The End of Monetary Policy

I apologize in advance since this post isn't as tight as I'd like it but I've been dwelling on three things this evening, the President-elect's news conference on Monday in Chicago, the expected fed funds rate cut on Tuesday and some comments by Paul Krugman in Germany's Der Spiegel. So with this introduction . . .

Another reduction to the Federal Reserve's funds rate, the interest banks charge each other on overnight loans, is all but certain to be announced tomorrow. The Fed's funds rate is already near historical lows at 1.0% but most economists expect the Federal Reserve to cut the rate in half to 0.5%. Some economists are even pushing for a more aggressive three-quarters of a point reduction. Their argument is that such a cut might cushion some of the economic fallout and prevent a tailspin. Well, I think that's already too late. I think I am sanguine when I say we'll be lucky to lose only 750,000 jobs next year.

My sense is that a fed rate cut is spit in the ocean. Not that I am against the rate cut, it should be cut, but rather that the cut in and of itself isn't likely to spur the American economy much less the global economy. The bitter truth is that we have reached the end of monetary policy as an instrument. To spur the economy, we really waiting on President Obama's fiscal stimulus. Only a Keynesian style investment program is likely to soften the edges of the economic downturn.

Here's the problem as noted in MSNBC:

However deeply the Fed decides to cut rates, the prime rate -- now at 4 percent -- for many consumer and small-business loans would drop by a corresponding amount. The prime lending rate is used to peg rates on home equity loans, certain credit cards and other consumer loans. Cheaper rates could give pinched borrowers a dose of relief.

The goal of lower borrowing costs is to entice people and businesses to spend more, which would revive the flat-lined economy. So far, though, the Fed's aggressive rate reductions have failed to lift the country out of a recession that started last December.

Clobbered by the financial crisis, worried banks have hoarded their cash and been extremely reluctant to lend money to customers. Fearful consumers, watching jobs vanish and their investments tank, have sharply cut back their spending, including big-ticket purchases like homes and cars that typically involve financing.

Banks are hoarding cash, businesses have postponed making investments (including hiring) and consumers have cut their discretionary spending. In short, the crisis is now a problem of confidence. There isn't any. Hence the need for an optimistic and confident Obama. And Obama's fiscal package, his infrastructure proposals, his energy proposals highlighted today with his presentation of his energy and environment team speak well to this. I watched with fascination the press conference today from Chicago. While there was a measure of stern and sobering reality, the President-elect threw in heaps of we'll get through this. I swooned and learned to start loving Obama. A sobering reality confronts him and yet he smiled and spoke with measured determination that we have a way out. It, of course, helps that I agree with what he had to say from the role of science in the economy to the urgent necessity of having a decade to do what should have been done 30 years ago.

I'm a peak oiler and though I don't have an energy background, I know enough to realize that the era of cheap energy is coming to an abrupt end and that the free market will ride oil to the last drop to human detriment. To solve the energy and climate crisis will require a level of cooperation not only within the country but across the globe. Obama today in Chicago said everything that I have been to waiting to hear from a President. And not to shortchange Joe Biden because what I really enjoyed about his comments today was his partisanship. In terms of attack dogs, there are few better than Joe Biden and it's important that the American people realized that when it comes to energy and climate the GOP is almost wholly responsible for ignoring a reality that was frankly self-evident a decade or more ago.

In other economic news, Paul Krugman offered an interview to Germany's Der Spiegel. It's well worth a read though it mostly centers on Germany's woes and the lack of clarity and prudence from the German Chancellor Angela Merkel in confronting the economic crisis. This portion of the interview struck me as pertinent and analogous to our own situation.

SPIEGEL: Unlike Americans, Germans tend to spend less and save more. Is there a danger any kind of tax benefits might just end up in saving accounts?

Krugman: Yes, there is. That's why the focus of a program should be on government spending as much as possible. But the perfect is the enemy of the good -- we are in a severe plunge, and must do as much as possible quickly.

SPIEGEL: Are there no alternatives?

Krugman: In normal times monetary policy, combined with automatic stabilizers, is sufficient. I'm opposed to discretionary fiscal policy in normal times.

SPIEGEL: And what is different right now?

Krugman: Monetary policy has lost traction! When interest rates are either at the zero lower bound or quickly approaching that point, fiscal stimulus becomes essential.

The problem is global. The solutions likely will require closer coordination of policy across borders. Every day that passes without action is an opportunity lost that will make the climb out only that much greater. When it comes to financial contagions, time is critical yet we have to endure 34 days of more ineptitude. I don't blame Chairman Bernanke nor the Federal Reserve. They are policy makers whose instruments have failed because the economic crisis is far beyond the scope of interest rate cuts. We have reached the end of monetary policy. It's time for a Keynesian approach. As Dr. Krugman notes a fiscal stimulus becomes essential in times of a severe plunge. I hate to say this so bluntly but the world is really waiting on Obama.

Tags: Federal Reserve, Keynesian economics, Paul Krugman, US Economy (all tags)



You noted the problem in 4 words....

Banks are hoarding cash...

Nobody's waving a magic wand on January 20th, either.

That's our $8.5 in cash and supports they've given away over the past 90 days, dammit!

The banks must be forced to put some real liquidity into the marketplace right now! That liquidity is our damn money!

That would do wonders to soften the blows of our nation's other economic realities, right now.

It is the very recipients of Paulson's largesse that are making matters far, far worse than they need to be right now.

Stiglitz, and the other neo-Keynesians all agree!

And, Barney Frank was right in his comments where he paraphrased Obama, saying, "We only have one President! But, as Barney continued to put it, paraphrasing the matter, 'Not until January 20th.'

by bobswern 2008-12-16 12:30AM | 0 recs
Re: You noted the problem in 4 words....

Think the monetarists will shut up now?

I hope so, but I tend to doubt it.

They'll do anything, including debasing our currency, just to prove government spending isn't necessary.


by Bush Bites 2008-12-16 04:22AM | 0 recs
Re: The End of Monetary Policy

While I am totally in sync with you position that monetary policy has become ineffective, I have to disagree with your statement that the rate should be cut.  In fact I believe that moetary policy was never the right tool to use in the vaccuum that it has been used sinc ethe late 80's.

What we are seeing happening today is the culmination of a very long period of irresponsible monetary and fiscal policy aided by the manipulation of various metrics that were originally designed to help us gauge the current and future state of the economy.  It did not start with the bush administration, even though you can successfully argue that the Bush fiscal policy took a bad approach and put it on steroids.  There were many times in the past 20 years where this trend could have been reversed.  I believe that we reached the point of no return about 4 or 5 years ago.  In fact I am surprised that it took as long as it did for everything to finally collapse.  Many of my friends were accusing me of being too negative 3 years ago when I said I would not touch real estate in this country until prices dropped at least 40%.  Very few beleived that it could get this bad.  The few who did realize it (myself included) realized it because we remember history.  And unlike the pundits will have you beleive, this sort of thing has happened before.  In fact it has happened several times to varying degrees.  And it took a long time to recover when it did happen.

You see, cutting rates is inflationary.  It always has been.  Low interest rates have the double impact of lowering returns on safe investments while simultaneously encouraging borrowing which can stimulate an economy under certain conditions, provided the economy is already set up for a growth trend.  Economic growth leads to inflation.  Paul Volcker understood that when he was Fed Chair and used interest rate policy to battle double digit inflation in the 80's.  Many politicians and pundits will argue that those were horrible times.  But I remember Americans buying a new car every 3 years and my parents getting 12% returns in their savings accounts and CD's.  In fact, such rates encouraged savings, something we have none of right now.

So if that's the case, why have we arrived at an age where we see cutting rates as the be-all and end-all of every crisis?  It's quite simple.  I did say that various metrics have been manipulated over the years.  The most eggregious example is CPI and PPI.  These metrics were designed to measure inflation, but they have not been reliable indicators for over a decade since pracitces like Hedonics have been implemented, along with the falsehood of the "core rate" which excludes prices on items that most Americans spend more than half of their disposible income on.  All these manipulations have been designed to disguise the real inflation story so that the fed would be free to cut rates and encourage a society of debt as opposed to a society of saving.  This laid the ground work for excessive consumerism were the average middle class person was told that it's OK to mortgage their future for the latest iPod nano.  Then came the straw that broke the camels back...

Tax Cuts!  Yes, at a time when we were just getting ready to reverse this country's trend of going deeper into debt, Bush 43 swept into office with his plan to take a poorly conceived economic notion and put it on steriods by giving tax cuts to the wrong portion of the population.  There are way too many people on TV saying that raising taxes in an economic downturn is the wrong thing to do.  They could not be more wrong.  The tax cuts of the Bush adminsitration led to a growth periods where corporate profits doubled, but average workers incomes fell.  The tax cuts were a message to these corporations that it's OK to hoard cash.  You see, when you raise taxes on large corporations, they need to find ways to get rid of cash so they don't pay taxes.  The easiest way for them to do this is to higher workers and pay ALL workers bonuses or find other ways to distribute cash.  Of course when they need to distribute this cash, they want to find ways to keep it within their own ranks, and workers are often 2nd to executives, but at least the money will filter down to workers because for corporations it's better to pay workers than to pay Uncle Sam (they are the lesser of the two evils).  If you cut corporate taxes, corporations now start to hoard cash under very lax retained earnings rules.  This leaves a lot of cash sitting on the side lines while executives find the best ways to extract the cash for themselves.  If you don't believe me then take a look at the trend in the income gap between workers and management.  Executive pay in now over 500 times the average workers income.

So you see interest rate policy is a farce and cutting rates will not help the economy.  But it will reduce returns on savings, lead to even more inflation (which is already a huge problem), and further weaken the dollar.  The only investments that will benefit from this are precious metals which is where I have had my money since February (yes, I did see this coming).

by datorres 2008-12-16 04:30AM | 0 recs
Mostly right

But those 12% rates on bank accounts were great only if you had money in the bank, which most Americans did not. And that 12% wasn't so great when inflation was eating 10% of it's value. The Volcker period saw the destruction of the American industrial base, the destruction of the family farm, and the destruction of the liberal Social contract. That old bastard caused more destruction than Cheney and W.

by antiHyde 2008-12-16 07:13AM | 0 recs
Re: The End of Monetary Policy

Do you think we are headed to a global currency so we can start over with something else to peg value on? The way that the dollar is being devalued in debt seems a slippery slope to its eventual demise, but I don't really see another nation's currency out there that would supplant it either.

by Jerome Armstrong 2008-12-16 05:06AM | 0 recs
Re: The End of the Republican scam

The reason that monetary policy is so ineffectual is that what we have is not really a liquidity crisis but an insolvency crisis. Do consumers really need more access to credit or do they need to get out from under upside down mortgages and credit card debt that they can not afford? Will lower interest rates make whole fraudulent credit default swaps that were sold with no assets to back them up in the event the counter-parties had to pay up?

People don't need more credit they need more INCOME and that only comes from good paying jobs. To mask the biggest transfer of wealth in American history the Republicans pushed easy credit and asset speculation as a 'replacement' for income growth. Who needs unions, who needs to work and save when we can borrow our way to riches buying and selling houses to each other with money we borrow from China. Real estate, oil, agricultural commodities, industrial metals prices skyrocketed as  a tidal wave of borrowed money pushed prices to the moon. All the while the real income of the American middle class was falling off a cliff as a bigger and bigger slice of real wealth went into the pockets of the top 2%.

It was a Ponzi scheme more crooked and vastly larger then the Madoff scam. Madoff scamed 50 Billion but the Republican scam that is unraveling involves 60 Trillion in phony credit instruments and predatory investment scams. That is an amount the size of the entire world economy.

by hankg 2008-12-16 05:11AM | 0 recs
YOU have it right! n/t

by antiHyde 2008-12-16 07:14AM | 0 recs
Demand Side Economics

Cutting interest rates doesn't do any good if nobody's borrowing. I think Krugman has called it "pushing on a string".

A lot of rich people and banks just have money sitting in the bank. Why build a new building or mini mall or factory when they are already sitting vacant?

How about some demand side stimulus: Tax the rich and/or use government borrowing and give more to the poor and middle class.  In the infinite wisdom of the market place, they'll start spending, causing those factories to sell more widgets.

Obama already has some of these ideas on the books: infrastructure projects (mass transit?), health care, alternative energy. Some of these projects are in already place, waiting for funding. Here in Denver we have a major light rail expansion underway. Due to declines in the tax base and high cost of materials, these projects have been delayed. That would be reversed by a federal infusion.

by MetaData 2008-12-16 05:50AM | 0 recs
Re: Demand Side Economics

Yes.  Demand side stimulus.  And here's the irony - someone who is really a free marketer should be much happier with demand side stimulus than with propping up companies that have failed.  When the government chooses specific companies to save, it is as anti-free market as you can get.  When they pump money to consumers, it allows the market to work much closer to a "free" situation.

And yet, it's the supposed free marketers who oppose demand side stimulus the most.

by edparrot 2008-12-16 06:01AM | 0 recs
Re: Demand Side Economics

I like it.  It could be marketed as "Trickle-up" economics.  Or maybe "DooVoo economics".

by the mollusk 2008-12-16 06:02AM | 0 recs
Re: The End of Monetary Policy

Bombard your senator, particularly McCain and Specter, with your desire for them to support a huge simulus package.

by R Howe 2008-12-16 06:01AM | 0 recs


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