Apropos of his latest and plenty of pieces before that.
People often talk about interest rates as if they can be divided into two parts: the “real” rate and the component that reflects inflation expectations. The real rate should be reflective of expectations for true growth in the economy; the difference between the real rate and the nominal rate reflects expectations about the change in the value of money. So, if inflation was running at 2% and was expected to continue to do so indefinitely, and the 10-year bond yield was 4%, you’d say that “real” interest rates were 2%. Similarly, if the 10-year bond yielded 2% but we were experiencing deflation of 1% per year, and that was expected to continue, you’d say that “real” interest rates were 3%.
The idea behind QE2 is for the Fed to force up inflation expectations while keeping down nominal yields. If inflation expectations go from 1% to 2%, and the 10-year Treasury yield is also 2%, then real rates go to zero. That’s very stimulative. Obviously, business and individual borrowing costs aren’t the same as the Treasury’s cost, but they are pretty closely linked, and if real rates were zero the incentive to borrow money and invest it in, well, just about anything would be pretty high.
Another way to think about it is this: right now, expectations for real growth are pretty anemic. Arguably, though, market rates reflect higher real interest rates than would be justified by these anemic growth expectations, simply because of the zero bound problem (nominal rates will always remain positive even if inflation is near or below zero). So if the Fed can engineer higher inflation expectations while keeping rates down, real rates would be more reflective of the real current expectations for growth – namely, that there won’t be much. Which, in turn, would be good, because it would remove one barrier to the resumption of growth, namely: relatively high real interest rates.
That’s a big “if,” though. Hence my questions:
1. If the Chinese intend to let their currency float, and if the general assumption that a free-floating Yuan would appreciate significantly against the dollar, they should probably unload their Treasury holdings first, to avoid taking a big loss. Certainly, they should stop buying more of them. But America is producing debt at a prodigious rate. If what QE2 accomplishes is mostly to convince the Chinese to stop subsidizing low interest rates in America, leaving the Fed to basically pick up the slack, how is that going to improve the American economy? Wouldn’t we just wind up with higher inflation and higher nominal interest rates – i.e., stagflation?
2. The reserve army of the unemployed in China is numbered in the hundreds of millions. Millions of new workers migrate annually from rural areas to China’s cities, whether the economy is growing at 10% per year (producing enough jobs to absorb the newcomers) or 6% per year (producing not nearly enough jobs to absorb the newcomers). That problem is really the only thing China’s economic managers think about. Trade may not be terribly important to America’s economy all things considered, but it is enormously important to China’s economy, and specifically enormously important to providing for rapid employment growth. The Chinese have been doing a lot of infrastructure investing to increase domestic demand, but it is not going to happen overnight. So, assuming the last thing the Chinese are going to do is accept a significant dislocation in their export industries and allow employment growth to slow, what do you think China will do to respond if America makes it clear we’re acting without regard to their interests? Doesn’t it make sense that their first response would be not to show up for the next Treasury auction? And wouldn’t that be a problem?
3. Higher inflation expectations should reduce demand for money and increase demand both for depreciating goods (consumer goods) and for goods that retain value in an inflationary environment (commodities). But while trade is a relatively small proportion of America’s economy, so is QE2. The volume of our international trade is large enough to absorb a good chunk of the money created by the Fed, and if much of that money does “leak out” that could well have negative feedback on the real economy. If, for example, higher inflation expectations mean higher oil and copper prices, that would act against any stimulative effect of a weaker dollar. If easier money means the marginal investment dollar goes to a commodity-based economy like Chile’s, that creates real problems for Chile without particularly helping stimulate demand in the United States. The question, of course, is the magnitude of this leakage. I don’t know what that magnitude will be any more than Yglesias does, but the people responsible for managing the economies of a variety of emerging markets seem to think it could be big.
4. The “big bang” danger lurking behind any proposal for a seriously expansionary monetary policy is the risk of a dollar crisis. I continue not to expect one, but I am cognizant of the fact that the United States benefits greatly (in the form of lower nominal interest rates than we deserve) from our status as the world’s reserve currency, and that inevitably we will lose this status one of these days. We’re in the process of losing it right now, in fact – but we’re losing it slowly. I can’t see how it could be good to lose it precipitously. But many of the more radical proposals for monetary stimulus have a flavor of “we need to convince people that we’re being irresponsible – that we actually want to trash the currency, so that they don’t just wait for us to withdraw the liquidity we’ve created but actually go out and buy stuff.” And it seems to me that anything that actually convinced the market that the Fed was going to be irresponsible in money generation would surely also convince the market that dollar should no longer be the preferred reserve currency. Right? So, again, you aim for lower real rates and wind up with higher – much higher – nominal rates.
I keep harping on this point, so I’m going to harp on it again. The United States cannot fund its own debts. I don’t mean the United States government – I mean the United States. Japan, for example, has an absurdly high public debt, but historically – though this is in the process of changing – had so much private savings that they could more than cover the cost of public debt domestically and still export capital abroad. The high public debt was really an accounting problem, something that impacted the distribution of wealth within the society but not the solvency of Japan as such.
But in America, private as well as public debt exploded in the last decade. If your economy has a private savings rate high enough to finance large public deficits, then you can run an expansionary fiscal policy as a way of basically getting around the big rise in the risk premium that accompanies recessions. You can also run an expansionary monetary policy as a way of getting private capital moving again without recycling it through the government. You can devalue your currency to improve your trade position and not worry that this will make it prohibitively expensive to borrow abroad because you don’t need to borrow abroad.
Our private citizens are busy rebuilding their balance sheets. Personal savings rates have finally gone up, to around 5%, which is low by longer-term historic standards but high relative to the last 20 years. That is absolutely right and necessary, even though it contributes to the recession in the short term (people are spending less, hence businesses expect people to spend less and don’t invest in new factories and bigger sales forces, and so forth). But net of individual, corporate and government accounts, nationally we are still borrowing from abroad – borrowing more, in fact, than we ever have before. Any expansionary policy, fiscal or monetary, depends on the goodwill of those who are actually financing that policy. So commentary on what our monetary policy should be that ignores or dismisses the international dimension strikes me as downright peculiar, unless it’s inviting us to play a kind of game of chicken, in which it makes game-theoretic sense to tell your opponent that you are unaware of or unconcerned by facts that are kind of important to your well-being.
Right now, real growth expectations are very low, and arguably real interest rates are too high relative to those expectations. If we get monetary policy just right, perhaps we’ll be able to bring down real interest rates, keep nominal rates low, and engineer a more robust recovery. But if we get it wrong, we’ll get higher inflation expectations without a recovery, and we’ll be substantially more constrained in terms of what kind of economic policy we can pursue going forward because of our continued dependence on foreign capital and the jaundiced eye with which foreign investors will view America after such a failure. So I don’t want to bet America’s economic future on getting monetary policy “just right.”
The other response to real interest rates that are “too high” relative to growth expectations is to figure out how to improve the prospects for real growth – which means, primarily, productivity growth. The traditional Republican mantra on this subject – cut taxes and all will be well – doesn’t even deserve the dignity of a response, which is why I spend essentially no time responding to it. But the question which that mantra is attempting to answer is the right question, the most important question for us to be asking.