Wednesday, July 12, 2017

In the Idiocy of Kevin Warsh: More Evidence for the 'Self-Induced Paralysis' Thesis

I believe it is clear that the main reason the economy has been growing slowly since the financial crisis is overly tight monetary policy. Inflation has been chronically low. The unemployment rate now admittedly looks good, but this is primarily due to workers leaving the labor force. The employment rate has not recovered, as can be seen below. Certainly, things are improving, and things will look better if you limit to prime-age adults, but then again, you could argue that the prime-age employment rate numbers might look better than usual due to baby boomer retirement. Wage growth is also slow, pointing to a still-weak labor market, nearly 10 years after the recession began. And, yet, despite that, the Fed has taken five consecutive tightening actions in terms of ending QE and raising interest rates. The result of this has surely been to help keep inflation below target and GDP growth below its long-run level.

In particular, look at the above graph in 2009, when the Fed adopted no new stimulus despite headline deflation and mass job losses, on net (in terms of rates or asset purchases, forward guidance was done), or in 2010, when the Fed raised the discount rate. What on Earth could they have been thinking?

Despite this logic, I suspect that many economists have a deep respect for Ben Bernanke, who I also like and respect, even if I disagree with him on some things, and thus wonder how he could have gotten things so wrong. Part of the answer might be that Ben Bernanke, ever a consensus builder, would have liked to do more, but was also constrained by other members of the FOMC. Sam Bell provides some evidence for this in a can't miss article on Kevin Warsh, who now appears to be a front-runner for the Fed Chair job, who was still worried about inflation pressures even after Lehman Brothers failed in 2008.

First, Bell notes that Warsh is a lawyer by training, who was only appointed to the Fed at age 35 with a light resume after his father-in-law, Ronald Lauder, heir to the Estée Lauder fortune and apparently a confidant of Donald Trump, likely influenced his selection with donations.

Even as the economy was tanking in 2008 and 2009, Bell writes that "Warsh adopted a skeptical and increasingly oppositional posture. He doubted the Fed could do much good without creating much bigger problems."

Much bigger problems? What could be a bigger problem than letting the economy burn in a financial crisis?
"In March 2009 he told his Fed colleagues that he was “quite uncomfortable with the idea of purchasing long-term Treasuries in size” because “if the Fed is perceived to be monetizing debt and serving as a buyer of last resort in the name of lowering risk-free rates, we could end up with higher rates and less credibility as a central bank.”"
The Fed should hold off on more stimulus in the worst recession in 75 years because it might actually end up with higher rates and lose credibility? Why wouldn't the Fed lose credibility if it was perceived as not fighting the recession? Warsh continued to warn about the dangers of both monetary and fiscal stimulus in 2010.

Warsh was also far and away not the only crazy one at the Fed at that time. In 2011, when I worked as a Staff Economist at the President's Council of Economic Advisors, I had a conversation with Daniel Tarullo, who told me he believed that Jean-Claude Trichet's interest rate hikes in 2010 -- which are widely seen to have been premature and to have helped ignite the European Debt Crisis -- were justified. These comments suggested to me that Tarullo was somewhere to the right of Genghis Khan on monetary policy. Then, there were also worthies like Richard Fisher, Often Wrong but Seldom Boring, who "warned throughout most of 2008 that inflation was the primary danger to the economy". 

And that, my friends, is how the Tea Party was born.

The other thing to note about the FOMC is that it's a job most people seem to not want to do for very long. It's a revolving door. Most people will do it for 4-5 years, and then quit for greener pastures, as it is not a job that pays that much, particularly by the pornographic standards of finance and banking. Even top university professors can make much more. It's a mix of people who are politically connected, bankers, and academic macroeconomists. And even the latter group can be a mixed bag. And, despite this, (or, should I say, in part because it is a revolving door) the Obama administration never took its appointments seriously. They left in place an FOMC made up mostly of Republicans, including staunch white male MBA-holding Republicans raised in the south in the 1960s. Obama's economic advisors apparently did not see this as potentially problematic.

And, then we had Bernanke, who apparently still holds the view that economic growth in the US economy is still more-or-less OK. In 2011, I also had a conversation with Ben Bernanke. I saw as soon as I began talking to him that he figured I would criticize him for QE, or inciting hyperinflation with all this money printing. He was actually surprised when I asked him why he wasn't doing more, given that core inflation at the time was running around 1.4%. His response is that higher inflation wasn't costless. But I didn't see how inflation of 2% vs. 1.4% would be as costly as millions of people out of work. It seems, few people at the Fed were trying to influence him in the direction of doing more.

What all of this evidence does is make the thesis of "Self-Induced Paralysis", that the major problem with the US economy is overly tight monetary policy, more plausible. You had the competent, but cautious Bernanke who likely wanted some more stimulus, but was surrounded by a group of idiots concerned about inflation in 2008. And, even Bernanke himself clearly seems to be in a state of denial about US growth prospects. The reality is that the people who controlled monetary policy since 2009 are a mix of those who believed hyperinflation was just around the corner, those who believed monetary stimulus in a severe recession would do more harm than good, and on the dovish side a Chairman who hasn't noticed that the US economy that, since 2008, has consistently been growing slower than it used to.

In any case, let's return to Kevin Warsh for a minute. How bad would he be as Fed Chair? Likely a disaster. Certainly a disaster on regulation, and likely also a disaster on monetary policy. The only catch here is that he will be a perfect Fed Chair for Trump, as he'll be a yes-man Trump can control 100%. Although Trump sounded hawkish on monetary policy on the campaign trail, I always imagined he would eventually change his tune as President -- particularly once the election is on and he realizes the Fed can deliver faster growth. Thus, he could, in fact, adopt looser monetary policy and pave the way for a second term for Trump. Or, he could be the Kevin Warsh he was during the Financial Crisis, and continue the Yellen tradition of slightly-too tight policy. I think we won't know the answer to this until it happens, although I would probably put higher odds on the latter.

Note: you can follow me on twitter @TradeandMoney


  1. Excellent discussion. Your opening paragraph perfectly captures my view of the state of the labor market and the role of monetary policy. Of course the real point of this discussion is how badly Kevin Warsh got everything - as well as how he came to have his position. I guess this means he is Trump's perfect choice for FED chair. Sad.

    1. Thanks. I'm also a fan of your blog, which I've added to the Blog list at right...

  2. The Fed can do damage if they raise rate too much.
    However, if they put rates back to 2010 levels, would the economy boom?
    Since 2008, there has been a massive transfer of wealth from those who spend all they earn (and save almost nothing) to the wealthy who save or invest a good portion of what they earn. This has led to slack demand for goods and services and as a result our economy is demand constrained not supply constrained.
    In an economy constrained by supply, lowering interest rates can stimulate investments in production of more goods and services to meet demand.
    In an economy with slack demand, lowering interest rates does not encourage expansion if demand can be supplied from existing capacity.
    Traditional monetary policy which stimulates investment and supply will have only weak effects in an economy with slack demand. Fiscal and regulatory policy designed to create more demand will have a much stronger effect. Our economic policy problems are primarily fiscal and regulatory in nature. Monetary policy is accommodating compared with past history but is only weakly affecting the economy.
    - jonny bakho

    1. Interesting comments.

      The answer to the first question is that if the Fed were to cut interest rates from 1-1.25 all the way to zero tomorrow, I think for sure you'd see the dollar drop like a rock, and the stock market have a big day, and bond yields fall at all maturities. The economy is certainly growing already, so even I doubt that the economy necessarily needs that much stimulus to hit 3% growth. If it wanted, of course, the Fed could go negative on interest rates, and it could do plenty more QE.

      I agree that in severe recessions, fiscal policy is likely to be more helpful than monetary policy. But I think the evidence shows that monetary policy can still be effective even then. It affects the exchange rate, for sure, and the US manufacturing sector does appear to be fairly sensitive to the exchange rate, for example.

  3. "I believe it is clear that the main reason the economy has been growing slowly since the financial crisis is overly tight monetary policy."

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  5. "the main reason the economy has been growing slowly since the financial crisis is overly tight monetary policy"

    You're stupid too. AD = M*Vt (where N-gDp is a proxy). Vt falls as more savings are ensconced and impounded within the framework of the payment's system. DFIs do not loan out existing deposits saved or otherwise. Unless savings are expeditiously activated and put back to work a dampening economic impacted is persistently exerted. The only way to activate savings is for the saver-holder to spend/invest directly, or indirectly via non-bank conduits. This is the sole cause of stagflation and secular strangulation period.

    All savings originate within the payment's system. Savers never transfer their savings outside the system unless they hoard currency or convert to other National currencies. All bank-held savings are lost to both consumption and investment. Bankrupt u Bernanke is wrong. Money is not fungible. One $ is not like any other. Money is robust not neutral.

    1. "Stagflation and secular stagnation period". Have you had a look at inflation statistics recently?

      QE announcements do seem to affect various asset markets -- bonds, stocks, and foreign exchange -- in ways consistent with it working. Even if you don't like QE, there are plenty of other options central banks have in a liquidity trap. I'd also have liked to see more fiscal policy used, but the Fed could have done much more from 2008-present.


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