Excellent EconTalk Podcast

by Liberty and Power

Check out Russ Roberts's recent interview with Michael Belongia (University of Mississippi), in which they discuss the operations of the Fed. Although I do not agree with all of Belongia's proposed reforms, he has many insightful observations that complement some of the arguments that David Henderson and I have made. For instance:

1. An early draft of our article on Greenspan exposed the Vockler myth, arguing that Vockler's monetary policy was not as tight as many believe and that his role in bringing down inflation in the early 1980s is grossly exaggerated. That section was edited out of all the published versions as too much of a digression, but Belongia offers some surprising (and even chilling) confirmation of our claim.

2. Belongia not only wholeheartedly agrees that interest rates are a poor way of gauging monetary policy, but he goes so far as to argue that, over the period when everyone claims that Greenspan's policy was expansionary, it was in fact too tight.

3. Belongia manages to score some significant points against the Taylor Rule, pointing out that if it had been subjected to the same standards that led to the rejection in the mid-1980s of money stock measures as a target for monetary policy, the rule would have been abandoned long ago. (For more on the ambiguity of the Taylor Rule, see this post by Brad DeLong.)

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William J. Stepp - 3/11/2010

The discussion between Russ Roberts and Michael Belongia is quite interesting, especially about the political infighting and one-directional back stabbing. His comment about Greenspan's lowering the discount rate six times in three years on the back end of a concomitant drop in the Fed-funds rate was good. I also liked his statement that "money data" are "scientifically meaningless."
Shout it from the roof tops, brother! I've always thought that various kinds of economic statistics, including GDP statistics, are so much twaddle, and not just for Rothbardian (Y = [C + I] - [G + T], not C + I + G) reasons.

That said, Prof. Belongia is a standard-issue monetarist, and says that interest rates are determined by the supply and demand for bank reserves.

They didn't get into the question of the cause of what The Economist in 2008 rightly called the biggest credit bubble in history. Nor did they venture outside the commercial banking system and into the shadow banking system, which provided up to 70-75% of the credit that fueled the multi-sector boom, a boom and bubble that saw outsized price increases in assets ranging from raw land to new housing and commercial real estate, to stocks, bonds, and commodities, to private equity and art, and in the later stages to various forms of structured finance vehicles, derivatives, etc.
Jeff Hummel and David Henderson blame the boom on the Chinese savings glut, but Chinese savings went mainly into the bond market, and only offset some of the financial effects of the decline in the U.S. savings rate.

Jeff links to his Cato paper (with David Henderson), in which they wrote that interest rates are determined by supply and demand (for what?), and that the Fed has little to no influence on them in a world economy. But consider stock prices. They're determined by the supply and demand for firms' shares, right? And anyone anywhere in the world can buy a stock trading in New York, London, Tokyo, etc.
Well, yes, but if you look under the hood of a stock price, you'll see that the State's corporate income tax affects it. For example, at www.valuepro.net, type in any stock price, say IBM, then change the tax rate to 0 and revalue it. You'll see a big increase in the stock price.
Both prices are determined by supply and demand, but they are quite different thanks to the tax.

Getting back to the actual determinants of interest rates, the first is time preference: the supply and demand for present goods. The former determines the demand for future goods, and the latter determines the supply of future goods. There is also a risk component added to the time preference part of interest rates.
When the Fed put downward pressure on interest rates, this compressed the risk component and lowered the weighted average cost of capital throughout the economy. It had the disastrous effect of causing investors to value long-dated cash flows with discount rates that were sub-market (not to say sub-prime). At the same time, the likes of Countrywide Financial, New Century Financial, Household Financial, Wsashington Mutual and other firms were feeding the binge and exacerbating the problem by lowering their mortgage underwriting standards. This was part and parcel of the credit boom, and worked in a virtuous feedback loop. Add in the effects of adaptive expectations, and you get the Greenspan edition of extraordinary popular delusions and the madness of crowds

One problem pointed out recently in a Wall Street Journal article (can't put my hands on it right now) was that in 2006, when the Fed-funds rate rose in small increments, investors expected that the economy would continue to be strong and adapted their expectations accordingly.
I agree with the free banking critics of Greenspan that interest rates were too low in the bubble years.

William J. Stepp - 3/10/2010

I listened to 28 minutes of the podcast, then had to leave, but will listen later to the rest of it.

It dawns on me that a key difference between the Fed policy makers’ (a k a monetary planners’) meetings and the Soviet political (and economic?) planners’ meetings is that dissenters at the former might merely have their research suppressed (and burned?), whereas the apostates at the latter might be banished or shot after a show trial, then airbrushed out of “official” photographs.

I didn't know much about the politics of the Fed planners' meetings, but I'm a bit surprised that the two discussants seemed almost shocked at the political and bureaucratic infighting shenanigans Easy Al and Volcker got up to.