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No, the Federal Reserve Is Not a Market Manipulator

Over at Equitable Growth: Let me pile on to something Paul Krugman published last week, and make fun of William Cohan for writing and the New York Times for publishing hopelessly confused austerity pseudonomics:

Paul Krugman: Artificial Unintelligence: "In the early stages of the Lesser Depression...

everywhere you looked, people who imagined themselves sophisticated and possessed of deep understanding were resurrecting 75-year-old fallacies and presenting them as deep insights.... [Now] I feel an even deeper sense of despair--because people are still rolling out those same fallacies... So here’s William Cohan in the Times, declaring that the Fed should ‘show some spine’ and raise rates.... READ MOAR

Like any commodity, the price of borrowing money--interest rates--should be determined by supply and demand, not by manipulation by a market behemoth. Essentially, the clever Q.E. program caused a widespread mispricing of risk, deluding investors into underestimating the risk of various financial assets they were buying.

Oh dear.

Cohan’s theory of interest rates is basically the old notion of loanable funds.... As Keynes and Hicks explained three generations ago, this is... inadequate... misses the reality that the level of income isn’t fixed, and changes in income affect the supply and demand for funds.... There are arguments that the Fed should be willing to abandon its inflation target so as to discourage bubbles... but... they have nothing to do with the notion that current rates are somehow artificial, that we should let rates be determined by ‘supply and demand’. The worrying thing is that, as I’ve suggested, crude misunderstandings along these lines are widespread even among people who imagine themselves well-informed and sophisticated. Eighty years of hard economic thinking, and seven years of overwhelming confirmation of that hard thinking, have made no dent in their worldview. Awesome.

Let us suppose that instead of a Federal Reserve Board we have a Federal Potato Board. And let us suppose that the Federal Potato Board wants to peg the price of Idaho potatoes above its market-clearing value--just like, William Cohan claims, the Federal Reserve Board is now pegging the price of bonds above its market-clearing value. Suppose the FPB decides to set the price of potatoes at $12/50 lb. rather than the market clearing $8/50 lb.

What happens in the potato market?

Well, 14 billion pounds of Idaho potatoes are produced each year. And 14 billion pounds are eaten. At a price 50% higher than the market-clearing price, something like 20 billion pounds would be produced. And something like 10 billion pounds would be eaten. The FPB would have to buy the excess 10 billion pounds each year--at a cost of $2.4 billion/year. But it could not then sell them, because that would increase market supply and so drive down the price. It would have to destroy them. That would be a waste: $2.4 billion/year of hard work and sweat rotted away, literally.

What happens in the bond market?

Suppose, as Cohan seems to think, that the equilibrium market price of 5-year-duration bonds ought to be 1000 at a 3%/year interest rate, but the Federal Reserve artificially pushes the price up to 1150 and pushes the interest rate on them down to zero by printing money and buying bonds. Bond producers see that bond production is now highly profitable and they start producing more bonds...

How do you produce a bond, anyway?

Well, one way to do it is that you build an extra factory, and you then commit the profits from that extra factory to amortizing the bond. It was not profitable to undertake this when you could only sell the bond for 1000, but now that you can sell the bond for 1150.

One way to think is then this: You sell the bond for 1150 to the Federal Reserve--if it doesn't buy it then the supply of bonds is greater than demand and the price of bond would fall. But the Federal Reserve cannot then sell the bond because that, too, would increase the supply of bonds. The Fed has to destroy the bond... No it doesn't... The Fed can simply hold the bond to maturity, and then roll it over... But the FPB had to tax people to raise the $2.4 billion, and so the FRB would have to... No, it doesn't: it, after all, simply prints the money... As SF Fed VP Glenn Rudebusch told an audience once: "We print money. We use it to buy bonds, We then clip the coupons. It's a very good business model..." But just as all the time and energy that went into growing the excess 10 billion lb/year of potatoes was a waste of hard work and sweat because in the end nothing useful was produced... Oops... We know have a useful factory. And all the previously-unemployed people who got to work building the factory had jobs while it was being built. They liked that... And now the factory can employ more people, boosting wages...

If the economy had been at full employment when the FRB lowered interest rates, there would indeed have been a waste: The building of the factory would have pulled people out of jobs where their societal value was greater than their value as factory-builders. And we would have seen this waste reflected in inflation: The lowering of interest rates would have increased total spending in dollars without increasing the total amount of useful goods and services produced, and the result would have been previously-unexpected inflation.

But no unexpected inflation, no waste. As long as we are below full employment, the lowering of interest rates causes production to expand in accord with total spending and demand. It is simply a win.

(Better-prepared students will by now have noticed that the FRB, unlike the FPB, does not have to keep buying more and more bonds each year in order to keep the price at 1150. The extra workers employed building the factory have higher incomes. And they spend and save those higher incomes. And employment rises in other industries as well. And the people put to work in those industries spend and save their incomes. And with their savings they buy the bonds issued to finance the construction of next year's factory. So all the FRB has to do--unlike the NPB--is get the ball rolling. Thereafter there is no disequilibrium between the supply of and the demand for bonds that requires the FRB to step in.)

But suppose that the FRB decides in the future to lower the price of bonds back down from 1150 to 1000. Doesn't it then lose 150? Doesn't it then have to raise taxes to make up for that loss? Aren't those extra taxes a waste? Somehow?...

The fact is that the costs and waste of pushing interest rates "too low", when they exist, show up as unexpected inflation. No unexpected inflation, no costs. Those who claim that expansionary monetary policy that lowers interest rates causes people to make bad economic decisions--to think that they are creating more real wealth than they are--are saying that when people go to market they will find that aggregate demand is higher than aggregate supply, and that there is as a result unexpected inflation. Planned investment in excess of desired savings--Cohan's "widespread mispricing of risk, deluding investors..."--shows up, by the metaphysical necessity of the case, in aggregate demand greater than aggregate supply times the anticipated price level and thus in unexpected inflation.

Cohan's argument is thus, at bottom, the inflationista argument: that expansionary monetary policy has somehow stored up a lot of inflation that is or is about to reveal itself in a rising-price tsunami. Thus my view: Cohan should join the inflationistas where they wait on their mountain top down-valley in Jackson Hole for their inflationocalypse, and stop bothering the rest of us.