Saturday, August 27, 2011

Thomas Hoenig and the Ever-Expanding Universe of Excuses for High Interest Rates

It’s now a week old—an internet lifetime—but we shouldn’t let this pass without comment.  In an interview with Gretchen Morgenson, departing Fed district president Thomas Hoenig offers this bizarre justification for his votes against near-zero interest rates since the 2007 collapse:
We as a nation have consumed more than we produced now for well over a decade. Having very low rates for an extended period of time encourages us to continue focusing on consumption, but to correct our imbalances, we have to focus on production.
Global imbalances made me do it!  Think for a moment, however, and the argument makes no sense at all.

Low interest rates encourage borrowing of all kinds, for production as well as consumption.  All the current export-oriented economies—Germany, China, and before them Japan and Korea—achieved their miracles in low interest rate environments.  The thing is, they had cultures, institutions and policies that steered credit toward producers and away from consumers.  In recent decades the US has had none of the above, and a loss of export capacity and competitiveness has been the result, even though the corporate sector is awash with liquidity.

High interest rates, on the other hand, choke off consumption, but they also discourage investment, and deficient demand is hardly a spur to the creation of new capacity.  There is no theoretical or empirical basis for Hoenig’s argument; it reflects badly on him and the normally shrewd Morgenson should have picked up on it.

To be charitable, however, Hoenig’s fantasies are no more implausible than those of many other inflation-hawks.  We hear claims that inflation reaches an ominous tipping point at 3% or so, after which it is nearly irreversible.  Or that big shifts in the velocity of money are simply a mirage, and central bank injections have to be reflected in price increases, ever and always.  Or the ultimate whopper, peddled shamelessly to the masses, that inflation represents a decline in purchasing power, an assault on the poor, defenseless consumer, even though this is contradicted by the simple logic of the circular flow.

The fact is, there will always be a market for high and low arguments in support of tight money and excess inflation hawkery.  From a social point of view, inflation can be either too low or too high, but from the perspective of creditors the risk is always on the too-high side.  Thus arguments have to be crafted, out of thin air if necessary, to justify putting the war against inflation ahead of all other social objectives.  Hoenig, no matter how absurd his pronouncements, will always be more accepted in the higher circles of finance than apostates like Blanchard and Stiglitz, who look at inflation rationally, in the context of broader economic policy.


CJF said...

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Best Regards,

freebird said...

I have no background in economics, but I wonder has anyone considered the possibility that higher interest rates can increase overall consumption in today's environment? Granted higher interest rates makes credit and therefore investment harder, but that is not what is lacking today-- I've read that the gate is insufficient aggregate demand. Interest may be a cost input for a producer, but it also represents income for a large segment of the population, retired folks for example. I can tell you firsthand what today's CD rates are doing to my retired mother's spending habits, that's for sure. So I ask-- has anyone tried pulling on the string?

Peter Dorman said...


At a first approximation, the income effects of changes in interest rates are a wash: interest is a transfer from debtors to creditors -- what one gains the other loses. Of course, there are real effects. Two predominate: since interest rates set the price of debt, higher rates lead to less borrowing, and, if creditors are wealthier on average than debtors, they will tend to spend a lower fraction of their income.

ProGrowthLiberal said...

Hoening is hoping that higher interest rates will increase national savings (decrease consumption). Hey if we were at full employment, an outward shift of the investment schedule might just increase national savings. But wait - we have too little in the way of aggregate demand right now. And Hoening wants consumption to fall now? Maybe he should read Keynes on the paradox of thrift.

Anonymous said...

The circular flow can take 30 years to reach from what you pay for to what you earn. During our lifetimes we have seen it, with increases in crime, divorce, abortion, environmental destruction and every other social disorder. The academic definition of inflation doesn't allow for that and so is not useful in explaining what is happening around us.

Anonymous said...

Can you expand on that, wellbasically, what you wrote about circular flow?

Anonymous said...

«The fact is, there will always be a market for high and low arguments in support of tight money and excess inflation hawkery.»

Well, but "ceteris paribus" does not happen, spo both Hoening's statement and yours are quite wrong, even if Hoening's seems more useful for all that it does seems hawkish.

The past 30 years of decreasing nominal interest rates and the past decade of negative real interest rates have indeed caused an investment boom, actually two investment booms:

* A series of paper asset bubbles in the USA.

* A productive asset boom in China and India which has generated a series of job booms outside the USA.

As to the latter, low nominal (negative real) interest rates have enabled USA companies to shut down productive capacity in the USA and build new productive capital in China and India.

The reason for this is that the cost base of China and India is more profitable than that of the USA, so any capital that a USA company has should be invested in China and India, not the USA.

Unless the capital is in the USA and tangible and expensive to move, in which case it may be cheaper to just continue using it.

But if a company gets near free capital to invest in either upgrading an expensive USA factory or building a new cheaper factory in China or India, they will do the latter.

If capital is expensive it makes sense to keep the tangible capital you have and work it; if capital is cheap, then getting rid of old less productive plant and building new more productive plant make sense.

But Hoening is right in a broader sense. With the end of the Cold War, the second and third world have gone from enemy territory and battlefield to reserve army of labour.

The only reasonable outcome is a massive rebalancing where the cost base in the USA goes down towards parity with that of China and India, in other words massive deflation, of both assets and wages.

A ZIRP means instead that USA asset prices get vastly inflated, and USA wages instead of shrinking towards Chinese and Indian levels get in part zeroed: those that adjusted with productivity are competitive "survive", and the others get zeroed.

A low interest rate policy might work "ceteris paribus", but other things are no longer "paribus".

Anonymous said...

The definition of inflation we use is simply "all prices going up". So in the situation we are in, houses are very cheap but gas and food is very expensive. So it's not inflation because the total is not rising.

Looking at inflation numbers alone will not explain what is happening around you. For an economist to appeal to the circular flow ignores the fact that the flow travels into very different producers under a severly weakening dollar like we have now than it would if the dollar was strengthening.

Products with short contracts, of which the entire yearly supply is sold out in under a year, will adjust to the new value quickly. Products with long contracts which take 30 years to sell the whole supply, will take that long for average prices to show the new value of the dollar. Only at that point will those who watch the total value of sales say "we have inflation".

By the time houses do go up, you are mostly on your way to screwed. But if at that point you attack inflation by raising rates at your central bank, you're just going to kill the economy instead.

The effects are obvious now, Rick Perry is simply riding the wave of spending on oil, not because he's any smarter than any other governor, but because the major products of his state are at an advantage during the period when the dollar is weakening.

Gold does not show inflation, it shows the value of the dollar. That is why it worked in the past as a fix for your currency, and attempts to compare its present performance with inflation numbers will never work.