He writes,
The Fed cannot have much impact on market rates through pure intermediation—borrowing with interest-earning deposits to purchase other financial assets—any more than Fannie Mae or Freddie Mac can. The Fed can do so, even in a highly segmented market, only by altering the quantity of outside money. Only then will it have any temporary effect on the net quantity of loanable funds and the net portfolio of the public’s real assets. Today’s low interest rates are not ultimately the result of Fed policy but of a decline in the natural real rate.
Pointer from Scott Sumner.
If the Fed is just a bank, then it’s just another bank. And that is how I think of it. Where I disagree with Hummel is that I don’t think that altering the quantity of outside money by a few percent does anything, either.
In any event the paper is a good antidote to the magical thinking that tends to surround central banking.
Not surprisingly, Sumner has a take that differs from mine. He writes,
some people claim the Fed has little or no control over the economy. In that case they could set rates where ever they wished, and life would go on as usual. I take almost the opposite view. I believe they have very little room to adjust rates without creating a spiral toward hyperinflation or hyperdeflation. Why don’t we see those disasters more often? For the same reason we rarely see buses plunge off 100 foot cliffs–the Fed usually follows the road.
Think of the financial market as creating the road. I think of it as more like a set of railroad tracks than a paved road. In my view, the Fed has to really jump the tracks to have any effect. Small changes in policy, within the range of what we observe, don’t change where the train is headed.
Was it the market and economy that took us to zero percent interest rates in 2008? Why would that be? Wasn’t there a lot of fear in lending, worries about return of capital rather than return on capital, and counterparty risk? I would expect higher market rates of interest.
Yes, it was the market and economy. Real rates are down the world around.
So is inflation, except in basket-case countries in the midst of crisis.
We can interpret low real rates as there being a lot more savings relative to known good investment opportunities.
The question is, is this problem coming mostly from the demand side, the supply side, or closer to an even mix of both.
I would say that despite all the talk of a “savings glut”, the supply of savings hasn’t changed too much and isn’t much correlated with interest rates. Consider, the personal savings rate in the US is now near its historic lows again, below 4%.
So the problem is mostly on the demand side.
The demand for loanable funds comes mainly from people needing credit for consumption, and businesses needing credit for capital investment. Governments borrow a lot of this money too, most of which goes to consumption, and some of which goes to “investment”, though it’s not easy to agree on how much, or what the actual returns on those investments are. I think I’m safe in assuming those yields are pretty low, and certainly lower than in the private sector.
The demand for new consumer debt is limited by current indebtedness, and expected future income. Wages are pretty flat, and consumers (in the US at least) are already pretty heavily indebted. So this part of the demand side is indeed stagnating.
What about business investment? Notice that lots of big companies are sitting on truly gigantic piles of cash, not knowing what to do with it. Warren Buffett’s Bershire Hathway is now sitting on $100 Billion – a cash reserve which has doubled in just 3 years, and doesn’t know what to do with it. All the big banks are collecting 1.25% on $2.1 Trillion in Excess Reserves, because they don’t know anything more lucrative to do with that money. (By the way, what is the current market value of an enterprise with $26 Billion in practically risk-free income a year? That’s what the Fed has given the banks with the IOR policy, which is still around … why?)
So businesses aren’t borrowing as much because they’re out of ideas for what to do with the money that would have a high return on investment. How can that be?
Well, the simple story of business investment is something like this. A dairy farmer can only milk so many cows in a day, and he gets an income of $1,000. But someone invents a machine which costs $5,000 (assume zero maintenance and depreciation for the moment). And with that machine, he can milk 50% more cows, and get an income of $1,500. But he doesn’t have $1000 in savings. But if he can borrow $5,000 at anything less than 10%, he will be able to pay the interest and still come out ahead. That’s because the new piece of capital equipment will make him more productive.
But imagine there was no new invention. The farmer’s productivity would stagnate, but importantly, his demand to borrow lots of capital would be much lower.
Skipping over a long explanation I’ve laid out here before, the point is that most people in most developed (and even developing) economies are now no longer involved in complementing working capital in the form of machines to produce physical output or “stuff”. Instead, a large and increasing majority of the labor force is providing some kind of service in close proximity to other people.
Certain irreversible technological and economic developments mean that most workers must, necessarily, be performing services which can only be done by humans and at human speed. They are Baumol jobs. The fundamental nature of the tasks being performed means that there is just no way to keep squeezing out more output per man-hour year after year for these services. So they have flat and stagnating productivity, and more and more people are doing jobs like that, until, sometime soon, nearly everyone in the world will be doing jobs like that. “Victims” (in a perverse sense perhaps) of mankind’s own success: of the astounding technological progress in the stuff sectors.
The main source of productive capital, not in the aggregate necessarily, but for most workers these days is not machines or IT, but a very tiny percent of the earth’s real estate, the only places where it is possible for the most productive people in the world working in particularly lucrative sectors to exploit extremely large economies of agglomeration. But borrowing to buy zero-sum central real estate for residential and commercial uses is different than buying new machines.
And that means practically every business is now in the same situation as the farmer was in when nobody invented the new dairy machine. If there is no way to augment these kinds of workers with new working capital to make them more productive, then there is no business demand to borrow money to purchase that capital, and the demand side for loanable funds collapses. Everywhere in the world.
And there is literally nothing anyone, anywhere can do about any of that. It is a technologically determined inevitability that is policy independent, a fact that is attested by the observably global nature of the phenomenon.
In fact, the only thing that could really change the current situation of low interest rates and stagnating average productivity are sci-fi-level, game-changing technologies like strong-AI or emulated minds, that will cause changes so radical that really all bets are off and it’s not reasonable in the slightest to discuss them in the context of some road to a “return to normalcy.”
Indeed, the more we look at the best parts of the era immediately following WWII, where one could be average and still share in good amounts of social status, social capital, and general prosperity, the more we realize that, from a broad historical perspective, that era was far from “normal”, and was a kind of long, pleasant aberration. And now, “Average Is Over:”.
Of course, with depreciation, there is a large demand for loanable funds, even in the world you describe.
Not necessarily. Businesses can pay for depreciation out of revenues, and it only makes sense to borrow to pay for it under certain conditions and expectations which don’t hold in the current marketplace. Also, a lot of “depreciation” these days is constructive for tax, public policy, and accounting purposes, not being of a physical and tangible nature, and this gives rise to all sorts of conceptual trouble when working with aggregated numbers. Finally, depreciation rates of certain economically important mechanical objects like motor vehicles seems to be decreasing, which is itself due to technical progress. Cars last longer and need fewer repairs, and when repaired, the depreciation cost in terms of actual replaced parts is usually small in comparison to mechanic labor – a Baumol job. Indeed, it’s amusing to buy some state of the art piece of equipment or depreciation-curing replacement part from amazon and see them now advertise instalation, and the labor costs are often comparable to or exceed the item costs.
> Yes, it was the market and economy. Real rates are down the world around.
This is an unsatisfying explanation, given that central banks were juicing the money supply and lowering their rates the world around. It still seems far fetched that zero interest rates are a market phenomenon, particularly given the timing, precipitous drop, a central bank’s understood role, and their actual actions according to the crisis response playbook.
> So is inflation, except in basket-case countries in the midst of crisis.
Measured inflation may be relatively flat, but have you seen the securities, education, housing, and healthcare markets lately. Sure looks like inflation from here.
It depends on how much credit you want to give the Fed for the Great Moderation. The difficulty is it couldn’t go on forever because it led directly to zero rates and it would take something like jumping the tracks to convince anyone they want something different but perhaps they have with recent increases, though only tentatively at best.