Wednesday, June 10, 2009

Arthur Laffer's WSJ Op-Ed

I'm a fan of Art Laffer, and I think he is one of very few economists you see on TV who actually understands fiat currency economics.

However, his article today left me scratching my head. The following paragraph in particular makes no sense to me:

With an increased trust in the overall banking system, the panic demand for money has begun to and should continue to recede. The dramatic drop in output and employment in the U.S. economy will also reduce the demand for money. Reduced demand for money combined with rapid growth in money is a surefire recipe for inflation and higher interest rates. The higher interest rates themselves will also further reduce the demand for money, thereby exacerbating inflationary pressures. It's a catch-22.

Let me try to parse it.

To start, the first sentence doesn't capture the complexity of how the crisis unfolded. "Demand" for money usually means a desire to borrow for the purpose of spending ("spending" includes investment in a business, by the way, and not just consumption). Money demand increases when the economy is growing, and prospects look rosy. And higher demand with fixed supply means higher interest rates.

However, this bears no relation to the crisis. People didn't want money so they could spend it. They just wanted to move it to a safe place. There was a collective loss of faith in the creditworthiness of the financial system. In September 2008, T-bill rates were effectively pinned at zero (there were even some scattered trades at negative yields). That shows just the opposite of a demand for a money. Yields on all risky fixed-income products sky-rocketed, but this wasn't because of a sudden spike in the demand to borrow. It was due to a belief that defaults were imminent. That's a big difference.

The Fed's response, of course, was to devise a number of programs to flood the market with money as a way to induce investors to buy the risky products again. The flood of money hasn't worked all that well actually. Other things have. What brought down the interbank lending rate (i.e. Libor) wasn't so much the flood of money but the government's increasingly explicit guarantee of all of the big banks. What brought down spreads in the agency debenture and agency mortgage market was the Fed's direct purchase program. What brought down credit spreads in the consumer loan market is the Term Asset-Backed Loan Facility (TALF) which basically grants a government subsidy to investors in the form of a free put option.

It's all pretty obvious when you think about it. If you don't want to loan Chrysler money because you think they'll default, you're not going to change your mind just because the Fed is willing to lend you $100MM interest-free to do it. You still have to pay back the Fed after all.

Laffer's second sentence is unobjectionable. A recession causes a reduction in the demand for money since business prospects look bleaker and people are more inclined to save money rather than spend it. I should point out that causality works the other way as well. An increase in the desire to save money means less consumption and investment and therefore less economic activity.

The third sentence is completely screwed up. Reduced demand for money is offset by the Fed's increase in the supply of money which lowers the price of money (i.e. the interest rate), which in turn raises the demand for money (since the price is lower). Yes, when the demand rises again (due to the lowered price), the cycle will renew itself. The economy will start growing again, and inflation will start to pick up, but interest rates will be wherever the Fed wants them to be.

Short-term interest rates will go up only if the Fed chooses to raise them (by reducing the money supply) in order to fight inflation. Intermediate-term rates will go up only if the market anticipates that the Fed will raise short-term interest rates. Long-term rates are driven by more complicated factors including risk premia, but let's just say that if the Fed maintains its inflation-fighting credibility, long-term rates will remain moderate.

The fourth sentence in our excerpt starts out ok, but then ends with a completely false statement. Yes, higher interest rates will reduce the demand for money (which had already been raised by lower interest rates and subsequently a growing economy), but this will serve to quash inflation, not stoke it. Higher interest rates do not exacerbate inflation; they do exactly the opposite. They discourage borrowing and spending and encourage saving. They reduce the aggregate demand for goods and services and therefore cause prices to rise less quickly (or even drop). Yes, some economists have theorized that there can be a small short-term cost-push effect on prices in which businesses try to pass on their higher borrowing costs to the consumer, but this isn't real inflation. It is at worst a very short-term and very small effect. At best, it doesn't exist.

Finally, I disagree with Laffer that the Fed is in a Catch-22. A better metaphor is that the Fed is trying to thread a needle. It must aggressively lower the price of money in order to boost aggregate demand for goods and services, but once the economy is safely back on track, it must move quickly to drain the excess liquidity from the system and raise interest rates. If the Fed moves too soon, the economy could be thrown back into recession (this was the Bank of Japan's mistake 10 years ago). If the Fed moves too late, then inflation could get out of hand.


Anonymous said...


Excellent analysis, as usual. You are the brightest new financial blogger of 2009.

What do you think of Laffer's proposed course of action for the Fed, from the same editorial:

Now the Fed can, and I believe should, do what it must to mitigate the inevitable consequences of its unwarranted increase in the monetary base. It should contract the monetary base back to where it otherwise would have been, plus a slight increase geared toward economic expansion. Absent this major contraction in the monetary base, the Fed should increase reserve requirements on member banks to absorb the excess reserves. Given that banks are now paid interest on their reserves and short-term rates are very low, raising reserve requirements should not exact too much of a penalty on the banking system, and the long-term gains of the lessened inflation would many times over warrant whatever short-term costs there might be.

I would imagine that Steve Conover, for one, would not agree. At least, not at this time.

-- DAB

Anonymous said...

Sorry everyone, messed up the link to Steve Conover's Skeptical Optimist blog. This one should work.

-- DAB