of risk. And I can understand where people were very risk averse. I don't live in that world, by the way. Most of us don't. Most people are sitting around thinking, 'Gee, where can I take some risk and get some decent money.' Now, I don't want a lot of risk. Obviously there's a tradeoff. Guest: Sure. Russ: But I don't understand this idea that people were so risk averse that they were willing to just accept low rates. Doesn't there have to be a change? I know there does. It's a rhetorical question. There has to be a change in people's willingness to borrow or save. And which piece of that do you use to explain this long, secular, downward trend in interest rates? One thing that would cause that would be a lack of interest in investing. A lack of interest in risky investing. Anxiety about the future. Yes, there were times like that. There have been times like that throughout human history. Throughout the last hundred years. And in those times, maybe interest rates were lower. But they don't go down there and stay down there. Eventually people recover and start taking risks again. Are you suggesting there was a huge increase in savings that drove this? Was this the giant pool of money that you hear in the National Public Radio version of what caused the Crisis? Guest: The savings glut. Russ: Yeah. I don't understand that. Where is it coming from? Guest: Well, I think there are several things going on. So, there is a longer term trend that you would refer to and I would call those 'structural factors.' What I was referring to here more recently is more the cyclical ones. But the structural ones have been--the world has grown rapidly with globalization, and a lot of these places have grown: China, Asia, their income, their modalistic[?] income has grown faster than their capacity to produce safe stores of value. They don't have the institutions, the deep capital markets we have. You're right: my portfolio is not going to be all just safe assets. So we diversify. But of that portion that-- Russ: It's a point, but when I'm 40 or 50 years old, 30 years old, it's not-- Guest: Right, as you get older. But for a young person, in Asia, there's still some portion of their portfolio that they want to preserve that's very safe. Russ: Sure. Guest: And they can't find it at home. And so, part of the story is, as the world has become more integrated financially, there hasn't been a commensurate increase in financial deepening. They don't have the same markets. So, naturally, places around the world go looking for a safe bank, a safe place where they can hold, safe--they get liabilities from a financial institution. And the United States is it. As well as the United Kingdom, Germany. They all provide safe assets. But the world has grown more rapidly than has the capacity to produce safe assets. So there increased pressure on the places that can produce safe assets to supply more. So, the demand for our Treasuries--that's one of the things going on. I believe it's globalization. The other part-- Russ: Just to--again, let's pause for a minute, the micro side. As people are demanding more, say, Treasuries--relatively safe assets--that pushes down the yield that the Treasury has to offer on a bond. And therefore interest rates are generally going to be lower. Guest: Yeah. Russ: But that's not safe assets. What about the rest of the world? What about building a house? Starting a business? All the things that people lend and borrow money for throughout healthy times? Why should that be so low? Guest: Okay. Well, because these safe assets are kind of the basis for all other interest rates. There are, you know, we talked about-- Russ: Anchor it[?] Guest: They anchor. We talked about, you know, what is the key pricing mechanism for financial markets is the Treasury yield curve. You always price a few basis points, maybe it's 100 basis points, above whatever the Treasury gets. Or, if you get a loan, it's so many points above LIBOR (London Interbank Offered Rate), and LIBOR is kind of based on Treasuries. Russ: So if you got the Fed--excuse me--if you got the Treasury out of the borrowing business--if the U.S. government ran a balanced budget starting now--a dream for some, a nightmare for others. But if that happened, you are suggesting that there wouldn't be a lot of safe assets. Right? They wouldn't be available. There would be a shortage of those. People would be forced to put their money into riskier things. They'd be unhappy doing that. They are not going to just spend, though. I assume, they are still going to save. They are going to have--they have to live in the real world, where investments are risky. That's something that happened for, again, most of human history--investment is taking a chance for tomorrow; and you get a return on your money. Would that have been a problem? Would there be a long--excuse me, a long secular trend in falling interest rates in the absence of U.S. government Treasuries being available? Guest: I think there would, at least for the structural components. It's an interesting question. I don't know the answer. I've thought of this myself. Would they go to gold? Would they--is there enough supply of other assets that are considered safe? We had this question arise in the late 1990s when we ran budget surpluses. There were people kind of freaking out: What are we going to do without Treasury Securities? But there is-- Russ: I don't get that. I find that mysterious and weird. I mean, I understand it's nice to have a sugar daddy or a safe home or a sanctuary. But it's fake, first of all, because the U.S. government could go bankrupt. It's not literally safe, right? And-- Guest: It's comparatively safe. It's safer than any corporation on the planet. It has the ability and the resources far greater than-- Russ: the power of the gun, yeah-- Guest: In tax base, absolutely it does. Russ: But institutions, relatively. Guest: I guess so we have, you know, globalization, also aging demographics is also part of the story, I think, long term. China, if you've been reading, has demographic issues, as well as the United States and Europe. Those are kind of the long term, structural stories. And then you have the Crisis in 2008. So, I've shown this picture on my blog and other places, and other people have reproduced it; but since 2008, that descent has accelerated. It's gotten even sharper. So, Switzerland right now, like it's 10 years close to -2.5%. It's hard to fathom a 10-year--Germany, it's close to like .20%. There's really low yields over there. On one level it's very puzzling how all these people are--why people so want to embrace us. But apparently there is. I do want to mention though that these safe assets are not just people wanting a safe store of value. There is also a place for them in the shadow banking system, what I would call institutional money markets. So, they effectively function as money. So, Gary Gordon tells a story--and I kind of buy into his story--that we had this run on the shadow banking system. People begin to question what was behind their repos, what was behind mortgage-backed securities, playing the role of Treasuries; and they panicked, they ran. And there was a sharp decline in money supply. When the collapse of shadow banking occurred, it was very similar in spirit to what happened in the Great Depression. In the Great Depression, there was all retail. Russ: Right. Guest: So, we have--these safe assets-- Russ: Bank runs. Whereas this is a shadow bank run. Guest: Right. Shadow bank. So, there is the--I think a money story going on here, too. Another way of saying a safe asset shortage--that kind of pulls[?] my monetary instincts--is there is excess money demand for these safe assets. They facilitate transactions for institutional investors. And in the absence of them--there's another, I think, reason since 2008 the Crisis--I think there's new regulations that have made it--banks have to hold more safe assets. They could add political uncertainty to some of these discussions. There are a lot of things going on since 2008 that I think intensify the demand.
39:36Russ: So, let's go back to the--try to bring this full circle back to the earlier conversation. See if I understand this. I just want to clarify some of the microeconomics of this safe asset issue, and if they didn't exist. So, if they didn't exist, there would be riskier assets to choose from. And a large increase in world saving, say, due to growth, unexpected and large growth in large parts of the world that were stagnant before. That's going to push down interest rates across the board for all assets. They're not going to push them down as low as Treasuries. But that would be the normal set of events that would happen if suddenly there were people who were saving more and looking for investment opportunities. Then yields would fall over time. And that would be a good thing--not literally a good thing in and of itself, but a sign of--that's only an effect; it's not a cause. The cause is the world is getting richer; people have some excess funds for the first time ever in most of their lives; they are looking for places to invest them and in trying to do so they push rates down. That's all fine. But bring it back to our earlier discussion, you are suggesting that the mistake that the Fed made is they didn't realize how low those market-clearing rates were. They chose to hold the rate, the short-term rate that they do control, above the rate that would clear the market in the absence of that. Why is that so bad again? I already asked you this, I think, but what's the problem there? What does that encourage banks to do, given that the Fed has made this "mistake"? Guest: Well, there is a direct and indirect effect. The indirect one is that it's signaling that the Fed's going to be tight going forward. And that reinforces the panic, the fear; they begin to hoard money; people don't spend as much. I think it sends a signal, and a big part of-- Russ: Expectations. Guest: Absolutely. The direct effect is, it's putting a direct choke on economic activity. If the return on some investment--if I'm a firm trying to decide whether to build a new plant, I look at the return on capital. And if it's falling well below the financing cost, if the Fed has rates up here--and again, in the long run the Fed's going to lose control of that, but in the short run, if the Fed has rates above what the probability is on some firm--the firm that's not going to build the plant; maybe there won't be jobs; maybe they'll fire people. Russ: So, are you arguing that--I continue to be mystified by the Fed's decision to pay interest on reserves. I continue to be mystified by the fact that banks are holding massive--massive--excess reserves rather than investing them. Which is all related to what we've been talking about. So, I don't understand that. And you are suggesting that the Fed encouraged--let me try to spin a story and see if you like this, because I hear this sometimes: Well, the reason that the banks hold all these excess reserves is they can't find anything to do with them. So, until 2008 or so, in this Crisis, textbook monetary theory, banking theory, said the Fed requires banks to hold a minimum amount of reserves. Of course they wouldn't hold more than that because they are just sitting there, not doing anything. And then, so they lend those out; and the claim has been that now that these banks have all these excess reserves they are going to soon get rid of them--inject them into the economy. That's going to cause the inflation that all the monetary theorists have claimed is coming--it hasn't, but they say it will be coming. And people like you and me--at least I feel like [?] you and I exempt ourselves from this--but we say things like, 'Well, it would have gone into the economy, but the Fed offered interest on them, so they just sit there; and then the Fed's really basically neutered itself. That's the reason Quantitative Easing accomplished so little. They injected all this cash into the banks; and then they encouraged banks not to do anything with it.' The skeptic says, 'Yeah, but the rates are so low it's not really worth it. It's just an extra tool the Fed created; it doesn't have any real effect.' What do you feel about that? Guest: There's truth in both of those stories. Early on--I think the first part of the story is right that the Fed hit that, introduced some reserves--it was a binding constraint. They did encourage banks to put their reserves at the Fed, as opposed to in the economy. But then the indirect effect would be that as part of the bigger tightening cycle that it was doing caused the economy to collapse. And as the economy collapsed, then the return on capital, profitability, they all go down. So I do think if the Fed got rid of interest on reserves, 2010, 2011, you probably wouldn't have seen an explosion in lending. The demand for borrowing just wasn't there, because the economy was so weak. So I think interest on reserves early on did put a binding constraint or caused banks to reallocate their investments towards the Fed as opposed to the economy. But that helped spiral things down so far that even if that was removed they wouldn't be interested in putting those funds to work somewhere else because there wasn't demand for those funds in the economy. Russ: Is it possible that the collapse of the housing market being as large as it was, and the backlash on the part of the government in changing credit standards, which they did very dramatically--having loosened them to very, to absurd levels, they then said, 'Oh, that was a mistake; now we're going to be very vigilant about who gets a loan and we're going to put a lot of restrictions on banks who make a lot of bad loans.' Is it possible that there's a microeconomic reason that banks are less aggressive with their excess reserves? I mean, the standard story is they are all nervous. 'Are they crazy? What do you mean, they are all nervous? Economy is doing okay. It's just an ex-post story. They are always nervous. Nobody wants to lose their money. Economy is growing. Why aren't they lending the money out?' And could one argument be that a lot of what they lend that money out to do is to buy new homes? Build new homes. And home building fell off a cliff, stayed on the floor; and the government's restrictions on credit-worthiness made it very unpleasant for banks to take risks that they normally would have. So there were people who wanted loans; there are banks who would have provided them in the previous regime--and even in the regime pre-crazy times. But, as an over-reaction to the credit easing and credit monitoring that they had imposed before, that that's part of the problem. Guest: Oh, absolutely. There's definitely supply side stories going on, I think: We were too risk-loving overall--regulators, borrowers, lenders--before the Crisis; and afterwards I think it's swung too far the other way, that the heavy regulations have--yeah; banks are far more careful. Far more documentation and all those things. But on top of that I do think the weak economy and the policies that the Fed has pursued since the Crisis has also made banks less than eager to engage. Again, I view it kind of from the demand for loans. They may not be as strong as they otherwise would be, had Fed policy been more appropriate.
48:48Russ: So, let's turn to what the Fed should do going forward, or what the Fed should do in general. Or what the Fed's mandate really should be. The Fed gets, in my mind, way too much attention, treating them as if they do control the economy. Even though I'm sympathetic to your story to some extent I really don't like the idea that somehow everything depends on wise monetary policy: If we get that right, everything is going to be hunky dory, and if we blow it, we're going to have big problems up and down the asset market. So, there are a lot of different ideas for what the Fed could have done, or what it should do going forward. Where do you, what do you feel about those things--like the Taylor Rule, or since we are sitting in the Center for Monetary and Financial Alternatives--I hate to use the g-word, but should we think about a gold standard, which like, in some circles brands you--you may just walk around with a [?] written on your forehead. What are your thoughts on where we ought to head going forward? Or do you think we should stick with the current system and the Fed just needs to be more vigilant about where they put the Federal Funds rate? Guest: The starting place for me--the Fed needs to be more systematic, more predictable, more rule-based. And I--part of the reason we do pay so much attention to the Fed--I mean, I'm guilty. I get on Twitter, I turn on Bloomberg TV, I'm live-twitting Janet Yellen's press conference-- Russ: Do you check your investment portfolio often? Guest: I don't. It's more I-- Russ: I'm just curious--is it like a systemic personality disorder related to financial things? Guest: No. I think it's because I found my tribe on Twitter: when Janet Yellen starts talking, we can speak to each other, criticize her, whatever our views. So I do think it's important to go more rules-based, systematic approach. If you look at the history of QE or 'forward guidance' it was made up as it went along. Now, again, maybe if I were in the Fed--it would have been tough to make it more systematic. But as a guiding principle going forward: We want the Fed to be able to respond in a manner that everyone can anticipate. We don't expect the Fed to know the future, but we should have some idea what the Fed would do under different circumstances. So, more rules-based would be the first thing. Russ: And what does that mean, when you say 'rules based'? Guest: That means the Fed says, 'Look, Scenario A, we'll respond in a certain way; Scenario B, in a certain way.' And the Taylor Rule would be one manifestation of that. So, the Taylor rule provides--for our listeners--a way of how the Fed should adjust the Federal Funds Rate in a systematic manner to changes in inflation and to changes in how fast the economy is growing. And it's been a useful, maybe, benchmark tool to look at. But it has some problems, as well. The output gap, which measures how hot the economy is, is imprecisely measured and definitely not measured precisely in real time. And so there is a--part of this is a knowledge problem. Hayek's knowledge problem. Simple bankers don't know in real time what to do. So, I want a rule-based approach, number 1, but one that can offer it within the fact that we're ignorant. And I think nominal, a nominal spending rule, nominal GDP rule, where the Fed aims to stabilize total dollar spending and the situation where they do that, they are like, 'We don't know what's happening on the real side of the economy. We're not going to pretend to know. We're just going to put the economy on a path where total spending grows at a stable path.' Now, one of--if you flip to what they are doing today, where they are really focused on inflation: Inflation can respond to changes from the real economy, supply side shocks as well as demand shocks. And in theory, the Fed should just focus on demand shocks. But in real time, how do you know which is driving what? And that's the knowledge problem. And with nominal GDP targeting or total dollar spending, you put aside that knowledge problem and say, 'Look, we're just going to focus on demand. On spending.' And that might mean, you know, one period, if there's rapid productivity gains, maybe things are cheaper so the spending goes farther. If there's a negative supply shock, maybe oil gets more expensive or there's a war, well, there's the same amount of spending on fewer things. So things get more expensive. But let the markets' real side sort out how that spending gets allocated. But just focus on spending. You think--the total dollar spending, it's a nominal measure; it's money times velocity. That's what the Fed should be focused on in going forward. Russ: So, let's get in a time machine. Guest: Okay. Russ: Whoo! And we're going to go back to April 2008. And you are not a fly on the wall in that Fed meeting. You are sitting in the room, and you are saying, everyone's--I've got those Minutes; I've never read them. You, and Alan Meltzer has. There might be a few more people. But I know two people have. And they are saying, the people around them are saying, 'Gee, it's scary; I'm worried about inflation. I think we should hold rates. I don't think we should lower rates. If anything we might think about raising them. And if we don't raise them, we ought to at least mention that we are thinking about it, because we want to keep that inflation from going off out of control.' And of course as you do know, in human history, when inflation has gotten out of control it's a devastating-- Guest: sure-- Guest: destructive economic force. It has a very powerful effect on real activity that's horrifying. So, that's a good thing to worry about. Then they turn to you, David, and they say, 'What do you think we ought to do?' And what would say, and what would you use to justify it--now that you are so smart? Guest: I don't know about that last part. But what I would say-- Russ: Smarter. Guest: I'd say: Based on my time travel with Russ Roberts, here's what we should do. I would point out that the current inflation shock is supply-side driven--it's a commodity response. That temporary spike in inflation was driven by supply side changes that were temporary; they are going to abate. Even--to some extent the Fed knew this. And I would tell them: Look, we need to be more focused on what's happening to spending. On spending. And even if you want to stick to inflation, why not look at what the bond market is screaming at us? So, again, by that time, the expected inflation from the bond market was, is fallen off a cliff. And, you know--this is not quite accurate; I'm going to exaggerate here. But it's as if the Federal Reserve was driving a car looking in the rear view mirror at, you know, 'Headline: CPI (Consumer Price Index) inflation is high because of commodity prices,' as opposed to looking forward at what the market--the market is screaming, 'There's a cliff ahead. Stop! Stop! Do something.' Russ: Here's the big challenge. Right? Here's the hard, $64 thousand dollar question. So, now, you would point out a bunch of stuff that, ex post, with the benefit of hindsight, you see gave some indication that inflation was not a problem. That they were wrong. I'm sitting next to you in the room, and I say to you, 'Well, we have this knowledge problem. It's nice; yeah, there's some evidence that this was just a supply shock. But I've got this other evidence--which you haven't told me about, but I bet it's out there--that says: Now, actually it could be a real, this actually could be a serious problem, that money has been too loose. Even though it doesn't look that way. And now it's time to think about tightening. Which is to say, when it's 2023 and you are the Chair of the Federal Reserve and we won't speculate whose Administration it is--too depressing--but just leave that alone. 2023 and all the people have said for years, 'Oh, we are sitting on another crisis.' The crisis comes along. You are Chair of the Fed. And you are trying to decide whether to tighten or loosen. You are trying to decide whether to move the Federal Funds Rate up or down. And you've got 9 million data points. Which point in different directions. So, you're thinking, well, there's a lot of discussion around there, so what to do? And nobody knows. And so you think, 'Well, I'm going to err on the side of caution. I'm going to make sure I don't have inflation happen on my watch.' And you make the same mistake that you say Ben Bernanke did. Isn't that a real possibility? Guest: It is a possibility. However, I hope by that point we'll have moved to nominal GDP targeting. And you just have one metric to look at. You don't have all these other data points. And if we're even luckier than that, more fortunate, we might have Scott Sumner's nominal GDP futures contracts. Which would be really be the market telling us where the market is going, not just nominal GDP data.
54:57Russ: So, let's speculate in our remaining few minutes about the pursuit of truth here, and how we know what we know. We're now 80 years out from the Great Depression. In the first, I'd say, 30 years out of it there were a bunch of crazy theories that had proponents. Guest: Right. Russ: They all kind of fell by the wayside. More or less. And were demolished by an extraordinary piece of empirical work by Friedman and Schwartz called The Monetary History of the United States, that allowed people to seriously claim that it wasn't all that all that other stuff: it wasn't a stock market speculation; it wasn't the greed of the banks; it wasn't farmers' over-speculating with land buying. It wasn't whatever your crazy theory is of the Great Depression. It actually was just a monetary failure. And a lot of people believed that. That idea, which, you know, I was raised on, and many economists were raised on, is now, I'd say much shakier. A lot of people right now own[?] that, 'Friedman and Schwartz, they just didn't know what they were talking about. They were wrong.' Etc. We're now 10 years out, almost, from the Great Recession. We are going to spend the next 50 years in this so-called social science of ours debating where the problem came from. Do you think that your explanation will gain adherents going forward? Or will it struggle, as many theories have, to explain what happened? Will make any progress there? Guest: I'm pretty sure it will be a long struggle to get this idea articulated. I am hopeful, though, because even people on the Left, like Paul Krugman, they see the collapse in aggregate demand or nominal spending. They agree there is a spending problem. Russ: The question is what caused it. Guest: What caused it? Russ: Could it be fixed? Guest: Right. Russ: Could a spending collapse be fixed by, merely by the Fed saying, 'Oh, don't worry. We are going to induce a spending [?]'? Guest: Oh. Absolutely. You know. So, I do see more and more people come out in favor of it. So there is, I think there's some common ground we can build off of. But on top of that, there's been prominent endorsements of Christina Romer, came out in front, for it, in 2011. Michael Woodford, probably the most prominent monetary economist alive today had a speech at Jackson Hole, Wyoming, where all the big ideas are often released, where he advocated for nominal GDP targeting. There have been people slowly making this argument. What I think will be difficult will be to get, maybe a broader support, a broader base for this. Because telling this story about inflation and money is a very complicated--you know, I play basketball; I'll think of [?] my church; and they are always asking me questions that--you know, 'Interest rates high? Or low?' Russ: They ask me, too, and I wouldn't know less. I don't know what they are thinking. Guest: It's hard. Like, one guy asked: 'Isn't low inflation something we always want?' I say, 'Well, it depends.' And he's like, 'What? What do you mean, it depends?' And I don't have time--so I think part of our struggle is just to educate--and maybe this will be a 50-, 60-year struggle. But if we can get to the point where we can show people that the Fed should focus on their dollar income growth, stabilize their dollar income growth, as opposed to being fixated on how much things cost--if we can somehow get the focus shifted over there through time--that's my hope. That's the way--if we can get there, I think the world will be a much better place.
58:27Russ: So, let me ask you a trickier, weirder question. You and I probably agree that it would be foolish to hope that politicians would do what is best for the country rather than making sure they get re-elected--if they conflict. We would say, 'Well, human beings, institutions, we don't expect--it's silly to expect things that are not reasonable to expect.' We understand public choice. We understand incentives. So, our profession would never, I don't think, push relentlessly for a program that would convert the most prominent macroeconomists in the country into something of a robot. Right? There's something really fun about being the Chairman of the Fed where you are steering this great, massive ship with all kinds of dials and levers etc. So, one of the challenges of this approach is that the proponents of this approach, people like you and Scott Sumner, are on the outside--right--and suggesting that people on the inside should behave differently. And they are not really so motivated. They kind of like the current system. How would you overcome that problem? And I ask that because, might it not be better to champion a different monetary system altogether, that wouldn't rely on human beings trying to pretend they are robots--because they are not so good at that? Guest: And there have been people championing alternative monetary arrangements. I think that's an even bigger struggle. And even tougher-- Russ: problem-- Guest: I mean, Scott and I, even George--we are on a path that is even between those two points where it's feasible that nominal GDP targeting could one day be what the Fed targets. It's mainstream. The idea is not novel to us. It's been in the literature for many years. Russ: Since Hayek. Guest: It goes back to Hayek. But it was a prominent discussion in the 1980s, before inflation targeting came in in the 1990s. So it's not a strange idea. There's been people who like it. There's just been some practical questions: how do we implement it, and just the inertia of the current system. I think there is a way to do this. If we can get, Number 1, get to the point where they accept Nominal GDP Targeting, and then, Second, if we can go to Scott's idea of Futures Targeting--now there's where I can see some big tension. Because at that point it does become automatic. It becomes, based on his system, futures contracts, that sells by futures contracts, it automatically leads to an increase and decrease in the monetary base, which could put things relatively on autopilot. It would make, you know, certain Fed functions less important. And there would be this incentive problem that you've talked about. Because it would undermine, you know, well maybe, lead to vaster research staffs-- Russ: It reminds me a little bit of asking the umpires whether they think it would be better to have a computer calls balls and strikes. Right? Because they do want to get it right. They want it to be accurate. And certainly the computer does a better job? But strangely enough, they don't think it's good for the game. And many other people don't, either, by the way. But this, I think, would be a different case. I think there'd be a lot of people who'd like to see a different approach. But I can understand that the main people who would market that approach and who would sell it to the American people and the politicians might have a conflict of interest. It's kind of interesting. Guest: You are absolutely right. And it's quite frankly disappointing that we have gone through a great recession and we are still sticking to the old methods. The old ways. I mean, if you look at the Eurozone, I think they are suffering too because of the inflation-targeting approach they've taken. I think the Fed as well. So, I would hope that we would learn from this experience. It doesn't seem we've learned a lot. But there are some signs of progress. Some people are thinking beyond inflation-targeting. So, going forward, I hope we do make progress. Russ: Are you optimistic? Guest: Slightly. Again, maybe not within my lifetime. Russ: Ah-hhhh. Guest: I mean, [?] Russ: I don't call that optimistic. That's very. Guest: Take the long view, Russ. Take the long view. Russ: Would you say your children's lifetime? Guest: Yeah. Yeah. My children. Russ: I don't want to go to [?] your grandchildren. Guest: Maybe I'll be a retired professor with a cane and I'll be doing my victory lap out in the yard. But you know, I think it's going to take a while. I think it's the nature of the beast. It's an institution. Those bureaucrats. There is educating to do. There's just a lot of barriers to cross. But there is, again, there is hope. There is progress. Prominent people are advocating this; [?] not [?] completely new idea. It just takes time to change that big, you know, shift: you've got to slowly move it back towards nominal GDP targeting.

COMMENTS (35 to date)
Nonlin_org writes:

Sorry, this has been a very boring discussion about optimizing what you don't understand let alone control. This shows that at core, all economists including those self-titled libertarians are tyrant wanabees.

As always, economists of all stripes miss the PURPOSE of money which is simply to facilitate the exchange of goods among people, NOT to stimulate the economy, to drive a bus, act as sex partner, or any other craziness of this sort.

Let money do its job (whether people want to use gold, bitcoins, USD, or cow hoofs), and let the economy self adjust with the only goal of keeping a level play-field and no concern whatsoever for optimizing the unknown and unknowable. You might be positively surprised in the long term. Yes, many economists would be out of a job or may have to work for (gasp) a private employer. Can you make this sacrifice?

macro_man writes:

[Comment removed for supplying false email address. Email the to request restoring this comment and your comment privileges. A valid email address is required to post comments on EconLog and EconTalk.--Econlib Ed.]

camille writes:

In relation to individual responsibility versus how individuals react to systems or organisations, and particularly related to the previous EconTalk "Leonard Wong on Honesty and Ethics in the Military", I think one blind spot of economic analysis is the overstatement of an individual's ability to make free choices. The Ethics in the Military discussion is a good example because the military provides a clear (even if somewhat extreme) example of of a system where rules and and rule makers give out edicts for how individuals should behave, however there is no direct connection between these rule makers and the majority of individuals in the system who have to follow these rules. The 'no direct connection' part is significant in as far as the person following the rule can't turn around and ask "what do you mean by X?" and seek clarification from a rule maker to ensure they exercise their duty in the way that was intended (a similar problem arises when you have a conflict between two or more rules/obligations).

This relates to any economic analysis more broadly when we fail to take into account how a system (an interlinking web of people, rights, responsibilities, hierarchies and obligations) impacts the choices and behavior of an individual or group of individuals.

Taking it back to the Military example for simplicity - the fact that a solider might lie about complying with dozens of different training and administrative rules does not necessarily bring in to question that soldier's ethics, it doesn't mean the solider has become numb to lying, or that he/she is picking and choosing which rules to follow to suit themselves. What is does mean, if it is a widespread occurrence, is that there is a system failure whereby those who are in a position of responsibility or in a position to affect change, have put in place a set of rules which cannot be followed thereby potentially undermining the intended effect of each rule (as with a complex system of rules it will not be clear which are being carried out honestly - rather than just on face value - or not).

Blaming the undesirable situation on the soldier's ethics is as though we are saying that the many more senior, more experienced, and better paid men and women who were putting these rules in place do not hold a responsibility for their actions which effected many, rather it is the most junior person in the chain who is somehow found to have lacked ethics in dishonestly filling out administrative forms and regulatory procedures which in their sum total would equate to more hours in a day than readily available, keeping in mind the solider still has a day job to complete.

With this in mind, is it not the responsibility for those issuing rules and requests to do so somewhat mindfully of the consequences of those requests, rather than the responsibility of the person with the least power and agency in the system to somehow field an innumerable amount of requests destined to always, at some point, fail to do something in the constant quest for prioritizing the infinite variables and responsibilities that arise in any system.

This doesn't detract from an individual's responsibility, but raises the question of when we apportion blame, especially on a person with the least power in a given system, we assume that that person has more free will, choice, and free time than exists in reality, and we also forget who actually holds the responsibility for good outcomes in that system - and good outcomes are almost always reliant on having some cognisance of the real constraints and real motivators of people at the bottom of the hierarchy.

Kent Lyon writes:

While focusing on and attempting to understand the impact of the Fed's actions or inactions is important, this podcast leaves one with the impression that the over-riding understanding of economic rhetoric as elucidated by Deirdre McCluskey, has been lost on economists, who miss the forest for the trees. The response to the financial crisis was predominantly anti-bank and anti-business and anti-free market rhetoric, followed up by ham fisted attempts to stimulate the economy with a massive spending bill that was a shotgun approach if there ever was one, and did nothing except increase public debt and thereby likely adversely affect the economy generally, but also insane regulatory expansion based on the rhetoric that the private sector is evil. Between the rhetoric and the regulatory action, one can understand the reluctance of banks to lend, the reluctance of business to invest and expand, and the reluctance or ordinary individuals to assume risk in investment. The heavy and damaging rhetoric accompanying the financial crisis is perhaps the most important factor of all. One might note that the Great Depression only really came to an end with FDR's death, following which the economy took off. Pardon the paraphrase of James Carville, but, "It's the RHETORIC, stupid." The economy will never recover as long as the rhetoric continues, and there appears to be no likelihood of that.
One might add that the overwhelming duplicity of the federal government coupled with the obvious cronyism and influence peddling bode ill for the economy in the long run. Understanding the fed will be fruitless in the end. The politicians are determined to make us into Venezuela. And, unless the public wises up, they will succeed.

Nonlin_org writes:

Sorry if I offended Russ or David with my comment above. That was not my goal.

jw writes:
  • The Fed cannot control the economy. It cannot create wealth. The best that anyone can hope for is that it does a minimum of harm.

    The Fed’s stated goal is to create 2% inflation. It has failed for eight years. The ECB has failed to hit its inflation target for eight years. The BOJ has failed to hit its inflation target for eight years. At some point, people have to start thinking that either: 1. They have no idea what they are doing or 2. They aren’t really targeting inflation.

    Yet this cult of Fed watching continues.

  • There is nothing magical about 2% inflation. I have no idea why 2% inflation is preferable to 0% inflation for the general public. It would be challenging enough to keep a stable money supply considering that one has to account for population growth, economic growth and trade balances, let alone omnisciently generate just the right amount of inflation. Their stated reason is that 0% may mean that we are too close to a deflationary environment. Deflation is generally good for consumers (no one ever complains about $500 55” HDTV’s that cost $2,000 five years ago, they seem to be able to live with that deflation), but very bad for debtors like the US government. A cynic might say that they are targeting 2% inflation because we run a 2-3% deficit every year and they are debasing the currency by a like amount – but again, that would be cynical.

    Or they might argue that if Treasury rates were allowed to return to a more normal average rate of 5-6%, our interest expense would be $750B/yr, our deficits permanently above $1T and we would be in a debt spiral.

  • Beckworth claims that rates need to go lower to “clear” the markets. Let’s imagine ourselves in a Bagehotian universe in 2008 and the Fed provided liquidity but RAISED interest rates to say 8%. The markets would have VERY quickly “cleared”. There would have been no Maiden Lanes, no QE, and we would have had a severe, but short lived, recession (like Volker in 1981) and a number of TBTF banks would have failed (and subsequently bought or reorganized). What matters is not the depth of the recession, but the area under the curve, which would have been much less economic pain than we are experiencing now. The Fed has traded a short, sharp recession for a much, much longer recession and done nothing to clear the risk in the market, while greatly increasing moral hazard.

    BTW, moral hazard was evident in financial crisis as well. Thousands of signatures were forged, contracts ignored, titles lost, regulations ignored, laws clearly broken, but no one went to jail. This continues today, with regular headlines about banks being fined billions, admitting no wrong, but promising not to do it again. The only reason that they do it is because the rewards outweigh the financial risk and there is no possibility of being imprisoned (per Eric Holder’s legal theory and practice).

    Cynics might argue that the Fed reacted to their primary purpose, to protect the banks that own them, not serve the public that merely chartered them, or adhere to the King Canute-like “mandates” of the ridiculous Humphrey Hawkins Act. It would also be cynical to mention the $250K that ex-Fed governors charge their many ex-regulatees to have dinner with them or their multi-million dollar consulting contracts with same.

  • There is some unfortunately statistical sleight of hand. The Fed may still own 18% of their portfolio in Treasuries, similar to their pre-2008 holdings, but the Fed’s total assets have increased over 300% in ten years! So if the Fed theoretically increased their assets to $100T and owned all $19T of treasuries, there would be no problem?

    Also, the US still pays interest on intergovernmental holding of debt. To assume that it is not a liability is to assume that future social security recipients don’t mind being paid in script.

  • People take time to change their attitudes towards risk. This explains the lags in some of the data discussed and the international differences. When people understand that we have more public and private debt that we had in 2008 and still have $1Q in derivative exposures, they may change their attitudes about risk again.
  • As discussed in comments in earlier podcasts, the $2-3T in Fed provided excess reserves enables $20-30T in available new loan capacity, enough to create runaway inflation. It is a great risk, not a stabilizer.
  • Russ mentioned the gold standard. The US has about $300B in gold reserves. The Fed printed that every 3-4 months during QE (alternatively, the US runs a larger deficit than that every year). Gold is far too small a market to go back to it, or it has to rise by 10X in price. BTW, M2 has increased by 70% since the beginning of 2008 and M1 by 130%. Clearly, the Fed is not targeting monetary growth (but isn’t it directly related to inflation?).
  • I REALLY don’t understand this point: Beckworth correctly states that there is a serious Hayekian knowledge problem in that there is poor modeling, wide error bands, vague mechanisms, undefined lags in effects, offsetting effects, poor or long after the fact fundamental data and an extremely poor track record for inflation targeting. He then goes on to recommend some theoretically utopian new computer model to accurately determine a poorly defined, untested theoretical natural interest rate (subject to all of the limitations above) to run monetary policy instead? Hayek will rule this new model as well.
  • As before, negative interest rates are a tax/theft of saver’s assets. There is no financial rationale for them. (On the other hand, give me an interest only loan at -4% and I can buy a $100M house and live quite nicely!)
  • One good thing is that in going to Beckworth’s site, I found his new podcast. So now there are two high quality economic podcasts competing for my very valuable time. Since both are free, the only way to “clear” the market is for both of them to start paying me to listen. Maybe with the proceeds I can buy a ticket to “Through the Looking Glass”…
Andrew writes:

There is no ability for banks to lend out excess reserves. Excess reserves are a function of two variables: 1) the size of the Fed's balance sheet (which is determined exogenously by the Fed), and 2) the public's demand for cash. See There is no ability for excess reserves to be "drawn down" from the Fed without the Fed being willing to shrink its balance sheet in response - otherwise, the reserves can only be passed from one bank to another.

Michael Byrnes writes:

@ Andrew

Banks holding excess reserves can certainly do either of the following:

1. Swap to the Fed for currency, which [i]can[/i] be handed out to customers

2. Step up their lending activities. Strictly speaking, it isn't the reseves themselves going out of the bank to its customers. But as lending activities increase, excess reserve balances decline as the amount of required reserves increases.

Wes Lawe writes:

I am a long time listener but have only left a comment once before. I want to thank Russ and David for doing a podcast on monetary policy. Almost all Econtalk episodes are great, but the ones on monetary policy are my favorite. I'll leave a longer comment when I have time and a keyboard.

jw writes:


If banks can't lend out excess reserves then why is the Fed paying interest on them?

Ajit writes:

The elephant in the room with all these podcasts is: The fed wanted to keep interest rates at 2 percent. Selgin touched on this that its a function of modern nk theories.

I would love a future podcast on this topic, discussing how it works and why it should be used. Preferably woodford, but John Cochrane would be a good guest too.

Michael Byrnes writes:

jw wrote:

The Fed cannot control the economy. It cannot create wealth. The best that anyone can hope for is that it does a minimum of harm.

This is neither here nor there. David Beckworth does not advocate Fed control of the economy or Fed creation of wealth.

Their stated reason is that 0% may mean that we are too close to a deflationary environment. Deflation is generally good for consumers (no one ever complains about $500 55” HDTV’s that cost $2,000 five years ago, they seem to be able to live with that deflation), but very bad for debtors like the US government.

Deflation is not necessarily good for consumers. It can be good if it is the result of supply side factors or rising productivity. It can be disastrous if it is the result of demand side factors (i.e., when the supply of money is inadequate to meet the demond to hold it). See 2008.

Beckworth correctly states that there is a serious Hayekian knowledge problem in that there is poor modeling, wide error bands, vague mechanisms, undefined lags in effects, offsetting effects, poor or long after the fact fundamental data and an extremely poor track record for inflation targeting. He then goes on to recommend some theoretically utopian new computer model to accurately determine a poorly defined, untested theoretical natural interest rate (subject to all of the limitations above) to run monetary policy instead?

No. Beckworth advocates targeting nominal spending, a relatively straightforward measure, rather than attempting to estimate the rates of inflation, real GDP growth, productivity, etc. As Beckworth states:

And so there is a--part of this is a knowledge problem. Hayek's knowledge problem. Simple bankers don't know in real time what to do. So, I want a rule-based approach, number 1, but one that can offer it within the fact that we're ignorant. And I think nominal, a nominal spending rule, nominal GDP rule, where the Fed aims to stabilize total dollar spending and the situation where they do that, they are like, 'We don't know what's happening on the real side of the economy. We're not going to pretend to know. We're just going to put the economy on a path where total spending grows at a stable path.' Now, one of--if you flip to what they are doing today, where they are really focused on inflation: Inflation can respond to changes from the real economy, supply side shocks as well as demand shocks. And in theory, the Fed should just focus on demand shocks. But in real time, how do you know which is driving what? And that's the knowledge problem. And with nominal GDP targeting or total dollar spending, you put aside that knowledge problem and say, 'Look, we're just going to focus on demand. On spending.' And that might mean, you know, one period, if there's rapid productivity gains, maybe things are cheaper so the spending goes farther. If there's a negative supply shock, maybe oil gets more expensive or there's a war, well, there's the same amount of spending on fewer things. So things get more expensive. But let the markets' real side sort out how that spending gets allocated. But just focus on spending. You think--the total dollar spending, it's a nominal measure; it's money times velocity. That's what the Fed should be focused on in going forward.
As before, negative interest rates are a tax/theft of saver’s assets. There is no financial rationale for them.

Not true. The rationale for them is similar to the seller's rationale for selling something at a loss. There are occasionaly, times when sellers choose to do this because it is in their best interest to do so even though they do incur a loss. If the supply of the product is greatly in excess of the demand for that product, it may not sell, except at a loss - the seller in such a scenario may decide the selling at a loss is better than incurring costs due to inventory, spoliage, whatever. When it happens, we don't call it theft.

Andrew writes:

Michael Byrnes: Customers just don't want to hold that much cash, and having large cash balances is costly itself, as mentioned in the podcast. Required reserves are a function of deposit balances, not lending. Banks are capital-constrained and don't want to increase the size of their balance that much.

jw: Good question. I believe that the Fed's answer on the subject is that they want to be able to manipulate interest rates in a band when they start shrinking their balance sheet. For example, Bernanke said, "without the ability to pay interest to banks and other private counterparties, the Fed would likely have to implement any tightening of monetary policy by rapidly selling assets it holds. This would have difficult-to-predict effects and would likely prove highly disruptive to financial markets, to say the least."

jw writes:
  • My opening point was regarding the current Fed, not Beckworth’s points. The Fed is specifically claiming that it is trying to stimulate demand. Sorry that this wasn’t clear.
  • My “generally good” vs your “not necessarily good” – a difference without a distinction. I strongly disagree that 2008 was a lack of money supply.
  • I understood what Beckworth said, I disagree that it is a simple metric. NGDP is measured quarter to quarter with significant revisions and volatility. Are you monitoring/reacting it on a real time (implying a volatile monetary policy) or rolling basis (implying an even longer lag between stimulus and reaction, let alone effect) or try to get ahead of it and forecast it (current best model CBO/Fed forecasts have been terrible). What monetary or interest rate tools will be used to affect it based on what theories? How will you affect velocity? Will the models be tested out of sample (and un-modified) for at least a full business cycle to ensure their accuracy? What are the unintended consequences?
  • I absolutely agree that it is in the best interest of the government for you to take a loss on your savings. I disagree that it is rational for savers to stand for it. In your analogy, the agent making the pricing decision incurs the loss. In the real world, the Fed is imposing a loss on savers.

    As Beckworth says, maybe there can be a -0.25% rate for a short period to offset the holding cost, but as a policy, it must fail. Cash will be the rational choice, so currency controls must follow negative rates (see the extinction of the 500 euro note and Lindsey trial ballooning the extinction of the $100 bill, along with other cash controls including the US $10K transaction “pattern” limits).

    As interest rates go down, savers (including large pensions) must either accept more risk or save MORE to hit their long term targets (an effect completely the opposite of the Fed’s theory). If one uses a very basic MPT ratio of 60% equities and 40% bonds (and MPT says that you DON'T change your risk tolerance due to exogenous stimuli), and bonds yield zero, pensions go bankrupt and people’s portfolios are trashed. These are very real effects of the Fed’s actions. Worse, of all of the countries that have gone negative, none of them are seeing the theoretical effects advertised.

Adam Graham writes:

I believe Russ's comment at 37:22 was "power of the gun", not "outgun".

[Fixed. Thanks! --Econlib Ed.]

Scott Singer writes:

This theme has come up multiple times now and I'm trying to work through...

If interest rates are set by the market and not the fed, than yields are determined by demand and supply for capital (savings). When there is too little supply (of savings) yields rise, when too high supply (of savings) they fall. This makes sense to me.

Currently yields are at all time lows. This indicates a lack of demand (for savings) or a huge supply (of savings) ? Which is it and why?

and why do we hear/see lack of savings at least in America? I'm so confused help!

Ismael writes:

There is a point made by the guest that I find baffling.

The guest says that the natural or market-clearing rate was going down pretty much to zero. Therefore, the Fed should have lowered the rate to zero as well to match this. He further says that without a Fed, rates would be zero and that is further reason for why the Fed should not have stopped at 2% for all of five months.

If that is so, why have a Fed then? If the Fed is supposed to figure out what the market would do and set the rate as such, why not just let the market do it? Or is this a market failure and we need smart people to determine what the market should do?

I must be missing something.
Thx Russ for all the podcasts and knowledge. You make Mondays a little less annoying:)

jw writes:

Scott Singer and Ismael,

Your questions are interrelated. You can see the US savings rate here and observe that the savings rate has actually been increasing since 2003. While not as high as the 60's, it is encouraging.

There are other implications for savers besides the ones I mentioned above. If you are doing retirement planning, and the cash/bond part of your portfolio is now assumed to be zero, and due to your time to retirement your risk tolerance cannot increase, you MUST save significantly more to make up the difference AND increase the size of your nest egg to account for a lower return during the withdrawal period, shifting consumption from the present to the future (again, directly contradicting current Fed theory and goals).

The Fed drives interest rates. If you plot Fed rate changes vs general interest rates, you will see that the changes happen in the Fed rate first (or upon the Fed announcement). The Fed is entirely responsible for your $10,000 savings account yielding $1/year. The difference between the $500 that you would normally receive (at 5%) and that $1 is a transfer of your wealth to somebody.

The last thing we need are more "experts" trying to divine the right interest rate to do anything but keep inflation at zero. That is an insanely difficult thing to do by itself, adding additional goals is simply hubris.


Sorry for the trick question. The Fed specifically stated that they are paying interest on excess reserves to prevent the banks from loaning out the money and stoking inflation.

While the Fed has greatly increased their balance sheet, the velocity of money has plummeted, tempering inflation. If the velocity goes back to normal and/or the excess reserves get into the money supply (at 10x leverage), things may get very interesting.

Michael Byrnes writes:

jw writes:

The Fed drives interest rates. If you plot Fed rate changes vs general interest rates, you will see that the changes happen in the Fed rate first (or upon the Fed announcement). The Fed is entirely responsible for your $10,000 savings account yielding $1/year. The difference between the $500 that you would normally receive (at 5%) and that $1 is a transfer of your wealth to somebody.

This is wrong. If the Fed were leading rather than following, we would see elevated inflation. There's no way that the Fed can peg interest rates below the natural rate and not see prices rise.

The Fed specifically stated that they are paying interest on excess reserves to prevent the banks from loaning out the money and stoking inflation.

This is absolutely right. The merits or demerits of QE aside, they are paying IOR to keep inflation down, and (thus far) succeeding.

It sounds weird to say it, but I think QE was sort of the Fed's alternative to actual monetary easing (i.e., monetary policy intended to raise spending/inflation).

If the velocity goes back to normal and/or the excess reserves get into the money supply (at 10x leverage), things may get very interesting.

Other than a massive screwup, which I'll agree is possible, this excess money will never see the light of day, and the Fed will offset any changes in velocity with additional contractionary policy.

Gandydancer writes:

Beckworth would have you believe that the purpose of NGDP targeting is to make the functioning of the Fed automatic, but Sumner makes it quite clear that the actual idea to to conceal his unwelcome prescription of higher inflation under the rubric of "higher wages". And the reason this is supposed to be desirable is (a) to restore the weapon of cutting inflation to the Fed's arsenal (so much for autopilot) and (b) to make the default condition of wage-earners to be a wage cut, the better to make wage cuts easier to accomplish.

No thanks.

Gandydancer writes:

jw writes:

The difference between the $500 that you would normally receive (at 5%) and that $1 is a transfer of your wealth to somebody.

Michael Byrnes writes:
There's no way that the Fed can peg interest rates below the natural rate and not see prices rise.

The Fed makes dollars out of thin air. Of course it can drive interest rates below the rate which would be "natural" if it did less of that. And it has. "Zero inflation" isn't happening, and the difference is being stolen exactly as jw suggests.

Michael Byrnes writes:


No, that is not at all what Sumner and Beckworth advocate. They want inflation over the long term to be about what it has been over the past 30 odd years.

jw writes:

Michael Byrnes,

While I don't disagree that is what the Fed is targeting, I don't see why any rational person would want to see the value of their money be debased by 55% over 30 years (BLS Inflation Calculator here).

msouth writes:

All I hear is a bunch of people flailing around trying to figure out the magic formula for how we should interfere with the natural function of the market. All the uncertainty and "well, we now know that what we were really sure about was actually wrong but we'll just keep experimenting"--when the market would just do thousands or millions of experiments and figure out what works.

It's ridiculous. In the end, you're basically getting to a suggestion "maybe we should have the fed do things based on the market's prediction of where rates should go"...i.e. maybe the rate SHOULD BE DETERMINED BY THE MARKET. Gee, ya think?

Fatal conceit is not limited strictly to socialists, but extends to those who just want socialism in this one thing that they think they know how to control.

You aren't going to beat the market's ability to figure out what a price should be, nor to correct it itself if it (or part of it) guesses wrong.

It's never been more clear to me than when listening to this podcast that none of these people that want to pull the levers have any idea what the other end of the lever is actually connected to.

We don't need the fed. We don't need interference in financial transactions by the people with the biggest guns. That's the case you guys were really making here, whether you realized it or not.

Gandydancer writes:

Michael Byrnes writes:

No, that is not at all what Sumner and Beckworth advocate. They want inflation over the long term to be about what it has been over the past 30 odd years.
What I said is exactly what I discovered Sumner wrote as the reason a non-zero inflation rate is desirable. Who am I to believe -- you or my lying eyes?

As to what he wants the long term inflation rate to be, that is neither here nor there. He wants inflation NOW for the jiggery-pokery reasons I quoted. The long term will have to take care of itself.

Michael Byrnes writes:

msouth wrote:

You aren't going to beat the market's ability to figure out what a price should be, nor to correct it itself if it (or part of it) guesses wrong.

The flaw here, at least with regard to what David Beckworth advocates, is that prices don't depend on just on the supply of a product relative to the demand for that product. They also depend on the supply of the medium of exchange relative to the demand to hold the medium of exchange.

Any overproduction or underproduction of money (relative to the demand to hold money) is going to drive prices changes that are based on the changes in supply and demand of money rather than changes in the supply and demand of the product being bought and sold. And, making matters worse, some prices will adjust faster than others, so relative prices will be mucked up.

Beckworth's argument is simple - if supply of, and demand to hold, money are roughly in balance then total dollar spending, in nominal terms, will be on a stable trend. When supply of, and demand to hold, money are not in balance then you get a 2008, or a 1978, either of which interfere with a market's ability to "figure out what a price should be".

jw writes:


I do not envy the Fed. I do not know how to take into account millions of loans being created and retired every quarter over an near infinite number of time periods (generally from overnight to 30 years, but also everything in between) and near infinite numbers of interest rates, some of which vary, millions of businesses reporting revenues, employment and unemployment inputs and estimates (which sometimes make no sense, especially this week!), government spending, population growth, illegal industries, interest based derivatives, and on and on and come up with a reasonably precise number of dollars to create in that quarter and a discount rate to charge banks. So it is hard for me to say that there is an easy to understand "market interest rate".

I do know that the "natural" interest rate is a chimera, based on assumptions layered upon assumptions, and its current "logical" conclusion is zero or negative rates to force businesses to invest. But lowering interest rates to force business to invest when demand does not exist is the definition of malinvestment. It also doesn't make sense to pay interest on excess reserves to discourage lending while dropping rates to encourage it.

As I mentioned before, these Fed driven experiments on the entire country's economy will only be complete when interest rates return to their long term averages and the Fed's balance sheet returns to pre-2007 levels. Only then will we know the true cost of this new math.

jw writes:

A correction to my post above that the BoJ has been using QE for eight years
- the Bank of Japan has been using QE for 15 years and still hasn't
experienced the theoretical effect promised.

And yet, QE retains credibility as a theory.

Andrew writes:


When a bank wants to lower its level of excess reserves, it has two choices. 1) it can take out cash, or 2) it can lend those reserves to another bank. I am not concerned about case #1 because demand for cash is going down, not up. Any individual bank may increase lending via route #2 but that means that another bank will increase its excess reserves and the system as a whole will not change. IOER is irrelevant.

If you disagree, please explain from a credits and debits perspective how the overall level of excess reserves can change if the Fed doesn't change the asset side of its balance sheet.

Russ: you should invite Jamie McAndrews on the show! He recently retired from the FRBNY.

jw writes:


Banks can also reduce their excess reserves by creating loans. For every $10 in new loans, their excess reserves will shrink by $1.

They currently have $2.3T of excess reserves (here), so that could theoretically create $23T of new credit.

This is not just some wild eyed speculation, for example, see this paper by the Minn Fed.

Take particular note of their response to their own question regarding the potential for inflation: "So, 60 percent of the entire monetary base is now in the form of excess reserves compared to roughly 0 percent precrisis. Does this matter? It might."

I am not reassured.

jw writes:

I just came across this paper:

"Negative Interest Rates: A Tax in Sheep's Clothing"
Christopher J. Waller, Executive Vice President and Director of Research, Federal Reserve of St Louis

It is a fairly straightforward read and he concludes (spoiler alert): "At the end of the day, negative interest rates are taxes in sheep’s clothing. Few economists would ever claim that raising taxes on households will stimulate spending. So why would they think negative interest rates will?"

Keep in mind that just as compound interest has an amazing power to grow money, inflation and negative interest rates compound in the opposite direction.

Andrew writes:


That is just not true that their excess reserves will shrink by $1 for every $10 of new loans they shrink out. I don't even understand how you think that. I want you to give me the debits and credits to its balance sheet that would result in such a change.

The Mpls Fed paper only notes that _required_ reserves are roughly equal to 10% of deposits (actually, just demand deposits, time deposits have no required reserves, but the paper doesn't mention that). It's a very confused paper in my opinion. The binding constraint for banks these days is not required reserves at all; it's capital and liquidity requirements.

Furthermore, I agree that it is possible for a single bank to increase or decrease its excess reserves, but it is not possible for the banking system as a whole to change the level of excess reserves without the Fed taking action.

jw writes:


The opening paragraph of the Minn Fed paper clearly states: "Banks in the United States have the potential to increase liquidity suddenly and significantly—from $12 trillion to $36 trillion in currency and easily accessed deposits—and could thereby cause sudden inflation. This is possible because the nation’s fractional banking system allows banks to convert excess reserves held at the Federal Reserve into bank loans at about a 10-to-1 ratio.", so I am not making this up.

Keep in mind that the excess reserves are a part of total reserves. I agree that total reserves are a function of cash, demand deposits and Fed balances. But when a new loan is made, everything else being equal, EXCESS reserves will shrink by 1/10 of the new loan, but TOTAL reserves will not change.

In 2007, the asset portion of the banks balance sheet (for banks, loans are assets) fell dramatically because the value of the houses underlying the mortgages fell dramatically (along with a lot of run of the mill poor loans and some outright fraud). Since the denominator assets fell in value, the reserve ratio increased beyond legal limits.

jw writes:

My last sentence above is not clear. The reserve ratio can be looked at as a percentage (reserves are 10% of loans outstanding) or as a ratio (loans to cash are at a 10:1 ratio). I am referring to the ratio increasing above legal limits.

Lehman was operating at a more than 30:1 ratio when all of its exposures were properly accounted for and so a 3% loss to their assets/loan book made them insolvent.

There is a theory that the entire crisis was caused by a FASB accounting rule change in Nov 2007 that disallowed "mark to model" valuations (banks valued their assets based on "sophisticated" models - long term listeners of Econtalk will understand the pitfalls). Granted, this is a difficult problem since many instruments traded in very illiquid markets. It was difficult for banks to price them correctly,so they modeled a (very favorable) price.

Under political pressure, FASB reversed itself in May 2009, beginning the end of the crisis.

However, this did not end the systemic risk.

john penfold writes:

No real variables matter? No regulatory policy or rhetoric, dead weight burden or spending and taxes matter? Just small changes in interest rates? So if the Cubans could just their interest rates dead right, it would all be rosy. What am I missing?

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