Arnold Kling  

Interest Rate Debate

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Brad DeLong argues,


There is a 5m-worker gap between household-survey employment today and what it would be if the employment-to-population ratio were at its average level for 2000. This suggests that we are extraordinarily far from anything that could be called "full employment" - and that an appropriate monetary policy would be one that permitted employment to grow at a very strong pace indeed for the next few years.

Edward Lotterman replies that DeLong's case,

is highly dependent on the assumption that the employment levels reached in the late 1990s and continuing into 2000 were normal, readily achievable ones that could be sustained over the long run...

The argument that continued monetary slack is necessary to add millions more jobs scares those of us who are skeptical about the wisdom of Keynesian micromanagement in general. Thankfully, it is doubtful that the men and women who sit on the Federal Open Market Committee will swallow the "below potential" argument hook, line and sinker.


I tend to agree with DeLong's view of the macroeconomic world, even when the internal consistency is a bit tenuous. That is, we believe that there is a bond bubble, which would suggest that interest rates are too low. And yet we believe that the economy is operating below potential, which would suggest that interest rates are too high.

Where I differ with DeLong is that I tend to think of interest rates as being set by the market rather than by the Fed. Yes, I know that the Fed sets the one-day interest rate on Federal Funds. But the long-term bond market has its own views of where the economy stands with respect to potential. And perhaps bond market participants are just as torn as we are between thinking that rates are too low and that rates are too high.

For Discussion. DeLong argues that the economy is unusually sensitive to interest rates right now, because of the significance of housing. Is there a case to made that housing should be more responsive to interest rates now than at some other time?


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COMMENTS (18 to date)
Jervis Ninehammer writes:

If housing is overvalued, then it might be more sensitive to interest rates movements. Small movements in rates might derail momentum.

However, long rates appear to be stable. Perhaps they'll begin moving up again in the near future, but for now they're steady.

Bob Boyd - Software Projects & Offshore Labor - rlboyd.blogspot.com writes:

What if there was a large labor pool available outside the pool for which we calculate unemployment? What if the cost per labor unit of that pool were very much lower? Would that be a cause for low-ish long term interest rates?

I realize that the US Department of Labor argues that few US job losses are due to employers moving jobs to lower-cost labor markets. They claimed that fewer than 5000 jobs were lost for that reason in Q2 this year.

But, what if they are miscounting. From my view down here in the corporate-software-project weeds, I can point to at least 400 jobs that, if they weren't being done by non-US nationals, might have helped reduce US unemployment.

I don't mean to argue against 'offshoring'. It's just another blessing in reverse in this best of all possible worlds.

However, one could argue that the bond market has a correct view of long-term interest rates. With such an abundance of low-cost labor, albeit, outside the US Department of Labor's view, the ROI of investment in plant and equipment, especially in computers and software for services, is very low.

Do we need to stop conflating the Global money market with the US labor market? Do we need to ask what the Global unemployment and under-employment rate is before raising Fed Funds rates?

Marty writes:

"Where I differ with DeLong is that I tend to think of interest rates as being set by the market rather than by the Fed."

Isn't that a little disingenuous? You imply that DeLong doesn't know how the yield curve operates.

Arnold Kling writes:

"Isn't that a little disingenuous? You imply that DeLong doesn't know how the yield curve operates."

He tends to forget. He writes as if the Fed can put the economy on any path it wants.

Jervis Ninehammer writes:

DeLong seems to think the biggest threat to the economy is poor fiscal discipline on the part of George Bush and Republicans in Congress. There has been a great deal of irresponsible spending of late, but the bigger problem is the Medicare program. Not only is this program seriously out of balance fiscally, but the costs involved are so variable that it's nearly impossible to come up with an estimate for needed funding. Congress seems intent to add massive new benefits, such as prescription drug coverage, and now obesity and mental health coverage. No thought is given to the cost of these new benefits, much less to the fact that the Medicare is currently underfunded. Politically, Medicare is a sacred cow. No sane politician would dream of doing anything but expanding the program. But at some point the bill will come due, requiring rationing of health care, default on government promises, socializing health care, or massive new taxes.

Lawrance George Lux writes:

The Housing market is sensitive to interest rates if and only when Housing is over-valued. This because it artifically lowers the monthly mortgage payment size, to fit into the Supply Curve of monthly mortgage payments.

Interest rates should be low for economic performance, if and only if you buy into Monatarist theory. I am a Demand-sider, rather than a Supply-sider, Keynesian, Monatarist, neoconservative, or von Mises worshipper. I have seen Boom conditions with 12% interest rates, with relatively little comparative inflation. I have seen Bust conditions with 1% interest rates, with relatively high inflation.

I will be the Devil's Advocate again: Proposed Economic policy: set mortgage interest rates at 20%, so people will stop buying equity Housing, and use their spare cash to buy Consumer Goods. lgl

David Thomson writes:

“He (Brad DeLong) tends to forget. He writes as if the Fed can put the economy on any path it wants.”

Arnold Kling is going out of his way to be nice. Brad Delong is a man who doesn’t realize that he may no longer be a serious player in the Democrat Party. The neo-Liberal Bill Clinton of 1992 wouldn’t stand a chance in 2004. John Kerry’s campaign is all about populism and other anti-economic growth policies. The current Democrat insiders seem hostile toward free trade. Blasting so-called Benedict Arnold CEOs has become the norm.

Guys like Brad Delong and Robert Rubin are being played as punks by Senator Kerry. Am I possibly jumping to an invalid conclusion? Oh well, there is no way to reconcile the economic beliefs of someone like DeLong and those of Barbara Ehrenreich. One of these individuals will be severely disappointed if Kerry is elected president. Somebody is indeed being played for a punk and must be ultimately marginalized. Which one is it? I report---and you decide.

DSpears writes:

"Interest rates should be low for economic performance, if and only if you buy into Monatarist theory. I am a Demand-sider, rather than a Supply-sider, Keynesian, Monatarist, neoconservative, or von Mises worshipper. I have seen Boom conditions with 12% interest rates, with relatively little comparative inflation. I have seen Bust conditions with 1% interest rates, with relatively high inflation."

Monetarist theory, at least the Milton Friedman inspired version that I am familiar with, absolutely does NOT advocate low interest rates for economic performance. Monetarist theory boils down to providing the amount of money to the market that will allow maximum economic growth without creating inflation. It says nothing about the correct level of interest rates, other than they should (and will) be set by the market conditions of supply and demand, not government. In fact, monetarism focuses on the amount of money, not it's market price (interest rates).

Supply Side economics does NOT advocate artificially low interest rates as a driver of economic growth either. Quite the contrary, Supply-side economics assigns the role of fighting inflation to the Fed, the money supply, and interest rates. Artificially low interest rates (i.e., inflationary) are anathema to Supply-side economics bacause they cause inflation, which destroys the wealth, capital and investment that supply-side theory maintains is essential to sustainable long-term economic growth.

The Austrians, the von Mises worshippers, abhor loose credit and are universally, violently opposed to low interest rates in any situation, even in a deflationary environment. I have seen numerous screeds by those of the Austrian school singing the praises of deflation, restraint of credit and any increase in the money supply under any cirumstance. This is the group you have most mischaracterized, and I would bet that any von Mises worshipper would fight you in the street if you made any of these statements to their faces (they are a very spirited group).

In fact, your statement about interest rates is pure Rothbardian dogma.

Keynsian economic theory is "demand-side" economics, which is where the reationary term "Supply-side" comes from. It was a reaction to the over-emphasis that Keynsian economics put on stimulating demand (through budget deficits, government spending, and low interest rates), wrongly assuming that in the chicken and the egg debates of economic growth that the chicken (demand) indeed did come before the egg (supply).

In all fairness, I don't know what neo-conservative economic theory is, and I don't think they do either.

Maybe you should go research your terms a little further. You might find out that the label you have assigned yourself doesn't fit at all.

If you are going to disparage an idea, you should at least know what it is first.

2nd subject:

"Isn't that a little disingenuous? You imply that DeLong doesn't know how the yield curve operates."

I would submit that DeLong and Robert Rubin and Larry Summers and Paul Krugman, etc... DON'T understand how the yield curve operates. I have read enough of their brand of economic ciphering to know that they believe a steeply sloping yield curve is "bad". By inference, a flat or even inverted yield curve is "good" or at least benign so long as long-term interest rates are maintained.

An inverted yield curve is precisely what Rubin (whose policy theories DeLong helped formulate with Summers et al)engineered while at the Treasury, with the predictable (by most economists and wall street veterens anyway) result of a recession. At the time (and since) they have continued to argue that this is the proper condition for economic growth.

The problem is, in a flat or inverted yield curve environment, there is no incentive to grant credit and every incentive to hold on to cash, because the return on long-term investments is not worth the risk. The whole financial system is based on financial institutions obtaining credit at low short-term rates and lending it long-term at higher rates, and pocketing the difference. When short term rates are forced above or near long-term rates (which is what happens when the Fed tightens too sharply) you get the classic "credit crunch" where financial institutions no longer want to fund long-term investments because there is no profit in it. They hold onto their funds as cash, which is exactly the situtation we had from 2000-2003.

Why on Earth would anybody lend money for 30 years, with all the uncertainty of inflation and credit conditions that could result in a negative return, when they can get the same return by lending for 3 years or one year? This is the inverted yeild curve in it's essence.

The Rubin Treasury engaged in a foolish attempt to bring down long-term interest rates directly (on the theory that this is the most important driver of the economy), by buying back 30-year notes, thus increasing the money supply, at a time when the Fed was trying to engineer just the opposite by raising the Fed Funds rate. The Treasury's actions not only made it more difficult for the Fed to contract the money supply from the low end, but it also flattened the yield curve by more than it otherwise would have been in the classic "soft landing" that the Fed was trying to engineer through the tightening of credit from the short end.

The soft landing of gradually increasing short term rates (slowing the growth of the money supply) with a corresponding orderly increase in long-term rates, was made more difficult by the Treasury effectively acting as it's own independent Federal Reserve at odds with the institution whose job it is to do these things.

I believe this is what Mr. Kling is talking about, but I won't presume to speak for him.

"Guys like Brad Delong and Robert Rubin are being played as punks by Senator Kerry."

Actually, Rubin has been mentioned as the most likely replacement for Alan Greenspan, assuming there ever is such a thing as President Kerry. That sends chills up my spine.

Kerry has repeatedly talked about returning to the "policies of the 1990's", meaning Clintonomics or Rubinomics. Rubin is a god in Democratic circles because they beleive that the economic growth of the 1990's and Rubin's unique explanation of it (and the disingenuous credit he has taken for it) gives them the justification for raising taxes. In fact, if you delve deeply enough into almost any Democratic party economic thinking, it will eventually come around to the idea that raising taxes is good. That is because all of these theories were built from the question "how can we justify raising taxes"? When you look at it that way, it all makes a lot of political if not economic sense.

Lawrance George Lux writes:

DSpears,
I do understand the basic positions of all the major current schools of economic thought. I tried to portray that I was not tied to any specific school--whether Liberal or Conservative.

I have long maintained that Interest rates were too low, and such rates (whether low or high) did not determine the rate of capital accumalation or the rate of investment. Investment will never occur in the face of soft Consumer Demand.

My position on Interest rates is quite simple: the Fed should set rates and Reserve percentages to ensure that Bank deposits always provide a rate of interest of at least 4 percent. This would increase Consumer Demand as effectively as a $1 per hour raise on all Wages. I have had many discussions on mortgage rates, and are convinced they should range between 7-9% with the Fed tasked to maintaining that rate through the purchase and sale of Securities. I finish by stating Consumer Credit rates should be focused around 12% per year, in order to suppress overconsumption by inadequate Incomes.

Final Point: To curb excessive Government spending, I favor a constitutiional amendment stating the Governments (Local, State, Federal) are prohibited from borrowing funds at interest rates less than 6%. lgl

David Thomson writes:

“Actually, (Robert) Rubin has been mentioned as the most likely replacement for Alan Greenspan, assuming there ever is such a thing as President Kerry. That sends chills up my spine.”

Robert Rubin unambiguously rejects populist economics, the very mindset underpinning the John Kerry campaign. One only needs to read Rubin’s --In An Uncertain World--. On page 353, he even warns that that “populist rhetoric in the campaign (Al Gore’s) could hurt business confidence and investment, which is not the way to start a new administration.” If Kerry indeed chooses Rubin for this most important position---the left wing of the Democrat party will feel betrayed. Somebody is ultimately being played for a punk. There’s simply no way to reconcile the economic views of these differing factions. So I am compelled to ask you, who is being punked? Who will be immediately marginalized if John Kerry becomes our next president?

DSpears writes:

Other than protectionism, which is a nebulous concept that as many Republicans are embracing these days as Democrats, what other populist Dem. policies are at odds with "Clintonomics"? The schemes of Robert Rubin were really recycled Eisenhower administration thinking, which conveniently proscribes raising taxes and government spending. I don't think anybody in the Democratic party will feel the least bit "punked" by that that. It is the bedrock of their belief system.

LGL:

Interest rates should be set by the market. The idea of the Fed targetting long term rates (Mortagage rates) is unworkable. Their limited control mechanism (buying and selling government securities) is a VERY blunt instrument in which they have a hard enough time manipulating the shortest of short term rates (the overnight rate).

This is a misunderstanding of how the Federal Reserve works. The Fed does NOT, control interest rates. What they control is the money supply. How interest rates react to changes in the money supply depends on factors largely out of the influence of the Fed. Such a policy would lead to a lot of extreme and pointless fluctuations of the money supply in chasing something that has a very distant and incomplete connection to Fed action (mortgage rates).

Long term interest rates (mortgage rates for instance) are set almost entirely by expectations of future inflation, not by direct Fed action. The Fed is the most important player in that regard, but not improtant enough to use it as a control mechanism. It can literally takes years for Fed action over time to affect inflation in either direction.

The Fed spent most of the period from the great depression until Paul Volker took over chasing another economic goal that was entirely outside of it's control: full employment. That ended disasterously, as would this idea.

The government trying to manipulate market demand is the bedrock essence of Keynsian economics. It doesn't work and leads to a whole host of problems, most of which were exhibited in the 1970's.

William Woodruff writes:

Republican or Democrat, expenditures (gov't) should not exceed income (tax collection). Interest rates are adversely affected (long and short). Which, obviously indirectly affect demand and investment.

William

DS writes:

While the relative balance of the budget has some effect on interest rates, it's very slight. The fact is that government debt is but a small portion of the total debt markets. For each 1% of GDP of government borrowing, interest rates are about 0.03 percent higher than they would otherwise be, all things being equal of course. Interest rates can vary by more than 0.03% in a matter of minutes, with no effect on the economy as a whole.

The real question is, if the entire national debt is costing the market about 1.8% in higher interet rates, what kind of negative effect would the policies required to pay of the $7 trillion dollar be? My feeling is that it would absolutely devastate the economy, something that 1.8% higher interest rate certainly wouldn't.

Remember this: The last time the National debt was paid off was in 1836. Our entire monetary system is based upon the national debt. If it disappeared, the whole thing would collapse. I'm not sure what would replace it, and an imaginary totally free-market system is very interested to contemplate, but it's not happening any time soon. Something to think about to keep things in perspective.

That's not to say that the national debt can be increased indefinitely, but I have no idea what that limit is. People have been predicting the appocalypse of national debt since the founding of the nation and so far the appocalypse has never come.

Sam Jew writes:

It seems to me that the movement of the dollar relative to the Euro, oil, and gold indicates that we *are* moving towards that point.

Lawrance George Lux writes:

DSpears,
You would find the long-term attempts to control the mortgage rates easier than the overnight rate, because it is indeed control of the Money Supply. I have long advocated the Fed be allowed to buy and sell more than U.S. securities, but State and Local bond isssues, Corporate Bonds, etc. This would bring real control of the Money Supply, truly curb Inflation, and maintain consistent interest rates with acceptable rates of return for Investors. This acceptable rate of return would deflate the Stock bubble incited by the monthly investment pattern of Mutual Funds, and reorganize the Price and Investment schedules of Corporations.

The issue of the National Debt is a total disaster. Your fears about the maintenance of the Debt are groundless. It is like saying a Business can not survive, if they self-finance. People said Jackson was going to destroy the American economy by shutting down the central bank and paying off the national debt. The period 1836-1854 was probably as lucrative a Period as the 1940-1970. lgl

Boonton writes:
If Kerry indeed chooses Rubin for this most important position---the left wing of the Democrat party will feel betrayed. Somebody is ultimately being played for a punk. There’s simply no way to reconcile the economic views of these differing factions. So I am compelled to ask you, who is being punked? Who will be immediately marginalized if John Kerry becomes our next president?

Since when did Kerry become the left-wing Democrat? When he won the nomination & the GOP spin machine kicked out of first gear? If Kerry was the left-wing Dem. then where did Howard Dean, Al Sharpton, Kuchinich and Braun fall on the spectrum? How about the fact that many centrists were touting Edwards as the post-Clinton Clinton? Now he is the VP nominee instead of Gephardt.

DSpears writes:

LGL,

You're vision of expanded government power to regulate the economy is frightening. Assuming for a second that we suspend reality and pretend that some theoretical Federal reserve (not the one we have today) has the power to make interest rates go wherever it wants them to:

1) You are assuming that the Federal Reserve is omnipotent and can correctly foresee the immediate and distant future enough to make the correct decisions about what size the money supply should be. Of course this omnipotentence doesn't exist. The Fed works with imperfect numbers, that are revised over time (like the employment reports for instance), that are based on what already happened. The Fed has no "real-time" data at it's disposal, that's why it has been derided as "driving through the rearview mirror".

2) Then there is the assumption that IF the Fed had the correct numbers (it doesn't) in a timely manner (it doesn't) that it's model of the universe would allow it to a) predict what the economy will do in the future (it doesn't), and b) be able to predict what it's own future actions would have on the economy in the future (it doesn't).

None of these conditions are even close to being fulfilled today, and according to Hayek's information theories can NEVER be fulfilled. The individual interactions of the economy are too distributed for any one entity to have enough information at any given time.

Now assuming that all of those problems can be solved, there is the problem of whether the economy SHOULD be manipulated by government.

"This would bring real control of the Money Supply....."

Maybe.....

"..., truly curb Inflation,...."

Again, maybe, but this still assumes that the government has the omnipotence to know the right buttons to push and when. It also doesn't take into account that curbing inflation is only one component of a healthy economy.

"...and maintain consistent interest rates with acceptable rates of return for Investors."

What is the definition of "consistent" interest rates? If the fundamentals of the economy are telling interest rates to move, forcing them to be "consistent", which I read as not changing very much, would cause enormous other problems with supply and demand. If this "consistent" number was too high, the result would be shortages, if too low, inflation. Price controls (since interest rates are simply the price of borrowed money, that is what you are advocating) never work. Their history is clear, consistent, and universally bad.

The market sets interest rates. If the government tries to fight this trend it only causes supply and demand problems elsewhere.

"Acceptable rates of return": Who gets to play God and determine what an "acceptable" rate of return is, you? Greenspan? Each individual determines their own acceptable rate of return and reacts to the market accordingly. There is no such thing as an "acceptable" rate of return for the entire economy. It is a contradictory statement like the "common good". These concepts do not exist ofr the aggregate population, only for individuals.

All of the issues you bring up highlight the falacy of Central Banks, based on the theory of the Omnipotent Bureaucrat. Such thing doesn't exist.

"People said Jackson was going to destroy the American economy by shutting down the central bank and paying off the national debt. The period 1836-1854 was probably as lucrative a Period as the 1940-1970."

I can't argue with that. Central Banks cause as many problems as they solve, as I've highlighted above. But the lack of a Central Bank is no panacea either.

Note: the National Debt only stayed paid off for a fraction of that period, though.

"Your fears about the maintenance of the Debt are groundless."

Are they? Lay out your plan of spending cuts and tax increases, and what effect they would have on the economy.

First, there is no way for the government to tax their way to paying off the debt. Period. Tax revenues as a percentage of GDP have remained around 17-19% from the time of the 91% top rate all the way down to 28% and everywhere in between. The only option for getting that kind of money from taxes is to grow the economy enormously while keeping spending increases to zero. What happened the last time the elected officials had convinced themselves that the budget was in surplus? Did they hold spending constant? Or did they spend like a college kid with a new credit card?

So that leaves significantly shrinking the size of the government. Who is going to do that? Democrats? Republicans? Ralph Nader? Until the Libertarian party can get more than 1% of the vote in any election I wouldn't count on it.

So......

Of course without government debt how can we have the ominipotent Federal Reserve control the economy? The Fed can not, and SHOULD NOT buy private debt instruments. Period. That is off the table and would be (in fact it IS) the first step to Fascism.

So how does the Fed control the money supply then? Only the Treasury can print money, you want to give that job to the Fed?

A lot to consider.....

Boonton writes:
Of course without government debt how can we have the ominipotent Federal Reserve control the economy? The Fed can not, and SHOULD NOT buy private debt instruments. Period. That is off the table and would be (in fact it IS) the first step to Fascism.

If the National Debt was paid off, how would the Fed control money supply and/or short term interest rates? Some possibilities:

1. Buy the debt of other countries, by paying in US dollars the Fed would be able to increase the money supply or decrease it by selling that debt off.

2. Buy physical products. Gold & silver, for example.

3. To create money, the Fed could create its own instrument. Imagine a 'monetary policy lottery ticket' that businesses and individuals could purchase. The 'ticket' would require the holder to maintain a balance in a Fed. Reserve account. When the Fed expands money supply the balances are increased thereby allowing the holders to profit. On the negative side, the Fed is free to drain money out of this account when it wants to contract money supply.

4. I don't see the Fed buying private debt instruments as the 'first step to facism'...whatever is meant by that.

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