Feldstein on quantitative easing

In a WSJ op-ed last Friday, Harvard economics professor Martin Feldstein casts serious doubt on whether the fed's quantitative easing (QE) policy is doing much good.  Frankly, I have wondered this myself, since it is hard for interest rates (short or long) to get much lower.  But lower long-term rates are but one of a host of mechanisms through which QE is supposed to stimulate the economy.  Another key part, Feldstein argues, is a "portfolio-balance" effect.

Here is how it works: the Fed buys so many long term securities (government bonds and mortgage-backed securities mainly) that investors have to buy stocks in search of yield.  This raises stock prices, makes people wealthier and (in theory) they should spend more. 

Feldstein shows that even if ALL of the recent run-up in stock prices between 2009 and now has been caused by QE, the impact on spending would be small (0.3% of GDP) because one dollar of stock wealth is associated with only four cents of extra spending.  It is highly unlikely QE is the only factor behind the stock market, other things like earnings per share and new savings also are at play.  So the real net impact has to be even smaller than 0.3% of GDP, he claims. 

Bernanke's midyear report

Fed chair Ben Bernanke gave his midyear report on the state of the economy to Congress yesterday, and the news is not encouraging: "The U.S. economy has continued to recover, but economic activity appears to have decelerated somewhat during the first half of this year."  Investment by businesses in plant, equipment and inventories is especially worrisome, Bernanke said.

Some lawmakers encouraged Bernanke to do more to stimulate the recovery.  However, his means to do so appear extremely limited.  The Fed's main tools are lowering interest rates and buying bonds to create more liquidity.  Yet banks have mountains of excess reserves and have decided it is better to keep them at the Fed to earn 0.25% than to loan them out. 

NYT op-ed: US should mimic Argentine economic policy

So says Ian Mount, a freelance journalist with two degrees in English who has a forthcoming book about making malbec and was able to convince the NYT editors that he was a serious person.  Mount argues that because the Argentine economy has been growing rapidly since 2002, other countries should take a serious look at its policies.  The two most recent Argentine presidents (the late Nestor Kirchner and his wife Christina) raised taxes (especially on agricultural exports) and then overspent the proceeds on a wide range of government programs.

Mount ignores three inconvenient truths.  First, the World Bank statistics do show a remarkable turnaround in recent years as Argentine GDP per capita rose from $2708 in 2002 to $7626 in 2009.  He perhaps is not aware of the fact that Argentina still has not caught up to its standard of living in 1998 when GDP per capita was $8279.  In other words, living standards in Argentina have improved over the last 10 years but they have fallen since 1996. 

Second, ever since the days of Juan and Eva Person, Argentina has had a cycle of booms driven by expanded government activity funded by debt followed by devastating busts.  The current boom is being driven by exports and government spending funded through printing money.  The chickens will come home to roost again; the only question is what will happen first -- a drop in commodity prices or inflation rates topping 50%.

Third, and most importantly, Argentine economic growth has been abysmal.  In 1900 Argentina had a standard of living close to that of the US, it has since fallen very very far behind.  The real Latin American success stories are Brazil and Chile, both of which lagged significantly behind Argentina until the mid 1970s.  Chile adopted free market economic policies at that time and caught up with Argentina by 1989 and surged ahead since 2000.  Brazil became more market-oriented as well in the 1990s (although not as much as Chile), caught up with Argentina in 2002 and was 8% ahead in GDP per capita in 2009. 

Hard to see how we can learn much about economics from a country that jails its own economists who dare tell the truth.

Time to update the macro textbooks

Monetary policy has completely changed since 2008, argues John Williams, CEO of the San Francisco branch of the Federal Reserve, in a recent speech (thanks to Craig Newmark's blog for making me aware of this item).  So maybe we need to change the way we teach monetary policy in macro classes? 

I stand guilty as charged in my Global Econ for Managers class.  We use a well respected but now outdated text by Harvard professor David Moss.  According to Moss (and repeated in my lecture notes), the Fed has three tools it can use to influence the economy: open market operations (buying or selling Treasury bonds to create or withhold liquidity in the banking system), reserve requirements, and the discount rate charged to banks who borrow from the Fed.  Williams explains how this has completely changed because of technology (not that many people holding cash these days for transactions) and the challenges posed by the financial crisis.  Well worth reading.

Are we headed for a replay of 1937-38?

Most of the general public (not all, see the "don't know much about history" piece in yesterday's WSJ) is well aware of the Great Depression that started in 1929 and really did not end until World War II.  Fewer are aware of the depression within the depression that took place in 1937-38, when unemployment rose from 11 to 20 percent (it had peaked at 25 percent in 1933).

Yesterday WP economics columnist Robert Samuelson asks whether we are headed for a replay: There are eerie parallels between now and then. Then as now, commodity prices (grains, minerals) were rising rapidly; fears of inflation grew. Then as now, the federal budget deficit was criticized as too large. Then as now, the president was widely perceived as being anti-business.

Samuelson points out that both fiscal and monetary policy were responsible for the 1937-38 recession.  Roosevelt moved quickly to a balanced budget at the same time that the money supply tightened significantly.  Paul Krugman in a recent NYT op-ed argues that we will repeating those mistakes if government spending is cut and interest rates are increased.  Samuelson isn't convinced, mainly because (1) the magnitude of any spending cuts that might be approved by Congress pails in comparison to those enacted in the late 1930s and (2) the Fed remains committed to low interest rates for the foreseeable future.  My take: the economy continues to be in a fragile position and cutbacks in state and local government spending are not going to help.  An unexpected shock, such as $6/gallon gas or a failure to contain the fallout of Greece's likely default, might be enough to move the GDP growth number into the negative zone.

EU follows through on higher interest rates

The European Central Bank said a few weeks ago that it was going to raise short-term interest rates, as noted in this earlier blog post.

Guess what?  They meant what they said.  Last week the ECB raised rates from 1 to 1.25%.  As is the case in the US, the ECB is trying to balance a possible reduction in investment and GDP against the need to adjust interest rates for rising inflation.  The economic situations are not exactly alike -- inflation is currently higher in Europe than it is in the US and unemployment is not as high in Europe as it is here. 

Nonetheless, the days of zero short-term interest rates are probably numbered.  I would be careful about buying any 24 month CD paying 1.5%.

Plosser on monetary policy

Philadelphia Fed President Charles Plosser (also former dean at Rochester's Simon Business School) is interviewed in today's WSJ about monetary policy.  Plosser is a QE2 skeptic:

You can't change the carpenter into a nurse easily, and you can't change the mortgage broker into a computer expert in a manufacturing plant very easily. Eventually that stuff will sort itself out. People will be retrained and they'll find jobs in other industries. But monetary policy can't retrain people. Monetary policy can't fix those problems.

QE2 backlash overseas and at home

Things I thought I would never see: Brazil lecturing the US for printing too much money.  At last week's G-20 summit, President Obama received a considerable amount of criticism from his colleagues around the globe for the Fed's recent actions.  WSJ summarizes the concerns succinctly:

Printing more dollars, or cutting U.S. interest rates, tends to weaken the dollar and makes U.S. exports more attractive. The accompanying rise in the value of other countries' currencies tends to damp their exports and can fuel inflation or asset bubbles, as emerging-market officials note. U.S. officials maintain the Fed's action is about stimulating domestic demand, and that a weaker dollar is a consequence, not an objective.

There are two questionable links in this argument: will interest rates fall that much and, even if they do, will the lower rates have a sizable impact on the dollar's value relative to other currencies.  The value of the dollar also depends on the volume of transactions between the US and its trading partners and the relative prices of goods in the US compared to the rest of the world.  If goods in the US are cheaper (more expensive), that increases (decreases) the demand for the dollar and raises its value.  The economics profession has a justifiably humble record in predicting currency movements, so it is far from clear whether the dollar's value will be affected at all by QE2. 

On the home front, well known monetary economist Sarah Palin weighed in with her concerns.  According to the same WSJ piece, she asked Ben Bernanke to "cease and desist" QE2 and channeled her inner Marty Feldstein saying "It's far from certain this will even work." You betcha.

Bernanke: What the Fed did and why

Op-ed on today's WP.  What keeps Bernanke up at night? High unemployment plus the fear that very low inflation might yet become deflation.  The Fed is going to buy an additional $600 billion of long-term securities which it hopes will lower long-term interest rates.  This should encourage investment by lowering the cost of capital through one of two channels.  First, with lower Treasury yields corporations and state and local governments also will be able to lower the coupon rates on newly issued bonds.  Second, bond prices will rise and thereby shift private investors to the stock market, raising stock prices and thereby making new stock issues more attractive.  Bernanke also thinks higher stock prices will raise consumption and stimulate the housing market. 

So what's not to like?  I see two issues: (1) long-term interest rates are already at historical lows, will making them even lower make that much difference (more technically, how elastic is corporate investment and housing to lower interest rates?) and (2) the stock market has seen this coming for some time, so any stock appreciation may have already happened (look at the charts for September and October).  Harvard's Marty Feldstein (who taught macro to Harvard PhDs when I was there) sees even more serious issues.  In a FT op-ed on Tuesday, he argues that easing now runs the risk of creating yet another bubble in asset prices that will deflate once interest rates return to normal levels.  What would Marty do? 

The truth is there is little more that the Fed can do to raise economic activity. What is required is action by the president and Congress: to help homeowners with negative equity and businesses that cannot get credit, to remove the threat of higher tax rates, and reduce the out-year fiscal deficits. Any QE should be limited and temporary.

Stiglitz on easier money

Nobel Laureate Joe Stiglitz writes in this weekend's WSJ about the Federal Reserve's plan to pump more money into the economy.  Stiglitz is quite skeptical that this will do any good.  The most interesting part of this op-ed is his description of the lending market for small and medium size firms who are starved for cash and have seen their main form of collateral (real estate) drop in value.  Hard to see how lower interest rates will help out firms that cannot get a loan in the first place.  Stiglitz also appears concerned that interest rates might actually rise as greater money growth spurs fears of inflation. 

Two different takes on job creation in NYT

I was struck by two different columns that appeared Tuesday in the Times about job creation.  The first sentence in David Leonhardt's column tells you exactly what to expect: "One of the political mysteries of the last year is why the White House and Congress have not been even more aggressive about trying to put people back to work."  Leonhardt seems to believe that job creation depends on tax and spending policy in DC, along with a little help from Ben Bernanke.  He thinks we really need another stimulus package -- as if the 2008 and 2009 stimuli worked so well.  Another quote: "the Fed has taken no recent action to spur the economy."  Hello!  Hasn't lowering short term rates to zero been enough?  Do we start taxing people's cash balances so that we get negative interest rates?  End of rant. 

Tom Friedman's "A Gift for Grads: Start-Ups" column focuses on encouraging entrepreneurship and innovation.

We need three things: start-ups, start-ups and more start-ups.

Good jobs — in bulk — don’t come from government. They come from risk-takers starting businesses — businesses that make people’s lives healthier, more productive, more comfortable or more entertained, with services and products that can be sold around the world. You can’t be for jobs and against business.

Friedman suggests that we provide green cards to foreign students who graduate from US universities and change immigration rules to make it easier for entrepreneurs to enter the country.  As Alan Greenspan suggested, make them buy a house as part of the deal.

Two columnists for the same paper: one who thinks government creates jobs and another who thinks government needs to get out of the way.

Why the euro's days may be numbered

My former professor Marty Feldstein has a great column in the Weekly Standard about the euro.  He does a good job of explaining why the euro was always bound to cause trouble.  One of the key reasons: all euro-adopting nations have to have the same monetary policy and the same exchange rate, even though all nations have their own unique economic situation.  Nations with budget deficits and high unemployment are locked into the same monetary and exchange rate policy as those with budget surpluses and low unemployment.  Of course the US has the same issue with the dollar -- all 50 states and D.C. must have the same monetary and exchange rate policy too.  But Feldstein points out that the US gets around this issue because of greater wage flexibility and higher labor mobility than Europe.  Also each US state, unlike Greece, must have a balanced budget each year. 

What does the future hold?  Severe economic retrenchment may or may not happen in Greece.  It remains to be seen whether that country will be able to balance its budget and grow economically.  This is not so much an economic problem as a political one.  The government that adopts the economic policies that Greece needs to return to good standing in the euro-zone runs the risk of being quickly voted out of office and replaced by a populist regime supported by unions and government employees.  Such a government might instead decide to default on its bond obligations and issue a new currency that effectively lowers Greek purchasing power by a substantial amount.  The Argentines did the same thing in 2002.

Keynes vs. Hayek smackdown

Kudos to my colleague Jim Yuill for sharing this YouTube video of rappers representing the ideas of Keynes and Hayek. Not likely to put Eminem and Jay-Z out of business, but the summary of the ideas is actually pretty good. Markets vs. government -- an age-old question.

We really do have reason to be thankful

Great column in yesterday's WSJ by James Stewart about why we should be thankful for Henry Paulson, Tim Geithner, and Ben Bernanke. Stewart's message in a nutshell: Many of us seem to have forgotten how close the economy came to a total meltdown last fall. The Paul Krugmans and Glenn Becks of the world are making emotionally charged arguments (and collecting huge salaries and speakers fees, I might add) second guessing the bailouts and stimulus packages respectively. But guess what? The Bush and Obama economic teams made the right calls on the biggest issues. Without the bailouts 2009 would have been an economic rehash of 1930. Without the monetary and fiscal stimulus (from both Bush and Obama) unemployment would easily be 12 or 13 percent. Stimulus packages in other countries also have been effective; the global economy is starting to recover. Money quote:

We're a lot better off today than we were a year ago. This week I'll be giving thanks for that.

When will the Fed start raising interest rates?

We will be talking about the Fed in MBA 505 this coming week. The big question right now, according to this recent WSJ article, concerns when will the Fed start raising interest rates. The fed will be looking at GDP, unemployment and inflation signals. Before raising rates, the Fed is likely to send out signals weeks, if not months, in advance. Next year's midterm Congressional elections will not make the Fed's job any easier. It is quite possible that the Fed will need to raise rates some time in 2010 to defend the value of the dollar and send a strong signal about its commitment to fight inflation even though unemployment is likely to be 8-9 percent when the rates start going up. Congress may choose to challenge the Fed's independence in such a situation.