Iceland does it again. The small country's leaders continue to buck the trend by refusing to force citizens to pay for banks' losses. The latest news relates to the Icesave dispute. When Iceland's Landsbanki went bankrupt in 2008, Iceland declined to reimburse overseas depositors. The United Kingdom and the Netherlands subsequently stepped in and used their own money to reimburse Landisbanki depositors in their countries. They have been pressuring Iceland to repay their costs ever since. In the latest chapter of the Icesave saga, President Ólafur Ragnar Grímsson is putting the decision of whether to reimburse the United Kingdom and the Netherlands to a public referendum in Iceland, thereby giving citizens control over the outcome.
You can read more about the Icesave dispute at Wikipedia and Bloomberg
During the last few years of financial turmoil, Iceland has tended to protect taxpayers while forcing bank creditors to suffer losses. The economy has suffered, but has not been the victim of the sort of crippling collapse that leaders in Europe and the United States continue to insist would occur if we did not bailout banks. Unemployment in Iceland is still lower than it is in Ireland, where politicians have imposed severe hardship on taxpayers to keep banks afloat.
Monday, February 21, 2011
Saturday, February 12, 2011
Costs of the Fed, Part 2
In the previous post I discussed how lowering interest rates adversely affects people with money in savings accounts. I argued that because savers receive less interest income, they have less money to spend, which dampens economic activity. In this post I will return to the idea that lowering interest rates can cause consumers to spend less money. But whereas Part 1 discussed how a decline in interest income affects people who have already saved money, this post will examine how the Fed's actions can change the behavior of people who are trying to build savings.
Economists often teach that lowering interest rates causes consumers to save less and spend more. "Low interest rates provide a powerful incentive to spend rather than save," declares one Federal Reserve publication. The logic underlying this assumption is straightforward: When rates are lower, saving is less attractive and spending is more attractive, so people save less and spend more. If true, this makes Fed policy more effective because when people spend more, the economy grows. And growth is exactly what the Fed is hoping to achieve by lowering rates.
But there is another way to look at this. Consider a family that is trying to save $25,000 for college and $250,000 for retirement over the next 20 years. If interest rates are 5% for the next 2 decades, the family will need to save about $547 per month. With rates at 2%, they will need to set aside $762. The lower the rate, the more they have to save. This runs counter to some of the dominant thinking about lowering interest rates.
Lowering rates probably does cause some people to save less, especially people who are deciding what to do with money that they do not need for basic expenses (ie., rich people). The thinking might go something like: "Should I buy a new Mercedes now or earn 5% for a year and then get the Mercedes with a moon roof? I'll earn the 5%. But if rates are only 2%, it's time to shop." Makes sense. Of course, that is not how a household of limited means and specific financial goals should go about making decisions. For the vast majority of Americans, lowering rates should cause savings rates to increase and spending to decline.
None of this is to say that there are not other factors that might cause people to save less when the Federal Open Market Committee lowers interest rates. When the stock market goes up, people feel richer. I do not dispute that, though I do intend to address some problems with the phenomenon in a later post. Additionally, if the economy does better, confidence rises, prompting people to spend more. However, Federal Reserve publications and Ben Bernanke's many recent statements would have us believe that monetary easing (lowering rates and printing money) categorically stimulates economic growth as long as inflation is not a problem. There has been very little discussion by Fed officials of the ways in which Fed policy causes some pockets of the economy to contract. A cost-benefit analysis that models who wins and who loses - and how much they win or lose - is sorely needed.
Economists often teach that lowering interest rates causes consumers to save less and spend more. "Low interest rates provide a powerful incentive to spend rather than save," declares one Federal Reserve publication. The logic underlying this assumption is straightforward: When rates are lower, saving is less attractive and spending is more attractive, so people save less and spend more. If true, this makes Fed policy more effective because when people spend more, the economy grows. And growth is exactly what the Fed is hoping to achieve by lowering rates.
But there is another way to look at this. Consider a family that is trying to save $25,000 for college and $250,000 for retirement over the next 20 years. If interest rates are 5% for the next 2 decades, the family will need to save about $547 per month. With rates at 2%, they will need to set aside $762. The lower the rate, the more they have to save. This runs counter to some of the dominant thinking about lowering interest rates.
Lowering rates probably does cause some people to save less, especially people who are deciding what to do with money that they do not need for basic expenses (ie., rich people). The thinking might go something like: "Should I buy a new Mercedes now or earn 5% for a year and then get the Mercedes with a moon roof? I'll earn the 5%. But if rates are only 2%, it's time to shop." Makes sense. Of course, that is not how a household of limited means and specific financial goals should go about making decisions. For the vast majority of Americans, lowering rates should cause savings rates to increase and spending to decline.
None of this is to say that there are not other factors that might cause people to save less when the Federal Open Market Committee lowers interest rates. When the stock market goes up, people feel richer. I do not dispute that, though I do intend to address some problems with the phenomenon in a later post. Additionally, if the economy does better, confidence rises, prompting people to spend more. However, Federal Reserve publications and Ben Bernanke's many recent statements would have us believe that monetary easing (lowering rates and printing money) categorically stimulates economic growth as long as inflation is not a problem. There has been very little discussion by Fed officials of the ways in which Fed policy causes some pockets of the economy to contract. A cost-benefit analysis that models who wins and who loses - and how much they win or lose - is sorely needed.
Costs of the Fed, Part 1
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.
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.
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