Monday, August 25, 2014

Economists know about the crisis. They know they missed a big one. They know they misunderstand something. Yet they go back to the same old song and dance.

From Robert J. Samuelson in the Washington Post, Interest rates and the Fed’s great ‘slack’ debate:

Call it the great “slack” debate. For nearly six years, the Federal Reserve has held short-term interest rates near zero to boost the economy. Is it time to consider raising rates to preempt higher inflation? The answer depends heavily on the economy’s slack: its capacity to increase production without triggering price pressures. Although economists are arguing furiously over this, there’s no scientific way to measure slack.

“Slack” is economics jargon for spare capacity. It means unemployed workers, idle factories, vacant offices and empty stores. Its significance is obvious. If there’s a lot of slack, inflation shouldn’t be a problem.

How much slack is there today?

We don’t know.

Economic policymaking is not an exact science. Ideally, the Fed would begin raising interest rates sometime just before the economy exhausts its slack. But we don’t know where that point is.

There is absolutely nothing new in Samuelson's view. People always argue whether the economy's growth indicates that interest rates should go up now or go up later. There's nothing new in that.

There's nothing new, either, in thinking that raising interest rates is the right solution to the inflation problem. That's widely agreed upon.

That's the problem. Raising interest rates is the ideal solution, according to Robert J. Samuelson. But it isn't. It's not even a good solution. It's a bad solution. It undermines growth. It increases "slack". It increases unemployment.

A better solution arises from looking at the problem in a new light.

Why cut off new growth by raising rates? Isn't that foolish? It's not future growth that is responsible for inflation, if and when we have inflation. It's recent growth.

Much of that recent growth will have been funded by recent borrowing. Recent borrowing. The money has already been spent. That's how we got the growth. And there is "extra" money that's still in the economy, contributing to price pressures.

Our solution, the universally accepted solution, Robert J. Samuelson's ideal solution, is to raise interest rates, cut off new growth, and cut off inflation.

I think not.

Leave rates low. Let it grow. If you're concerned about inflation, take the money out of the economy that's already in the economy, causing inflation. Take out the extra money that was put there by recent borrowing. Take that money out of the economy by getting the people who borrowed it to pay it back. Pay back that debt, extinguish that debt, and extinguish the money that came into existence along with that debt.

Fight inflation by reducing private debt. Fight inflation by creating incentives that encourage people to pay down debt. Pay down debt to fight inflation.

Borrow, you bastards! Borrow, and grow the economy. But tomorrow, pay it back.


Auburn Parks said...

Great Post Arthurian. I too am extremely skeptical about the efficacy of raising interest rates to combat inflation.

Reducing the money supply does seem to correspond to decreasing inflation:

Although strangely enough, increasing the money supply seems to have a much smaller correlation (if any) to increasing inflation.

The Arthurian said...

Thanks Auburn.

Hey, I must have looked at a thousand different graphs of debt, but I don't think I ever looked at one showing debt and inflation. Good one!

The Arthurian said...

Auburn, it occurs to me that your observation --

Reducing the money supply does seem to correspond to decreasing inflation... [but] increasing the money supply seems to have a much smaller correlation (if any) to increasing inflation.

-- perfectly matches the "pushing on a string" analogy. Reducing the money supply is like pulling on a string. It is effective. But increasing the money supply is like pushing on a string. It doesn't really work.

If there is a balloon on the other end of the string, and you are letting out string, you still have to hope there is enough helium in the balloon to make the thing rise.