Less Fed Financial Repression Irrational?
In a recent Bloomberg Views piece, mainstream economist Noah Smith accused his Austrian critics of having “brain worms” and even “anti-semitic overtones.” He then mischaracterized what his critics were saying so that he could ridicule it.
This wasn’t very conducive to a dialogue. His last Bloomberg piece, out on July 10, is better. It offers a specific proposal: don’t raise today’s ultra low interest rates. Unfortunately it doesn’t say whether this advice is forever, or for now. But it is a specific proposal.
This is all the more helpful because it is difficult to tease specific proposals out of mainstream ( usually Keynesian) economists. For example, during and after the Crash the best known Keynesian economists ( Krugman, Shiller, Romer, Yellen etc.) kept saying we needed more government stimulus of the economy, but refused to give us the exact prescription.
This was very convenient when the stimulus failed; they could just claim that there hadn’t been enough. Never mind that they had refused to tell us in the first place how much was needed or for how long.
In his latest piece, Noah Smith not only says that short term interest rates should stay where they are, close to zero, and well below even reported inflation. He further argues that these giveaway interest rates ( made available to Wall Street, not to Main Street) are not creating a stock market or other asset bubble like the dot com or housing bubbles.
Smith then gives us what he calls Finance 101. Here is what he says: “The value of a financial asset is the discounted present value of its future payoffs, and when the discount rate — of which the Fed interest rate is a component — goes down, the true fundamental value of risky assets goes up mechanically and automatically. That’s rational price appreciation, not a bubble.”
Let’s see. The Fed artificially represses interest rates for now, with no guarantee that they won’t go bounding back up anytime in the future, even the near future, but stocks should be valued as if the artificially repressed rates are permanent. Sorry, this isn’t “rational” and it certainly isn’t Finance 101.
Smith further notes that “bubbles form when people think they can find some greater fool to sell to.” Hm. Why do people expect to find “greater fools” at some times and not other times?
George W. Bush famously said that “Wall Street got drunk” before the 2008 crash. But where did the cheap alcohol come from, if not from the rivers of new cash created by the Fed and delivered to the bars in Manhattan and around the world?
Even Smith admits that “there’s laboratory evidence for bubbles, too — it’s by far the most-researched phenomenon in experimental finance. And it’s true that when you give traders in the lab more cash, you get more and bigger bubbles.” Exactly. More cash, cheap cash, and the promise of bail-outs. It’s a deadly combination.
Smith even argues against his position when he thinks he is arguing for it. He says that “the Fed has been regulating the monetary base for many decades, and for a lot of that time there were no big bubbles.” Right again. The Fed isn’t operating as it did in the pre-Greenspan era. Far from following a “cautious, middle-of-the-road policy, It has embraced radical and recklessly untested new methods of money creation and interest rate repression that would have horrified earlier Fed boards and chairmen.
The main thrust of Smith’s piece is that interest rates should not be raised. For reasons he does not give, repressing interest rates and driving up stock prices are entirely rational while increasing rates is “irrational.” Rate reductions are wise policy; rate increases are a “blunt hammer.“
This echoes Keynes’s argument in the General Theory that the way to create a boom is to lower interest rates and the way to keep it going is to lower them further. Unfortunately history reveals that this doesn’t work; it just feeds bubbles. And even Keynes did not argue for forcing interest rates below inflation.
Smith has at least a glimpse of what his critics find troubling. He asks: “ what good is a crash to prevent a crash?,” but acknowledges that the critics have a “mental model …[of]… a little pain now to prevent a lot of pain later.” That’s it. They don’t want a crash at all; but they certainly don’t want an even bigger crash than the last one in 2008.
Smith rejoinder is curious: “If the rise in prices has been a rational response to Fed easing, then there’s no need for such medicine; causing a crash today will just cause a crash today, period.” But, as we have already noted, this only makes sense if the Fed will hold rates down forever and never bring them back up.
If the Fed will at some point bring them back up or perhaps even lose control of them, there will have to an adjustment. The only question is whether it would be healthier to have it now, or later, after even more new money has flooded the economy and created even more mal-investment and unrepayable debts.
Solving these problems for the long run requires abolishing the Fed and restoring honest money and banking practices. But, for now, maintaining giveaway rates for favored special interests just makes everything worse.