Are interest rates the most effective economic policy tool?
By Marshall Auerback
This post first appeared on AlterNet
Cutting rates at this juncture simply perpetuates current bubble-like conditions and therefore will make the ultimate outcome worse when the bubble inevitably bursts.
The one silver lining in the nomination of political hack Steve Moore to the Federal Reserve is that it might spur a productive discussion on the benefits (or lack of them) of monetary policy as an instrument of economic growth. This is principally because it’s just one ingredient for what is necessary to instill economic growth, and not a particularly good one at that. A more direct approach is via appropriately targeted and sufficiently large fiscal actions.
In regard to monetary policy, low interest rates kept in place for a long time can actually constrain economic growth unless they are coupled with sensible compensating fiscal policy, due to the adverse income impact to savers emanating from a resultant lower income stream. There is also a problem of political legitimacy when so little of the funding is explicitly approved by Congress, and is left instead to the discretion/creation of the Federal Reserve (which has historically tended to prioritize the narrow interests of finance over the rest of the economy). And Steve Moore, a leading advocate of cutting rates to promote additional economic growth (even as he has historically championed spending cuts), will simply perpetuate the (unfortunately) widely held notion of monetary policy as an effective cure-all, if his ideas gain policy traction within the Powell-led Federal Reserve.
In fact, what is truly required is well-formulated fiscal policy and less monetary policy activism, precisely the opposite of today’s prevailing trends. Solvency per se is not the issue. The key here is how the money is spent, lest fiscal policy become as diffuse in its effects as monetary policy has become, as well as discredited politically because of perceived ineffectiveness when long-standing structural issues (such as inequality) remain unaddressed.
Moore, a Heritage Foundation fellow and former Wall Street Journal editorial board member, has called for the Federal Reserve to cut rates in order to spur faltering economic growth. Here’s the problem: interest rates are a diffuse tool to manage economic growth. For every distressed borrower who benefits from lower interest rate charges, there is a saver adversely affected by the resultant loss of income. Additionally, as Bloomberg columnist Noah Smith argues, “Cheap credit does a poor job of weeding out zombie companies that compete for scarce resources.” In fact, a case can be made that low rates actually exacerbate prevailing deflationary trends. Low rates lower investment threshold returns, and reduce the costs of holding inventory, both of which can create oversupply, as well as perpetuating asset bubbles—a highly toxic combination that prevails in the United States (indeed, globally) today. Even with lower unemployment, the U.S. economy is largely characterized by middling growth, spread too thin and too inequitably. Moore’s policy prescriptions would likely make things worse.
Low interest rate regimes have also helped to promote reckless financial engineering that has enabled corporate CEOs (and their trusty investment bankers) to inflate profits and sustain company share prices as high as possible, often at a cost of ignoring the strategic long-term planning required to handle global competitive challenges from overseas companies that are slowly eating our proverbial lunch. In essence, therefore, lax monetary policy has become the handmaiden of the “speculation economy.”
In general, the Fed’s obsession with interest rates and bond yields (along with the corresponding shape of the yield curve) has obscured the manner in which such rates have provided a low-cost laboratory for the creation of Frankenstein-like instruments of financial mass destruction. Furthermore, as Professors L. Randall Wray and Scott Fullwiler have argued, “this was made even worse by the Fed’s cultivation of a belief that no matter what goes wrong, the Fed would never allow a ‘too big to fail’ institution to suffer from excessively risky practice. If anything, this encouraged more risk-taking.”
The real paradox of using monetary policy in general is that it only “works” to the extent that it induces the private sector to spend more out of current income, or encourages binging on private debt (which low rates can facilitate). If current income is adversely impacted by weak income flows, however, the interest rate is a highly flawed tool to solve the underlying problem, especially if it means simplistically cutting rates further, as Moore advocates. Such an action can foment bubbles in a multitude of assets—stocks and real estate being two of the most prominent examples—the collapse of which ultimately creates greater deflation, as well as exacerbating income inequality. This is because asset bubbles create huge increases in income for top earners, particularly in the finance sector, due to the relentless expansion of credit brought about by prevailing low rates. Changes in technology, and increasingly poor and outdated regulation in the context of a rapidly globalized financial system have accelerated a trend of asset growth and accumulation increasingly being funneled into fewer and fewer hands at the top.
When asset bubbles burst, the economically distressed sell to those with higher prevailing cash balances, setting the stage for further increases in inequality during the subsequent cycle, as the post-2008 environment clearly has done. As a New Economics Foundation report argues, “The process is self-reinforcing because increasing wealth accrues both higher income returns and greater political power.” This means that those with the highest amount of wealth have the means to lobby governments to maintain status quo policy structures that perpetuate inequality.
Cutting rates at this juncture simply perpetuates current bubble-like conditions and therefore will make the ultimate outcome worse when the bubble inevitably bursts. Moore’s policy prescription of cutting rates is therefore akin to giving a junkie another shot of heroin, rather than dealing with the underlying addiction itself. Moreover, the single-minded focus on interest rate levels has (per Fullwiler and Wray) diverted the Federal Reserve’s attention “away from its responsibility to regulate and supervise the financial sector, and its mandate to keep unemployment low. Its shift of priorities contributed to the creation of those conditions that led to [the 2008] crisis.”
By contrast, fiscal policy can also deal more effectively with the pathology of inequality via targeted spending, which can impact distributional outcomes, as it means directing funds toward those with the highest spending propensities (as opposed to the 1 percent, who generally save more of their income, which means less bang for the fiscal buck). Contrary to prevailing neoliberal theology, economic redistribution in such circumstances actually enhances an economy’s growth potential, rather than hindering it.
But we also want to avoid the fiscal zombie mindset as well. The key is ensuring that deficits are used toward productive job creation, not a perpetuation of crony capitalism. All too often, fiscal policy has been used in service of the latter. This means it has become somewhat politically discredited as an instrument of policy by both parties: in the first instance back in 2009 because the initial fiscal rescue package was insufficiently robust given the loss of almost $2 trillion in economic output in the United States alone. Then-President Obama’s $700bn stimulus package, while helpful, mostly kept the recession from being far worse rather than enabling a significant economic recovery, which later led to Republican charges that the policy was ineffective. (By contrast, on the monetary policy front, financial institutions received commitments from the Federal Reserve that may have been as high as $29 trillion, according to a report from the Levy Institute.)
More recently, the benefits of Trump’s highly touted tax “reform” have proven to be more apparent than real. The whole premise behind the lower corporate tax rate was that it would result in literally trillions of dollars allegedly parked offshore being repatriated back to the United States, resulting in a surge of job creation. However, as financial writer Alex Kimani has illustrated, “corporate America brought back just $664.9 billion of offshore profits, or just 16.6 percent of the $4 trillion Trump said they would return as a result of the tax overhaul.”
In reality, even Kimani’s analysis overstates the case. There has been no massive dollar “repatriation” as such. These dollars have always remained deposited in U.S. bank accounts, but have simply been classified as “offshore” via accounting legerdemain in order to exploit lower corporate rates abroad. As Yves Smith of Naked Capitalism points out: “Apple… managed to get a special deal with Ireland that allowed it to report corporate profits nowhere for tax purposes, kept the cash related to its Irish sub in banks in the US and managed it out of an internal hedge fund in Arizona.”
Given the prevailing deficit phobia that afflicts both political parties (depending on which is in power), this kind of gimmickry with minimal benefits being experienced by the bulk of the population has legitimized a political narrative against additional fiscal spending, on the grounds that it didn’t do what it promised to do and placed the United States closer to national bankruptcy.
While it is true that government that creates and issues its own currency can never run out of money, a policy that ignores how funds are spent can easily produce undesirable outcomes (such as inflation or rising inequality). One of the great post-Keynesian economists of the 20th century, Hyman Minsky, insisted (in the words of one of his students, L. Randall Wray), “that the impact of the budget on the economy depends on where spending and taxing is directed. Military spending and transfers, for example, are less productive and therefore more inflationary.” And yet this is precisely where much of Trump’s new spending is being directed, even as vital social spending is being cut back. Unfortunately, this has led opposition to Trump to fall into the intellectual cul de sac of obsessing about debts and deficits, rather than focusing on what we do with those deficits.
And as the paltry benefits of last year’s tax package have largely dissipated (to the extent that they created any economic benefit at all for the bulk of Americans), the focus has come back to the Federal Reserve just as Steve Moore’s nomination has been announced. A decade on from the collapse of the 2008 bubble, the latest data on inflation shows an invidious combination: Consumer Price Index figures are now rising at their lowest level in almost two years, but virtually all core inflation, reports Rana Foroohar from the Financial Times: “was in rent or the owner’s equivalent of rent (up 0.3 per cent). Core goods inflation, meanwhile, was down 0.2 per cent.” This means higher house prices at a time when quality affordable housing is still out of reach for the average American. Lowering interest rates, as Moore suggests, will likely exacerbate the housing bubble, and fuel additional stock market speculation, without fundamentally doing much to promote further spending power on the part of the average American citizen. Meanwhile, the relative absence of a proper role for fiscal policy means that the toxic prevailing macroeconomic imbalances (such as ongoing huge levels of household indebtedness and wealth inequality) will continue.
Every tool and target deployed by the Federal Reserve has simply restored an unhealthy status quo ante in financial speculation, while the comparative diminution of fiscal policy has left us with an inefficient economy that still leaves tens of millions of workers behind in terms of wage gains, access to decent public infrastructure, and denial of quality health care. Imagine if some of those trillions of government loan guarantees, standing credit facilities, and bailouts to various financial institutions had gone toward more productive uses. How much better would the U.S. economy look today? Regrets aside, it’s becoming increasingly difficult to make the case that cutting interest rates alone is a panacea. In fact, in the current context, it may well make things worse.
This article was produced by Economy for All, a project of the Independent Media Institute.