Tuesday, January 14, 2014

Lowering Interest Rates is a Panacea

In a post entitled Why Have Investors Given Up on the Real World?, Kevin Drum says the following,
How should we respond to sustained economic weakness? ...
In a nutshell, the argument for higher inflation is simple. Right now, with interest rates at slightly above zero and inflation running a little less than 2 percent, real interest rates are about -1 percent. But that's too high. Given the weakness of the economy, the market-clearing real interest rate is probably around -3 percent. If inflation were running at 4-5 percent, that's what we'd have, and the economy would recover more quickly. 
There are two arguments opposed to this. The first is that central banks have demonstrated that 2 percent inflation is sustainable. But what about 5 percent? Maybe not. If central banks are willing to let inflation get that high, markets might conclude that they'll respond with even higher inflation if political considerations demand it. Inflationary expectations will go up, the central bank will respond, and soon we'll be in an inflationary spiral, just like the 1970s.

I find it remarkable that Drum is so easily drawn into the rabbit hole of monetarism, a world where the Fed Chair reigns as the Wizard of Oz and economic weakness is solved by a willingness to let inflation get high.  What conceivable logic lies behind such fantasy?

All countries have structural economic problems.  In the United States, our labor force is not competitive because labor is cheaper elsewhere and the technology and political structure exists to move jobs to these other locations.  That is the "economic weakness" of which Drum speaks.  In spite of extremely low interest rates, the American consumer isn't earning enough money to consume more and make additional private investment profitable.

How could the solution to this be just to reduce interest rates?  How would that address the structural problem in any way?  We've been trying this in the U.S. for over 30 years now (see this graph).  Phil Pilkington and others discuss how well this has worked:
Kalecki’s argument was that if central banks try to control the level of effective demand through the interest rate they will find that they will have to drop the interest rate over and over again as each boom peters out until, ultimately, they end up at the zero-lower bound. As Steve Randy Waldman of Interfluidity notes, this appears rather prescient if we look at the period after 1980 when central banks moved toward trying to steer the economy by using the interest rate alone.
[Fixing the Economists]
In sum, a group of bizarro monetarist economists and their naive followers have captured the high, serious ground  They believe that structural problems, such as offshoring and outsourcing of jobs, can be fixed by lowering interest rates.  This has been tried for 30 years whenever the economy falters, and the problem is worse than ever, and rates can't go any lower.  Lower interest rates have yielded lower inflation, to the extent that there is any discernable effect of monetary policy on inflation.  But they believe the problem would be solved if we just somehow get interest rates into negative territory.


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