Look: I am eager to learn stuff I don't know--which requires actively courting and posting smart disagreement.

But as you will understand, I don't like to post things that mischaracterize and are aimed to mislead.

-- Brad Delong

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Saturday, May 28, 2011

Moron More on Short Term Interest Rates

A few days ago I drew these tentative conclusions:

1) The Fed has very little power to influence interest rates.
2) An attempt to move counter to the market might have an incalculable distorting effect.

But now, due to phantom inflation fears and the influence of zombie ideas, there are serious desires to raise short term rates both here and in Europe.

This is what 10 year bonds rates are doing.  I've posted the long term trend before.  You can see an update here.  Since peaking on Feb 8, well within the long range channel, rates have dropped from 3.725% to 3.06%.   Meanwhile, TIPS spreads have fallen from 2.66% on April 11, to  2.275% today.  The clear message of the market is that inflation expectations are low, and falling.

If the Fed succeeds in raising the Federal Funds Rate, which has been stuck at 0.25% for over two years, it will flatten the yield curve.  What will this accomplish?  With nominal rates vanishingly low, and inflation low, but still positive, we're in uncharted policy waters.  I suppose it depends on how far they go.  

Would a change of 0.25% matter to anyone?  Maybe not. But if it does, it will be harmful.

A change of 1% almost certainly would.  But with real short rates negative (nominal rate minus inflation {low, but still > 0.25%}) business is still sluggish.  What would a real positive interest rate do?

Still - the Fed usually makes it's changes in increments, not whole percentage point jumps.  Even a half percent change would be huge in the current environment.

Any attempt to raise short rates at this time would be a serious market distortion, in the direction of stifling the economy.  With unemployment high, the recovery sluggish, and no real sign of inflation, this would be insanity.

That word often gets used hyperbolically, but I am deadly serious.  It is very difficult to imagine a policy decision (short of adopting the Ryan budget plan) that would be more destructive to the economy - and more obviously so - than raising interest rates at this time.

Yet that is what very serious people want to do.

We're screwed.


BadTux said...




- Badtux the In-agreement Penguin

The Arthurian said...


From your opening --
A few days ago I drew these tentative conclusions:
1) The Fed has very little power to influence interest rates.
2) An attempt to move counter to the market might have an incalculable distorting effect.

The graphs you did in that post certainly support #1 there. I don't think they support #2. I don't see how they could: Number 2 is a fear-of-the-unknown statement. As you say in the current post: "If the Fed succeeds in raising the Federal Funds Rate ... we're in uncharted policy waters."
So...// now I am only exploring here. If I say anything offensive call me on it but I trust you won't take offense!
...so I am wondering if you are confusing what you thing with what Paul Krugman thinks. Your next-to-last line here -- that is what very serious people want to do -- is surely a Krugmanism.

I try to avoid reading too much on a topic or by an author if I feel repetition is being used to convince me.


I don't know what would happen if the Fed raises rates, and don't try to guess. But the typical pattern is that borrowing costs rise until borrowing slows, and then we have a recession.

But if 1) the Fed cannot influence rates, and if rates rise, then it is the market that's raising rates and the Fed is just complying with the market (as they always do, as you have shown). So then there is no 2) "attempt to move counter to the market" and thus no "incalculable distorting effect".

A little history: I went into hibernation when Reagan got elected. I thought it was the end of the world. I went and taught myself the C language and left economics alone for a while. But guess what: It wasn't the end of the world.


Finally, I oppose increasing interest rates because it is a self-defeating policy. Why does the Fed wants to raise rates? To head off inflation. That's the only reason, right?

The trouble is, when we raise rates we raise the price of putting credit to use, so the demand for new uses of credit falls. In other words, new, stimulative spending that will help the economy grow is cut off at the knees. That's what causes recession.

Meanwhile, existing uses of credit -- money borrowed last month and last year and over the last decade, which is the money that is actually causing the onset of inflation -- these existing uses of credit are permitted to remain on the books. They even become something of a bargain for the borrower, as rates have gone up.

Note that existing credit in use -- existing debt -- is transformed by the first spending into money in circulation. No longer is it with each new spending being used for some new investment or some new necessity. It is simply extra money in circulation and, somewhere, somebody is making interest payments to keep that money in circulation. So, it is costly money in circulation.

To fight inflation I would create policy to get that costly money paid off at an accelerated rate.

To encourage growth I would leave interest rates low, so that new uses of credit are not hindered, because it is the new uses of credit that stimulate the economy.

And to compensate for the declining money supply caused by accelerated repayment of debt, I would have the Fed increase base money, the no-cost or lowest-cost money we can have.

Jazzbumpa said...


No offense taken.

Actually, #2 is a recognition that the unknown is unknowable. The graphs were never intended to support the unknowable.

Yes, I borrowed from Krugmanism. I borrow freely from sources I consider reliable. But I'm pretty sure I know what I think.

Krugman does repeat himself a lot. When he does, that's how you know that 1) the topic is important, and 2) the message doesn't seem to be getting through.

(As an aside, when I see somebody criticize Krugman for saying something, I look to see if it's something he harps on, or if it's a one-off. The one-offs are much less important, and broad conslusion drawn from it are often self-serving bullshit.)

So 2) is a "what if?" What if the Fed goes counter to market forces? The historical fact that they never have doesn't mean that can't, or they never will.

As near as I can tell, the stated purpose of raising rates is to combat inflation. This is bone-headed in the current environment.

And I still suspect that whatever effect there is will be negative.

Curiously, I think you are agreeing with Krugman here, though I might have that backwards.


The Arthurian said...

It is one thing (and quite right) to point out that deflation would be terrible in a debt-laden economy. But it is something else again (and quite wrong) to call for inflation, ever, regardless of the level of debt. Inflation can solve the debt problem, yes, but inflation is not a solution to the debt problem.

Krugman and I do agree that "public debt is not our only problem — in fact, it’s not the core problem. The key problem is, instead, the overhang of private debt". This is not the first time PK has said private debt is the problem. But tomorrow, he will be off on some other topic again. Makes it difficult to believe he really means what he says about private debt being the key problem. Where is his focus?

Q: If the inflation of the past 40+ years is due not to excessive printing but to excessive lending (and it is), then why should the solution require even more inflation? Krugman's approach doesn't make sense.

Before I stopped reading them, I used to see calls (from Austrians and such) for letting the banks collapse rather than be rescued. Their solution calls for deflation, to un-do forty years of inflation by wiping out all that debt and credit-in-use. This solution is absurd from a personal perspective, but in some ways it makes more sense than Krugman's plan.

As I see it, we already had the inflation; that damage is done. What is needed is a third option: Not to opt for inflation, and yet to wipe out debt without causing deflation.

Krugman's approach is an attempt to correct the imbalance between money and debt by increasing the quantity of money. And the Austrian approach is an attempt to correct the imbalance between money and debt by decreasing debt (via default). Both are flawed attempts to correct the monetary imbalance. Neither uses the fiat system wisely.

Note that Krugman's approach will only work of the quantity of money grows faster than the level of debt. Otherwise, we would have corrected the monetary imbalance with the inflation of the 1970s and been into another golden age by the early '80s!

The Arthurian said...


Note that Krugman's approach will only work IF the quantity of money grows faster than the level of debt.

Jazzbumpa said...

Gotta run, so no time for a substantive reply. For now I'll just say that if you think Krugman isn't making sense, then you need to check your own assumptions, data, algorithms and arithmetic. PK is human and therefore fallible. I have no problem with anyone disagreeing with him, or me, or anyone else. But he is brilliant, honest, and he knows his stuff.

If you think he has screwed up badly, I recommend you take another hard look.


The Arthurian said...

Excessive debt is the record of excessive credit use. Excessive credit-use caused inflation.

If excessive credit-use caused inflation, then the simplest solution is insufficient credit use. This is the austrian approach (or, what I have anyway called the austrian approach). The trouble with this approach is that it "runs the replay backwards". It relies on deflation and the collapse of the quantity of money. It is not a workable solution. However, there is a clear forward-and-backward logic in it: increasing credit-use corresponds to rising prices, and the collapse of credit corresponds to the collapse of prices. It is a tidy solution, if psychotic.

In contrast, there is Krugman et al. Krugman's approach looks at the problem of excessive debt (which is the same as excessive credit-use, which has incidentally caused inflation) and almost recognizes that debt is excessive relative to the quantity of money. But Krugman's solution is to increase the quantity of money, causing even more inflation.

Krugman's solution is illogical because he wants to solve a problem that caused inflation, by causing even more inflation. His solution is neither tidy not psychotic, but I believe PK does not understand the fundamental problem of monetary imbalance.

Since the growth of debt was the cause of inflation, logic insists that solving the problem need not cause additional inflation.

The monetary imbalance can be solved either by decreasing the quantity of debt or by increasing the quantity of money. I propose to do both: Print money and use it to pay off debt. Print money and use it to pay off private sector debt. Paying off debt destroys the newly printed money, and it also destroys the debt.

Krugman's approach will only work if the quantity of money grows faster than the level of debt. Otherwise, the inflation of the 1970s would have corrected the imbalance long ago, paving the way for renewed growth.