Friday, February 18, 2011

Geanakoplos and the Can of Worms

Peter Schiff writes:

The government has been subsidizing housing since the Roosevelt administration, and we never had a bubble of this proportion. It was not until these guarantees were combined with a 1% federal funds rate that they became supercharged.

Schiff says the low interest rate causes problems. I think he's right. But I know the low rate is a policy intended to solve a problem. So the picture is not as simple as Schiff seems at first to suggest. But then he says:

The reality is that no one wants to blame the crisis on loose monetary policy because monetary policy is even looser now then it was [sic] then. If the commission had correctly blamed the housing bubble on easy money, then it would have called into question current Fed policy. Given the fragility of our economy and its continued dependence on low rates, no one has the guts to open that can of worms.
It could have been a good thing to call current Fed policy into question. If the commission was able to recognize not only that low rates create a problem, but also that there was a different problem that low rates were intended to solve, it could have put emphasis on that pre-existing problem.

A "can of worms" indeed. Peter Schiff clearly recognizes that the economy remains fragile and dependent on low interest rates. At the same time, he says low interest rates are "the primary factor behind the financial crash of 2008."

This low-interest-rate policy causes a problem the way U.S. fire-suppression policy did: A policy of prevention of small forest fires led to less frequent, more severe large fires. A policy of keeping interest rates low to prevent recession leads to bubble, panic, and severe recession.

But the economy is not a forest. An analogy to fire-suppression policy is not evidence that a policy of not preventing recessions would have beneficial effects comparable to the policy of not preventing small forest fires. Peter Schiff, however, seems to think the analogy applies:

We simply need to return to a sound monetary policy...

Jack rates up, he suggests, and everything will be fine. I don't agree. I think you jack up rates, and you make the pre-existing problem worse. Jacking up rates is like testing fragility with a hammer. As Schiff himself points out, our economy exhibits "continued dependence on low rates."

A Long-Term Problem

"Neither Democrats nor Republicans want the Fed to turn off the monetary spigots," Schiff writes, "for fear of the short-term shock."

The short-term shock. Schiff suggests that a sound monetary policy may make the economy hesitate briefly, but then everything will be fine. This is the difference between me and Peter Schiff. I think there is an underlying, long-term problem that is not addressed by his plan.

The short-term shock. The small forest fire. The minor crisis. It's a nice, symmetrical argument. But economic analysis does not depend upon symmetry of presentation. It depends on an understanding of the interaction of economic forces.

Our need for low interest rates did not arise from the financial crisis.

The need for low interest rates arose in response to a more fundamental problem, a pre-existing, long-term problem that Schiff does not discuss. And as a glance at Graph #1 will show, we have evidently needed lower rates for a long time -- since Paul Volcker decided it was time to ease, early in Reagan's first term.

The Growth of Debt

Schiff does not discuss the obvious consequences of easy money -- the increase in credit-use and the increase of accumulated debt. Rather, he sees the low-rate solution itself as the problem. This is circular analysis, for clearly there was a pre-existing problem, to which low rates were applied as a solution. That original problem, which came before the low interest rates, cannot have been caused by low rates.
Nonetheless, low rates surely do contribute to our problems. Low rates make the accumulation of debt bigger, faster than high rates.
The original problem, which we find already in the late 1960s, was an excessive accumulation of debt. In order to prevent the cost of this debt from crippling economic growth, policymakers found it constantly necessary to accelerate the increase in the quantity of money. That led to inflation.

In the 1960s we said the inflation was the result of "guns and butter" spending and the Viet Nam war. In the 1970s, the policy led to higher and higher rates of inflation, along with higher and higher interest rates. When the war ended and inflation did not, we at last understood that there was an economic problem. Then with Reaganomics in the 1980s came the trend of falling interest rates, as Graph #1 shows.

Surprising as it may be, the easy-credit policies in place since the 1980s did not cause accumulation of debt to increase noticeably faster than it did in the 1950s and '60s and '70s. The accumulation of debt continued at a remarkably constant rate, as shown by the straight-line trend of Graph #2.

In the years leading up to 1980, debt increased despite rising interest rates. But in the years since 1980, falling interest rates did not cause debt to grow faster. Our fix for the long-term problem pushed interest rates to lower and lower levels, simply to obtain a growth rate equivalent to the period before 1980.

The Ultimate Bubble

To summarize: Low interest rates lead to an increase in the growth of accumulated debt. But low interest rates were a solution. Policymakers applied low rates to a long-term, pre-existing problem. That problem was the excessive accumulation of debt. Yes, the solution contributed to the problem. But surprisingly, the rate of debt growth did not accelerate. Low interest rates only prevented the decline in debt growth that is a natural result of debt accumulation.

Schiff thinks the blame for the recent crisis should be placed on loose money policy -- for allowing the quantity of money to increase too rapidly, which allowed us to end up with too many mortgages and too-expensive houses. But there was no acceleration of debt growth due to the low rates. And it was the luck of the draw that housing turned out to be the place where the money went, this time around.

We've had one bubble after another, these past three decades. One crisis after another. That's far more significant than the isolated fact that the most recent bubble occurred in housing. The real question is: Why all the bubbles? What makes us bubble-prone? We have to figure this out and fix it before some ultimate bubble does us in for good.

The short answer: Bubbles arise because that's where the profit is.

The problem is that finance has become more profitable than production. So when we get growth, we don't get a burst of production. We get a bubble in the profitable sector, in finance, some part of finance. This time it was mortgages. We call it housing. It was finance.

Finance is more profitable than production because we use credit for money. No matter what we do there are finance charges, because we use credit for money. And we end up with an economy where Ford makes more money by financing cars than by making cars. Because we use credit for money. It's not good for output. It's not good for income. It's not good for the economy.

All that credit-use creates debt. All that debt has to be maintained. All that maintenance is a cost that holds our economy down.

Graph #3 shows the U.S. "capacity utilization" trend since the mid-1960s. Since that time, the high points have come at progressively lower levels. The economy has peaked, or inflation has arisen and the Fed raised rates to fight inflation at progressively lower levels. This is a result of the long-term problem. Accumulating debt is that problem.

There are two exceptionally low peaks in the 1980s that I did not mark with red lines, as they do not fit the down-stepping trend. These two severe lows are associated with the Volcker squeeze.

Those lows are examples of the "short-term shock" that Peter Schiff wants from policy. Graph #3 shows two things about such shocks. First, they are quite severe. Second, they do nothing to change the long-term down-trend of the pre-existing problem.


Albert Einstein's definition of insanity is "doing the same thing over and over again and expecting different results." By that standard, U.S. economic policy is insane.

It is time to stop doing policy the way we've been doing policy for 65 years: We raise interest rates, and we lower them. We raise them, and we lower them. It's insane.

When we lower interest rates, borrowing increases and total debt increases. When we raise interest rates, new borrowing decreases. Total debt does not. It's insane.
This is a "stocks and flows" thing, evidently. The "flow" of new debt stops increasing so quickly; but the "stock" of existing debt remains.
We need a plan to reduce the accumulation of existing private-sector debt. We have no such plan. This is the problem in a nutshell.

The Plan to Reduce Debt

In his Banks as Social Accountants PDF, Dirk Bezemer observes that

Geanakoplos called for an end to ‘the obsession with interest rates’ and asserted that ‘regulating leverage, not interest, are the solution for a troubled economy’.

Yes, absolutely. The problem is not that interest rates are too low, but that the level of accumulated debt is too high. We need to keep interest rates low and we need to reduce the accumulation of debt. Both.

People say we need credit for growth. It's true. But it begs the question: How come we have all this debt, and no growth to show for it?

The answer is, existing debt does not help the economy grow. What we need is new uses of credit. That's what supports growth. We don't need the accumulation of old debt. That's just an impediment to growth.

So what we need is easy money, combined with incentives designed to accelerate the repayment of debt. That's the whole plan, right there. John Geanakoplos called it "regulating leverage." I call it tax incentives to accelerate the repayment of debt. As an added bonus, we get to use the repayment of debt to reduce the quantity of money and fight inflation. If you think about it, this is the right way to fight inflation.


I do not think the lowness of the number is what bothers Peter Schiff about the federal funds rate. I think what bothers him is the consequence of holding that number down -- the growth of debt and the growth of credit-funded economic activity. And this is exactly the problem that is solved by a tax designed to "regulate leverage."
I should add that such a tax need not be a revenue-raiser. I always imagine my tax notions as revenue-neutral. But it could be used to cut taxes.
The great advantage of this policy will be that its effect is in proportion to taxpayer indebtedness. By contrast, the existing policy of raising interest rates affects all borrowers alike, and hinders new growth.

Anyone who likes the idea of raising interest rates at some point in the business cycle should keep an open mind to the notion of using tax incentives to accelerate the repayment of private-sector debt.

The Accelerated Repayment Tax hinders economic activity in proportion to taxpayer indebtedness: Those who have little debt are encouraged to borrow and spend. Those who are heavily in debt are encouraged to reduce their debt.

If we are thinking about eliminating the tax deduction for interest expense, we can replace it with the Accelerated Repayment Tax, and offset the stick with a carrot that helps heavily indebted taxpayers reduce their existing debt.

And we still have the interest rate to use as a policy tool if we need it.

The time to put this tax in place is now -- before interest rates start going up again, again.

What Einstein said.



Greg said...


Reads like your Magnum Opus. Does a nice job of showing where people like Schiff are right but also where they go wrong.

The only place I differ is when you said that it was just chance that housing is where the bubble showed up. I think you can find many of examples of people from the president down to the janitor pushing housing on everyone.

I know we've talked about this here before but having the banking industry so deep into our politics pretty much guarantees that it will be impossible to get change without another huge crisis. The banks want to make something off EVERY transaction, no matter how mundane the transaction is. They want no money going to peoples hands unless its accompanied with an interest charge.

The Arthurian said...

Thanks, Greg. Yeah, this one was a lot of work. Some of 'em go easy. Some don't.

Does a nice job of showing where people like Schiff are right but also where they go wrong.

Things like that in my writing, I worry that people will miss them, that my writing isn't good enough. But you don't miss them Greg, and I appreciate that.

I know we've talked about this here before but having the banking industry so deep into our politics pretty much guarantees that it will be impossible to get change without another huge crisis.

I don't imagine I have anything original to say on that topic...

The Arthurian said...

On second thought, Greg, it occurs to me that -- as the Tea Party has shown -- all that is needed is widespread agreement among voters, and changes can be made.

jbpeebles said...

Nice to see a recovery-minded alternative to Schiff's market model, one to which I typically--though not dogmatically--prescribe.

In this post, I can see through the Arthurian perspective our problems far more clearly. The black'n'white, more "G" or not Keynesian paradigm is tired. We need more accurate models in order to judge the effectiveness of policy alternatives. By addressing the shortage of credit--Arthurian-style--perhaps we can allow for more recovery. I'm still fascinated by Arthur's concept that we need more credit, which flies in the face of limiting access to credit/money.

Schiff would say we need to make money harder to get/borrow, and use higher rates to which Arthur is spot on to say how that would reduce/slow recovery.

Since money itself is debt, and debt is the root of the problem, but perhaps it's the solution. And how separate can credit-money be from debt? 97% of dollars exist in electronic form only.

Traditional Monetary theory seems to indicate that spending is everything. Yet rather than predicate economic growth on a more borrowing we need to seek out a more sustainable model AFTER the recovery. (Like the addict we always say "after," when things get better than we'll pay it off. Sure, buddy).

We also have a nasty new set of currency wars largely founded on government's intention to buoy export growth through cheaper currencies. This manifests in massive expansion of the money supply, which in turn seems to booster financial industry profits at expense of the Real Economy.

The financial economy has eclipsed the real one since about 1980, when it compromised only 10-12% (?) of the economy compared to 40% (?) now.

The notional value of derivatives is up 12 fold since 1996 (Ure). This is synthetic private debt created largely between financial entities, which seem to be the tapeworm, a la Austin Fitts.

One other issue with comparing private debt to gov't. While private debt may not have grown as sharply, the elimination of Glass Steagal and liberalization of Commodities Futures Exchange rules (Greenberger et al.) allowed more leverage of existing debt, which typically flowed into housing, though commodities prospered near the end of the peak. With enforcement limited by crony influence, this was a regulatory failure-based collapse, with systemic roots, as Stiglitz says in Freefall.