Thursday, June 28, 2012

When Zero Rates Don't Work

Frederick J. Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession  (McGraw-Hill, 2009) and "The Coming Collapse of the Municipal Bond Market" (, 2009)

Jon Hilsenrath, the Wall Street Journal's ferret at the Fed, reports what the Federal Reserve wants the public to know while retaining anonymity. He found the professors in a stew. In the June 19, 2012, edition, Hilsenrath disclosed: "Fed officials have been frustrated in the past year that low interest rate policies haven't reached enough Americans to spur stronger growth, the way economics textbooks say low rates should. By reducing interest rates-the cost of credit-the Fed encourages household spending, business investment and hiring, in addition to reducing the burden of past debts. But the economy hasn't been working according to script."

Since the professors wrote the textbooks, Fed headquarters is not a source of economic inspiration. Textbooks in the U.S. are the monopoly of Bernanke, Romer, Mishkin and a few other cross-pollinated primates.

Notable in Federal Reserve Chairman Ben Bernanke's Essays on the Great Depression is its inbreeding. The professor is unsparing in his praise of such contemporaries as Romer, Mishkin, and of course, devoted to Friedman and Schwartz. He neglects earlier economists who might have modified the certainty of his negative real interest rate policy.

There were many prominent economists - two, three, and four generations ago - who warned that low- and lower- and zero-percent interest rates may fail to waken an economy. Bank reserves may sit in the bank. That's that.

This happened in the Great One. It was obvious by the mid-1930s there was little appetite for lending or borrowing, even with interest rates below one percent. If ever the phrase "it takes two to tango" fits, here we are. A loan includes two parties: a lender and a borrower. Reading Hilsenrath's article, the stalagmites in the Eccles Building only think about the lack of lending. The possibility that credit-worthy customers do not want to borrow is apparently negligible.

By 1934-1935 the domestic banking system had become saturated with idle cash. So notes David Stockman, former director of the Office of Management and Budget under President Reagan, in the draft of his future book: The Great Deformation: How Crony Capitalism Corrupted Free Markets and Democracy. Stockman writes that excess bank reserves at the Fed rose from $2.7 billion in 1933 to $11.7 billion by 1939. These fallow dollars remained sterile, like Grandpa Joad's farm. They accounted for 75% of the Fed's balance-sheet growth during the period.

            Bernanke has entirely ignored earlier scholarship, but it may be of interest to readers:

In 1910, William Beveridge (of the 1942 Beveridge Report) wrote:

"Clearly a mere offer of cheap money does not suffice; banks at times of depression may go on offering cheap money for months or even years together before any recovery happens."

-- William Beveridge, Unemployment: A Problem of Industry, Longman, Green and Co. (1910)

In 1926, Dennis Robertson:

            "...while there is always some rate of interest which will check an eager borrower, there may be no rate of money interest in excess of zero which will stimulate an unwilling one."

Robertson also wrote:

"...those theorists are right who have found cause of 'crises' in a 'deficiency of capital.' But what is deficient is not money, otherwise the situation could be cured, as all experience shows it cannot, by continued inflation."

            -- Dennis Robertson, Banking Policy and the Price Level, King, 1926

In 1936, Wilhelm Ropke:

"The American experiences have amply verified the surmise that even an interest rate which approaches zero may be induce entrepreneurs to enter upon new investment."

            --Wilhelm Ropke, Crises and Cycles, William Hodge & Company, Limited, 1936

In 1937, C.A. Phillips, T.F. McManus and R.W. Nelson:

"[W]e have witnessed for four years and more a policy of deficit borrowing which has forced Government bonds on the banks and has created new credits to such an extent that the demand deposits of the Federal Reserve System are now higher than they were in 1929 ($16,324 million on June 29, 1929, $19,161 million on March 1936); and for almost five years we have experienced excessively low rates of interest for short-term capital coincidentally with unprecedented excess reserves in the banking system; both conditions indicate that the basic immediate need is not for more credit, but rather that conditions in the investment market are still such that extensive long-term investment is not being made."

Also from the trio:

"What is to be desired is a greater use of bank credit now in existence rather than a greater absolute volume of credit....The total volume of bank deposits now in existence is in excess of the 1920 total ($51,335 millions of deposits [exclusive of interbank deposits] on June 30, 1936, as against $37,721 million in June, 1920), yet the price level and the cost of living are both below the levels prevailing in 1920-1921. Between December 30, 1933, and December 31, 1935, total deposits [exclusive of interbank deposits] increased by $10,459 million, or at a rate of $100 million a week."

--Banking and the Business Cycle, 1937

            The reader may note a common theme in the titles to these books, "banking" and "cycles" recurring. This suggests why Bernanke & Co. may remain detached from such tomes. They do not believe in cycles. If bad things happen, the intruders are thwarted by good policy. That the policy is "good" is assumed. (I am not making this up.)
In 1937 (probably: this is from the 1946 edition), Gottfried Haberler:

"During a depression, loans are liquidated and gradually money flows back from circulation into the reserves of banks....Interest is by this time fallen to an abnormally low level; but, with prices sagging and with a prevalence of pessimism, it may be that even an exceedingly low level of interest rates will not stimulate people to borrow."

            -- Gottfried Haberler, Prosperity and Depression: A Theoretical Analysis of Cyclical Movements, United Nations, 1946.

            Haberler discussed Ralph Hawtrey, who changed his mind. Hawtrey's shift is mentioned since there is an inverse relationship between one's status (regardless of whether we are discussing economists, biologists, or motor mechanics) and the willingness to admit one's error. Hats off to Hawtrey:

"Mr. R.W. Hawtrey is confident that eventually, if only the purchases of securities are carried far enough [and, by implication, interest rates are low enough - FJS] the new money will find an outlet into circulation, consumers' income and outlay will begin to rise, and a self-reinforcing process of expansion will be started."

Haberler wrote of Hawtrey's maturation: "In more recent publications, under the impression of the slump of the nineteen-thirties, Mr. Hawtrey has modified his views to some extent. He still believes that 'a failure of cheap money to stimulate revival' is 'a rare occurrence' but he admits that since 1930, it has come to plague the world and has confronted us with problems which have threatened the fabric of civilization with destruction."

As Bernanke would say: "et cetera, et cetera." (See: The Professor Who Did Not Save the World)