Money, interest, and the economy

John Cochrane writes,

Investment responds to the stock market, and the stock market moves because risk premiums move, not because interest rates move.

He goes on to suggest that if monetary policy can effect the economy, it must work through the channel of affecting the risk premium. That seems dangerous. To me, it also seems far-fetched. I view this as helping to reinforce the Fischer Black/Arnold Kling ultra-heterodox view that central banks are not macroeconomically significant.

The theory that central banks are irrelevant can withstand the supposed counter-example of hyperinflation. We view hyperinflation as a fiscal phenomenon. The government cannot tax and borrow enough to match spending, so it pays its bills by printing (ultimately worthless) paper.

Cochrane links to an essay by Dan Thornton, in which Thornton argues that the evidence is weak that the interest rate affects spending.

“So why do policymakers believe that monetary policy works through the interest rate channel and that monetary policy is powerful?” Well, there was one important event that brought economists and policymakers to this conclusion. Specifically, the Fed under Chairman Paul Volcker brought an end to the Great Inflation of the 1970s and early 1980s.

Indeed, this is the great counter-example to my view the central banks are irrelevant. I have to argue that the Great Inflation and the Volcker Disinflation were not the monetary-policy phenomena that they are widely viewed as being.

My best alternative hypothesis concerning the Great Inflation is that the breakdown of the sort-of gold standard of Bretton Woods and the use of “incomes policies,” most notably the Nixon wage-price controls, caused a change in pricing norms away from stability and toward upward ratcheting. The actions of the oil cartel in the 1970s can be viewed as both a response to the breakdown of the Bretton Woods system and as a causal factor in itself that affected pricing norms throughout the economy.

My best alternative hypothesis concerning the Volcker disinflation is that it was not Volcker that produced the shift to a regime with less inflationary pricing norms. Perhaps deregulation, particularly in transportation, played a role. The collapse of the oil cartel, a collapse which decontrol of the U.S. oil market probably helped to foster, was a factor also.

Incidentally, I am not as convinced as Thornton that housing construction and consumer durables are insensitive to interest rates. Those sectors certainly are highly cyclical, with Ed Leamer showing that they are almost always implicated in recessions. For much of the post-war period, the institutional environment, including key financial regulations, ensured that any rise in long-term nominal interest rates caused credit for housing to dry up. But the regime of the 1960s, with strong restrictions against interstate banking and with deposit interest ceilings, was dismantled by 1990.

The new regime appeared to be nearly recession-proof until 2008. Then what happened? I think that we will be arguing forever about what exactly caused the recession to be so deep as well as what role, if any, monetary and fiscal policy played in the recovery.

8 thoughts on “Money, interest, and the economy

  1. The new regime appeared to be nearly recession-proof until 2008.

    How about 1990 and 2001? Sure they were not as deep statistically but did the job markets took two years to hit the high point of Unemployment. Real wages took a significant hit in both recessions. And wasn’t the 1990/1992 sort of the dress rehersal for the 2008 crash? 1992 was big enough that a weird third party candidate won 19% of the vote because of his position and has swept under the rug (say like the 1957 recession in the Keynesian 1950s) as the boom was so large afterwards.

    Anyway, I still think of the 2008 Financial Crisis as the Reagan Revolution finally over-heated with consumer debt. Any consumer debt chart shows a significant break in 1983.

  2. I view the impact of central banks like your education null hypothesis – within “normal” operating parameters, the actions of the bank make no difference. But if you move outside of normal parameters, all bets are off.

  3. >..hyperinflation as a fiscal phenomenon.
    >…the breakdown of the Bretton Woods system.

    I agree completely with this. Monetarism is really money mysticism IMO.

  4. So if I am a real world businessman contemplating a capital investment decision (e.g. to buy a new warehouse) an interest rate hike by the Fed wouldn’t affect my decision?

    You could make an argument that the new world that Greenspan referred to as a “conundrum” (when long rates didn’t increase despite multiple Fed Funds target hikes) validates the “central banks don’t matter” hypothesis. But I’d counter that their tightening is still going to make my businessman pause his investment because of the risk that the Fed will derail the capital markets like in 2007-08.

    • I like it. The Fed should act crazy, but do it early and not actually follow through on destroying the economy.

  5. The power of a central bank is asymmetric, powerful on the restrictive side, weak on the stimulative side, the whole pushing versus pulling on a string thing.

    Paul Volcker’s high interest policy showed the power of a central bank’s ability to wreak havoc on an economy, killing off inflation in the process, at a high cost in terms of unemployment and business failures.

    But as we have seen, lowering interest rates has no effect in a balance-sheet recession, with consumers hellbent on repairing their balance sheets. There, the central banks are weak and impotent.

    For that reason, one should not talk about the power of a central bank outside the context of what problem in the economy they are trying to solve.

  6. The equity risk premium I keep reading about is like phlogiston. It’s unmeasurable and may not exist, but it makes for nice theories.

    There are many investments with high risk and low expected returns: movies, plays, venture capital, private equity, options, commodities, and penny stocks come to mind.

    Anyone who really believes in “stocks for the long run” should go short at-the-money-forward puts on the S&P 500, 20 years out. These should be close to worthless, according to risk premium theories, but in fact there’s a good bid for them. Merton made a similar point years ago.

Comments are closed.