Paul Krugman doesn’t like this Washington Post piece on how slow growth could be the new normal for the US. He’s right that it’s a pretty bad piece but there are strong arguments for a slow pace of growth over the next few years for the U.S. economy. Thoughts here.
While the Federal Reserve’s quantitative easing program has not yet caused an increase in inflation, many are concerned that the money creation due to QE will provoke serious problems at some point. So when leading economist Robert E. Hall of Stanford releases a paper (co-authored with Columbia‘s Ricardo Reis) focusing on the “risks to solvency” facing the Fed then many people are going to pay attention. This is particularly so when the paper includes scenarios in which the Fed loses control of the price level and “the central bank would likely be dissolved and a new currency introduced.”
So is the Fed going to go bust and be dissolved? Will the dollar have to be replaced? Let’s start with a spoiler alert. In the end, Hall and Reis conclude the possibility of a doomsday scenario for the Fed is “remote”. Still, given the nature of controversies about the Fed, the extreme scenarios cited in the paper are likely to become part of public debate on the Fed’s future. In this post, I argue that even the “remote possibility” scenarios put forward by Hall and Reis rely on a range of counter-factual assumptions.
A Potential Problem?
Hall and Reis’s concerns can be summarised as follows. Because the Fed now holds very large amounts of long-dated low-interest-rate bonds, future increases in interest rates may reduce the value of these assets. They describe a scenario in which the Fed reaches a point where its assets don’t generate sufficient income to cover its costs.
In particular, Hall and Reis are concerned about the Fed’s ability to pay interest on the reserve accounts that banks hold with it. Payments made to Fed ultimately arrive via deductions from various reserve accounts that institutions such as private banks or the Treasury hold with it while interest paid on reserves to banks takes the form of additions to the relevant bank reserve accounts.
Given this structure, if the interest payments made to the Fed don’t cover the interest payments it makes on reserves, then the total stock of reserves will increase. Hall and Reis express a concern that this process of additional money creation stemming from such an increase in the stock of reserves would result in higher inflation. (Exactly how this gets so bad that the currency ends up being dissolved is a little unclear to me.)
So it turns out that Hall and Reis are not actually concerned about the Fed going bust in the usual sense of being unable to meet its obligations. Rather they express a concern the Fed might only be able to meet its obligations by creating a quantity of money that generates high inflation. Alternatively, they discuss a scenario in which the Fed keeps the interest rate on reserves low to restrict the growth in total reserves but this low interest rate results in a loss of control of the price level.
After crunching some numbers, Hall and Reis finally assure worried readers that their scenario in which the Fed loses control of inflation isn’t a likely event. However, this still leaves some room for doubt that there may be some more extreme set of losses than those contemplated in the paper that could result in a doomsday scenario.
A Problem that Simply Isn’t a Problem
In fact, the doomsday scenario outlined by Hall and Reis simply doesn’t make any sense and it doesn’t require crunching of numbers to dismiss it.
The scenario revolves around the problems caused by payment of interest on reserves. However, it’s worth noting that, far from being a time-honored tool for controlling interest rates, the Fed only began paying interest on reserves in 2008 and had little difficulty controlling interest rates prior to the introduction of this policy.
As explained in this paper, the principle argument for paying interest on reserves is that it acts as a floor on money market interest rates and so reduces day-to-day volatility. However, when central banks pay interest on reserves or a deposit facility, this interest rate is rarely the one used to set the target for short-term private sector borrowing rates.
For example, the ECB has a deposit facility that pays interest to banks, an emergency marginal lending facility for overnight borrowing and a weekly refinancing operation in which it lends money to banks. It is the refinancing rate that usually dictates average money market interest rates with the deposit facility rate acting as a lower floor. So, in general, there are few grounds for the idea that setting a low interest rate for remuneration of reserves (or indeed a zero rate) will lead to the Fed losing control of inflation.
Still, with banks currently flooded with reserves, one could argue that it might be difficult over the next few years to raise the federal funds rate without hiking the interest rate paid on reserves. So one could still ask whether concerns about income shortfalls could lead to the Fed having to abandon paying interest on reserves and the operational efficiency gains that come with it. This is extremely unlikely.
Firstly, the Fed holds large amounts of assets that are set against currency “liabilities” which in practice pay no interest. So it could incur losses on the rest of its operations and still make a profit. Moreover, there is no operational need for the Fed’s stock of assets to exceed its stock of notional liabilities.
Secondly, the Fed holds long-term assets and short-term liabilities and yield curves generally slope upwards. So, on average, the Fed is going to make profits even without the assets backing currency notes. It could thus go through a period of making losses and simply offset these losses with later profits that are partly retained rather than handed over to the US Treasury.
Hall and Reis note in their paper that this latter option of smoothing out profits and losses by varying dividends to the Treasury may not be possible if the Treasury decided to prevent the Fed from accumulating too much profit income without handing it over to the rest of the US government. Here I can only say that any future world in which the Treasury is allowed to bully the Fed into providing it with more income would indeed be one in which price stability is endangered but only because the Fed will have lost its independence, not because of QE-related losses on assets.
The US economy has many real problems for people to focus on. Economists can help by focusing on those problems rather than fairy stories about the Fed going bust and the dollar being abandoned.
Some thoughts on today’s FOMC announcement and the contrast it represents to the ECB’s approach to monetary policy.
The mood surrounding the U.S. economy is finally picking up. The housing market is recovering, consumer sentiment is getting off the floor and, most importantly, unemployment is falling. However, Ben Bernanke, ever the dismal economist, has managed to find the cloud at the end of this silver lining. In a speech this week, Bernanke pointed out that falling unemployment in a period of sluggish growth has worrying implications for the future. Bernanke said:
Output normally has to increase at about its longer-term trend just to create enough jobs to absorb new entrants to the labor market, and faster-than-trend growth is usually needed to reduce unemployment. So the fact that unemployment has declined in recent years despite economic growth at about 2 percent suggests that the growth rate of potential output must have recently been lower than the roughly 2-1/2 percent rate that appeared to be in place before the crisis
In other words, what everyone sees as good news (falling unemployment) is actually a sign that the economy is set to grow at a slow pace over the next few years.
If you find that thought a bit depressing then don’t read the rest of this article.
Bernanke pointed to a number of ways in which the financial crisis may have slowed the potential growth rate of the economy but he seems to believe the economy will recover to its normal growth rate once the financial sector has sorted itself out. However, there are there are reasons to believe that slow rates of growth are perhaps here to stay.
Economic growth comes from two sources: Growth in the number of workers and growth in the average amount of output these workers produce (i.e. productivity growth). The news on both fronts is bad.
Start with productivity growth. Normally at this point in a business cycle, productivity is growing at a fast pace as under-utilized workers get busier and businesses increase their investment in productivity-enhancing equipment. However, average productivity growth over the past two years has been under 1 percent.
Traditionally, productivity growth has been driven by the invention of new technologies. When I worked for Alan Greenspan at the Federal Reserve in the late 1990s and early 2000s, he and other Fed staff believed that new computing technologies were driving increases in productivity growth (with good reason – my own research at the time suggested these effects were real).
It may appear that we still live in a world where new technologies are being developed all the time, with smartphones, computing tablets and lots of other new devices coming on stream all the time. However, some of those who know the technology industry well are sceptical about whether the true pace of advance is a fast today as previously. Peter Theil, founder of Paypal, points out in this article in the Financial Times co-authored with Garry Kasparov, that technological innovation is now confined to a very small part of the economy and that people are missing the stagnation of innovation in the rest of the economy.
In a recent paper, Northwestern University economist Robert Gordon, perhaps the profession’s sharpest observer of technological history, offers a telling thought experiment that provides a comparison of the true value of recent innovation compared to the advances of the past:
You are required to make a choice between option A and option B. With option A you are allowed to keep 2002 electronic technology, including your Windows 98 laptop accessing Amazon, and you can keep running water and indoor toilets; but you can’t use anything invented since 2002. Option B is that you get everything invented in the past decade right up to Facebook, Twitter, and the iPad, but you have to give up running water and indoor toilets.
No prizes for guessing which option most people pick. Gordon warns that “Future growth in real GDP per capita will be slower than in any extended period since the late 19th century.”
Looking beyond productivity growth, the trends for the other element of economic growth, increases in the numbers at work, are perhaps even less encouraging. While employment may be growing because of the falling unemployment rate, there is little to suggest there is enough momentum to produce a fast pace of increase in employment over the next decade.
After many years of steady growth, there has been almost no growth in the labor force in recent years. This is partly driven by slower population growth but also by the reversal of a long trend of rising female participation in the labor force.
Another factor restraining the growth in numbers at work is the aging of the U.S. population. Projections from the Census Bureau show there will be a large increase in the dependency ratio (i.e. the ratio of people not working to people working) over the next decade because of the large increase in numbers of retired people as the baby-boomers step out of the workforce.
Taken together, these calculations suggest a future average growth rate for the U.S. economy that is far lower than people have been used to.
If this scenario comes to pass, it would have serious implications for future political decisions. As in most countries, political tensions in the United States often come down to arguments about how to divide up a growing economic cake. If the economic cake stops growing, these tensions would become more severe. Even more complex is the question of what to do about promises made to future generations that are premised on the assumption of years of strong growth if that growth never shows up.
I think the “sectoral balances” viewpoint of the macroeconomy, which emphasises that income equals spending, is hugely important for understanding what is going on in today’s global economy. However, an article today by Joe Weisenthal that appeals to this framework to pin the blame for the global financial crisis on Bill Clinton, struck me as incorrect. My response here.
Those watching the ongoing Euro-mess might be surprised at a policy recommendation that the Fed should behave more like the ECB. That’s what Republican Senator Bob Corker does in today’s FT. My comments here.