The Federal Reserve and the World Economic Crisis—Posner

It may be an overstatement to say that the world’s economy is in crisis, but if so it is only a slight overstatement. Unemployment in the United States is abnormally high, and it is substantially higher in much of Europe. Europe’s finances are in a terrible state, and its output is falling, contributing to economic slowdowns in China and other expanding economies, such as India and Brazil, and harming U.S. exports. 

The Federal Reserve is under some pressure, both internal and external, to reduce interest rates in an effort to stimulate U.S. output and employment. The Fed can do this by buying securities, whether short-term Treasury notes—the traditional method of stimulating the economy—or longer-term obligations, including 30-year mortgages. By buying short-term securities for cash, the Fed increases the supply of money, which in turn reduces interest rates. There is an indirect effect, because of substitutability, on long-term interest rates as well. But by buying long-term securities, the Fed can reduce long-term interest rates slightly more. A reduction in long-term interest rates will reduce mortgage interest rates, which, since houses are bought mainly with debt, should increase the demand for housing, and hence home prices. At the same time, lower short-term interest rates will make credit card debt and other forms of consumer debt and by thus stimulating consumer borrowing will stimulate consumption. The lower long-term rates will increase personal wealth by raising housing values (a house being the most valuable asset owned by most families), reducing the savings rate and thus further stimulating consumption. The higher consumer spending is, the higher the production of consumer goods will be, as well as of capital goods to enable that higher production; and the higher production, the greater the demand for labor, so unemployment will fall. 

In this way monetary policy can, in principle anyway, raise an economy from the doldrums, and in the current setting protect the U.S. economy against fallout  from Europe’s economic crisis and from the downward global economic spiral that that crisis may be inducing. 

But there are three reasons for doubting that the Federal Reserve’s using its monetary authority to reduce interest rates at this time is a good idea. The obvious ones seem to me weak: that the necessary measures would create serious inflation risk and that they would increase the already enormous federal debt. The rate of inflation is at present very low, and, judging from the interest rate (less than 2 percent) on long-term Treasury securities (for example, 10-year Treasury bonds), is expected to remain low for some years. This expectation is influenced by beliefs about whether the Fed will try to reduce interest rates; but since no one thinks the probability zero, it seems unlikely that the 10-year interest rate would be so low if action by the Fed to reduce interest rates were expected to cause inflation, which of course would raise interest rates. Moreover, as long as interest rates are low, increasing the federal debt is a low-cost proposition. At 2 percent, the annual cost of borrowing $1 trillion is only $200 billion. That is a large number, obviously, but only about half would be borrowed abroad, and $100 billion is a small fraction of the annual federal budget. The half borrowed from Americans would be an internal money transfer rather than a transfer of money abroad. 

The more serious objection to the Fed’s pushing down interest rates is that it probably would have little effect on borrowing, consumption, production, and employment. The reason is that interest rates are already very low, yet borrowing is lackluster. One reason is that, in part because of pressure from regulators, banks have raised their credit standards, so that many individuals and firms, though they would like to borrow and would be willing to pay the current interest rates, cannot persuade banks to lend to them. Another reason is that household savings are still below historic standards because of the depression in housing prices (and as I said a house is the most valuable asset that most households have) and because of continued economic anxiety people want to increase their savings—and savings are the obverse of borrowing. And finally concerns with bank solvency and new federal regulations are inducing banks to increase their cash reserves, which is an example of hoarding rather than spending. 

If banks are reluctant to lend and consumers to borrow, increasing the supply of money will not lead to a big increase in borrowing. Instead the banks will use the money to buy Treasury securities, which are riskless assets. The money will go in a circle: the Treasury will buy securities from banks, and banks will use the money to buy securities from the Treasury. Or the Treasury will buy securities from nonbank owners of them, who will deposit the proceeds in banks, which will use the additional cash to buy Treasury securities or increase cash reserves. This is an exaggeration, but can help one to see why increasing the money supply need not increase productive activity. 

The idea that increasing the supply of money must stimulate economic activity, though mistakenly thought to be an idea of Keynes’s, is actually an echo of “Say’s Law,” which Keynes famously attacked, though he was not the first economist to do so. Say’s Law, rather confusingly paraphrased as supply creates its own demand, treats money as a medium of exchange and a standard of value, but nothing more. This is essentially a barter theory of the economy. But modern economies are not barter economists. In a modern economy, receiving money in exchange for some good or service doesn’t dictate that you exchange the money forthwith for some other good or service. You can save the money indefinitely. If you put it under your mattress, it makes no contribution to productive activity. Similarly, money can pile up in Federal Reserve Banks if people are disinclined to spend, without contributing to economic activity. 

Largely for political reasons, there is no possibility of a different kind of attack on our sluggish activity, which would be for the Treasury to borrow a large amount of money at the current low interest rates and lend it to enterprises that would use it to increase production and with it employment. By raising wages such lending might increase incomes and economic confidence, leading to increased tax revenues and an eventual reduction in the federal deficit. But since that kind of economic stimulus spending is not in the cards and an increase in the money supply seems unlikely to have a significant stimulative effect, it seems that we shall have to be patient and let the economy recover under its own steam.

Comments

[Thomas Rekdal]

If "quantitative easing" is not having the expected (or hoped for) effect in increasing production and employment (apart, perhaps, from elevating stock prices higher than they would otherwise be); and if the federal government, because of political constraints, is unlikely to take advantage of lower interest rates to borrow long and finance massive infrastructure spending, what exactly is it accomplishing beyond penalizing savers, pension funds, and people on fixed incomes? As one of the latter, I can personally testify that my own spending has been dramatically curtailed by the current Federal Reserve policy.

[kostis]

At 2 percent, the annual cost of borrowing $1 trillion is only $200 billion ?????? maybe 20 billion?

[BigEd]

So you recommend " . . . . the Treasury borrow a large amount of money at the current low interest rates and lend it to enterprises that would use it to increase production and with it employment"

That sounds almost Keynesian. Your lunch pass at the U. Chicago faculty dining room may be under review.

[Terry Bennett]

Perhaps the Judge was rushed this week: a word or two went missing, and 2% of a trillion is $20B rather than $200B - making the point all the stronger. Regardless, we of course appreciate you giving what you can to the discussion.

If the national debt is $16 trillion, the interest on it at 2% is $320 billion, about 8% of the 2012 federal budget of $3.8 trillion - not horrible. Still, Congress and the Presidency have shown with exceptional clarity in recent times that they cannot be trusted to spend our money prudently, as seen by the rate of increase in the debt - i.e., the deficit. While it might not be expensive to dig the hole deeper right now, it is still ill-advised because (a) it is still digging the hole deeper, an undesirable practice in principle, and (b) I have no confidence that our money will go to anything other than boondoggles that will increase the wealth of the connected and do little else. (I speak of legislative initiatives.)

The option to "be patient and let the economy recover under its own steam" is appealing, because this prolonged period of economic calm is teaching fiscal discipline to the populace. Guess what, most people in fact can't afford a boat to go with their big house and 3 or 4 big cars. It is important to our long-term economic health for everyone to make the fundamental causal connection between production and consumption, which was lost to us a few years ago. In 2007, you could actually live in the churn, and lots of people jumped in. Now there is no churn, and in the clearing we are once again learning to see a direct correlation between how much money we make and how much we spend. Instead of grousing that you can no longer afford your dreams, here's an idea - wake up. Find your true niche, the true market value of your production, and either bring your spending into line with that or find a way to produce more.

As I have said before, the economy will rebound when people grow confident beyond their mere ability to pay their bills, and give into the urge to consume. We want stuff, and the day will come when we start buying it again, responsibly.

[Misaki]

>At the same time, lower short-term interest rates will make credit card debt and other forms of consumer debt and by thus stimulating consumer borrowing will stimulate consumption.

The amount of debt held by the poor and percentage of income that debt payments make up is already much too high. http://www.epi.org/page/-/BriefingPaper292.pdf

If the only benefit of lower interest rates is that they cause the POOR to spend more, this can really only create "more demand" to the extent that it causes people to declare bankruptcy.

Job creation without government spending and without injection of more money into the economy by the Fed. http://jobcreationplan.blogspot.com/

[Misaki]

>Say's Law... In a modern economy, receiving money in exchange for some good or service doesn’t dictate that you exchange the money forthwith for some other good or service.

This is not why Say's Law is not observed in practice. In theory, if people reduced the amount of work they did when they had enough money, then someone who offered to work could create 'demand' by lowering their wage price compared to what other people offer.

But people don't work less, either because they're already doing minimal or no work or because they are following the groupthink/illogical idea that "working harder helps the unemployed". An accelerated work week would fix this and cause Say's Law to be observed in practice. http://jobcreationplan.blogspot.com/

>and lend it to enterprises that would use it to increase production and with it employment.

Money that is lent must be paid back. Very few companies are in a position to make even higher profits (since it is profits that determine business decisions, not revenues) because those that could already have plenty of cash or can already cheaply borrow money to make necessary investments.

This idea of "lending" money to fix an unexplained shortfall in demand is the same logic that lead to the housing bubble.

[Atlas]

Would free banking perform any better?

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[NEH]

Oop's, "Typo", one significant digit can have a major impact. :) The operant terms seem to be "Confidence" and "Hoarding". Which seem to be borne out by the latest June 6, 2012 FRB Beige Book Report. The National Summary reports that across the 12 Districts, on average, National production is flat to moderately up and loan demand is up slightly. Although loans are harder to get. Overall the confidence level is "Cautiously Optimistic" controlled by fears of the current U.S. political uncertainty and the ongoing European Debt Crisis.

All of this indicates a continued sluggishness and lethargy in Economic recovery since the grand failure in the Financial/Commercial sectors, the occurence of the Great Recession/Depression and the subsequent collapse of Production.

Hopefully, things will continue to improve (provided an obstructionist Congress gets out of the way) and we can truly begin to bring down the unemployment rate by increasing sales and production.

[Bill]

"But there are three reasons for doubting that the Federal Reserve’s using its monetary authority to reduce interest rates at this time is a good idea. The obvious ones seem to me weak: that the necessary measures would create serious inflation risk and that they would increase the already enormous federal debt."

How does the Fed's using its monetary authority to reduce interest rates increase the "already enormous federal debt"? Is the assumption the Fed would buy newly-issued Treasury securities?

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[tani and tallulah]

I understand little of economics but I have a suggestion. What if the govts or the reserve or whoever, created packages to give money (real pay type money) to unemployed or small businesses to create 'clean up' strategies AND implement them. I am thinking from small to grand scales, so that not only do you stimulate the economy by creating employment and new jobs, but also clean up the environment at the same time. So if Mr Obama gave me (insert decent weekly wage here) to clean up the local parks. Or on a larger scale offered grants for communities to create groups that can clean up larger messes or install solar panels or compost green matter into parks or invent new microbes to break down pollution. I am sorry, it is late and I am not stating this very coherently. Anyway, you get what I mean, a double feed solution. Man, if someone offered me a $100 a week to keep an eye on and tidy the local park (on top of and aside from what the local council does - or more to the point doesn't do). Obviously there would have to be accountability but this could be a huge global concept, on the nanno (individual), micro (small biz under 100 employees) and macro (big corps) level. Real Positive Stimulus. We make so much junk on this planet, and we have to keep making more to keep the economies of the 1st world functioning, but where does it end? How much rubbish can we make and how much can we consume? When you have a tv as big as a cinema screen??? It is why everything is now designed to either break, fall apart or be redundant within a year of course, to keep the growth happening, but ultimately resources are finite. Recycling? REAL recycling. Watch a documentary called SLUMMING IT. About a slum in India. It is a life changing doco. They recycle around 80% of their waste (the conditions are horrid though, but the concept is amazing) Have an awesome day folks. May your big brains be able to sort all this out. http://www.abc.net.au/tv/programs/kevinmccloudslummingit.htm

[tani and tallulah]

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[Jack Walton]

Household "Personal Interest Income" has declined over $400bn from 2008, ("Personal Dividend Income" has recovered to 2008 levels) YET "Personal Interest Expense" has declined only $120bn. The difference is close to 2% of nominal GDP. Let's call this a "perverse difference". The only beneficiaries seems to be the Federal Government and investment grade bond issuers.

And it's not just under-water homes which can't be refinanced that keeps consumers from borrowing -- there is a heightened perception of risk by householders, an uncertain economic outlook and tax clime for those capable of borrowing, and no inducement from the tax code to borrow post the 1986 reforms.

I agree with David Malpass --

[TANSTAAFL]

Most any sentient being would recoil at what the Fed is doing. The fact that so many take the Fed's macroeconomic experimentation for granted is troubling.

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[NEH]

affl, "Any "sentient" Being"? I guess this only includes the New "Right" or is it "Wrong" and the likes of the "Tea Party". Or other Progressive Political Economists who would like to see the whole current Financial/Commercial system overhauled and brought into the 21st Century...

[Christina]

So, why does the fed, the government and the people insist that something needs to be done if the best course of action is to just let things run their course? I think that there are simply too many chefs in the kitchen (oh no, the soup has been over salted!!!). Leave politics and the government out of this.

Why are people not spending and banks not lending? Because we are all scared that worse is going to come. That is really it. If we can find a way to incite confidence again, which can only be done if the economy finally turns around (in my humble and noneconomic schooled opinion), then people are going to start spending again.

Also, Dr. Posner, very informative and well written. I am learning a lot from this blog.

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[Ray Lopez]

"The idea that increasing the supply of money must stimulate economic activity, though mistakenly thought to be an idea of Keynes’s, is actually an echo of “Say’s Law,” which Keynes famously attacked, though he was not the first economist to do so. Say’s Law, rather confusingly paraphrased as supply creates its own demand, treats money as a medium of exchange and a standard of value, but nothing more. This is essentially a barter theory of the economy. But modern economies are not barter economists. In a modern economy, receiving money in exchange for some good or service doesn’t dictate that you exchange the money forthwith for some other good or service. You can save the money indefinitely. If you put it under your mattress, it makes no contribution to productive activity. Similarly, money can pile up in Federal Reserve Banks if people are disinclined to spend, without contributing to economic activity. " - this passage is amazingly bad revisionist economics, bad paraphrasing of the liquidity trap, and ignores Keynes Money Illusion short term stimulus argument. This is economic 'science'? Wow.

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