Symposium on Low Interest Rates

From the Mercatus center. The contributions are not coordinated in any way. We wrote essays about causes, effects, predictions, …whatever we felt like, on the general subject of the implications of low interest rates and the potential for them to rise. So far, we have

David Beckworth:

the 10-year Treasury yield has fallen more as a result of business-cycle pressures and policy uncertainty than because of structural changes like demographics. Consequently, more normal levels of interest rates are likely to prevail in the future.

If he is right, he could make a lot of profit by shorting bonds. And he may be right.

Joseph Gagnon writes

There are at least five reasons for the current low real rates of interest: (a) labor force growth has declined around the world, thereby reducing the need for business and housing investment; (b) a large cohort in many countries is entering the maximum saving years immediately prior to retirement; (c) productivity growth has declined around the world, thus reducing the demand for business investment; (d) regulatory changes have increased the demand for safe assets, including those that are commonly used to quote interest rates; and (e) driven by government policies, developing and emerging market economies have become net savers instead of net borrowers since 2000. In late 2009, I noted that the decline of real interest rates had been going on for about 30 years, and I pointed to several of those factors. This phenomenon is not limited to the aftermath of the Great Recession.

George Selgin writes,

Interest rates, like other prices, can change for all sorts of reasons; the implications of the change generally depend on the particular reason for such a change.

I had the same problem that Selgin had in starting the discussion with the value of an endogenous variable. I wrote,

The fiscal effect of an interest rate change depends on the source for that change. The source could be an increase in real economic growth, an increase in inflation, or an increase in the risk premium that investors assign to government securities.

Ben Bernanke takes on Sebastian Mallaby

Bernanke writes,

Mallaby’s argument that Greenspan should have known that a tighter monetary policy was appropriate in 2004-2005 (if that was in fact the case!) strains credulity. In 2003 the Fed was navigating a deflation scare and a jobless recovery from the 2001 recession—no net payroll jobs were created in the U.S. economy over 2003—which had led the Federal Open Market Committee to cut the fed funds rate to a record-low 1 percent. The FOMC did not stay at that level for long, however; Greenspan began to prepare the ground for a rate increase in January 2004, when the Committee’s language about keeping policy accommodative for a “considerable period” was modified. As Brad DeLong has pointed out, citing the FOMC transcript, at that point Greenspan was far from certain that the rise in housing prices was a nationwide bubble or that it could pose a threat to financial stability. Indeed, much of the increase in housing prices was still to come

Pointer from Tyler Cowen. Read the whole thing. I take Bernanke’s side on this one. Feel free to re-read my earlier post on Mallaby.

If David Cutler were an Entrepreneur

He would buy a hospital. Let me explain. The IGM forum polled economists to see if they agreed with this statement:

Long run fiscal sustainability in the US will require some combination of cuts in currently promised Medicare, Medicaid and Social Security benefits and/or tax increases that include higher taxes on households with incomes below $250,000.

Most economists agreed, as would I. However, Cutler disagreed, writing

There are ways of making the health care programs much more efficient, which would obviate the need for tax increases for some time.

He thinks he knows how to compensate health care providers more efficiently. If he were an entrepreneur, he would buy a hospital and prove his theories there. But he is a professor, so testing his theories is an all-or-nothing proposition, and we will have to pay for it.

Doug Elmendorf on the Debt

He writes,

Together with Brookings Senior Fellow Louise Sheiner, I have analyzed alternative explanations for low Treasury rates and the implications of each for budget policy (Elmendorf and Sheiner, 2016). We found that most explanations imply that the country should have a higher debt-to-GDP ratio than otherwise. We find that most explanations also imply that federal investment should be higher than otherwise, and I will come back to that later. The intuition for these results is that interest rates show the direct cost to the Treasury of its borrowing and provide information about the indirect cost to the economy of Treasury borrowing—and if costs will be persistently much lower than we are accustomed to, then more borrowing, especially for investment, passes a cost-benefit test.

Pointer from Tyler Cowen.

Of course, one possible explanation for low interest rates is that growth prospects are poor. Another possible explanation is that we are in a bond bubble. If either of those turns out to be the case, then we are going to wish that we had less debt to contend with.

Another Idiosyncratic Comment

Kevin Erdmannn comments,

It seems like you’re making the very mistake Smith is warning about. I don’t think historians looking at the newspapers of 2005 would be struck with the high level of trust we had in financial intermediaries. We imposed our distrust on them politically. The GSEs had four CEOs during the 2000s. All four were driven out. Ironically the second pair are accused of understating loss reserves in 2007. The first pair were paying fines in 2007 because they had been accused, among other things, of overstating loss reserves to manage earnings. It was impossible to be a GSE executive in the 2000s without being accused of fraud. The idea that the housing boom happened because of too much trust in financial intermediaries is laughably implausible. The only reason it seems plausible is because communal distrust is so ubiquitous that you will always find support for the idea that we trust them too much.

I agree that political meddling with Freddie and Fannie was harmful, and that they were better run before their CEOs were forced out in scandals that were either minor or perhaps not scandals at all. However, once that happened, confidence in Freddie and Fannie to invest in quality mortgages was unwarranted. More important, the confidence in the private mortgage securities market, based on AAA-ratings for mortgage tranches, was quite unwarranted. That form of financial intermediation got out of control.

Common-law Banks

A commenter asks,

What do you think of the limited purpose banking proposal advanced by Laurence
Kotlikoff and others? Link to PDF:

I am skeptical of the ability of government to design banks. It is one thing to write legislation that defines the activities that constitute banking and to issue charters and regulations to these legislatively-defined banks. It is something else entirely to keep banking from breaking out somewhere else.

Consider the money-market fund as an example of what I mean by a common-law bank. Money market funds are not banks as legally defined. They were not eligible for deposit insurance. And yet, I would argue that the regulators hit the panic button in 2008 because of what happened to Reserve Primary money market fund as a result of the Lehman failure. So from a common-law perspective, money market funds had become banks by the time of the financial crisis.

What Was Glass-Steagall?

I don’t think that Robert Reich actually knows.

Some argue Glass-Steagall wouldn’t have prevented the 2008 crisis because the real culprits were non-banks like Lehman Brothers and Bear Stearns. But that’s baloney. These non-banks got their funding from the big banks in the form of lines of credit, mortgages, and repurchase agreements. If the big banks hadn’t provided them the money, the non-banks wouldn’t have got into trouble. And why were the banks able to give them easy credit on bad collateral? Because Glass-Steagall was gone.

Pointer from Alex Tabarrok. Reich seems to think that Glass-Steagall was some sort of magical regulation that allowed regulators to keep banks from making unwise loans.

In fact, my understanding (like most commentators, I have not actually read the law itself) is that it was intended to separate commercial banking from investment banking. That is, one type of institution could take deposits and make loans, and another type of institution could underwrite securities. It started to fall apart in the 1970s, when money market funds were invented, allowing investment banks to issue debt that looked a lot like deposits. This caused banks to complain that financial activity was going to shift out of banks, which was going to hurt banks and make bank regulation irrelevant. The 1980s were spent with lobbyists and legislators trying to work out a fair way for commercial banks to compete in investment banking and vice-versa.

Ironically, what Reich is describing, with commercial banks lending to investment banks, shows that the two were still somewhat separate even ten years ago. I am willing to be corrected, but as far as I know, there was nothing in Glass-Steagall to stop a commercial bank from lending to an investment bank. Repurchase agreements and lines of credit were not forbidden. And when Reich says that non-banks received mortgages from commercial banks, he is completely unhinged.

I continue to believe that the Nirvana Fallacy it what drives a lot of analysis of the financial crisis, and of government intervention in general. That is, if you believe that Nirvana is achievable through government intervention, then if we have disappointing outcomes it must be because government is being held back from intervening the way it should.

The overall Atlantic piece to which Tyler refers includes comments from some left-leaning economists that are actually reasonable concerning the irrelevance of Glass-Steagall. But on the whole, the left is locked into its Nirvana fallacy of financial regulation.

Larry Ball Gets Pushback

From Stephen G. Cecchetti and Kermit L. Schoenholtz:

There is certainly room for debate, but we see the question of whether Lehman’s net worth was negligible or sharply negative as ancillary to the real issue. In important ways, lending to a bank of doubtful solvency is little different from lending to one that is certainly so. It will continue to put other institutions, and therefore the system, at risk. In this case, central bank lending to Lehman, an institution widely thought to be bankrupt, would have tarnished everyone else.

Pointer from Mark Thoma. My thoughts:

1. For those of us inclined to agree with this point, an implication is that Citigroup should have been allowed to fail. In fact, the whole bailout policy was misguided. Remember how some banks were forced to take bailout funds even if they did not want them? The idea was exactly to “tarnish everyone else” in order to avoid tarnishing the insolvent banks!

2. Regardless of the merits of letting Lehman fail, one of Ball’s main points still stands. That is, Bernanke and others have been lying by claiming that the decision was based on legal considerations. Ball did not find any evidence that the Fed made a judgment based on such considerations. In fact, it appears that it was not the Fed’s judgment at all, and instead Hank Paulson was calling the shots.

Paulson, Bernanke, and Lehman, continued

James B. Stewart writes,

One of the more intriguing questions Professor Ball tackles is why Mr. Paulson, rather than Mr. Bernanke, appears to have been the primary decision maker, when sole authority to lend to an institution in distress rests with the Fed. The answer, he suggests, is to be found more in psychology than data.

“By many accounts, Paulson was a highly assertive person who often told others what to do, and Bernanke was not,” Professor Ball writes. “Based on these traits, we would expect Paulson to take charge in a crisis.”

Pointer from Mark Thoma.

Stewart, who did his own reporting on the events, supports Professor Ball’s view. My reading of Paulson is that he is a high-testosterone guy. My reading of Bernanke is that he isn’t. I have always viewed Paulson as the great villain of the financial crisis response. I do not believe that any of the bailouts were justified, and I view him as the driver of the bailouts.

Suppose you take a Bagehot view, which is that in a crisis the central bank should lend freely, on good collateral, at a penalty rate. In the case of Bear Stearns, my recollection is that the Fed took on crummy collateral. Ball claims that Lehman had good collateral that the Fed could have lent against.

Jason Collins reviews Jonathan Last

Collins writes,

So, if government can’t make people have children they don’t want and can’t simply ship them in, Last asks if they could help people get the children they do want. As children go on to be taxpayers, government could cut social security taxes for those with more children and make people without children pay for what they’re not supporting. (Although you’d want to make sure there was no net burden of those children across their lives, as they’ll be old people one day too. There are limits to how far you could take that Ponzi scheme.)

Keep in mind that lower birth rates are an international phenomenon, so I am reluctant to place much weight on U.S.-specific factors. My sense is that the decline in birth rates is correlated with, if not caused by, increased education of women. If that is the main causal factor, then it probably is not something that is going to be reversed.

Also, I am not convinced that there is such a down side to slower population growth and eventual decline. Yes, it messes up entitlement programs for the elderly, but that is because those programs are ill conceived, particularly in not indexing the age of government dependency to longevity. You should fix the entitlement programs to deal with the demography rather than try to fix demography to deal with entitlement programs.