Imagine that
we had national policymakers in charge of cancer. Imagine also that when you
said you thought you had a specific type of cancer, the policymaker--without
knowing anything about chemistry or biology--decided to give you advice about
curing your cancer. Perhaps you should take a vacation to Sanibel Island. Or
maybe you should instead lie on a bed of sharp objects. While you might like an
excuse to go to Sanibel Island, you still might be leery and ask your best friend,
what does this policymaker know about cancer? Really?
Sounds
stupid and far-fetched? Maybe, but that’s how I feel about what I have been reading
with respect to recent economic policy discussions. Two issues come to mind from the
business news lately. First is the idea that the US Fed must follow what
foreign central banks are doing. If the Bank of Japan or the European Central
Bank decides to reduce interest rates, then of course, the Fed must too. It has
no other recourse. It must follow.
Second is the idea that if the inflation
rate in the USA is below some pre-ordained rate, say 2%, then of course the USA
Fed must reduce interest rates as a means to prop up inflation. Heaven forbid
we should have an inflation rate of below 2% in Alaska or Atlanta. If inflation is too low, then the Fed must attend to raising it.
This is what
we are reading today, and serious economists and policymakers repeat these
mantras daily. But where do they get this crap from? Clearly they don’t get it
from economics textbooks. The common thread among the two examples above is the
immediate conclusion that government policy is the first line of defense for all economic problems. While
economics does allow for a role for economic policy, economics ALWAYS teaches us
about cause and effect and brings policy in only when basic economic forces are
somehow missing. Economic policy is the last resort. Economic policy is called
upon when basic economic factors don't resolve the problem.
What is this
basic economics? Simply put, it is all about supply and demand and how they come
to impact price and quantity. Each semester, we teach hordes of freshmen and grad students this stuff. On the white board or
classroom screen, it looks pretty abstract and when we put it into math models
it looks even crazier. But the formalization of economics is the result of
observing behaviors of customers and providers in real markets. Formalization
perhaps overdoes each particular situation, but the formalization captures the
interplay of important themes.
Consider a
market in which demand greatly exceeds supply. Without naming any specific good
or service, our mind envisions a time when it is not easy to find that good. It
might be that the scarcity allows firms to charge higher prices for that
good. But that is not the end of the story. Economics suggests that the scarcity
and the rising prices creates the incentives for firms to bring more of that
good to the market. It might take a while to make that happen but the
incentives are there.
Thus scarcity comes and goes and economics explains why.
Notice that the basic economics does not immediately conclude that the
government must provide the extra goods that are wanted. It does not suggest a business
tax cut to create incentives for producers to create more of it. Adam Smith talked about an invisible hand, by which he meant that you don’t need the ever visible hand of the government
to solve all divergences of supply and demand.
Economists
take the economics one more step. We believe that when markets are not free it
might take some assistance from the government to overcome a market failure. But
notice that the focus of economics is on a specific failure for government to
address – it does not require a government that is everywhere and always
solving problems.
Isn’t
economic theory fun?
Back to my
two spouts for the day. If the ECB reduces interest rates, then the Fed must do
so too. What? If the ECB reduces interest rates then people will want
to invest money at higher interest rates in the USA. But the very act of all
those folks wanting to buy US assets causes US asset prices to rise and US interest rates to fall. We call that a market result. If the EU drives down
their rates, our rates in the USA fall too – and the Fed doesn’t have to do a thing.
It's just economics. The dollar/euro exchange rate might be affected in the
interim but once the interest rates equalize the exchange rate goes back to
its previous level.
How about
the idea that the Fed has to push up the inflation
rate. Inflation is too low so the Fed must increase it. Really? What about
the idea that if goods and services become cheaper in the USA this might affect
where people buy goods and services. Better priced items in the USA should divert
spending or demand away from other countries and into the USA. That
diversion of demand would cause the USA inflation rate to rise. Notice—the Fed
doesn’t need to do it.
If the Fed is
pretty sure that inflation is not behaving and is causing real problems then it
should ask why. Why is inflation low? Why is it stubbornly low? Maybe there is
a reason that requires a Fed policy. Maybe the reason requires some other
policy.
I am not
saying that government should never intervene into economic markets. I am saying
that government intervention is never the first thing to ponder. Economics can
be helpful but not if politics is always the primary goal of policymakers. Sad
that we seem to put the cart before the horse these days.
Dear LSD. I had to dive a little deep to recover vague memories of your involvement in Vietnam advising them on their central bank (kerrect-0-mundo?). Diving deeper I found another vague recollection of you saying the Fed is needed after I suggested its history is not all that rosy and maybe not needed. Today you seem partial to letting market forces kerect a specific failure and then maybe—maybe—the govomit should act. Seemz yer suggesting an optimal market force/Fed action combo that would result in homeostasis. Remindz me of chasing the elusive butterfly.
ReplyDeleteWhat if the Fed decided to take a permanent dirt nappy-nap? What do you think would happen to inflation, employment levels, interest rates, the money supply, etc.? Not look’n fer a specific two-handed answer but in general would the U.S. survive? Should Adam Smith jump on your wooden high horsey horse wid you and with his invisible hand provide some guidance?
Homeostasis is a big word for a Tuna. Yes I spent some time in Hanoi lecturing the folks in the central bank about central bank policy. That was a hoot!
DeleteAs a sort of moderate person I acknowledge that with any sort of government policy, there might be circumstances when markets might not produce the best outcomes and so I recognize it often takes a one-two punch with private and public sectors dealing with problems. Not an elusive butterfly. To me it is a practical outcome. Sort of like you reading the map while Diane drives. The Fed cannot take a permanent nap. We need to have a central bank. The issue is about how active you want it to be. Do you want it to try to swat every fly or to just wait for the fat juicy ones? Milton Friedman wanted to replace the Fed with a computer that basically let the money supply grow by X% per year. That could work. We could survive that. But its hard to win elections with a Fed like that. And if we got a major recession, they's probably kill the computer and start dishing out the moolah. Is that too wishy washy for you dear Tuna?
Not too wishy-washy . . . the visibility your sentimental wishy-washy water for the Fed is quite clear—as in bathtub gin clear. You want it ‘round to make sure the economic ship is not swamped by a recession or inflation tsunami . . . implying (hoping?) the Fed navigator can keep the ship righted. Given the Fed will be ‘round for at least our lifetimes it’s academic/debatable whether the Fed with all its wise men and ladies can keep the ship off reefs and shoals with a one-two accurate punch of market/Fed action combo so as not to under/over correct. As I sed before the Fed don’t got a rosy history. So, at best we’ll have to cast our fates to the wind . . . or tsunami . . . and see if the Fed navigator can fine-tune the ship’s course.
DeleteHave you got your life boat ready and provisioned with sufficient JD?
Just bought a new bottle of JD today. I think maybe you read between the lines or maybe I write like crap. Anyway, I am always on the side of less Fed intervention. While I think they should act as a lender of LAST RESORT as in a great depression or recession -- I always dislike when they try to fine tune economic growth. It is the pols who love it when the Fed fools around and tries to act like a hero. As you said, their mistakes greatly outweigh any incidental benefits they might have created for a moment here or there.
DeleteHorses and carts
ReplyDeleteResponse to Larry Davidson.. August 20th. 2019
From Korcula Croatia.
Being a simple minded engineer I am always in thrall of Professor Davidson’s economic diatribes! Not that I understand much about economics which is why I look forward to Uncle Larry’s annual arrival on Sanibel the better to expand my intellectual horizons. In my profession a macro engineer would build Pyramids while a micro engineer might make watches.
Likewise I imagine that a macro Economist is much larger (I won’t use the word corpulent) and probably deals with large piles of money as opposed to the micro economist who is much smaller, more nimble and engaged in activities like shaving the penny in your daily interest allocation back to the nearest whole number…saving the shavings so to speak.
But back to the current dilemma, this Horse and Cart business has me a little perplexed. Growing up in Jolly Old England and in silly Suffolk as the locals say, there was a huge beast called a Suffolk Punch which we young striplings were told was a “Cart Horse”…note that the Cart at least in silly Suffolk comes before the Horse. Make no mistake these carthorses are huge, every bit the size of their Scottish cousins the Clydesdales which spend their lives all dressed up in fine livery dragging barrels of Budweiser all over America. Your observant readers will no doubt have got the point that in the case of the Clydesdale carthorses, the Horse goes before the Cart. One might be forgiven for calling them ‘HorseCarts’ but that might confuse your sports oriented readers from New York who like to bet on the Trotters… but there’s barely room for a diminutive jockey in those horsecarts let alone a Barrel of Budweiser!
Well not to worry, the good news is that at least so far the government hasn’t put the Horse IN the Cart… at least not yet… that would really put the cat among the pigeons. My advice is let sleeping dogs lie and don’t let the cat out of the bag lest it get among the pigeons.
Cheers
Harvey H Homitz
(With help from a bottle of fine Croatian wine)
Croatian wine is good and I can see that you are well into it. I very much miss our times of saving the world at the Office and other such places on Sanibel. I hope to see you all before one of us croaks but living on the Left Coast makes travel a bit more challenging. Perhaps I can find a horsecart to bring me back.
DeleteDearest Doober: I agree with what you say. I have no libertarian tendencies, but the idea that economic policy is made by those who know less economics that those who took Art Benavie's ECON 101 Macro class is insanity. Maybe those students knew so much because you were the TA. Thanks for everything
ReplyDeleteI never said those government types know less. I said that they have swallowed the Kool-Aid that they must replace the Lone Ranger whose job was to save us from the bad guys. Instead of waiting until we really need help -- the Fed and the Pols have a hair trigger and are ready to save us minute by minute. Government policy should be the last not the first resort.
Delete