Thursday, May 3, 2012

In Which Noted Economist Paul Krugman Makes an Unforced Error – Argues the Federal Reserve Can Do More to Stimulate the Economy and Produce Growth and Higher Employment

Sorry – The Fed Has Fired Its Gun Repeatedly and Is Now Out of Ammunition

Economists like everyone else are part of the ‘can do’ attitude of America.  If there is a problem, it can be fixed.  The idea that in an advanced society like the United States there is nothing more that the Federal Reserve, the nation’s central banker, can do to end the weak recovery and stimulate the economy is just not acceptable.  If an institution like the Fed exists and there is an economic problem, the Fed can help fix it.

The current problem stems from what many (ok, most) economists think is policy symmetry. If action A produces results B, then taking the opposite of action A must produce the opposite of action B.  In monetary policy the thinking goes like this.

High interest rates and restrictions in the availability of credit and financing will slow down an economy and ultimately cause a recession with negative economic growth and rising unemployment.

Ergo, lowering interest rates and increasing the availability of credit and financing will stimulate and economy and ultimately cause higher economic growth and rising employment.

Unfortunately that is not the case.  The reason involves what mathematicians call necessary and sufficient conditions.  Low interest rates and the availability of credit are necessary conditions for economic growth and economic recovery from a recession.  But they are not sufficient conditions.  Just because the cost of borrowing is low and funds are available for borrowing does not mean business will engage in borrowing to make investments.  The demand for the products and services that are generated by that investment must be present.

So the problem with the economy in 2012 is that this demand is not present in sufficient amount to produce growth and higher employment.  The Fed has already lowered rates and made credit available to just about the maximum extent possible.  Yet because the economy is not in a strong recovery, people like the eminent economist Paul Krugman are writing about how the Fed can do more.

The U.S. economy remains deeply depressed, with long-term unemployment in particular still disastrously high, a point Bernanke himself has recently emphasized. Yet the Fed isn’t taking strong action to rectify the situation.

Mr. Krugman is a very smart man, and he recognizes that the Fed has done all it can do about lowering short term interest rates.

Right now, the Fed believes that it’s facing a weak economy and subdued inflation, a situation in which it would ordinarily cut interest rates. The problem is that rates can’t be cut further. When the recession began in 2007, the Fed started slashing short-term interest rates until November 2008, when they bottomed out near zero, where they remain to this day. And that was as far as the Fed could go, because (some narrow technical exceptions aside) interest rates can’t go lower.

So what is Mr. Krugman’s complaint about the Fed and what does he want them to do?  Well, two things. One is lowering long term interest rates.

Short-term interest rates may be zero, unable to go lower, but longer-term rates aren’t. So the Fed, which typically buys only short-term U.S. government debt, could expand its portfolio, buying long-term government debt, bonds backed by home mortgages and so on, in an effort to drive down the interest rates on these assets. This is the strategy that has come to be known, unhelpfully, as quantitative easing.

And the other is changing the inflation target to allow for the possibility of higher inflation.

 If the Fed were to raise its target for inflation — and if investors believed in the new target — expected inflation over the medium term, say the next 10 years, would be higher. Many economists, ranging from the chief economist of the International Monetary Fund to one of Mitt Romney’s top economic advisers, have argued, as I have, that higher expected inflation would aid an economy up against the zero lower bound, because it would help persuade investors and businesses alike that sitting on cash is a bad idea.

As for the first idea, long term rates are very low, home mortgage rates being near 4% for 30 year loans.  And Mr. Krugman ignores the fact that lowering long term rates lowers income for millions of people, particularly those retired Americans whose income comes in part from investment in long term bonds.  Lowering their income will reduce demand and lower, not raise economic growth.

As for the second idea, the fact is that no one outside the economist community pays attention to the Fed’s target inflation rate.  Don’t believe that, just ask any citizen or business leader what the Fed’s current target inflation rate is, and be prepared for those blank stares we all get when we say stupid things.

The problem is that monetary policy and the Fed cannot address the real problem of the U. S. economy, the fact that there is not sufficient demand to generate investment that creates jobs.  Mr. Krugman and all the others who are looking to the Fed for help just have to accept that.

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