Monday, April 21, 2014
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Central Bankers under Siege

CHICAGO – Poor Ben Bernanke! As Chairman of the United States Federal Reserve Board, he has gone further than any other central banker in recent times in attempting to stimulate the economy through monetary policy. He has cut short-term interest rates to the bone. He has adopted innovative new methods of monetary easing. Again and again, he has repeated that, so long as inflationary pressure remains contained, his main concern is the high level of US unemployment. Yet progressive economists chastise him for not doing enough.

What more could they possibly want? Raise the inflation target, they say, and all will be well. Of course, this would be a radical departure for the Fed, which has worked hard to convince the public that it will keep inflation around 2%. That credibility has allowed the Fed to be aggressive: it is difficult to imagine that it could have expanded its balance sheet to the extent that it has if the public thought that it could not be trusted on inflation. So why do these economists want the Fed to sacrifice its hard-won gains?

The answer lies in their view of the root cause of continued high unemployment: excessively high real interest rates. Their logic is simple. Before the financial crisis erupted in 2008, consumers buoyed US demand by borrowing heavily against their rising house prices. Now these heavily indebted households cannot borrow and spend any more.

An important source of aggregate demand has evaporated. As consumers stopped buying, real (inflation-adjusted) interest rates should have fallen to encourage thrifty households to spend. But real interest rates did not fall enough, because nominal interest rates cannot go below zero. By increasing inflation, the Fed would turn real interest rates seriously negative, thereby coercing thrifty households into spending instead of saving. With rising demand, firms would hire, and all would be well.

This is a different logic from the one that calls for inflation as a way of reducing long-term debt (at the expense of investors), but it has equally serious weaknesses. First, while low rates might encourage spending if credit were easy, it is not at all clear that traditional savers today would go out and spend. Think of the soon-to-retire office worker. She saved because she wanted enough money to retire. Given the terrible returns on savings since 2007, the prospect of continuing low interest rates might make her put even more money aside.

Alternatively, low interest rates could push her (or her pension fund) to buy risky long-maturity bonds. Given that these bonds are already aggressively priced, such a move might thus set her up for a fall when interest rates eventually rise. Indeed, America may well be in the process of adding a pension crisis to the unemployment problem.

Second, household over-indebtedness in the US, as well as the fall in demand, is localized, as my colleague Amir Sufi and his co-author, Atif Mian, have shown. Hairdressers in Las Vegas lost their jobs partly because households there have too much debt stemming from the housing boom, and partly because many local construction workers and real-estate brokers were laid off. Even if we can coerce traditional debt-free savers to spend, it is unlikely that there are enough of them in Las Vegas.

If these debt-free savers are in New York City, which did not experience as much of a boom and a bust, cutting real interest rates will encourage spending on haircuts in New York City, which already has plenty of demand, but not in Las Vegas, which has too little. Put differently, real interest rates are too blunt a stimulus tool, even if they work.

Third, we have little idea about how the public forms expectations about the central bank’s future actions. If the Fed announces that it will tolerate 4% inflation, could the public think that the Fed is bluffing, or that, if an implicit inflation target can be broken once, it can be broken again? Would expectations shift to a much higher inflation rate? How would the added risk premium affect long-term interest rates? What kind of recession would the US have to endure to bring inflation back to comfortable levels?

The answer to all of these questions is: We really don’t know. Given the dubious benefits of still lower real interest rates, placing central-bank credibility at risk would be irresponsible.

Finally, it is not even clear that the zero lower bound is primarily responsible for high US unemployment. Traditional Keynesian frictions like the difficulty of reducing wages and benefits in some industries, as well as non-traditional frictions like the difficulty of moving when one cannot sell (or buy) a house, may share blame.

We cannot ignore high unemployment. Clearly, improving indebted households’ ability to refinance at low current interest rates could help to reduce their debt burden, as would writing off some mortgage debt in cases where falling house prices have left borrowers deep underwater (that is, the outstanding mortgage exceeds the house’s value).

More could be done here. The good news is that household debt is coming down through a combination of repayments and write-offs. But it is also important to recognize that the path to a sustainable recovery does not lie in restoring irresponsible and unaffordable pre-crisis spending, which had the collateral effect of creating unsustainable jobs in construction and finance.

With a savings rate of barely 4% of GDP, the average US household is unlikely to be over-saving. Sensible policy lies in improving the capabilities of the workforce across the country, so that they can get sustainable jobs with steady incomes. That takes time, but it might be the best option left.

Read more from our "New Model Central Banking" Focal Point.

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  1. CommentedRay DAMANI

    Surely, you mean the people are under siege?

    The CBs have taken ordinary people and their savings in order to save bankers and their bonuses, and to bury the malfeasance of politicians!

  2. CommentedCharlie Savelle

    Although we might say that the pre-crises spending was irresponsible, it's clear that a strong fiscal stimulus should be instituted, something analgous to the defense spending for the second World War, which as Joseph Stiglitz has pointed out helped the US shift from an agricultural, to an industrial driven economy. The average citizen, as the author has pointed out is not in a position to spend, nor would monetary policy encourage them to spend, nor it even desirable that they do so we're either left with a painfully slow shift, as the poor face necessary austerity and learn to live simpler, and try to shift the next generation with meagre resources appropriately, or we deploy a strong fiscal stimulus to encourage cheap education, and help the poor by providing them with necessary fundamentals like healthcare--of course we could help pay for it through taxes on the rich who haev enough to save above average, which would be a way of forcing savers to spend, and have the dual effect of leaving less capital for possibly harmful financial wizardy.

  3. CommentedGary Palmero

    Real interest rates are not high with the nominal short term rate close to zero. This can only occur if prices are falling and since the consumer price index in the US is rigged because it does not include food, fuel, education,taxes and insurance costs, most consumers believe the CPI is understated. Strapped borrowers are not deterred by any interest rates, they simply cannnot borrow.

    However, government agencies are borrowing with abandon since service costs are low relative to notational debt with the borrowers operating under the belief that they can roll over debt indefinitely. This will end when interest rates rise, or MOST LIKELY, when notational debt reaches the excess point where the borrowing window is shut.

    I suggest that short term interest rates be raised in publicly announced increments to two per cent. Japan should go first since it is in most need of stimulating its savers and other advanced nations can follow. It is better to stimulate consumer spending for savers by raising their income than by forcing them to spend at the point of a gun (by inflation) and that won't work anyway.

    We need to think creatively out of the box and this is my suggestion.

  4. CommentedGordon Tolleson

    Some of you may get upset with me but Mr. Rajan does not truly address the unemployment problem. Corporations are flush with liquidity but are not willing to hire. The reason is the uncertainty of what this administration will do next. As a business owner I am in the same boat. I am not going to go into the details of planning and knowing what the cost of hiring a new employee.

    Housing is a problem and the bottom is still not in and until the market itself settles in some parts of the country, housing will continue to fall. Going back to 2006 prices is another 5 to 8 years away in the current environment.

    The banks should have been allowed to fail instead of transferring their bad debt onto the public taxpayers.

    I am sorry but the banks brought us to this point including the Fed. Of course people using their homes like ATM's was not good either.

  5. Commentedjames durante

    Doesn't any of the demand problem have to do with that full grown elephant in the room, extreme wealth and income inequality in the US? The top 1% now have something like 40% of the wealth and 25% of the income. Their shares keep increasing. Slashing tax rates on the wealthiest, undermining unions, shipping out jobs.... Economics is politics and vice versa.

  6. CommentedJohn Doe

    Respectfully, Raghuram Rajan doesn't understand the first thing about how the American economy works.

    He really needs to start from the beginning with Keynes. We are exactly where Keynes said capitalist economies are most vulnerable: when the average (not great) capitalist (better word entrepreneur) faces a wall of fear. The job of the Government, including the Fed., is to restore confidence so that the average capitalist will not fear borrowing and spending what little cash they have.

    Brad DeLong periodically puts the exact quote up on his web site. Rajan needs to make an enlarged copy, set it on his desk, and think about it for the rest of his life, doing nothing else, so that he does no further damage.

    That means that until real estate prices return to 2006 levels we are screwed.

    Why? Home equity is the source of capital (via 2nd deeds of trust) for most businesses. Banks can not lend to businesses unless their owners have equity in their homes that can be used as security for loans. Rajan says he teaches finance. He appears to know nothing about United States banking.

    Most all small business lending in the United States is secured by home equity. If you want business lending to expand, the only way to do such is to raise home values.

    This also permits consumers to borrower and spend, if they choose, but that is coincidential, not causative.

  7. Commentedsrinivasan gopalan

    a credit-backed society always faces challenges and the US is no exception to this canon. In a country where saving rate is deplorably low and people simply get carried away by borrowing binges, the end to any crisis hinges on return to values of conservation and harbouring savings impulses to provide for rainy days. Dr. Raghuram Rajan, a celebrated economist hailing from a country which preached simple living and high thinking, has rightly pitched for "sensible policies in improving the capabilities of the workforces across the country". But in a debt-driven economy of gargantuan size such homilies cannot gain currency unless the authorities preach austerity and saner fiscal course so that people take a cue from their leaders and reshape their way of living to drive development that is sustainable and endurable over the long haul. g.srinivasan

  8. CommentedDavid Doney

    Dr. Rajan does not discuss the likely cause of our high unemployment, which is trade with low-wage countries leading to a $650 billion U.S. goods trade deficit.

    Using $50,000 per job as a rough approximation, this is about 13 million jobs, versus our jobs shortfall of around 15 million jobs.

    If a wealth country allows its corporations to source their labor overseas in a low labor country without penalty (such as a tax on the wage differential) eventually the jobs engine of the wealthy country will sputter and die. Economists widely agree that globalization has caused U.S. real wages to stop growing for most of the workforce. But they have yet to agree that it is actually killing jobs engine.

    In the U.S., we created 15-21 million net new jobs each decade from 1970-2000, then only 2 million net new jobs 2000-2009.

    Take away the housing bubble and we've had about 1% annual GDP growth since 2000, according to Niall Ferguson.

    How many dots must there be before someone in authority will connect them?

    Protectionism and devaluation of the currency are key policy prescriptions to eliminate this trade deficit, or significant wage reductions (e.g., 30% across the board).

  9. CommentedProcyon Mukherjee

    Raghuram in his seminal analysis ‘The true Lessons of the Recession- The West Can’t Borrow and spend Its way to Recovery’ in the Foreign Affairs May-June 2012 issue had taken the debate to its logical conclusion; In the section ‘Disrupting the Status Quo’ the statistics are alarming, “In the United States, 35 percent of
    those aged 25 to 54 with no high school diploma have no job, and high school dropouts are three times as likely to be unemployed as university graduates. What is more, Americans between the ages of 25 and 34 are less likely to have a degree than those between 45 and 54, even though degrees have become more valuable in the labor market.”

    The dysfunctional lock between education growth and technology growth and the shifting of growth driver from conventional labor markets to technology linked markets had taken the unemployment situation to the current dimensions. This cannot have a solution in monetary policy through credit induced spending. The issue is one of investments in those sectors which would bridge the gap we have just talked about; for that America must decide where the public spending must be directed and for that the state capacity on revenues must be first better prepared and augmented, not enfeebled by tax cuts.

    Procyon Mukherjee

  10. CommentedAnil Maheshwari

    I agree with the policy recommendation. The discussion needs to shift from monetary policy to the discussion om real work. Working hard and winning real battles is critical in changing the economic situation in the US. Building superior skills and a strong work ethic is critical for young people, as well as those in mid-career. It requires inspiration, focus, and being heads down. It may not guarantee material success, but doing one's best and winning in our field often leads to happiness and joy.

  11. CommentedAtul Bhardwaj

    Most of the economists willingly want to remain trapped in the vicious cycle of inflation and interest rates. They just don't want to think of a world beyond these twin parameters.
    There is far too much of inequality in the world and the root cause of it is money and its manipulation. Just as the civilization advanced from pre-modernity to modernity through what Nietzsche identified as the death of god, similarly, to move into post modernity the civilization would have to kill something. The death of money and its progeny, the banking system seems to be the only solution to usher in a more egalitarian era.

  12. CommentedShiang Peow Foo

    Mr. Kerridge's comments are uncalled for and unfair to Indians. Please do not generalize and oversimplify by saying " Indians who received education in ideologically biased and technically focused economics typical of the USA become brainwashed.".

    By the way, I am a Chinese.

  13. CommentedKonrad Kerridge

    I honestly think that Indians who received education in ideologically biased and technically focused economics typical of the USA become brainwashed. They seem unable to question this version of orthodox economics - neoliberalism - that arose in the 1970s and 1980s and was popular under Reagan. It seems that their lack of previous training in questioning ideas in India, and then being overawed by America means that they swallowed what they were fed hook line and sinker. Bhagwati is another one. Ideas of the 1980s. Now ossified and the cause of many of the inequalities, poverty, low growth and crises of today. Where other economists...of western origin or of East Asian origin have been better able to move forward and embrace more contemporary thinking on economic development.

    1. CommentedMarco Hauptmeier

      The comment below by Mr Kerridge is racist. He would have done better if he would have engaged with Raghuram Rajan's commentary in a substantive manner.