Saturday, July 20, 2013

The hard-money people throw Gene Fama under the bus



In the last year, the Macro Wars have been mostly going well for the Monetarist Alliance. My prediction that the Fed would shy away from further QE was dashed, and Bernanke came through for the Alliance in a big way with QE-infinity; Japan's central bank has promised even more. Meanwhile, the Hard-Money Coalition has lost a lot of intellectual cred, as inflation has quite spectacularly failed to materialize in response to ATMP ("All This Money Printing").

But the Hard-Money Coalition is far from beaten. Driven from the Inflation Hawk line of defense, the HMC is regrouping and falling back. The new line of defense is the Financial Instability argument. Basically, the idea is that even if QE doesn't create inflation, it distorts financial markets. From the ramparts of Castle WSJ, Amar Bhide and Edmund Phelps write:
The Fed said it would end easing at serious signs of faster inflation. But as the housing bubble that preceded the financial crisis showed, imprudent speculation can be destructive without high inflation. Today we have banks, insurance companies and pension funds leveraging their assets and loading up on credit risks because prudence cannot provide acceptable returns.
And back in January, John Taylor alleged that QE would cause "reaching for yield":
The Fed’s current zero interest-rate policy also creates incentives for otherwise risk-averse investors—retirees, pension funds—to take on questionable investments as they search for higher yields in an attempt to bolster their minuscule interest income.
That prompted a fiery rebuttal from General Miles Kimball of the Monetarist Alliance. See also some responses by Mike Konczal, Nick Rowe, and Brad DeLong. (Also see this somewhat related debate between David Beckworth and Andy Kessler.)

Basically, what the Hard-Money Coalition is doing is throwing the Efficient Markets Hypothesis under the bus. Sorry, Gene Fama! (Note: Someone really needs to start the #sorryfamanists Twitter hashtag.) For a bit more on just why the "reaching for yield" idea contradicts the EMH, see this Krugman post.

This is a savvy switch in tactics. Inflation is something we haven't seen since the 70s. Financial instability, however, is something we've seen a lot of recently. The housing crash and financial crisis convinced dang near everyone outside of finance and econ departments that markets are unstable, especially housing markets and markets driven by credit and leverage. Two groups of econ commentators - Austrians and Post-Keynesians - emerged from the woodwork and occupied much of the econ and finance blogospheres.

The subtext of the "financial instability" argument, and what that some people say explicitly, is that QE is creating - might one even say "inflating"? - a new housing bubble. It's 2006 all over again!

So the Hard-Money Coalition has just recruited itself a huge new batch of allies, many of them from the liberal side of the American political divide. For example, here is George Soros warning that central banks are creating financial instability. Here is Yves Smith saying much the same. And here's Cullen Roche warning explicitly of a new, QE-fueled housing bubble (see also here).

This new Macro War is much less of a liberal-vs.-conservative thing than was the fight over stimulus. It's more about mainstream macro vs. a coalition of non-mainstream groups. Macroeconomics is currently dominated by the ideas of Milton Friedman, especially the idea of a NAIRU, short-term monetary non-neutrality and long-term monetary neutrality, and above all the primacy of monetary policy. This is reflected in the dominance of the New Keynesian approach in business cycle theory and in central banks, and in the centrality of Friedman's ideas in most Econ 102 (introductory macro) classes. But if the "financial instability" meme takes root, this consensus is going to find itself facing a huge and unexpected new challenge.

So it's going to be interesting to watch.

Now where does little insignificant gadfly Noah Smith stand in this new battle? On one hand, I definitely think financial markets are unstable, and that bubbles are the biggest and most damaging manifestation of that instability. And the experimental evidence certainly suggests that more liquidity sloshing around in a market can give rise to bubbles, just as Austrians and Post-Keynesians believe.

But then again, I don't see a lot of anecdotal indication that QE is creating Housing Bubble, The Sequel. I agree with Robert Shiller that bubbles are characterized by optimistic expectations and general excitement. I don't see a lot of excitement about eternally-rising asset prices or a New Economy or a "This time is different" mentality. In fact, if John Taylor is right that QE is creating fear and uncertainty about future unwinding, then that seems like it should be pushing asset prices down, not up. It is well known that lower interest rates (or expectations of lower future interest rates) cause the fundamental value of houses and bonds to rise...so even if QE raises asset prices, that does not automatically indicate Bubble. I think it's likely that since humans tend to overweight recent experience in our models of how the world works, that we are too jittery about a repeat of the recent crisis, and probably paying too little attention to whatever the next crisis is going to be.

So while I'm not ruling out the idea that QE could create financial instability, I don't think it's going to be of the Big Bubble type. It would have to be something weirder and more subtle. Maybe interest rate spikes in Japan are this kind of thing. I'm not sure. So for now, I'll be watching this new Macro War from the sidelines.

(Of course, the question of financial effects of monetary policy, and whether the costs outweigh the expected benefits, is far too big to be dealt with so glibly, especially because so few models include this sort of thing. So this is just the beginning...)

62 comments:

  1. Weirder and more subtle like a full blown JGB funding crisis when BoJ owns nearly all of the stock and flow? Hope the Inflation Expectations Imp shows up before then.

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  2. Mike Konczal has the best piece on this

    http://www.nextnewdeal.net/rortybomb/what-would-financial-instability-argument-look-any-other-industry

    "It’s hard not to read the financial stability arguments as saying “look, we can’t trust the financial sector to accomplish its most basic goals.” If true, that’s a very significant problem that should cause everyone a lot of concern. It should make us ask why we even have a financial system if we can’t expect it to function, or function only by putting the entire economy at risk."

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    1. Sorry, what was the financial sector's goals in Mike Konczal's mind?

      Because, in reality, its only avowed goal is to make its participants rich.

      So do I buy the financial instability argument? Yes. But, like Noah, I don't think it needs to manifest itself in housing prices alone or even primarily. People have been burned and I doubt that there will be more that pockets of 'justified' irrationality (say, Vancouver or London going up since wealthy immigrants are putting serious pressure on prices because supply can't adjust).

      However, I do remember seeing a graph of the S&P and commodity prices with a QE overlay/Fed balance sheet overlay. The correlation was pretty impressive...

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    2. Anonymous4:25 PM

      That's absurd. I can't stand this idea that the only purpose of anything in the private sector is to "make its participants rich." There's a million reasons people do things. Profit is only one of them. If the financial sector is causing much, much more harm than it is creating benefits for human beings than we should radically reform it.

      Let's be done with this "Profit is the only purpose of business" nonsense.

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    3. Nathanael8:16 PM

      Yes, that is an excellent piece by Konczal. And I agree with both F. Mari and Anonymous, too.

      The problem is that we have a defective financial system which is not doing its job as "handmaiden to industry", and is instead being run to loot the populace. This is a problem. And it is closely associated with the problem of the 0.1% stealing everyone else's money.

      What it means is that the QE from the Fed, rather than going to boost employment, is going to 0.1%er bankers, and as a result is being poured into commodities hoarding.

      https://www.nytimes.com/2013/07/21/business/a-shuffle-of-aluminum-but-to-banks-pure-gold.html?pagewanted=all

      The banking channel is broken. Keynesians: if you don't want to get outmaneuvered by the hard-money people, you have to admit this, and start advocating openly for "QE for the people, not for the bankers".

      Keynes himself was much more radical than most modern Keynesians -- he advocated nationalization of several industries including the railroads.

      FDR was also more radical: he established federally-owned, federally financed banks which lent directly to the people, with no private-banker intermediaries to steal the money.

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    4. Nathanael8:23 PM

      I'm going to hammer on the rhetorical problem a little harder.

      Advocates of easy money MUST make the distributional argument. If you do not make the distributional argument, you will LOSE.

      The distributional issues are absolutely key -- the 1% having all the wealth, the 99% having nothing, the bankers stealing millions per year while people get kicked out of their homes illegally.

      The primary goal of the "hard-money" people is to distract people from the distributional problem. They can then use populist arguments to get the 99% to vote against the 99%'s own best interests.

      If you do not argue, rhetorically, in public, for the crucial importance of fixing the distributional problem, people will ignore you and you will lose.

      If you do pick the right rhetorical stance -- if you focus on the distributional issue as the core problem and the "easy money"/"hard money" issue as a mere side effect of fixing the distributional problem -- which is actually the situation the economy is in right now -- then you have a chance of winning the argument in the public eye.

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    5. Anonymous4:29 PM

      This set of replies shows a massive misunderstanding of what the financial system is and what the benefits are. You know those little things like credit cards, financing for cars, mortgages, putting money in a bank, cashing checks? That's the financial system. The financial system involves facilitating the flow of money. We can go without it, assuming you're willing to return to a barter economy. That would only take us back around 8,000 years. Probably not a good idea.

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  3. Great post. But I actually didn't "explicitly" warn there was a housing bubble. In fact, I said I don't think this is anything like 2007:

    "Are we getting into a dangerous environment like we saw in 2007? I certainly don’t think so quite yet"

    Plus, is it even controversial that QE should distort asset prices? I recall the famous Brian Sack line where he said one of the goals of QE was to "keep asset prices higher than they otherwise would be".

    Not defending the hard money crowd as they've been terribly wrong, but those who said Fed policy would distort asset prices were basically just regurgitating what the Fed said they wanted to do. Unfortunately, most of them still didn't listen to their own advice and decided that shorting govt bonds and the USD was a good idea. Oh well. Ideology prevails!

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    1. Plus, is it even controversial that QE should distort asset prices? I recall the famous Brian Sack line where he said one of the goals of QE was to "keep asset prices higher than they otherwise would be".

      Is that a "distortion"?

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    2. "distortion" and "manipulation" all sound like you're saying the same thing wrt markets - you're adding another variable that changes the outcomes of one particular market and a host of others. Personally, I liked the positive "distortions" or "manipulations" caused by the federal government in 2009 to keep unemployment down and output from collapsing. But I definitely don't like any kind of "distortion" that leads to a climb in real estate and housing prices - as those are extremely dangerous as recent history has obviously told us (plus Japan, plus the Great Depression..).

      Interesting though how you conflate the Austrians and the Post Keynesians, even though their arguments are entirely different. But you're right I suppose: this is definitely a fight against Friedmanomics, but Austrians are concerned about losing the value of their money if a bubble popping hurts the economy, but generally accepts the Friedman view of how the monetary system operates. Post Keynesians don't like it because they think their analysis of the economy is operationally wrong and leads to inadequate results on the expansionary side (for one written about the era of high inflation, I'll refer you to:
      http://www.amazon.com/Scourge-Monetarism-Radcliffe-Lectures/dp/0198772483 ).

      Richard Koo is not for QE and he's not a Post Keynesian. He's worried about bubbles and higher commodity prices too.

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  4. Anonymous2:22 AM

    i thought cochrane was a chartered member of the hard-money coalition (at least PK seems to think so). Isn't he fama's son-in-law...

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  5. Argosy Jones3:00 AM

    I saw an ad online tonight about house-flipping...some seminar in California, I think. There's a big cultural component to these bubbles, or at least recognizing them.

    I bought my fannie mae foreclosure 1/5 of what was owed on it/ what it was worth(bubble peak) a couple years ago. Granted, we had to replace a great deal of busted/stolen plumbing and radiators, but I think we got a great deal on the place. A housing bubble right now would be the best thing imaginable for the investment, and for my family's future. Obviously, I know how when to buy, if not when to sell. I held off for years, by the way.

    Nevertheless I find the prospect of another housing bubble to be terrifying in the extreme. Such an occurance would indicate that nothing has been learned at the policy level since circa 2005-7 (when I first started to naysay the housing market to my family).

    I didn't have much basis for my housing paranoia beyond the idea that house prices were growing far faster than the ability to pay for them, and faster than the price of equivalent rents, the near substitute for mortgage payments. I told family in 2007 that house prices were going to fall. It was of little consequence, as few were in a position/inclination to to buy at the time, luckily.

    What makes me a bit worried about a possible housing bubble is the recent? FED purchases of mortgage backed securities. Enough FED purchases of such securities will raise the price for such securities, and thus demand for mortage debt, and thence house prices. I have little understanding of such matters, but still, I worry.

    What I want most is a stable, growing macro-economy for myself, my family and my descendants. As the crisis unfolds, this seems less and less likely: continued recession in Europe, and an uncertain future in Asia. It should go without saying that the situation in the US is impossible to change in the short run.

    If I start having children now, will they have a decent chance in 20 years at working for a decent living, or will continued good luck at timing asset markets be essential? Hard to see.

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    1. unless you're in the .5% expect a lot of uncertainty and not much advancement. downward economic mobility is the new normal.

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  6. Diego Espinosa10:50 AM

    Why does it have to be a renewed housing bubble? The word "bubble" itself is not that helpful, and sometimes just a strawman employed to dismiss concerns about risk.

    The questions are 1) do we have a credible explanation for how Fed policy distorts asset prices? and 2) what level of risk do those distortions pose if they need to be unwound?

    For instance, in housing, a good portion of buyers are arguably "reach for yield" type cash investors. If rates back up quickly, could these exit the market? There is not necessarily a "bubble" in terms of abnormally high (historically) house prices. There may be distortions that would cause home prices to fall when unwound. Falling home prices, in turn, would result in all matter of second order consequences.

    Unwinding distortions also pose risks in the areas of global currency volatility, G7 deficit projections, loss of central bank independence caused by portfolio losses, etc. These are not single risks but correlated ones. The question is how they interact as a "system" dependent on distorted asset prices.

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  7. The title of this post gave me a good laugh. However, I do agree with you, Noah - I think that the general outlook of an overwhelming majority of all participants in the American economy is that of diminished expectations. A widespread penchant for speculative activity in any form would have to take a while before something like boom-and-bust happens again - or something big would need to jolt many people's expectations into that sort of thing.

    (Out of curiosity, though...where does your idol, Richard Koo, fit into this Macro War, now that the Hard Money people are tossing Eugene Fama under the bus?)

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  8. Rob Rawlings12:14 PM

    Market Monetarists appear to believe that even if QE did blow up bubbles it would not matter. As long as the monetary authorities stick rigidly to the task of maintaining AD at a stable and predictable level then bubbles can do no real harm. 2007/8 may have been triggered by bursting bubbles and financial panic but the great recession was not caused by these things but rather by the fed failing to take appropriate action (swapping sufficient assets for money) to prevent NGDP from taking a 9% hit from which we have yet to recover.

    I think EMH makes the MM story more palatable but is not actually required for their model to work.

    Additional point: I think its interesting that hard money types have started to focus on financial instability rather than inflation. As stated in the post it seems somewhat unlikely that in a time of extreme uncertainty that serious bubbles are going to occur. However QE has put an awful lot of money into bank reserves and people's cash balances. When this uncertainty starts to abate how sure are the loose money supporters that all this money can be sucked back in again without inflation (and bubbles) causing real damage to the economy?

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    1. "When this uncertainty starts to abate how sure are the loose money supporters that all this money can be sucked back in again without inflation (and bubbles) causing real damage to the economy?"

      I'm not worried. The Fed can raise the interest rate on reserves (and give the banks even more money!) so that the sucking is more gradual and it all doesn't get sucked back in at once.

      You make a good point that the This Time It Wasn't Different in that the fiscal and monetary policy wasn't adequate to create a strong recovery. The lackluster policies should be blamed alongside the earlier bubble-blowing which created a need for strong government intervention.

      Alan Blinder has pointed out that their are other ways to fight bubbles other than high interest rates. You can limit leverage and margins. Regulate. The conservative economists supposedly worried about financial stability don't want to regulate though. Because the market is magically efficient. Except sometimes it isn't. The deregulatory fever of the bubble years and "Great Moderation" allowed a shadow banking system to arise. It was more profitable because there was no regulation and no FDIC insurance. But when things went south there was the mother of all bank runs.

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  9. John S12:42 PM

    It's more about mainstream macro vs. a coalition of non-mainstream groups.

    Where does David Beckworth fit? He took the Financial Instability position in "Boom and Bust Banking," but he certainly can't be classified as a "hard money" voice today.

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    1. disagreeing with the no-inflation lie makes you a nostadumbass, a derp, a non-mainstream, a heterodox, a quack, a ron paultard, etc

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    2. Nathanael8:08 PM

      There is no "inflation". It's not "inflation" until your wages go up.

      If you want to complain about "price gouging" or "staples getting more expensive", feel free, but that's not "inflation".

      Delete
  10. Did Noah & PK do one of these?

    http://en.wikipedia.org/wiki/Drawing_Hands

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  11. "I think it's likely that since humans tend to overweight recent experience in our models of how the world works, that we are too jittery about a repeat of the recent crisis, and probably paying too little attention to whatever the next crisis is going to be."

    We always fight the last war, applies to more than just wars.

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  12. Ok, so we've identified the Nostradumbass. Good. But there is another camp we need to be aware of as well:

    Question Mark Headliners.

    In terms of predictions, this is where you get to ask any question you like without pushback. If nothing pans out, it remains simply a question. In the event it does pan out, what was "just a question" immediately turns into an EXCLAMATION.

    This strategy also involves liberal use of "air quotes" and well-hedged phrasing. Big difference between a "crash" and a crash, even though they are used interchangeably when convenient. Or what was once just a "warning" can turn into "I told you so!" -- and vice versa.

    I need a better name (perhaps "name") though.

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  13. The fed has the 1% in their pocket

    no inflation. of course not except pretty much everything. Gas prices up huge this month, but it's transitory they tell us. it's volatile blah blah. college, insurance, rent & healthcare costs through the roof? free market at work. not inflationary at all.

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    1. Anonymous3:13 PM

      meh, gas prices have barely budged in general. you sound like a rentier.

      Delete
  14. Very nice post! One thing to add is this: we already knew that QE by itself, working on its own, would not do much. Whether it would start to have negative outcomes, without additional policies, was not much discussed, except in the incoherent fears of the austerians, who were of course actively preventing those other policies.

    The earlier (circa 2009-10) blog discussions about QE brought out the logical result that, without mortgage write-downs (or, failing that, without the fiscal stimulus to help poorer homeowners to deleverage,) QE would finally be ineffective in improving consumer demand. Or almost entirely ineffective, since it would allow for a holding pattern in the ownership of expensive assets of most sorts, until consumer demand repaired its output gap by other (unspecified) means. What remained of the possible virtues of QE was to stabilize the financial system (i.e., more-or-less maintain its interior paper-asset market dynamics, and thus the intentional structures of asset ownership) while the "real" economy repaired.

    This provides a key to understanding part of the reasoning behind the block-headed illogic of the hard money toads, who were (and some still are) oblivious to the possible existence and nature of a systemic short-term (Keynesian) demand-side crash. They had to resort to an enormous amount of "inflationary" and/or "business-expectations" gibberish to avoid acknowledging the fact that the supply-side could not respond to such an unusual situation. "Inflation" translated from the Bonehead language also means "money printing", "paper asset bubbles", etc.

    Now that it comes down to the question of getting back to investor-remunerative higher interest rates in a returning economy (although it isn't returning by much, and 20% of mortgages are still underwater), which is, Noah, the other half of what I think you are calling the "financial instability" argument, the austerians can renew their parallel alchemy of "economistics" (we need a name for their phony discipline), without further fear of being contradicted in public by facts they cannot handle.

    For people actually following the real world, the next self-contradictions for the austerians to bridge will be things like capital-biased technological change, increasing inequality, the need for the welfare state, regional climate change dislocations, etc.

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    1. Lee Arnold writes "For people actually following the real world, the next self-contradictions for the austerians to bridge will be things like capital-biased technological change, increasing inequality, the need for the welfare state, regional climate change dislocations, etc."

      My impression is that the austerians come in two varieties, those who think this is a list of non-issues and those who see all of these not as crises but as Good Things.

      The economic situation here is an epiphenomenon of a vicious class war, which the middle class is losing.

      -dlj

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    2. Two things, however: first, increasing inequality (and climate change) are going to cause social breakdown, no matter whether you believe in them now, or not. And second, social breakdown will harm the rich as much as the poor, because social breakdown will be violent, dangerous, entirely uncertain. So they can't let the crisis go as far as it is going to go, without putting themselves in danger. Long before that prospect though, they will be outvoted.

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  15. Anonymous3:11 PM

    low interest rates are a function of weak money inflation. This was true in 2003 as well. That is why global long rates sold off, a pat in the back to Abe.

    A compacted yield curve actually can hurt the economy in general as banks can't lend and this becomes a part of the lack of money inflation.

    Hard money types should just admit they want a complete collapse and for the wealthy capital owners to play a "game" of liquidation into all cash and see who can hoard the most. That is the only real point of it.

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  16. Anonymous3:53 PM

    I think macro is useless if we insist on moving it into the realm of psychology. Useless. And people are right to ignore any policy recommendations based upon psychology.

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    1. Nathanael8:07 PM

      Absurdity. All of economics is applied psychology, because money is a shared illusion (or if you prefer, a "social construct").

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  17. Considering the housing bubble was an attempt to maintain interest rates higher than they otherwise would be, the fall is to be expected along with a rise in asset prices. It is also why there is so little to fear from interest rates rising significantly or returning to some fantasy of normal. The only reason for interest rates to rise is the prospect of higher returns justifying increased borrowing, or the Fed putting us into recession in which case they will be soon be reversed. To fear financial instability is to fear capitalism but if they are calling for social investment, the only alternative, I am all ears.

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  18. Anonymous4:44 PM

    Considering the economics and politics here in the eurozone, I would say that it is more likely that the next financial crisis will be caused by the euro exploding in part from lack of QE on the ECB's part rather than by an asset bubble from too much QE on the Fed's part.

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  19. Isn't Simon Wren Lewis making much the same point about the unpredictability of unconventional monetary policy here.
    http://mainlymacro.blogspot.ie/2013/07/the-two-arguments-why-zero-lower-bound.html?m=1
    Guess there are recruiting everywhere. Surely the real problem is mainstream economists not calling loud enough or clearly enough for fiscal policy at the ZLB. QE is a poor substitute.

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  20. Any interest in having an evil IT guy try to help this crowd reach a broader audience? So far, I think not.

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  21. I want ask about this comment form the article where Edmund Phelps posited;

    "Today we have banks, insurance companies and pension funds leveraging their assets and loading up on credit risks because prudence cannot provide acceptable returns."

    Whats an acceptable return and who gets to determine it?

    There seems to be a view amongst some that they "deserve" a certain return. You get whatever return the conditions warrant. Sometimes 1-2% is very good. Avoid big losses is sometimes the best rule to follow. I think we have been in that environment for about 6 years now. I think we have to break certain people of the notion that they deserve a certain amount of return.

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    1. Nathanael8:05 PM

      For decades, or even centuries, governments legislated maximum returns (under the usury laws among other things), and actually prohibited banks from making more money than that.

      In the Victorian era, 1-2% was a sensible and acceptable return.

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  22. Many of those claiming we have a new housing bubble point to the reappearance of flipping in certain markets, with Phoenix the leading suspect (which may in fact be a local bubble). However, the evidence is clear that the vast majority of the flipping going on so far, particularly in Phoenix, has been of properties that were acquired in fire sales after foreclosures. So, this is arguably equilibrating activity that normalizes what was an overly depressed market from the crash of the previous bubble, not evidence of a new housing bubble.

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  23. Nathanael8:04 PM

    Central banks ARE creating financial instability.

    Not by having low interest rates (lowering interest rates is good).

    Not by printing money (printing money is good).

    They are creating financial instability by *who they allocate the money to*.

    They will bloviate about how they are "letting the market allocate", but the fact is, they're NOT. Instead, they are handing the money to the big money-center banks which are members of the Federal Reserve, or the equivalent banks in Europe. These are the banks whose managers *created the problems* which we have now.

    The Fed is quite literally handing money to the criminals who created the foreclosure fraud mess. And they are walking away with the money.

    If you look at your credit card bill, you'll probably see that interest rates haven't dropped at all since 2007! Isn't that interesting? It's because the banking channel is broken. The spread has increased, fees have increased on top of that, and the money-center bank executives are simply collecting it.

    The problem is MISALLOCATION. We need easy money for real industrial businesses and real individuals; instead we have easy money for the 0.1% and hard money for everyone else.

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    1. Nathanael9:53 PM

      I'd like some 0% Fed money with no strings attached, by the way. And you know what I'd use it for? Building a new solar panel design. Actually Useful Stuff. But I'm not a money-center bank, so I can't get that sweet, sweet 0% interest money.

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  24. If I didn't know better, Noah, it sounds like you are saying: "The Austrians and Post-Keynesians might actually be right, that monetary policy is causing financial instability and that this is a serious problem. I really don't have a strong feeling one way or the other, but the models I use are too crude to even handle this sort of thing, even though I admit it's a problem in the real world. So, in lieu of me taking a firm stand on the issue, I'm just going to mock the Austrians and Post-Keynesians on the point."

    Am I out of line with the above paraphrase?

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    1. Am I out of line with the above paraphrase?

      Well, I agree with this part:

      The Austrians and Post-Keynesians might actually be right, that monetary policy is causing financial instability and that this is a serious problem. I really don't have a strong feeling one way or the other, but the models I use are too crude to even handle this sort of thing

      But I think this is too strong:

      even though I admit it's a problem in the real world

      Better to say that I'm not sure if it's a problem. Not sure if monetary policy is a big driver of financial inefficiency/irrationality.

      I'm just going to mock the Austrians and Post-Keynesians on the point

      No, that's not right. If I mock Austrians and Post-Keynesians, it will be for other reasons, not this. ;-)

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  25. I support the QE b/c the incapability to enact fiscal stimulus means it's the last bullet in the gun for unemployment, which remains job one (pun not intended).

    However, the usual suspects of flipping houses are at it again:

    http://www.bloomberg.com/news/2013-07-19/gorilla-flipping-homes-as-rebound-revives-rapid-trades.html

    We need to eliminate the mortgage interest tax deduction as the most unstable market has been the housing market.

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  26. Anonymous12:39 PM

    "But then again, I don't see a lot of anecdotal indication that QE is creating Housing Bubble, The Sequel"

    How about "The Dead House Bounce"? , Act 2. or the new wave: "The locked-in to labor deficit location, under-funded bargain for the tax-roll , tied to underwater mortgage collapse"?

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  27. I think monetary policy created the housing bubble because of the GSEs. We wanted to treat housing investments as completely safe, but we ignored the financial aspect of the market. So while monetary easing did cause the housing bubble, it only did so because of the guaranteed mortgages. Safe investments that forgot that the price of the home matters, not just the mortgage rate.

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  28. Anonymous2:24 PM

    Great article. I have two minor notes though.

    1) Soros basically supports the unorthodox actions of Japan. I was actually there and listening in as he gave that interview and have heard him speak on the matter a few other times. Not surprisingly however all of the media outlets latched on to his aside or bit of qualification that "of course it is not without risk". People hear what they want to hear, and most of the media wants to focus on the fear of possible fall outs from deficits, QE etc. rather than the non-hypothetical problem of the long term unemployed (the cynic in me knows this media fixation corresponds to the interests of the wealthy and excuses to cut the social safety net). Soros is most definitely not arguing that central banks and governments in the developed world should be doing less, like the hard money types are.

    2) If housing prices had not been measured as renter's equivalent in the price indexes, that bubble would have been quite apparent even through the broader inflation measures (and monetary policy and credit would have tightened sooner). Similarly, the deflation during the outset of the recession would have been much greater as well. There is nothing even remotely like that going on with housing prices now. I don't think we need to replace the NAIRU type views of monetary policy, but it is possible we need to revise our measures of inflation.

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  29. I'd go a bit further and conclude that tightening monetary policy is unlikely to deflate asset bubbles. Contractionary policy would eventually lower asset prices, no doubt, but it would reduce all other prices as well--I see no reason why the relative price would change.

    The same "reach for yield" argument applies to a deflationary spiral at least as well: ie, "With all these assets declining in value, investing in subprime CDOs is guaranteed to preserve your hard-earned wealth better than bonds..."

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  30. Anonymous8:52 PM

    Noah, I believe there is plenty of anecdotal evidence that QE, especially rounds 2, 3 and 4EVER, which was deliberately executed by the FED to artificially boost housing prices, has sent the necessary price signals to spark another bubble, particularly in certain markets, such as California (Median Home Prices in Los Angeles are up 30% yoy in July 2013!).

    People have different definitions of a bubble (Asset Manager Jeremy Grantham has studied bubbles extensively and defines them as a 2-sigma or 2 standard deviation from historical price/cash flow ratios), but the one I think is intuitively most compelling is a market in which market participants are buying assets simply because they believe that prices are going to go up, which keeps driving prices up in a reinforcing spiral, as new market participants hear stories of huge windfalls reaped by others.

    Evidence of this is in housing what I would call "beta flipping" where people are buying homes in the open (non-distressed) market and are reselling them for a profit in short time period without increasing the value of the homes through renovations. This is different than what I view as "alpha flipping," where professionals or semi-pros acquire distressed properties at foreclosure auctions, fix them up, and re-sell them for retail prices.

    Beta Flipping was a force that drove the last bubble, along with NINJA loans and bad underwriting that enabled both beta flippers and end buyers to purchase over-inflated assets. Today it has been caused by the massive boost in marginal demand due to the sharp fall in 10 Year interest rates that occurred in late 2011 after QE 3. You can read many examples of this kind of flipping behavior on housing blogs, such as Dr.HousingBubble and others. The other side of this equation in today's market is that there is almost no supply, which ironically is a product of many people are still in negative equity or near-negative equity positions in their homes (35+% of the non-distressed housing inventory, which is HUGE).

    However, this time around today's beta flippers will likely be in trouble now that interest rates have gone up. The ability for end buyers to stretch will be limited, unless the banks want to relax underwriting standards again. My hope is they won't, especially because there are still 4.5 million properties in the distressed pipeline, and the banks themselves probably realize it is time for them to start liquidating more as they have got the most paper gains they are going to get from the FED's largesse.

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  31. Bernanke came up with a new trick to let him make new money but not cause inflation, for awhile. He makes the money and then pays people not to take it out of his building. He does this by paying banks interest on "excess reserves". Like any good new trick, it will fool people for awhile. In the short term it decreases inflationary pressure but in the long term it increases the risk of hyperinflation.

    http://howfiatdies.blogspot.com/2012/10/faq-for-hyperinflation-skeptics.html

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    1. Yeah, a 0.25% interest rate on reserves is keeping banks from pumping all that money into new loans...gimme a break!!

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    2. This was a period when Bernanke also kept all kinds of other interest rates at crazy low levels. Recently interest rates have been going up. We will see if Bernanke has to raise this 0.25% or if banks start loaning this money out to others.

      In any case, they really did leave their money at the Fed in huge amounts, which they never did when there was no interest on excess reserves.

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    3. Banks should loan money out when the expected return is greater than the opportunity cost plus a required spread S. With a 0 interest rate on reserves and a 0% rate on T-Bills, the opportunity cost is 0%. With a 0.25% IROR and a 0% rate on T-Bills, the opportunity cost is 0.25%. You're telling me that there are a huge ton of projects out there that have expected returns between S and S+0.25. To me that strikes me as absurd!

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    4. Banks never left huge amounts of money as excess reserves before Bernanke started paying interest. You think it is just a coincidence that after he started paying interest the quantity of excess reserves shot way up?

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    5. Excess reserves really competes with very short term government debt. Both are "risk free" and both are very liquid. As long as Bernanke is able to keep the interest rate on short term government debt is less than what he pays on excess reserves, it will continue to be rational for some banks to keep money as excess reserves.

      http://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yield

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    6. You think it is just a coincidence that after he started paying interest the quantity of excess reserves shot way up?

      Yes.

      Excess reserves really competes with very short term government debt. Both are "risk free" and both are very liquid. As long as Bernanke is able to keep the interest rate on short term government debt is less than what he pays on excess reserves, it will continue to be rational for some banks to keep money as excess reserves.

      No, because you're only comparing reserves to Treasuries. Compare them to the long-term risky projects in which banks are supposed to invest.

      Banks are not supposed to make their profit on the spread between cash and Treasuries. We do not need a banking sector to do that. Banks are supposed to invest in long-term risky projects. And a 0.25% opportunity cost is not, by itself, enough to stop them from doing that!

      DON'T YOU SEE???

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    7. The question of why banks don't invest in long-term projects and instead buy short term Treasuries or earn interest on excess reserves is an interesting and important question. But I don't think we need to answer that to see my point. Whatever the reason, it works the same for short term Treasuries and excess reserves vs long term loans.

      Let me try another way. If Bernanke did not pay interest on excess reserves and instead of putting $2 Trillion to earn 0.25% interest in excess reserves banks put this $2 Trillion in 3 month Treasuries that paid 0.25% do you think there would be any real difference for the banks or the economy? The same amount of money would be "off the street" but at the risk of flooding back at some point. So while off it would not be inflationary but when it came back into circulation it would be. Right?

      The Keynesian theory is that by having the central planners lower interest rates they can encourage more investment and make more jobs. The reality is that low interest rates make buying robots and replacing workers more attractive. Obamacare also encourages robots. Central planners don't usually see all the side effects of their actions.

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    8. So while off it would not be inflationary but when it came back into circulation it would be. Right?

      If so, the expected future inflation should cause the expected real IROR to go strongly negative, even if the nominal IROR is pegged at 0.25%. Right?

      Which should strengthen the incentive for banks to lend now and avoid those losses, right?

      Which should then cause the very same inflation the expectation of which caused the expected real IROR to go negative, right?

      That's called an "equilibrium".

      And THAT is what Keynesian theory says should be happening.

      Only, it is not.

      But the lack of inflation that is a problem for Keynesian theory is also equally troubling for AustroDerp and RBC type theories.

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    9. If there is expected inflation then lending long term gives you real losses. So perhaps they realize inflation is coming and are avoiding long term loans.

      If most of the new money is staying inside the Federal Reserve Building, for whatever reason, doesn't this explain the lack of inflation?

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  32. One thing I've never understood in this "debate" is how to tell "reaching for yield" from recovery. Isn't one of the points of monetary policy to create an environment in which banks are more comfortable lending, thus implying that they will take on more risk?

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  33. Anonymous2:00 PM

    Most economics blog posts, at least on the more serious blogs, don't so much convince me of anything as introduce me to something I didn't know much about or give me more understanding about some phenomenon. I don't come away convinced so much as thinking, well that's an idea to keep in mind. Over time, a general image starts to materialize.

    tl;dr => if you take a sponge approach, you're less sensitive to individual data points.

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    1. Anonymous2:14 PM

      (sorry, posted to wrong page, meant to go here: http://noahpinionblog.blogspot.com/2013/07/when-have-econ-blogs-changed-your-mind.html but there's no delete)

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