Sunday, June 17, 2012

When Judges overextend...

...into matters with which they enjoy no obvious expertise...

Richard Posner (of my glorious Alma Mater) is by all accounts a brilliant judge and a multi-faceted first rate intellectual.  Unfortunately, it is impossible in this world to be an expert on every subject so invariably short-cuts and heuristics to smooth over the premises that lead to suitably brilliant conclusions.

Such is the case with one of Judge Posner's recent posts concerning interest rates and the Fed.  I have included the relevant section with my comments in italics.


"But there are three reasons for doubting that the Federal Reserve’s using its monetary authority to reduce interest rates at this time is a good idea. The obvious ones seem to me weak: that the necessary measures would create serious inflation risk and that they would increase the already enormous federal debt. The rate of inflation is at present very low, and, judging from the interest rate (less than 2 percent) on long-term Treasury securities (for example, 10-year Treasury bonds), is expected to remain low for some years. This expectation is influenced by beliefs about whether the Fed will try to reduce interest rates; but since no one thinks the probability zero, it seems unlikely that the 10-year interest rate would be so low if action by the Fed to reduce interest rates were expected to cause inflation, which of course would raise interest rates. Moreover, as long as interest rates are low, increasing the federal debt is a low-cost proposition. At 2 percent, the annual cost of borrowing $1 trillion is only $200 billion. That is a large number, obviously, but only about half would be borrowed abroad, and $100 billion is a small fraction of the annual federal budget. The half borrowed from Americans would be an internal money transfer rather than a transfer of money abroad. "

Math is wrong...its 20 Billion, not 200 Billion, but whatever.  Again, this talk of "borrowed" needs to be re-thought.  The very concept arrogates the economics of exchange into a derivative of household economics.  With Sovereign Currency Issuers, the "borrowing" is more accurately described at the desire of foreign nationals to net save U.S. financial assets (for the myriad reasons constantly discussed on this blog).  The U.S. government does not need to "borrow" U.S. dollars from anyone.
"The more serious objection to the Fed’s pushing down interest rates is that it probably would have little effect on borrowing, consumption, production, and employment. The reason is that interest rates are already very low, yet borrowing is lackluster. One reason is that, in part because of pressure from regulators, banks have raised their credit standards, so that many individuals and firms, though they would like to borrow and would be willing to pay the current interest rates, cannot persuade banks to lend to them. Another reason is that household savings are still below historic standards because of the depression in housing prices (and as I said a house is the most valuable asset that most households have) and because of continued economic anxiety people want to increase their savings—and savings are the obverse of borrowing. And finally concerns with bank solvency and new federal regulations are inducing banks to increase their cash reserves, which is an example of hoarding rather than spending. "

Banks have raised lending standards because they need to conserve capital in an intensely competitive environment where any false move destroys any retained earnings and brand value they have left.  I agree with the balance of this paragraph.
"If banks are reluctant to lend and consumers to borrow, increasing the supply of money will not lead to a big increase in borrowing. Instead the banks will use the money to buy Treasury securities, which are riskless assets. The money will go in a circle: the Treasury will buy securities from banks, and banks will use the money to buy securities from the Treasury. Or the Treasury will buy securities from nonbank owners of them, who will deposit the proceeds in banks, which will use the additional cash to buy Treasury securities or increase cash reserves. This is an exaggeration, but can help one to see why increasing the money supply need not increase productive activity. "

An increase in the supply of "money" is not happening.  What is happening is swapping zero interest assets (cash) for extremely low interest assets (bonds).  The net effect is near zero and does nothing to stimulate the economy.  This notion of the "money supply" increasing is following false assertions that only "cash" is "money" in a fiat currency system with a massive and liquid bond market.  Ask yourself, dear reader, what is the difference between cash and a Treasury but for the tiny bid/ask spread to complete the transaction (which nicely offsets the interest spread of cash and Treasury assets in the first place).  This whole "money supply" notion should be re-thought when a zero-interest rate policy in emplaced.  I agree its circular, but its akin to the circularities of Copernicus and Kepler...yeah, they are similar, but the dissimilarities explain everything.
"The idea that increasing the supply of money must stimulate economic activity, though mistakenly thought to be an idea of Keynes’s, is actually an echo of “Say’s Law,” which Keynes famously attacked, though he was not the first economist to do so. Say’s Law, rather confusingly paraphrased as supply creates its own demand, treats money as a medium of exchange and a standard of value, but nothing more. This is essentially a barter theory of the economy. But modern economies are not barter economists. In a modern economy, receiving money in exchange for some good or service doesn’t dictate that you exchange the money forthwith for some other good or service. You can save the money indefinitely. If you put it under your mattress, it makes no contribution to productive activity. Similarly, money can pile up in Federal Reserve Banks if people are disinclined to spend, without contributing to economic activity. "

I have no idea how we go from supply creating its own demand to stating it (whatever "it" is) is "essentially a barter system".  The point of this exercise is that Judge Posner has the correct conclusion from entirely wrong premises...and would benefit from expanding his grasp of just what is a fiat currency system and how it completely changes the game.

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