Monday, October 4, 2010

Irrational Apoplithorismosphobia

Brian Sack, EVP of the New York Fed, spoke today. He said:

In terms of the benefits, balance sheet expansion appears to push financial conditions in the right direction, in that it puts downward pressure on longer-term real interest rates and makes broader financial conditions more accommodative.

Elsewhere in his talk he refers to inflation as being too low.

Of course, he said much more. These points are enough, though, for a post.

Is it really correct that lower real (inflation-adjusted) long-term interest rates is a good thing?

Here's a view from DEFLATION AND ECONOMIC GROWTH (from

The Bureau of Labor Statistics (2004) published estimates that show CPI
was negative for 11 years in the late nineteeth century, including 1879 and
1895. The NBER chronology shows the economy was in expansion for nine
months in 1879 and 11 months in 1895 despite a negative CPI both years.

Federal Reserve Bank of Minneapolis data show CPI was negative for 13
years in the twentieth century, including 1922, 1928, 1939, and 1955. The
NBER chronology shows the economy was in expansion for 12 months in
each of these years.

Thornton (2003) defines apoplithorismosphobia as “fear of deflation.”
These examples of expansions in periods of negative CPI suggest some laboring
in the Keynesian vineyard suffer from this malady. Unless they are willing
to argue the NBER chronology is invalid they should concede deflation is not
synonymous with contraction, and differentiate between good and bad deflation.
Good deflation occurs when prices and interest rates decline, consumers
receive more purchasing power from most assets, output expands and
productivity expands due to technological innovations. Bad deflation occurs
when prices and interest rates fall yet many consumers receive less purchasing
power from most assets, output contracts and productivity declines as a
result of central bank policies.

An ideal economic world would be one in which there are such marvelous opportunities for capital to bring a real return that due to productivity, prices fall while bond returns are strongly positive. Money would truly make money because it financed economically productive efforts.

In other words, capital should be scarce enough that businesses compete to have the best business plans to utilize said capital, If for no other reasons than, perhaps, time being out of joint, capital should be able to rest while the economy rested. This is why the authorities appear to be pushing on a string. Too much unproductive activity has occurred, most notably recently the housing bubble, but before that much wasted effort occurred at the height of the tech boom.

Capital was destroyed in these bubbles; meaning, real economic activity was wasted. The Fed is printing more "capital" (a form of counterfeiting), in large part for no other reason than that its ultimate master, the U. S. government, demands that it do so because of the strategy the government has chosen, which is to cause much more economic activity (spending) than it removes from society (taxing).

For the Fed to now argue that even easier money is a virtue is to argue for more and more marginal business projects and spending decisions to be undertaken with a lower and lower threshold of return required to "justify" these decisions.

Thus there will be large continuing "malinvestments" which will distort price levels and be marginally productive or completely unproductive. Whether this distortion of price levels will lead to shortages of raw materials or consumer products remains to be seen.

If the Fed, either due to market presssures or a sudden return of fiscal prudence in Washington, returns to a program of positive real interest rates all across the yield curve, gold would probably be as poor an investment as it was from 1980 to 2000. Gold is the most controversial "commodity", because of the beguiling argument: "Gold, what is it good for?"

For nine years, the financial markets have been answering that gold has a critically important monetary value, because the Fed has acted as if it suffers from irrational apoplithorismosphobia. If the Fed gets needed intellectual therapy plus a backbone and resolves that irrational fear, then gold can cease being of financial interest and can once again just sit there while normal investing resumes.

Copyright (C) Long Lake LLC 2010

No comments:

Post a Comment