Why the Fed Should Not Lower Interest Rates
Curious to hear your thoughts on my writings:
I awoke this morning thinking about the big picture. A view of things that I hadn't been able to concisely generate before started to form, so I thought I would write it down.
There is a great deal of discussion right now about debt. What is sustainable? What isn't? Well, let me try to explain what I was thinking of this morning.
Say you have a debtless $10T economy. It's built on the hard work of its participants; consumers demanding goods, suppliers supplying them, and exists without any debt whatsoever. For every transaction that occurs, a supplier delivers something to satisfy a consumer's demand with the consumer delivering immediate payment. (Believe it or not, it could happen.) Now assume that economy is growing at a 4% annual rate. In the absence of debt, that means that real supply *and* real demand must both grow at equal rates of 4%.
Now, what happens if demand grows by 4%, but the supply remains static? Since the supply is fixed and 4% more demand is available, prices would adjust to absorb the growth in demand - a 4% inflation results. Is it bad? Is it good? Neither. Everybody has static standard of living, as they get the same share of a static pie, assuming the demand grows 4% evenly.
Now, what happens if supply grows 4%, but aggregate demand's ability to pay for it is stagnant? Deflation would result. It's not a bad deflation, as real output has risen by 4%, but since there is static demand and a rising supply, prices would have to fall to compensate. In fact, everybody gets a 4% increase in standard of living, as they get the same share of a 4% larger pie.
Great. So equal supply and demand growth yields growth in both nominal and real standards of living. Demand growth without supply growth yields inflation, and static real standard of living. And supply growth without demand growth yields deflation, but rising standards of living. To sound like a supply-sider for a moment, *supply* is everything when it comes to standards of living.
Suppose you are on a long-term growth track with supply and demand growth both averaging 4% (meaning there are 4% more goods available each year, and as a result of the people supplying those 4% more goods taking home 4% more income, demand can increase 4%). Where it gets sticky is in the temporary imbalances between supply and demand growth. When a company invests a large amount of money in capital equipment, it can mean a surge in supply, but unless their employees get a similar surge in income, we have the situation in which there is supply growth without demand growth. So we see supply growth is pretty simple to gauge - what is the productive capacity of the economy? How much are suppliers able and willing to deliver for transactions? But demand growth is a little trickier. Demand is how much consumers are able and willing to pay for in transactions, but the ability to pay depends upon growth in incomes from their employers. As control over supply has shifted largely into the hands of corporations, with demand still based on individuals, economic growth becomes a tug of war, between supply growth via corporate investment, and demand growth as increasing corporate revenue is reluctantly shared with employees.
Now, introduce debt. To a clever monetary authority, debt allows for a mechanism to smooth out these temporary imbalances between supply and demand. Suppose there is a surge in capital investment and resulting aggregate supply without a commensurate increase in demand. A monetary authority can encourage the creation of debt on the demand side to fill the gap. However, since it reduces future demand, it must be used sparingly. If you assume a $10T economy with 4% supply growth but no demand growth, you can temporarily fill the hole by allowing the creation of $400B in debt. When demand growth picks up, the debt should be paid down.
Where it goes astray is over the long haul. If you continue the supply/demand imbalance for ten years, all of a sudden you have a $10T economy that has racked up $4T in debt and a decade-long mirage of growth. Is $4T too much debt for a $10T economy? Not likely. How about $14T? $40T? Where is the limit? Obviously it depends on interest rates, and how long creditors are willing to wait to be repaid. Conceptually, it doesn't matter where the number lies, but that there is some limit to indebtedness, and therefore an upper bound on how long inadequate demand growth can be artificially boosted with debt formation. The threshold can be increased by reducing interest rates, which is what the Fed has pursued for many years now. The clue that the indebtedness threshold is being hit is that either rates are as low as they can nominally go, or that debt levels fail to increase with falling interest rates. (Absent monetary authority intervention (interference?), the free market would manage this by changes in interest rates all by itself, but we've observed that the markets produce their own booms and busts, and perhaps true counter-cyclical activity by a monetary authority can be a net societal positive. I'm not going to argue that one today.)
Fortunately (?) we don't have either debt limitation, yet. As rates have fallen, debt levels have continued to soar as consumers pile on debt encouraged by lower interest rates, and rates aren't quite to zero yet. However, a quick examination of the aggregate situation shows how bad things really are. If debt levels are surging by $500B per year in a $10T economy, it says that demand is lagging supply by 5%, and in order to merely sustain economic activity at the current level, debts must continue to increase by 5% every year. Unless there is some magic way to boost real demand (the incomes of consumers), the debt formation must continue ad infinitum to merely maintain the status quo.
Of course, that is impossible. This level of debt formation has only been achieved through the steepest reductions in interest rates in history, and while the willingness of consumers to pile on debt is certainly there, their ability to borrow ever-increasing sums through ever-lower interest rates is about to hit the numerical wall. When Fed Funds are at zero, and mortgages are below 5%, there simply isn't any way to continue debt formation at existing rates. Aggregate demand will fall toward the level of real, sustainable demand, and the real level of economic activity will shrink.
So what's a responsible Federal Reserve to do? Well, first and foremost, don't ever let aggregate debt levels grow so high that you find yourselves in this situation to begin with. Debt formation should be encouraged as a *temporary* counter-cyclical stimulus to fill *temporary* imbalances between supply and demand. But, given that you're in this mess, you must realize that real aggregate demand has not kept pace with supply growth for many years, and that you had the responsibility of keeping the two in check.
Recessions serve the purpose of forcing real supply and demand back to parity, and pricing flexibility of products or wages during these corrections plays a central role in the rebalancing. We must take our medicine. Supply exceeds real, sustainable demand by several percent, and the gap can't be supported indefinitely. If the actions the Fed takes to stave off depression still permit the supply/demand imbalance to be worked out, they may be justifiable, even if they foster further debt creation. But if they come at the price of widening the gap further, then they will only make the correction more severe. The correction can be postponed, or spread out over several years, but it can not be eliminated no matter how clever we think we are. Supply must be brought into line with demand either through a price correction (deflation), a pass-through of corporate income to employees, or a combination thereof. And here's the crucial thing: the longer the Fed postpones dealing with the supply/demand imbalance, the fewer options it has.
Is the specter of deflation such a bad thing? Well, in the debt-free world postulated at the beginning of this piece, it obviously was not. It indicated a growth in supply and standards of living. However, in a world levered to the limit, the Fed has created a situation where the prospect of a downward adjustment in prices could result in a positive feedback, where existing debt levels are magnified by falling prices, and an unstable, fragile financial system might cease to function if credit formation backs off from its hectic pace. So, the Fed has created a situation where it feels it must at all costs try to avoid the normal rebalancing of supply/demand through price declines.
So what is our Fed actually doing? They have supplied far too much stimulus, and encouraged the supply/demand gap to widen even further since the equity market peak. This means that the imbalances to be corrected have only widened further, not narrowed, while propelling us even faster toward a collision with the zero interest rate floor beneath us. I expect that they have some appreciation for the fact that the economy has a large supply/demand imbalance that must be worked out, and that they will attempt to push the economy as close to the brink of working those imbalances out as possible, but when they must actually have the backbone to stand pat, risk a mild deflation, and let the corrections occur, they will fold as they have done every time before. They have become slaves to the debt load themselves, and are rapidly losing control of a monetary system that has taken on a life of its own.
I expect our Fed to permit us to have one more deflationary scare, to bring us to the brink and see if some of the supply/demand imbalance can be worked down. But, in their usual form, they will blink, and begin a dangerous, untried campaign of "unconventional" monetary measures. If they act without participation from our trading partners, the value of our currency will be destroyed, resulting in imported inflation, falling global economic activity, worsening deflation abroad due to demand shock, and declining standards of living. However, should they have the cooperation of the rest of the world, they may succeed in avoiding global deflation, instead readjusting nominal supply and demand through a vigorous global inflation. This would come at the expense of the responsible savers and creditors of the world, and the loss of monetary authority credibility. With a coordinated global effort, it could succeed in a transfer of wealth from creditors to borrowers large enough to sustain economic activity at existing levels. That is, if the creditors are willing to stand by and watch their purchasing power be taken from them. My guess is that they will wake up and demand repayment before that happens, shutting off the monetary spigot and finally producing the depression we've been building and trying to avoid for so long now.
My expectations are for another brush with deflation within the next year, followed by a multi-year global effort to destroy the value of currencies and paper claims, joined by all the major monetary authorities of the planet. Forced to choose between the known perils of a deflationary depression and the unknown spectre of an uncontrollable inflation, they will select the experimental inflation, falsely believing that they will be able to tame the beast once it has done its job. They will rub the lamp until the genie produces sufficient inflation to shrink the outstanding debt loads to manageable levels, and then attempt to stop it. Being an optimistic sort, they expect to be successful. I'm not so confident.
The Fed should *not* lower interest rates here. We should do everything possible to narrow the supply/demand imbalance as quickly as possible, with social programs from the government to lessen the human cost of the task. The sooner we begin unwinding the imbalances, the more "conventional" weaponry we'll have to fight the inevitable consequences. I don't trust "unconventional" monetary policy, and neither should you.
One thing is certain: financial risk has never been higher than it is now, and that remains entirely unappreciated by the vast majority of economic participants.
BC |
