Economists David Rose and Larry White make a compelling case, in this op-ed, that the root cause of today's economic turmoil is excessive growth in the money supply between 2001 and 2006. Here are two key paragraphs:
In reality, excessive money growth drove asset prices up and drove
interest rates down, making people feel richer than they really were
and lowering the cost of borrowing money to facilitate more spending.
Since the level of spending before the period of excessive money growth
was just sustainable, the resulting level of consumption and business
investment spending was unsustainable. The solution is to allow asset
prices to fall to levels that accurately reflect what our economy can
produce. This will make it clear to people that they are not as rich as
they thought two years ago and thereby return spending to sustainable
levels.
interest rates down, making people feel richer than they really were
and lowering the cost of borrowing money to facilitate more spending.
Since the level of spending before the period of excessive money growth
was just sustainable, the resulting level of consumption and business
investment spending was unsustainable. The solution is to allow asset
prices to fall to levels that accurately reflect what our economy can
produce. This will make it clear to people that they are not as rich as
they thought two years ago and thereby return spending to sustainable
levels.
Still, virtually everyone agrees that we need to further stimulate the
economy even though current attempts to solve our crisis by increasing
spending is exactly the wrong thing to do. No one wants to bear the
political cost for appearing to be uncaring by favoring a policy of
"doing nothing." Out of political cowardice, the federal government is
attempting to produce a solution that is penny-wise and pound foolish.
You can't solve an excessive spending problem by spending more. We are
making the crisis worse.
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{ 25 comments }
Please, this is not political cowardice. It is political opportunism.
Prescribing spending to jumpstart the economy is giving leeches to hemophiliacs.
This essay is so confused:
"People believed they didn't have to save as much for retirement or for their children's college education. And they could borrow more against their increased home equity, allowing them to buy more goods, services, stocks and real estate. Credit-fueled spending reinforced the rising prices of everything, but especially real estate and stocks."
They didn't have to save so much, so they bought stocks and real estate? Buying assets is saving. You don't consume a stock, you forgo consumption now to get a stream of dividends. Money growth shouldn't cause an asset bubble, money growth lowers interest rates and makes people want to consume more now, not in the future. Excessive money growth would cause rapid inflation in consumption goods.
A positive wealth shock, would cause increased spending today and tomorrow, but there is no reason that spending would be concentrated in a certain sector like housing. A positive wealth shock causes a consumer to consume more of everything (at least at the margin).
Also, why do Austrians always look at the fed funds rate?!? Who borrows at the fed funds rate? Not homeowners, not businesses, why not look at long term rates? If the fed funds rate is too low, long term rates won't budge because of forecasted inflation and higher future rates. Can someone please explain that to me?
Charlie
Just think how ticked they're gonna be when it doesn't work. There's gonna be a lot of "if they only did what I told them to do" statements,
Then blame the other party, then blame the press, and finally it'll be some fictional demographic that's just not spending the way we need them to.
everyone's at fault except the Govt
I was just about to make this point. The 10 year Treasury rate has been remarkably low for years, and a low Fed funds rate doesn't easily explain it. On the other hand, the largest group of would be retirees in history, both in absolute terms and relative to the following generation, expecting the longest retirement in history, is just now reaching an age at which they start investing for income rather than growth. The peak of the payroll tax surplus this year is more interesting because it signals this turning point than for its immediate effect on the Social Security system.
So why don't we discuss this peak daily here? Why don't we discuss the declining growth rate of the labor force? Why don't we discuss the predictable absence of any labor force growth in the U.S. (or Japan or Europe or China) by the end of the coming decade? Why don't we discuss the fact that Japan's labor force is already shrinking and will never grow again if current trends persist? Why don't we discuss the simultaneous explosion in the population of would be retirees? Why don't we discuss any real economic variables at all, only financial abstractions, like "the money supply", and politics?
If I hope to retire at 65, my desire to consume now, rather than in the future, is less a function of the prevailing interest rate than a function of my age. If I reach 50 without sufficient entitlement, I'm very concerned about future consumption regardless of the real interest rate. I'm even more concerned if the rate is low. If real interest rates are low, people at this age will try to defer more consumption rather than less, because they must hit a fixed target at 65 but expect less growth of their savings.
The general price level is correlated with the money supply, but correlation should not be confused with causation. Prices are seldom driven by the money supply. More commonly, the money supply reacts to changes in the general price level which can be affected in many ways unrelated to the money supply. Money growth depends on the demand for bank loans and the willingness of banks to lend. The Fed can influence the demand through its control of the interest rate. Only if it sets the interest rate too low for an extended period would the money supply grow fast enough to put upward pressure on prices.
http://wfhummel.cnchost.com/misconceptions.html
But the problem is no longer excess spending.
So you are attacking government for addressing the current problem, a shortage of spending rather than the old problem, too much spending.
Why am I not surprised?
Charlie,
Expanding the supply of credit lowers the interest rate, that is, the price of borrowing money, and at a lower price more is demanded. More people borrowed more money than they otherwise could, because the supply of credit was artificially padded by the Federal Reserve and the banking system. Borrowed money went toward creating the dot-com and real estate bubbles, and also to increased consumption.
The Federal Reserve does not set the Federal funds rate, but targets it. To meet reserve requirments, banks can reduce their lending. But by way of its open-market operations, The Federal Reserve can provide excess reserves to the banks. Any bank that has failed to meet its reserve requirement can then borrow from another without redusing its lending.
When the Federal Reserve targets a Federal funds rate of 0%, it pumps the banks full of reserves by buying up their assets (like government bonds) until the price of borrowing is practically 0%. In other words, it buys assets with freshly printed money until no bank has difficulty meeting its reserve requirement. Selling credit to a bank is then like selling snow to Eskimos, and the Federal funds rate plummets.
Interest rates then go down to ordinary bank customers, because the supply of credit has expanded greatly. The Federal Reserve simply targets the Federal funds rate, as opposed to another interest rate, because it is more easy to monitor.
The problem with all this is that people do not invest with money, but with resources. That which is earned but not consumed (i.e. savings) is the stock of resources with which to invest. By padding the money supply the Fed (and the banking system itself) artificially lowers interest rates, which makes it seem as though the stock of available resources to invest is larger than it really is. Inevitably this creates a credit shortage–the bust which follows the boom.
Mike,
Screw the 'general price level'. Higher prices caused by an expanding money supply do not occur equally across an economy.
Recent inflation (by which I mean higher prices) has been focused in real estate. Why? Because the supply of homes is inflexible: a lot of time and a lot of red tape. And also because so much of the excess credit entered the market as mortgages.
When people have more money, demand rises and supply is stimulated. Pumping money into the economy to buy cheap goods from China would not create much inflation, because China counteract the expanding money supply with more goods and services. They think everything is rosy, 'hey, look how much Americans want to buy our stuff!? Excellent'. What they do not realise is that the dollars they are receiving are being devalued, both because of a growing fiscal deficit and unsustainable monetary policy by the Fed.
Inflation (i.e. higher prices), therefore, shows up in places like real estate and gets a bubble rolling. Anything similarly inflexible and associated with housing also increases in price, such as construction workers' salaries.
Martin,
It is quite reasonable to take issue with that statement. It was quite loose. Money growth only lowers interest rates in the very short term anyway. If money growth leads to inflationary expectations, it can cause many/most interest rates to rise. But my critique of their article still stands, they appear not to know what saving is.
The real story has a lot to do with the "global saving glut" lots of saving by the rest of the world, of which the U.S. got a premium (if you were one of china's new wealthy class, where would you keep your money?).
Parts of their article are right. People did use their homes as ATMs. But their story is messed up. Just lumping houses and stocks in as consumption is dumb. There is no way in which buying a stock is consumption. And buying a house is consumption only to the extent that it isn't durable. So if you buy a house with a downpayment, you probably saved rather than consumed. Sure you have an outstanding liability (a loan), but you also have an asset (a house). You only consume whatever depreciation cost there is.
My response was a bit confused, but their article was worse.
Charlie
Nice clean up job, Lee.
And I didn't want to dispute one of the cites above, but a year ago the Fed Funds rate was 3.50. Today it's 0.25. I'd say that's a pretty significant change.
http://tinyurl.com/68h3o
More thoughts here:http://tinyurl.com/amtnfl
Prices rise and fall. It is the volume of money that inflates or deflates.
How about taxes and maintenance? Where I live I can rent house for half the cost of "owning" it. I can invest that "savings" in a lot of other things, like a 3% government guaranteed account at GMAC bank.
Oil Shock,
No, creating prosperity with a fixed money supply deflates, and likewise, destroying prosperity inflates.
Since the net change in the money supply created by credit expansion is zero (the upward pressure on prices created initially is offset by an equal downward pressure when a loan is defaulted on or paid off), the only way to create real inflation (after the effect of borrowing is offset) is to destroy prosperity.
Oil Shock,
No, creating prosperity with a fixed money supply deflates, and likewise, destroying prosperity inflates.
Since the net change in the money supply created by credit expansion is zero (the upward pressure on prices created initially is offset by an equal downward pressure when a loan is defaulted on or paid off), the only way to create real inflation (after the effect of borrowing is offset) is to destroy prosperity.
Lee,
You only have half the story. The Fed targets the fed funds rate, that is not the interest rate. It is the interest rate that banks lend to other banks overnight. That doesn't determine the amount of investment in the economy. The amount of investment in the economy is determined by the productivity of the investment compared to the interest rate over that horizon. If the fed is printing too much money, the long term interest rates should rise not fall.
The part you seem to be missing is that when banks loan money, it can finance consumption as well as investment. The crisis was caused by unproductive investment. The fed doesn't force people to make investments. If the investment did not yield more than the interest rate, people should have consumed. And consuming would show up as inflation. The fed isn't on the hook for unproductive investments, that problem lies with investors. The fed is on the hook for inflation, which was modest throughout the period.
Charlie
"You only consume whatever depreciation cost there is
How about taxes and maintenance?"
Maintenance is obviously included in depreciation. You can quibble with property taxes, I suppose. But what's the point? The point is a small part of the house is consumed each year and the rest is held as an asset.
The point you bring up actually strengthens why the fed isn't responsible. People should have been making the same cost/benefit you did (and I did), that is, a house at a high price can't possibly provide an income stream comparable to renting. Thus, no matter what the interest rate, there shouldn't have been an asset bubble.
Charlie,
The Federal funds rate is an interest rate. It falls to zero percent when the supply of money is unlimited, that is, when the Federal Reserve pumps money into the system faster than banks can loan it out. Then no bank has trouble meeting its reserve requirements, and without any demand and unlimited supply, the price of inter-bank borrowing falls to zero.
When banks have an unlimited supply of money other interest rates fall too. When the price of credit falls, more is demanded. Since the price of goods does not immediately adjust to the increased money supply, borrowers can then go out and spend spend spend. Some of the inflation (i.e. rising prices) is hidden behind an artificially increased supply (except in real estate where supply is less flexible).
But since investment is far outpacing savings (because the Fed pads the credit supply), the growth path is unsustainable, and many of the loans turn out to be malinvestments. Market participants are being fooled by low prices and high demand, but the Fed cannot fool all of the people all of the time.
Once the loans come due and the mistaken investments are exposed, reality kicks in and delivers unwelcome news: you just squandered your savings (that is, the resources with which to maintain future consumption), now you're poor and have to begin saving again.
The dollar has already been devalued because of this, and we're just waiting for prices to catch up and let everyone else know. Interest rates should rise because the Fed is printing too much money, and they would have already if the Fed hadn't started printing even more money. But you're right, and one way or another they will rise.
One thing everyone seems to forget is that worldwide inflation was indeed starting to take off in 2007 and early 2008. This was borne out by the price of a wide range of commodities as well as the reported inflation rates of numerous foreign countries whose currencies were pegged to the dollar. I remember reading articles in early 2008 about concern over dollar denominated inflation by bankers in China, Dubai, and other asian nations. If I remember right, part of the oil run-up was attributed to dollar inflation as that commodity is universally priced in dollars.
For inflation to start perking up in 2007 is just about right given a typical lag period from the loose finance/credit policies in the preceding 3-5 years, and the fact that growth in consumer spending was matched by a huge growth in retail production in places like China during the same period. The creation of new production slowed the appearance of inflation.
Unfortunately, the consumption was driven in large part by taking phantom equity from the one market that DID show inflation, real estate. i.e., the economy was growing primarily on credit. Now that the real estate (and associated derivative) bubble has burst, there isn't anywhere to steal equity from and it is obvious to see that the prior consumption levels were simply unsustainable.
To be sustainable, consumption must now come back down to a level where it is based on real income/profits rather than borrowing and excess production will have to go away. An individual who borrows/spends beyond their future income/ability to pay must eventually go bankrupt and reduce spending. This simple principle is simply applying itself to the economy as a whole.
Lee,
Of course the Fed funds rate is an interest rate, but it's not THE interest rate. And it's especially not a very meaningful one. It isn't the rate that is of concern for much investment. In your story the long term rate is under priced and the prices of consumption goods are under priced. That is not a very high opinion of markets. I take it you are shorting long-term bonds and buying durable consumption goods: gold, art, maybe baseball cards?
Charlie
Charlie,
The Federal funds rate is an important interest rate. What does a zero percent Federal funds rate signal? It means that banks are not borrowing from another to meet their reserve requirements, that is, the Federal Reserve is adding to banks' reserves (by purchasing bonds and other assets with freshly printed money) faster than banks can lend. This expansion of the credit supply pushes all interest rates lower than they would otherwise be.
If the false signals being sent by these manipulated prices were true, then there would be no problem with the current situation. The market is operating fine, but junk in, junk out; the Federal Reserve has been corrupting the market with false signals (i.e. lower interest rates). The discrepancy between savings and investment was too great, and now we are facing the consequences.
If I had any savings, I would be investing in commodities, precious metals, and buying more stable currencies.
I'm with Charlie here. I understand how the Fed persuades banks to lend to one another at a low overnight rate by paying dearly for T-bills, but I don't see how a bank's willingness to lend overnight at a very low rate drives down the yield of ten year Treasury notes. How do you suppose that happens?
Are you suggesting that banks borrow short and lend long without charging the long borrower a rate compensating for the bank's risk? Why would banks behave this way? A low short rate alone doesn't explain for the behavior. Unless banks behave this way, lending short at a very rate does not explain lower long rates.
A low short-term rate may send a false signal, but it's not a false, long term signal unless banks expect the low short rate to remain low indefinitely (in which case it's effectively a "long" rate rather than a "short" rate); therefore, the short term money borrowed at the lower rate does not compete with long term money chasing long Treasury notes for example.
Lots of money lent short might explain an inflationary consumption boom, but to explain the low long rate, you need lots of money lent long, not lots of money lent short. The low mortgage interest rate policies explain lower long rates to some extent, but the Fed didn't buy the mortgage backed securities, and banks presumably didn't borrow overnight to buy mortgage backed securities either, because even if these securities are nominally as safe as long Treasuries (not), they still carry a long term equity risk because long rates are variable.
So where did all of this long money come from? That's the question. If we believe the Austrian account of human action, people lend long to defer consumption, so why did so many people lend so long in recent years?
I suppose lots of people wanted to defer consumption, and this explanation is completely consistent with demography, i.e. a relatively large population of would be retirees has been trying to defer consumption lately. Right? Why ignore such an obvious explanation, consistent with Austrian theory, in favor of some theory focused exclusively on Fed policy?
This signal of desired future consumption is not false. Is it?
But what happens when we "save" lots of money without actually purchasing the real means of production required to produce the goods we didn't consume as we "saved"? And what are these real means of production?
If a bank has $100k of deposits and a 20% reserve requirement, then 80k of credit is available. Potential borrowers bid for credit, and an equilibrium interest rate is discovered.
For example, if demand for credit is too low, then the supply of credit will contract. Depositors find the rewards of saving to be insufficient, and the risks too great, to defer consumption, and the stock of available resources to borrow declines. Interest rates are then bid up until depositors once more find it worthwhile to save. Foregoing consumption increases the stock of available resources to borrow and interest rates fall again.
Banks borrow overnight to meet their reserve requirements. Suppose that our bank loans out $82k. To meet their reserve requirements, they might borrow overnight from another bank. The Federal funds rate is the interest rate which emerges in this market.
To lower the Federal funds rate the demand for overnight borrowing must decline. By way of its open-market operations the Fed can achieve this.
Suppose that our bank loaned $10k to to the U.S. treasury in exchange for a bond. To eliminate the demand for overnight borrowing (thereby lowering the Federal funds rate), the Federal Reserve can print money and buy the $10k bond from the bank. It then has no difficulty in meeting its reserves, and, in fact, now has an additional $8k to loan.
If the Federal Reserves is targeting a zero percent Federal funds rate, then the bank could loan all $100k of its deposits even though it has a 20% reserve requirement. The Federal Reserve will immediately buy up its assets (such as government bonds), until the reserve requirements are satisfied. Otherwise demand for overnight borrowing would increase and the Federal funds rate would rise.
By increasing the available credit our bank has to borrow, the Federal Reserve pushes down all interest rates.
Unfortunately, this "drives a wedge" between real savings and available credit. The stock of available resources to borrow is that which is produced but not consumed. As people consume more and save less interest rates ought to rise, since the stock of available resources to borrow is declining, but the Federal Reserve artificially pads the supply of credit.
I think your demographic insight is important, and perhaps a contributing factor to the current problems, but the Federal Reserve's reckless monetary policy seems to me a bigger culprit.
All macroeconomic reasoning must start
from the principle of scarcity.
White and Rose's argument is a nonsequitor. While spending may have been too high, higher than productive capacity, a couple of years ago, that doesn't mean that spending isn't too low now, below productive capacity. It doesn't mean that spending shouldn't be higher now.
They provided no evidece that current levels of spending are matching current productive capacity.
While I think it likely that there was too much investment in housing and maybe even too much consumption, that means that there is too little investment in things other than housing. (Well, if this is just the U.S. economy, we could export and increase our net worth relative to the rest of the world.) But there is no need for total spending to be less than productive capacity just because it was too high before.
There can be shifts in total spending to better reflect preferences. This can adversely impact productiion and employment as resources are redeployed. But there should be always be shortages to match surpluses.
The notion that we should spend less, so less will be sold, so that less should be produced — is basically false. It is contrary to the basic economic principle of scarcity.