I fully recognize that I’m treading on delicate ground here, with the potential to offend pretty much everyone. My intention is to not to belittle either religion or economics, but to help you understand why central bankers take the actions they do.
This explanation will need a little set-up. I have noted before, in an effort to be humorous, that when you become a central banker you are taken into a back room and given gene therapy that makes you always and everywhere opposed to deflation. Actually, this visceral aversion is imparted during academic training in the generally elite schools from which central bankers are chosen.
This is our heritage; it’s learning derived not only from the Great Depression but from all of the other deflationary crashes in our history, too, not just in the US but globally. When you are sitting on the board of a central bank, your one overriding rule is never to allow deflation to occur on your watch. No one wants to be thought responsible for bringing about another Great Depression.
And let’s be clear, without the radical actions taken in 2008–09 to bail out the banks, drop rates to the zero bound, and institute quantitative easing, we would likely have been facing something similar to the Great Depression. While I don’t like the manner in which we chose to bail out the banks, some form of bailout was a necessary evil.
Think deflationary depressions can’t happen today? Clearly, they can. Greece, for all intents and purposes, has sunk into a massive deflationary depression. That reality is not necessarily reflected in the prices of their goods, which are denominated in euros. No, the deflationary depression in Greece is in their labor market.
Normally, when a sovereign country gets into financial trouble (generally because of too much debt), it will devalue its currency so that the prices of products it imports go up and labor costs and the prices of products it sells abroad go down. But since Greece could not devalue its currency (the euro), it was essentially forced to allow its labor costs to fall drastically. Since it is basically impossible to go to everyone in Greece and say, “You need to take a 25% cut in your pay, even though the prices of everything you’ll be buying will still be in euros,” the real world simply produced massive Greek unemployment – precisely what you would expect in a deflationary depression. Greece will likely continue to suffer for a very long time, whereas if the Greeks had left the euro, defaulted on their debts, and devalued their currency, they would likely be enjoying a quite robust recovery.
Greece’s present is a possible near future for other countries in Europe (Portugal is likely to be next, and Italy will surprise everyone with its severe banking problems), which is why the European Central Bank is so desperately fighting the deflationary impulse embedded in the very structure of the European Union.
Now, the United States is clearly not Greece. However, we are subject to the same laws of economics.
By definition, recessions are deflationary. Whenever we enter the next recession, we are going to do so with interest rates close to the zero bound. Most of the academic research both inside and outside the Fed suggests that quantitative easing, at least in the way the Fed did it the last time, is not all that effective. If you are sitting on the Federal Reserve Board, you do not want to allow deflation to happen on your watch. So what to do? You try to stimulate the economy. And the one tool you have at hand is the interest-rate lever. Since rates are already effectively at zero, the only thing left is to dip into negative-rate territory. Because, for you, allowing a deflationary malaise to set in is a far worse thing than all of the potential negative consequences of negative rates put together. It’s a Hobson’s choice; you see no other option.
Let’s do a little sidebar here. There’s lots of discussion in the media of the possible moves the Federal Reserve could make. Some people talk about the Fed’s buying the government’s infrastructure bonds, or buying equities or corporate bonds, or even doing the infamous “helicopter drop” of money into outstretched consumer hands. Those are not legal options for the Fed. The Fed is actually fairly restricted in what it can purchase. All of these outside-the-box transactions would require congressional approval and amendment of the Federal Reserve Act.
I can tell you that there is almost no stomach in the leadership of Congress or at the Fed to bring up the Federal Reserve Act for congressional action. Everyone is worried about potential mischief and political sideshows. Quite frankly, if the Federal Reserve decides that it wants to do more quantitative easing, I would much prefer that Congress authorize the Fed to purchase a few trillion dollars of 1% self-liquidating infrastructure bonds – or, as a last resort, to do an actual helicopter drop. The infrastructure bonds would create jobs and give our children something for their future, a much healthier outcome than the ephemeral boosting of stock and bond prices yielded by the last rounds of quantitative easing. In those instances, the benefits of QE went primarily to the well-off. But I digress.
The reigning academic orthodoxy for central bank believers is Keynesianism. Saint Keynes postulated that consumption is the fundamental driver of the economy. If the country is mired in recession or depression, then government and monetary policy should be geared toward increasing consumption in order to spur a recovery. Keynes argued that the government should be the consumer of last resort, running deficits as deep as necessary during recessions. (He also advocated paying down the debt during the good times, prudent advice roundly ignored.)
The current belief in vogue is that another way to increase consumption is to get businesses and consumers to borrow money and spend it. Hopefully, businesses will invest it and create new jobs, which will in turn enable more consumption. One way to stimulate more borrowing is to lower the cost of borrowing, which the Federal Reserve does by lowering interest rates. The opposite is also true: if inflation is a problem, the Fed raises rates, taking some of the inflationary steam out of the economy.
How would negative rates work? The Federal Reserve would charge a negative interest rate on the excess reserves that banks deposit at the Fed. Note this is not a negative interest rate on all deposits, just on “excess reserves” on deposit at the Fed. An excess reserve is a regulatory and political concept that is a necessary feature of the fractional reserve banking systems of the modern world. Banks are required to maintain a reserve of their assets against possible future losses from their loan portfolios. The riskier the assets the banks hold, the less those assets count towards the required level of reserves. Reserves are required to keep a bank solvent. Banks are closed and sold off when their reserves and capital are depleted below the allowed levels.
Any reserves in excess of the regulatory requirements are counted as “excess.” The theory is that if the central bank charges banks interest on their excess reserves, the banks will be more likely to lend that money out, even if at a lower rate, in order to at least make something on those reserves. Right now, banks are paid by the central bank for their excess reserves on deposit. Given the level of excess reserves at the Fed, these interest payments amount to multiple billions of dollars that are fed into the banking system each quarter; and that is one of the reasons why US banks have been able to get healthier in the wake of the Great Recession.
Consumers and businesses would borrow this cheaper money from the banks and presumably spend it or otherwise put it to use, thereby stimulating the economy and vanquishing the evil of deflation. In theory, as the economy recovers, interest rates are allowed to rise back above the zero bound.
Of course that was the theory when we went to zero rates some six years ago. At some point the economy would recover and the Fed would normalize rates. Except the economy never got to a place where the Fed felt comfortable raising rates even minimally – until last December. And now the high priests of the FOMC are signaling that it might be longer than they originally thought before they swing their incense orbs and raise rates again.
There are some (including me) who would argue that, rather than focusing on consumption, monetary and fiscal policy should focus on increasing production and income. By lowering (repressing) the amount of income savers get on their money, you push savers into riskier assets. That is generally not what you tell people to do with their retirement portfolios, (nor can we overlook the fact that the country is getting older). Thus if interest rates are artificially low because of Fed policy, that reduces the amount of money retirees have to spend. The Federal Reserve and central banks in general seems to think it’s better to have consumers borrow than save.
It’s a Keynesian conundrum. If nobody spends and everybody saves, the economy slows down. While it may be a good thing for you individually to save and prepare for your retirement, if everybody does so at the same time the economy plunges into recession.
Now let’s get back to the intersection of economics and religion. There are multiple competing economic theories on the government’s role in monetary policy making. The operative word is theories. Each is an attempt to describe how to manage a vastly complex modern economy. Some see too much debt as the cause of our current malaise. Others think that lowering taxes would allow consumers and businesses to keep more of their income and hopefully spend it.
In the not too distant human past, shamans and soothsayers conjured theories about how the world worked and how to predict the future. Some examined the entrails of sheep, while others read meaning into the positions of the stars (or whatever their prevailing theory dictated) and told leaders what policies they should pursue. An astute priest would pretty quickly figure out that the best route to priestly job security was to foretell success for the politician’s/king’s/tribal chief’s pet policy course.
In today’s world, economists serve exactly the same function. They skry their data sets – a latter-day version of throwing the bones – and then, based on the theory by which they believe the data should be interpreted, they confirm the orthodox policy choices of their political masters – and so their careers prosper.
This is not to disparage economists – not at all. They really do try to come up with the best possible policies – but the range of policy alternatives is constrained by the economists’ (and the general society’s) belief system. If you believe in a Keynesian world, then you will prescribe lower rates and more fiscal stimulus during times of recession.
If, however, you believe in a competing model, such as the Austrian theory postulated by Ludwig von Mises, then you believe that smaller government, far less fractional reserve banking (if any at all), and a gold standard are appropriate. A recession should be allowed to “clear,” permitting defaulting borrowers to reduce their debts and putting the assets that collateralized their loans back on the market at reduced prices, thereby encouraging businesses to employ those now-cheaper assets in income-producing activities. (This is a very simplified explanation.)
There are other competing theories, each with its own model of how the world works. There is convincing logic and a believable rationale behind each theory. If we had adopted an Austrian model in 2008–09, we would have had a much deeper recession and unemployment would have risen higher, but the recovery would theoretically have come more quickly as prices cleared and debt was resolved. However, that period of time before the recovery began would have been devastating to the millions of families who would have faced even more crippling unemployment than we saw. That is an experiment we did not conduct, so we will never truly know whether that path might have been less painful in the long run.
Austrians are willing to face a series of small recessions as part of the price of maintaining a free economy, rather than postponing recession and trying to fine-tune what is supposedly a free market economy by means of monetary and fiscal policy. An analogy would be the theory that allowing small and controllable forest fires today might prevent a large, utterly devastating forest fire in the future. Nassim Taleb’s important book Antifragilemakes a strong case that businesses, markets, and whole societies are much better off if they allow relatively minor random events, errors, and volatility to correct as quickly as possible rather than continually patching them over to avoid short-term pain. Decentralized experimentation in the economy by numerous complex actors capable of taking risks works better than a directed economy that encourages the buildup of excessive risk throughout the entire economy.
The problem is, there really is no one clearly right answer as to which economics belief system is best. I know what I believe to be the correct answer, but that belief is based on the way I understand the world – and the world is vastly more complex than anyone’s theory can be. No theory allows for a perfect solution for all participants. Rather, each theory picks winners and losers, with the overall objective of creating an economy that has maximal potential to grow and prosper.
(Sidebar: Let me tell you where Bernie Sanders and I agree. He rails against the privileges of Wall Street, crony capitalists, corporate insiders, and lobbyists, and the political favors and laws they get passed that benefit them and not Main Street. The deck is stacked in their favor. In that he is right. But his and my solutions to the problem are not similar, as he wants to create even more regulation and taxation, and I would prefer to remove all of the tax preferences and greatly reduce the regulatory morass that favors large businesses over small. I don’t want the government involved in picking winners and losers; that’s the role of the marketplace.)
So this is what it comes down to: The reigning academic theory/belief system is Keynesianism. The head Keynesians are signaling that they are going to give us negative rates. In fact, according to their theory, it would be irresponsible not to do so. They believe that if they sit back and allow the economy to sort itself out, the outcome would be far worse than anything that could be wrought by the intended and unintended consequences of negative interest rates.
We can differ with those in charge, but the experiment with negative rates is going to happen, and we need to begin to adjust – to think through how to position our portfolios and our investment strategies, our businesses, and our lives.
The Fed is run by True Believers. Just as Christianity or Islam or any other religion has believers that range across a spectrum of faith and beliefs, so does Keynesianism. At the Fed, these are deeply held beliefs: our central bankers are well convinced that the facts demonstrate the validity of their belief system.
I am reminded of the apologetics courses that I took in seminary (yes I graduated from seminary in 1974 – go figure). Apologetics courses basically teach you reasoned arguments in justification of a particular view, typically a theory or religious doctrine. We would look for logic and evidence that our particular version of Christianity was the correct and true position. Apologetics gave us the techniques and facts that would back us up!
I am not really trying to equate religion and economics, but I am saying that both rely on belief systems about how the world works, and that the behavior of believers is modeled on those systems. Paul Krugman tells us that fiscal stimulus and quantitative easing didn’t give us enough of a recovery simply because we didn’t do enough. If we had just believed more, had more faith in the effectiveness of Keynesian doctrine, we would now be well on our way to the economic promised land!
The fact that neither Europe nor Japan nor the United States have seen a recovery – that much of Europe is either in recession or on the borderline of recession, that Japan is dealing with severe deflationary pressures, and that the US is visibly slowing down does not create a question in Keynesian minds with respect to the correctness and effectiveness of their policies. I believe that both Japan and Europe are going to double down on quantitative easing and negative rates in their respective countries, and the US will soon follow.
I am glad I am not a central banker. The pressure to “do something” in the midst of a crisis must be horrific. To feel a responsibility and not be able to respond would be emotionally draining. I do not envy any of them. I think my own current belief system would probably take us in the optimal direction over the long term, but I can assure you that in the short term quite a few of my fellow citizens would not be happy with the process. And whether it is I or the Keynesians selling a particular theory, promising people pie in the sky doesn’t help them much to deal with the problems they face here and now.
The fact is that all of these economic theories have at their core political views about how the economy should be organized and managed. Including mine. That doesn’t necessarily mean mine is right and theirs is wrong. To determine the “rightness” of a theory, you generally try to conduct controlled experiments that give reproducible results. That kind of gold-standard research is simply not possible in today’s world. So we actually are forced to rely upon our pet theories as to how the world works. I am certainly not a believer in moral equivalency, but until one operative theory is thoroughly discredited (as communism was) it can remain the controlling theory for a long time.
I have a lot more to say and will do so in the future, but this letter is getting overly long, and I need to close it. I leave you with one of my favorite Yogi Berra quotes: “In theory there is no difference between practice and theory. In practice there is.” In theory the economy should respond to stimulus, and an economy that is demonstrably overburdened with debt should be pushed to increase that debt. In practice, the outcome may not be quite as salutary as the theory suggests. Adjust your world accordingly"
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