The U.S. Federal Reserve has created trillions of new dollars in the last few years. This has been controversial. Opponents of this policy usually argue that creating so much money could lead to massive inflation. However, as more and more time passes without any serious bouts of inflation, the Fed increasingly seems to be winning the debate. But what if the Fed is doing other sorts of damage to the economy? What if inflation is not the only metric by which we should judge Federal Reserve policy?
There are many other costs to the Fed's recent radical interventions - costs that deserve a lot more attention. I intend to write a series of posts on this topic, starting today.
Costs of the Fed, Part 1:
One of the most obvious costs of increasing the money supply and decreasing interest rates is that people who save money in interest-bearing accounts earn less money. The elderly and people without significant wealth often suffer the most from low returns on savings accounts and CD's. Because these savers are not able to bear the risks associated with stocks and bonds, they put significant amounts of their savings into safer interest-bearing accounts. When the Fed floods the banking system with money, banks have less need for deposits, deposit rates go down, and depositors receive lower returns. Obviously, this is bad for people with money in interest-bearing accounts.
But there are other consequences as well. If these savers have less money, they will probably spend less, hurting the entire economy.* According to data from the Federal Reserve of Philadelphia, American households' annual interest income has declined by 150 Billion dollars since 2008. That amounts to over a full percentage point of U.S. GDP. This does not mean that lowering interest rates caused GDP to shrink. Reduced rates can help borrowers. Indeed, the same data that shows households earned less interest income also shows that households paid less interest on their debts. Unfortunately, the decrease in interest income was over twice as large as the decrease in interest expenses, so American households were net losers in this regard.
The Fed contends that the benefit to borrowers leads to increased economic activity in aggregate. However, the Fed has not done a good job of proving this. A publication by the Fed's St. Louis branch entitled "Low Interest Rates Have Benefits . . . And Costs" provides a sensible list of some of the benefits and costs of lowering rates. Lacking from this paper is any attempt to quantify the benefits or reach a conclusion about the net effects on the economy. Have lower rates caused borrowers to increase economic activity enough to offset the loss of income suffered by savers? The right answer is probably that it depends on an array of factors including the outlook for business, economic expectations, and household financial health, among other things.
The Fed does not seem to be calibrating its policy to these ever shifting variables. Rather, the Fed seems anchored to the notion that decreasing rates increases economic activity as long as inflation is not a problem. Consider a scenario in which a country had invested too much in housing and households had not saved enough. It is possible that under those circumstances, decreasing savers' income in order to increase investment is the wrong response and will not lead to a stronger economy. If it is indeed true that lowering rates can consistently be relied upon to stimulate the economy, then the Fed ought to better job of proving it.
*Many economists often argue that lowering interest rates causes people to spend more and save less because the return on savings is less attractive. I will address some complications with this theory in the next post.
Saturday, February 12, 2011
Monday, January 17, 2011
Krugman blames the Euro
In this weekend's New York Times Magazine, Paul Krugman offers his views on the European debt crisis. The thrust of his argument is that because Europe cannot devalue its currency - a point which is not altogether clear - its options are "Toughing it Out", "Debt Restructuing, "Full Argentina," and "Revived Europeansism." He concludes that Europe ought to seek a "Revived Europeansism," which means richer countries should give money to poorer countries. This seems unlikely given in current political climate. So, he seems to think that Europe will suffer some combination of debt restructuring and "Full Argentina." I will not attempt a full critique here - it would take too long. But I will highlight two major flaws in the Nobel Laureate's analysis. I believe Krugman's criticism of the European Currency Union is misguided and his assessment of how painful a European restructuring would be is exaggerated.
Krugman's comparison of Europe's monetary situation to that of Argentina at the turn of the century is unfair. Argentina had pegged its currency to the U.S. Dollar, meaning that it was essentially unable to control its own monetary policy. Krugman suggests that by adopting the Euro, member countries have likewise ceded their control over monetary policy, and are therefore unable to devalue their way out of the crisis. It is correct that countries that have adopted the Euro cannot unilaterally print Euros, but the European Central Bank can do just that. In fact, it has already done so, though not to as great an extent as Krugman probably prefers. Argentina, on the other hand, had no pragmatic means for creating U.S. dollars. Another crucial difference between Europe and Argentina is that the latter had promised the world that its currency could be exchanged for dollars at a fixed rate. As investors began to question its credibility on this promise, a run on the currency unfolded. Compounding Argentina's difficulties, the South American country had issued billions of bonds denominated in U.S. dollars. Europe has not fixed its currency to the dollar and most of its debt is denominated in Euros. Krugman's use of Argentine history to bolster his opposition to the European Currency Union is flawed.
Krugman also errs in his treatment of events in Iceland as they relate to Europe. Iceland decided not to bailout its banks during the current crisis. Investors suffered serious losses, but the economy did not collapse and appears to be rebounding quite well. At the same time, Iceland devalued its currency. Krugman says that the Icelandic path is appealing, but is unavailable to Europe because Europe cannot devalue its currency. However, he offers little evidence that devaluation of the currency has been important to Iceland's quick rebound. Although he claims that devaluation led to an increase in exports, the evidence does not support this conclusion. According to statistics at OECD.org, Iceland's exports did not expand any more than the exports from Eurozone members expanded. Iceland's recent success is a result of its refusal to save a banking sector that was too large for such a small country to bailout. Its ability to print money was of lesser consequence. The Icelandic path does indeed remain open to some European countries, particularly Ireland.
Krugman's comparison of Europe's monetary situation to that of Argentina at the turn of the century is unfair. Argentina had pegged its currency to the U.S. Dollar, meaning that it was essentially unable to control its own monetary policy. Krugman suggests that by adopting the Euro, member countries have likewise ceded their control over monetary policy, and are therefore unable to devalue their way out of the crisis. It is correct that countries that have adopted the Euro cannot unilaterally print Euros, but the European Central Bank can do just that. In fact, it has already done so, though not to as great an extent as Krugman probably prefers. Argentina, on the other hand, had no pragmatic means for creating U.S. dollars. Another crucial difference between Europe and Argentina is that the latter had promised the world that its currency could be exchanged for dollars at a fixed rate. As investors began to question its credibility on this promise, a run on the currency unfolded. Compounding Argentina's difficulties, the South American country had issued billions of bonds denominated in U.S. dollars. Europe has not fixed its currency to the dollar and most of its debt is denominated in Euros. Krugman's use of Argentine history to bolster his opposition to the European Currency Union is flawed.
Krugman also errs in his treatment of events in Iceland as they relate to Europe. Iceland decided not to bailout its banks during the current crisis. Investors suffered serious losses, but the economy did not collapse and appears to be rebounding quite well. At the same time, Iceland devalued its currency. Krugman says that the Icelandic path is appealing, but is unavailable to Europe because Europe cannot devalue its currency. However, he offers little evidence that devaluation of the currency has been important to Iceland's quick rebound. Although he claims that devaluation led to an increase in exports, the evidence does not support this conclusion. According to statistics at OECD.org, Iceland's exports did not expand any more than the exports from Eurozone members expanded. Iceland's recent success is a result of its refusal to save a banking sector that was too large for such a small country to bailout. Its ability to print money was of lesser consequence. The Icelandic path does indeed remain open to some European countries, particularly Ireland.
The Economist Recommends Restructuring
In this week's Economist, the publication concludes that Europe's ongoing attempts to solve its sovereign debt crisis "are failing." The article continues by arguing that unless rich countries become more willing to pay for the fiscal problems of their debt-ridden neighbors - a prospect the Economist deems a "political non-starter" - then the only reasonable alternative is to restructure debts. And the Economist believes this should all be done sooner rather than later.
I wholeheartedly agree.
However, the article goes on to argue that Europe's hitherto failed attempt to avoid default "was worth trying" and that "the dangers from debt restructuring have diminished." Because "Banks have had time to build up more capital - and palm off some of their holdings of dodgy sovereign bonds to the European Central Bank," restructuring will be a much more decent affair now, the magazine contends.
I wholeheartedly disagree.
Transferring the costs of a debt restructuring from bank investors to the citizens of Europe is hardly a good thing. Rather, it represents yet another forced expropriation of wealth from taxpayers to benefit the financial system.
European leaders seem reluctant to stick banks with the losses associated with sovereign restructurings. It is true that a good deal of financial turmoil would result if banks were made to suffer the full extent of the losses on their sovereign bond holdings. But there are far superior - and less costly - ways to avoid a major collapse of the European financial system than just transferring the losses to the public. For instance, the European Central Bank could recapitalize failing banks in exchange for massive equity stakes in any institutions requiring funds. These equity stakes might later be sold for a profit. Such a system is hardly ideal; it is a violation of free market principles and bails out failing institutions. But it is fairer and cheaper than the approach suggested by the Economist.
I wholeheartedly agree.
However, the article goes on to argue that Europe's hitherto failed attempt to avoid default "was worth trying" and that "the dangers from debt restructuring have diminished." Because "Banks have had time to build up more capital - and palm off some of their holdings of dodgy sovereign bonds to the European Central Bank," restructuring will be a much more decent affair now, the magazine contends.
I wholeheartedly disagree.
Transferring the costs of a debt restructuring from bank investors to the citizens of Europe is hardly a good thing. Rather, it represents yet another forced expropriation of wealth from taxpayers to benefit the financial system.
European leaders seem reluctant to stick banks with the losses associated with sovereign restructurings. It is true that a good deal of financial turmoil would result if banks were made to suffer the full extent of the losses on their sovereign bond holdings. But there are far superior - and less costly - ways to avoid a major collapse of the European financial system than just transferring the losses to the public. For instance, the European Central Bank could recapitalize failing banks in exchange for massive equity stakes in any institutions requiring funds. These equity stakes might later be sold for a profit. Such a system is hardly ideal; it is a violation of free market principles and bails out failing institutions. But it is fairer and cheaper than the approach suggested by the Economist.
Saturday, January 1, 2011
End The Fed?
I just finished reading Senator Ron Paul's "End The Fed." The book outlines the controversial libertarian's reasoning for wanting to shut down the Federal Reserve. Headed by Ben Bernanke, the Federal Reserve has the power to print U.S. dollars - a power the Fed has been using frequently in recent years. Paul argues that this is a form of tyranny enabling the Fed to covertly tax Americans by devaluing their money. And he believes the Fed uses this power to serve the interests of "the banking cartel" and "the most powerful politicians in Washington."
Perhaps Paul is correct that our central bank's manipulation of the money supply, interest rates, and asset prices does not benefit our economy. And perhaps it is true that the Fed enables a few powerful interests to enrich themselves at public expense. I increasingly suspect that he is onto something. But surely lowering interest rates does benefit some parts of the economy and can lead to growth and job creation in some industries, even if only temporarily. Paul would have us believe that the costs of monetary stimulus are higher than the benefits. Unfortunately, "End the Fed" provides little concrete evidence to support these conclusions.
Paul's best argument against the Fed is that it has a dangerous power in its ability to print money with little oversight by Congress. This does seem inconsistent with democratic values. But this is not new information. Americans appear willing to grant the Fed this power if the result is a stronger and more stable economy. Supporters of the Fed contend that the ability to change interest rates, help the financial system, and control the money supply is of great value to all Americans. After reading "End The Fed," I am not better able to rebut such assertions.
Paul deserves much credit for raising questions about the merits of our monetary system. His book has at the very least prompted more Americans to begin questioning the status quo. However, he fails to offer sufficient evidence to convince us that the Fed does more harm than good. We need to see some data showing that any gains are offset by economic losses elsewhere. The book does not even provide a theoretical explanation as to why any investment and spending spurred by monetary expansion is bad for the economy. More analysis is needed.
Perhaps Paul is correct that our central bank's manipulation of the money supply, interest rates, and asset prices does not benefit our economy. And perhaps it is true that the Fed enables a few powerful interests to enrich themselves at public expense. I increasingly suspect that he is onto something. But surely lowering interest rates does benefit some parts of the economy and can lead to growth and job creation in some industries, even if only temporarily. Paul would have us believe that the costs of monetary stimulus are higher than the benefits. Unfortunately, "End the Fed" provides little concrete evidence to support these conclusions.
Paul's best argument against the Fed is that it has a dangerous power in its ability to print money with little oversight by Congress. This does seem inconsistent with democratic values. But this is not new information. Americans appear willing to grant the Fed this power if the result is a stronger and more stable economy. Supporters of the Fed contend that the ability to change interest rates, help the financial system, and control the money supply is of great value to all Americans. After reading "End The Fed," I am not better able to rebut such assertions.
Paul deserves much credit for raising questions about the merits of our monetary system. His book has at the very least prompted more Americans to begin questioning the status quo. However, he fails to offer sufficient evidence to convince us that the Fed does more harm than good. We need to see some data showing that any gains are offset by economic losses elsewhere. The book does not even provide a theoretical explanation as to why any investment and spending spurred by monetary expansion is bad for the economy. More analysis is needed.
Friday, November 26, 2010
The Irish Bank Bailout
Authorities in Europe are scrambling to put together a bailout for Ireland before financial markets open on Monday. However, the circumstances of this latest bailout are perhaps the most interesting - and eyebrow raising - of the many rescue schemes launched in recent years. Unlike the banks and Greece, Ireland does not actually need any money in the immediate future. The country has already borrowed all the money it will need until the middle of 2011. And unlike most other bailouts, the terms of this bailout will cause the Irish economy to contract because of spending cuts. It is also likely to damage the fiscal position of the government. So what is going on?
Ireland's banks are in trouble. And they need money soon. It is difficult to ascertain how much the banking sector needs to stay afloat, but news sources have been reporting numbers ranging from about 30 to 60 billion USD. Controversy, of course, abounds about the wisdom of bank bailouts. But the logic of supporting the banks in this instance appears especially weak. The standard argument in support of bank bailouts usually goes something like: credit is vital to keeping the economy moving; if banks fail, lending will grind to a virtual halt. In Ireland, this line of reasoning does not hold water. In order to keep the economy moving, the country is giving a bunch of money to banks. In order to bailout banks, taxes are going up and government spending is being severely slashed. The effect of this massive fiscal tightening is to slow down the economy. It just does not make sense.
This looks nothing like the bank bailout in the United States, in which the American government has thus far been able to provide massive fiscal stimulus while also rescuing banks. In that scenario, one can at least argue that the government is trying keep the economy moving. But one cannot convincingly purport that the Irish are trying to stimulate their economy by raising taxes and cutting government spending to fund Irish banks.
Perhaps the more convincing argument in favor of another Irish bank bailout is the notion that by providing liquidity to Irish banks, Ireland and the rest of Europe can avert any further "contagion". If Irish banks fail, investors may next lose confidence in Portugal or Greece. But we have heard that argument before. Just this summer, politicians argued that Europe must save Greece so that other countries do not suffer from a lack of confidence. So Greece was bailed out. But today confidence in Ireland, Portugal, Spain and Greece is nowhere to be found.
Forcing Irish bank bondholders to suffer losses will indeed cause financial turmoil around the world. However, that turmoil will cause less real economic pain than would be caused by forcing European taxpayers to foot an ever growing bailout bill.
Ireland's banks are in trouble. And they need money soon. It is difficult to ascertain how much the banking sector needs to stay afloat, but news sources have been reporting numbers ranging from about 30 to 60 billion USD. Controversy, of course, abounds about the wisdom of bank bailouts. But the logic of supporting the banks in this instance appears especially weak. The standard argument in support of bank bailouts usually goes something like: credit is vital to keeping the economy moving; if banks fail, lending will grind to a virtual halt. In Ireland, this line of reasoning does not hold water. In order to keep the economy moving, the country is giving a bunch of money to banks. In order to bailout banks, taxes are going up and government spending is being severely slashed. The effect of this massive fiscal tightening is to slow down the economy. It just does not make sense.
This looks nothing like the bank bailout in the United States, in which the American government has thus far been able to provide massive fiscal stimulus while also rescuing banks. In that scenario, one can at least argue that the government is trying keep the economy moving. But one cannot convincingly purport that the Irish are trying to stimulate their economy by raising taxes and cutting government spending to fund Irish banks.
Perhaps the more convincing argument in favor of another Irish bank bailout is the notion that by providing liquidity to Irish banks, Ireland and the rest of Europe can avert any further "contagion". If Irish banks fail, investors may next lose confidence in Portugal or Greece. But we have heard that argument before. Just this summer, politicians argued that Europe must save Greece so that other countries do not suffer from a lack of confidence. So Greece was bailed out. But today confidence in Ireland, Portugal, Spain and Greece is nowhere to be found.
Forcing Irish bank bondholders to suffer losses will indeed cause financial turmoil around the world. However, that turmoil will cause less real economic pain than would be caused by forcing European taxpayers to foot an ever growing bailout bill.
Sunday, June 6, 2010
Krugman Laments Austerity
Krugman's Sunday blog post is entitled "Lost Decade, Here We Come". In this post he laments that many members of the G-20 have abandoned fiscal stimulus and commenced with fiscal austerity (ie., cutting deficits). He argues that governments should be pouring money into economies now and cutting deficits at some future date. Of course, anyone who has been following the recent travails of Greece, Spain, and Portugal can tell you that things are not so simple: Investors are reluctant to lend money to countries with excessive debts and deficits. Sometimes fiscal stimulus is not an option. Krugman seems to suggest that if countries had only outlined credible deficit reduction policies for the future, then markets would be more forgiving. I am skeptical of this view. Greece did exactly that to no avail, though perhaps Greece's extreme indebtedness makes it a special case. The American stimulus bill already accomplishes what Krugman is talking about: it stimulates the economy now, and automatically reduces spending in the future as it naturally expires.
Krugman, however, wants even more stimulus. He condemns "deficit hawks" who want near-term spending cuts as guilty of "utter folly." Europe's debt crisis is not a harbinger of things to come in the United States, Krugman asserts. Rather, he attributes the European turmoil to the unfortunate condition of being part of the Euro-zone. It is true that until a few weeks ago, being a member of the Euro-zone did present a special challenge: individual members could not just print Euros to solve fiscal problems as the United States and Japan can do. However, the E.C.B. rendered that point irrelevant when it began creating Euros to buy European government debt a couple weeks ago. Europe can print money too, it turns out, but is still mired in fiscal and economic problems. Krugman's argument that Europe is some sort of especially tough case that is not relevant to the United States is unconvincing. A loss of investor confidence in America's willingness and ability to repay its obligations could be catastrophic for the global economy. We should proceed very cautiously going forward. Deficits should be reduced and spending should be focused on areas that will lead to long-term economic growth: infrastructure, energy independence, and research and development would be good places to start.
Krugman, however, wants even more stimulus. He condemns "deficit hawks" who want near-term spending cuts as guilty of "utter folly." Europe's debt crisis is not a harbinger of things to come in the United States, Krugman asserts. Rather, he attributes the European turmoil to the unfortunate condition of being part of the Euro-zone. It is true that until a few weeks ago, being a member of the Euro-zone did present a special challenge: individual members could not just print Euros to solve fiscal problems as the United States and Japan can do. However, the E.C.B. rendered that point irrelevant when it began creating Euros to buy European government debt a couple weeks ago. Europe can print money too, it turns out, but is still mired in fiscal and economic problems. Krugman's argument that Europe is some sort of especially tough case that is not relevant to the United States is unconvincing. A loss of investor confidence in America's willingness and ability to repay its obligations could be catastrophic for the global economy. We should proceed very cautiously going forward. Deficits should be reduced and spending should be focused on areas that will lead to long-term economic growth: infrastructure, energy independence, and research and development would be good places to start.
Friday, April 30, 2010
Don't Blame the Germans
Greece's financial problems have shaken world markets over the last month. Each time the likelihood of a bailout seemed to increase, stocks rallied around the globe. And each time someone – usually in Germany - suggested that money might not be readily available, stocks sank and Greek bonds plunged. Recent market movements do suggest that a failure to rescue Greece would lead to some sort of sharp downturn in financial markets. But it does not follow, as many commentators assert, that the best policy is therefore to bailout Greece with all due haste. Germany's Chancellor Angela Merkel has taken flak from politicians and media outside of Germany because she has been slow to lend her taxpayers' money to the Greeks. The Economist chastises her:
This is a flawed analysis. It fails to account for what would have happened had Germany just offered the funds promptly. Consider the situation a few weeks ago: Greek Finance Minister George Papaconstantinou attempted to allay investors' concern about Greek indebtedness by trumpeting a 3% cut in the deficit and the Euro region's vague “commitment” to offer 45 billion Euros in loans should funds be needed. Meanwhile, large numbers of Greeks took to the streets to protest such draconian thrift. But the harsh reality is that to lend money to a country with a shrinking economy, a deficit of over 10% of GDP, and a debt of over 115% of GDP would solve nothing. In a matter of months, if not days, investors would realize that Greece was still hurtling towards default. And then where would Europe be? They would be 45 billion Euros poorer and Greece would have an even bigger debt problem to deal with. And the political will to pay for yet another bailout would surely be much abated.
That Germany chose another path should not be written off as mere political political posturing. Rather, Germany demanded that Greece submit to an I.M.F. austerity program. Involving the IMF has two major advantages that greatly increase the probability of Greece avoiding default – though some sort of eventual restructuring will still be hard to avoid. The first advantage is that the I.M.F. has expertise in lending to distressed countries and designing austerity programs. The E.U.'s initial attempt to rescue Greece by itself suffered from a lack of coordination and clarity of purpose. The I.M.F., on the other hand, seems to know exactly what it is doing and how it is going to do it. The second advantage of bringing in the I.M.F. is that unlike European politicians, the organization is known for tough quantitative assessments of what is really needed to bring foundering countries back to fiscal self-sufficiency. It now appears that in conjunction with the IMF, Germany will demand a much more drastic 10% cut in Greece's deficit. If this can be accomplished without causing the economy to contract too severely, Greece might just be able to pay its debts. Surely a plan in which Greece's debt will not continue to explode is superior to a scheme that would merely delay and exacerbate the current fiscal crisis.
Yes, it is true that a consequence of delaying the Greek aid package was increased uncertainty and volatility in markets. But that is a cost worth bearing. By delaying the package, involving the I.M.F., and demanding serious deficit reduction, there is now some chance that Greece escapes economic catastrophe. Had Germany not delayed its package, Greece's fiscal situation would have continued to deteriorate, necessitating more bailouts and causing even greater uncertainty and volatility at a later date.
“The chief culprit is Germany. All along, it has tried to have it every way- to back Greece, but to punish it for its mistakes; to support the Greek economy, but not to spend any money doing so; to treat this as just a Greek problem, when German banks and German citizens, who lend to Greece, stand to lose money too. German voters do not favor aiding Greece. But rather than explain to them why it is in Germany's interest, the chancellor, Angela Merkel, has run scared of upsetting them before a big regional election on May 9th.”
This is a flawed analysis. It fails to account for what would have happened had Germany just offered the funds promptly. Consider the situation a few weeks ago: Greek Finance Minister George Papaconstantinou attempted to allay investors' concern about Greek indebtedness by trumpeting a 3% cut in the deficit and the Euro region's vague “commitment” to offer 45 billion Euros in loans should funds be needed. Meanwhile, large numbers of Greeks took to the streets to protest such draconian thrift. But the harsh reality is that to lend money to a country with a shrinking economy, a deficit of over 10% of GDP, and a debt of over 115% of GDP would solve nothing. In a matter of months, if not days, investors would realize that Greece was still hurtling towards default. And then where would Europe be? They would be 45 billion Euros poorer and Greece would have an even bigger debt problem to deal with. And the political will to pay for yet another bailout would surely be much abated.
That Germany chose another path should not be written off as mere political political posturing. Rather, Germany demanded that Greece submit to an I.M.F. austerity program. Involving the IMF has two major advantages that greatly increase the probability of Greece avoiding default – though some sort of eventual restructuring will still be hard to avoid. The first advantage is that the I.M.F. has expertise in lending to distressed countries and designing austerity programs. The E.U.'s initial attempt to rescue Greece by itself suffered from a lack of coordination and clarity of purpose. The I.M.F., on the other hand, seems to know exactly what it is doing and how it is going to do it. The second advantage of bringing in the I.M.F. is that unlike European politicians, the organization is known for tough quantitative assessments of what is really needed to bring foundering countries back to fiscal self-sufficiency. It now appears that in conjunction with the IMF, Germany will demand a much more drastic 10% cut in Greece's deficit. If this can be accomplished without causing the economy to contract too severely, Greece might just be able to pay its debts. Surely a plan in which Greece's debt will not continue to explode is superior to a scheme that would merely delay and exacerbate the current fiscal crisis.
Yes, it is true that a consequence of delaying the Greek aid package was increased uncertainty and volatility in markets. But that is a cost worth bearing. By delaying the package, involving the I.M.F., and demanding serious deficit reduction, there is now some chance that Greece escapes economic catastrophe. Had Germany not delayed its package, Greece's fiscal situation would have continued to deteriorate, necessitating more bailouts and causing even greater uncertainty and volatility at a later date.
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