Is the Fed Pulling or Pushing?

I did a little interview with Mary Kissel of the Wall Street Journal, following up on thursday's oped. Mary is, as you can tell, a well-informed interviewer and asks some tough questions. She did a great job of pushing hard on the usual Wall Street wisdom about how the Fed, though it has not done anything but talk in years, is secretly behind every gyration of stock or housing prices.

The central point came to me hours later, as it usually does. Is the Fed in fact "holding down" interest rates? Is there some sort of natural market equilibrium that features higher rates now, but the Fed is pushing down rates? That's the conventional view, clearly expressed in Mary's questions.

Well, let's think about that. If a central bank were holding down rates, what would it do? Answer, it would lend a lot of money at low rates. Money would be flowing out the discount window (that's where the Fed lends to banks), to banks, and through banks to the rest of the economy, flooding the place with low-rate loans. The interest rate the Fed pays on reserves and banks pay to borrow from the Fed would be low compared to market rates; credit and term spreads would be large, as the Fed would be trying to drag down those market rates.

That is, of course, the exact opposite of what's happening now. Banks are lending the Fed about $3 trillion worth of reserves, reserves the banks could go out and lend elsewhere if the market were producing great opportunities. Spreads of other rates over the rates banks lend to or borrow from the Fed are very low, not very high. Deposits are flooding in to banks, not loans out of banks.

If you just look out the window, our economy looks a lot more like one in which the Fed is keeping rates high, by sucking deposits out of the economy and paying banks more than they can get elsewhere; not pushing rates down, by lending a lot to banks at rates lower than they can get elsewhere.

In reality of course, the Fed isn't doing that much of anything. Lots of deposits (saving) and a dearth of demand for investment (borrowing) drives (real) interest rates down, and there is not a whole lot the Fed can do about that.  Except to  see the parade going by, grab a flag, jump in front and pretend to be in charge.

Greece and Banking, the oped

Source: Wall Street Journal; Getty Images

A Wall Street Journal Oped with Andy Atkeson, summarizing many points already made on this blog. This was published August 5, so today I'm allowed to post it in its entirety. You've probably seen it already, but this blog is in part an archive. If not, here is the whole thing, with my preferred first paragraph.
Local pdf here.

Greece's Ills [and, more importantly, the Euro's] Require a Banking Fix 

Greece suffered a run on its banks, closing them on June 29. Payments froze and the economy was paralyzed. Greek banks reopened on July 20 with the help of the European Central Bank. But many restrictions, including those on cash withdrawals and international money transfers, remain. The crash in the Greek stock market when it reopened Aug. 3 reminds us that Greece’s economy and financial system are still in awful shape. 


Greece’s banking crisis revealed the main structural problem of the eurozone: A currency union must isolate banks from sovereign debt. To fix this central structural problem, Europe must open its nation-based banking system, recognize that sovereign debt is risky and stop letting countries use national banks to fund national deficits.

If Detroit, Puerto Rico or even Illinois defaults on its debts, there is no run on the banks. Why? Because nobody dreams that defaulting U.S. states or cities must secede from the dollar zone and invent a new currency. Also, U.S. state and city governments cannot force state or local banks to lend them money, and cannot grab or redenominate deposits. Americans can easily put money in federally chartered, nationally diversified banks that are immune from state and local government defaults.

Depositors in the eurozone don’t share this privilege. A Greek cannot, without a foreign address, put money in a bank insulated from the Greek government and its politics. When Greece’s banks fail, international banks can’t step in to offer safe banking services independently of the Greek government.

European bank regulations encourage banks to invest heavily in their own country’s bonds, even when they have lousy ratings. The flawed banking architecture of Europe’s currency union pretends that sovereign default will never happen. Wise Europeans have known about these flaws for years, but the system was never fixed because it allows indebted countries to finance large debts.

This is the euro’s central fault. A currency union must treat sovereign default just like corporate or household default: Defaulters do not leave the currency union, and banks must treat sovereign debt cautiously. When Europeans can put their money into well-diversified pan-European banks, protected from interference from national governments, inevitable sovereign defaults will not spark runs, or destroy local banks and economies. And government bailouts will be far less tempting.

That is the long-term fix, but how does the eurozone get out of its current mess? The ECB’s latest Greek bailout deal is focused on long-run structural reforms, asset sales, budget targets and illusory tax increases. It might at best revive growth in a year or so.

But without well-functioning banks, Greece’s economy will collapse long before such growth arrives. To revive the banks and the economy, Greeks must know their money is safe, now and in the future. So safe that Greeks put money back in the banks, pay debts and seamlessly make payments—with no chance of a euro exit, tightened capital controls that impede international payments or depositor “bail-ins,” a polite word for the government grabbing deposits.

The United States offers a precedent. The U.S. economy ground to a standstill in the banking panic of 1933. The administration of Franklin D. Roosevelt closed America’s banks with a national banking holiday to stem the bank run. It then took immediate steps to restore confidence with the clear promises of the Emergency Banking Act of 1933 to resolve insolvent banks, promises backed up by the remarkable rhetoric of FDR’s first fireside chat and the intact borrowing power of the federal government. When banks reopened, Americans lined up to redeposit their money. In the 1980s, the U.S. deregulated banks to allow extensive branch and interstate banking, further isolating local banks from local troubles.

Europe is headed toward bailing out both the Greek government and Greece’s struggling banks. Instead, Europe should resolve and recapitalize the banks alone, put them under private European ownership and control, and insulate them from further Greek government interference. Then Europe can let Greece default, if need be, without another bank run.

Then move on to Italian and Spanish banks, which are similarly larded up with government debts and are threatening the euro. These banks can still be defused slowly, selling their government debts, without huge bailouts.

Europe needs well-diversified, pan-European banks, which must treat low-grade government debt just as gingerly as they treat low-grade corporate debt. Call it a banking union, or, better, open banking. The Greek tragedy can serve to revive the long-dormant but necessary completion of Europe’s admirable common-currency project.

Autopsy -- the Op-Ed

This was an Op-Ed in the Wall Street Journal December 22 2014. WSJ asks me not to post them for a month, so here it is now. I was trying for something upbeat, and to counter a recent spate of opeds on how ISLM is a great success and winning the war of ideas.


An Autopsy for the Keynesians

Source: Wall Street Journal

This year the tide changed in the economy. Growth seems finally to be returning. The tide also changed in economic ideas. The brief resurgence of traditional Keynesian ideas is washing away from the world of economic policy.

No government is remotely likely to spend trillions of dollars or euros in the name of “stimulus,” financed by blowout borrowing. The euro is intact: Even the Greeks and Italians, after six years of advice that their problems can be solved with one more devaluation and inflation, are sticking with the euro and addressing—however slowly—structural “supply” problems instead.

U.K. Chancellor of the Exchequer George Osborne wrote in these pages Dec. 14 that Keynesians wanting more spending and more borrowing “were wrong in the recovery, and they are wrong now.” The land of John Maynard Keynes and Adam Smith is going with Smith.

Why? In part, because even in economics, you can’t be wrong too many times in a row.

Keynesians told us that once interest rates got stuck at or near zero, economies would fall into a deflationary spiral. Deflation would lower demand, causing more deflation, and so on.

It never happened. Zero interest rates and low inflation turn out to be quite a stable state, even in Japan. Yes, Japan is growing more slowly than one might wish, but with 3.5% unemployment and no deflationary spiral, it’s hard to blame slow growth on lack of “demand.”

Our first big stimulus fell flat, leaving Keynesians to argue that the recession would have been worse otherwise. George Washington’s doctors probably argued that if they hadn’t bled him, he would have died faster.

With the 2013 sequester, Keynesians warned that reduced spending and the end of 99-week unemployment benefits would drive the economy back to recession. Instead, unemployment came down faster than expected, and growth returned, albeit modestly. The story is similar in the U.K.

These are only the latest failures. Keynesians forecast depression with the end of World War II spending. The U.S. got a boom. The Phillips curve failed to understand inflation in the 1970s and its quick end in the 1980s, and disappeared in our recession as unemployment soared with steady inflation.

Still, facts and experience are seldom decisive in economics. Maybe Washington’s doctors are right. There are always confounding influences. Logic matters too. And illogic hurts. Keynesian ideas are also ebbing from policy as sensible people understand how much topsy-turvy magical thinking they require.

Hurricanes are good, rising oil prices are good, and ATMs are bad, we were advised: Destroying capital, lower productivity and costly oil will raise inflation and occasion government spending, which will stimulate output. Though Japan’s tsunami and oil shock gave it neither inflation nor stimulus, worriers are warning that the current oil price decline, a boon in the past, will kick off the dreaded deflationary spiral this time.

I suspect policy makers heard this, and said to themselves “That’s how you think the world works? Really?” And stopped listening to such policy advice.

Keynesians tell us not to worry about huge debts, or to default or inflate them away (but please, call it “restructuring” or “repairing balance sheets”). Even the Obama administration has ignored that advice, promising long-run solutions to the debt problem from day one. Europeans have centuries of memories of what happens to governments that don’t pay debts, or who need to borrow for a new emergency but have stiffed their creditors once too often. More debt? Nein danke!

In Keynesian models, government spending stimulates even if totally wasted. Pay people to dig ditches and fill them up again. By Keynesian logic, fraud is good; thieves have notoriously high marginal propensities to consume. That’s a hard sell, so stimulus is routinely dressed in “infrastructure” clothes. Clever. How can anyone who hit a pothole complain about infrastructure spending?

But people feel they’ve been had when they discover that the economics is about wasted spending, and infrastructure was a veneer to get the bill passed. And they smell a rat when they hear economic arguments shaded for partisan politics.

Stimulus advocates: Can you bring yourselves to say that the Keystone XL pipeline, LNG export terminals, nuclear power plants and dams are infrastructure? Can you bring yourselves to mention that the Environmental Protection Agency makes it nearly impossible to build anything in the U.S.? How can you assure us that infrastructure does not mean “crony boondoggle,” or high-speed trains to nowhere?

Now you like roads and bridges. Where were you during decades of opposition to every new road on grounds that they only encouraged suburban “sprawl”? If you repeat in your textbooks how defense spending saved the economy in World War II, why do you support defense cutbacks today? Why is “infrastructure” spending abstract or anecdotal, not a plan for actual, valuable, concrete projects that someone might object to?

Keynesians tell us that “sticky wages” are the big underlying economic problem. But why do they just repeat this story to justify inflation and stimulus? Why do they not advocate policies to undo minimum wages, labor laws, occupational licenses and other regulations that make wages stickier?

Inequality was fashionable this year. But no government in the foreseeable future is going to enact punitive wealth taxes. Europe’s first stab at “austerity” tried big taxes on the wealthy, meaning on those likely to invest, start businesses or hire people. Burned once, Europe is moving in the opposite direction. Magical thinking—that, contrary to centuries of experience, massive taxation and government control of incomes will lead to growth, prosperity and social peace—is moving back to the salons.

Yes, there is plenty wrong and plenty to worry about. Growth is too slow, and not enough people are working. Even supporters acknowledge that Dodd-Frank and ObamaCare are a mess. Too many people on the bottom are stuck in terrible education, jobless poverty, and a dysfunctional criminal justice system. But the policy world has abandoned the notion that we can solve our problems with blowout borrowing, wasted spending, inflation, default and high taxes. The policy world is facing the tough tradeoffs that centuries of experience have taught us, not wishing them away.

Mr. Cochrane is a professor of finance at the University of Chicago Booth School of Business, a senior fellow at Stanford University’s Hoover Institution and an adjunct scholar at the Cato Institute.

Update: "The Keynesian Shell Game" by Scott Sumner over at econolog has a nice collection of recent Keynesian doom-mongering, and makes the nice point that the definition of "G" shifts conveniently over time.

Autopsy

Autopsy for Keynesian Economics. (I don't get to pick the titles BTW) A Wall Street Journal Oped. I'm trying for something cheery at Christmas, and a response to the many recent opeds that ISLM is just great and winning the battle of ideas.  As usual, the whole thing will be here in a month.

This year the tide changed in the economy. Growth seems finally to be returning. The tide also changed in economic ideas. The brief resurgence of traditional Keynesian ideas is washing away from the world of economic policy.

No government is remotely likely to spend trillions of dollars or euros in the name of “stimulus,” financed by blowout borrowing. The euro is intact: Even the Greeks and Italians, after six years of advice that their problems can be solved with one more devaluation and inflation, are sticking with the euro and addressing—however slowly—structural “supply” problems instead.

Read more at WSJ...

Update: Hoover has an ungated version here;  Cato has an ungated version here.