1. Tyler Cowen cites a paper by three economists which argues that the lower bound for the interest rate does not matter. Cowen comments, “this evidence is the (current) final word, and I hope it will be heeded as such.”
2. Mark Thoma links to an article by Blanchard and Summers saying that the most important new development in macroeconomics is the significance of the lower bound for the interest rate.
3. My own view is that the lower bound is not significant, but that is because the impact of monetary policy is over-rated even above the lower bound. As an aside, I disapprove when macroeconomists talk of “the” interest rate, as if there were only one. Or, equivalently, when they use the term “interest rates” to imply that if you know one, you know them all.
My view is that the central bank is just another bank. It can no more hit an inflation target than Citibank can. If the government wants to really print money sufficiently to get people to notice, it has to use something like Modern Ponzi Theory.
I know that mine is an outlier view. Everyone else pays great heed to the Fed. If I am correct, then some day what everyone else claims to “know” about the importance of the central bank will eventually be understood to belong in the same category as astrology or 18th-century medical theory.
The central bank is not just another bank, just as a dollar bill is not just a portrait of a dead president. Each is far more if for no other reason than people believe that they are far more. That’s why I’m able to exchange my portrait of Washington for a candy bar and that’s why journalists breathlessly hang onto every word that falls from the Fed chairman’s lips.
Fed target rate and effective rate were both driven by the one year treasury, prior to 2008. Treasury, and the Congress have the greatest impact on the rates Fed uses for benchmark. This is a biased view, and unstable or pro-cyclic..
The lower bound does not matter in economies with shadow banking to expense the cost of a pro-cyclic Fed. At zero bound, the short end of the economy is still working, but the Fed is ignoring it, mainly because Treasury is in deep doo doo. That is the problem, we have a solution.
I view modern finance / economic policy as a confidence game. The difference is that the government and institutional players are not looking to swindle people out of their money, but they are interested in convincing the citizenry that asset valuations are rational and likely to increase in value.
Pundits are unanimous in recognizing the importance of the Federal Reserve in promoting confidence in monetary policy and in the banking system. Early on in the term of a new Fed chairperson, the most likely criticism of the Federal Reserve in the wake of a market sell-off is that the Fed is giving a confusing outlook and this is weakening confidence. The message of the criticism is clear: The Fed and the government and the banks must build confidence.
With this perspective it is easy to explain market bubbles and crashes. Crashes occur when the bubble of excessive economic confidence is punctured and replaced with economic despair. Stable monetary policy can minimize the frequency of bubbles and crashes but it cannot prevent them, as bubbles and crashes can be psychic events – driven by emotions and the mood of market participants.
The observation that our modern monetary system is a Ponzi scheme is accurate in abstract but the description fails to explain why the economy continues to work. I can’t make sense of it myself, except to attribute the phenomenon to a critical mass of the citizenry having confidence they can borrow today and pay later with fiat money earned in the meantime.
As you know, Scott Sumner argues “the immediate impact of policy announcements on market forecasts provides the best indication of whether stabilization policy is on target or off course.”
Do you agree that “surprises” from the Fed greatly affect financial markets, and if so, how do you interpret that fact?
I am inclined to believe the Fed matters a lot because, as you said, most economists believe so and because my impression is that financial markets react to the Fed. However, I do not believe it is easy to determine, even after-the-fact, what the effect of Fed actions are, for reasons you well understand. Scott understands too, but perhaps he glosses over the challenges a bit? Furthermore, Fed actions could only be interpreted as causing an effect in a specific context. We have every reason to believe the effect could be different in other contexts. Still, knowing that effects are hard to measure and contingent is not the same thing as knowing they are small.
Well, remember that no one is ever wrong in macroeconomics, not even Arnold Kling (or me!).
I do think helicopter drops are a much more effective method of macroeconomic stimulus than tweetybirdong around with interest rates and quantitative easing. Especially considering the claptrap system known as the Federal Reserve.
I would like to see Arnold Kling amplify his views.
How about helicopter drops that fly back and forth, dropping and picking up asynchronously?
The helicopter is simply realizing the market losses and gains incurred as the Fed acts as market maker in the currency function. The helicopter thus closes arbitrage moments as fast as traders can find them in a deposit to loan market place. Everyone gets the same fair deal: pricing to a specified accuracy.
You’re right about the lower bound, but maybe for slightly different reasons than you have cited.
1. You are correct that there are multiple interest rates. When I can get a fixed rate 0% 100 year non-recourse mortgage, then I’ll consider that we might be at the lower bound.
2. The lower bound is only an issue to the extent that the money which the Fed issues in exchange for assets through OMP is held rather than spent. But this is a problem for which there are two simple solutions. Either the Fed could simply buy assets (such as new car loans, industrial revenue bonds, or new home mortgages) which actually cause money to be spent. Or, the Fed could impose negative interest rates. For reserves this is trivial – negative IOR. For cash, negative rates could be implemented either through the introduction of electronic money, or if anonymity is a concern, the Fed could simply charge banks a fee for net currency withdrawals.
It is a number theory issue, Congress is moving right on the Treasury curve and dragging the Fed with. Eventually we ‘redenominate’ otherwise known as devalue.
The curve is piled up at the short end, right now, waiting for Congress to decide the entitlement issue, that is how will Congress devalue. The current answer is quite nicely, much better than Nixon Shock. The bond market thinks productivity gains will come almost automatically once we get our New Fed.
If Arnold’s theory is true, then what determines the absolute level prices?