When the majority of Americans examine the world around them, they see a stock market at record highs and modest apparent improvement in the economy, but they also have the sense that something remains terribly wrong, and they can’t quite put their finger on it. According to a recent survey by the Federal Reserve, 40% of American families report that they are “just getting by,” and 60% of families do not have sufficient savings to cover even 3 months of expenses. Even Fed Chair Janet Yellen seemed puzzled last week by the contrast between a gradually improving unemployment rate and persistently sluggish real wage growth.
We would suggest that much of this perplexity reflects the application of incorrect models of the world.
Before the 15th century, people gazed at the sky and believed that other planets would move around the Earth, stop, move backwards for a bit and then move forward again. Their model of the world – that the Earth was the center of the universe – was the source of this confusion.
Similarly, one of the reasons that the economy seems so confusing at present is that our policy makers are dogmatically following models that have very mixed evidence in reality. Worse, when extraordinary measures don’t produce the desired results, the only response is to double the effort without carefully asking whether there is a reliable, measurable cause-and-effect relationship in the first place. When there are broken links in the chain of cause-and-effect, “A causes B” may be true, and “C causes D” may be true, but if B doesn’t cause C, then all the A in the world won’t give you D.
Let’s review some relationships in the data that are clear, and some that are not so clear at all.
Quantitative easing and short-term interest rates
First, the following chart shows the relationship since 1929 between the monetary base (per dollar of nominal GDP) and short-term interest rates. This is our variant of what economists call the “liquidity preference curve” and is one of the strongest relationships between economic variables you’re likely to observe in the real world. After years of quantitative easing, the monetary base now stands at 24% of GDP. Notice that less than 16% was already enough to ensure zero interest rates so the past trillion and a half dollars of QE have done little but increase the pool of zero-interest assets that are fodder for yield-seeking speculation. Notice also that unless the Fed begins to pay interest to banks on their idle reserves, the Fed would have to contract its balance sheet by about $1 trillion just to raise Treasury bill yields up to a fraction of one percent. So the primary policy tool of the Fed in the next couple of years will likely be changes in interest on reserves (IOR). Get used to that acronym.
Interest rates, wealth effects and economic growth
Following this very strong economic relationship, let’s examine a very weak one. It should give pause to those who believe that low interest rates are naturally associated with stronger economic activity. The fact is that when productive opportunities to invest are available, strong economic activity and normal or even elevated interest rates are completely compatible, and those higher interest rates also raise the bar in a way that discourages borrowing for unproductive activities.
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