Changing places with Europe
By Scott Sumner
During 2008-09, both the US and the Eurozone had deep recessions, with the Eurozone experiencing an especially sharp fall in NGDP growth. In both areas, the central bank should have cut rates into negative territory, but neither bank did so (at the time).
Even so, there were clear differences in the response of the two central banks. The Fed reduced rates more aggressively (relative to the natural rate), and also did QE much earlier than the ECB. Some ECB officials were critical of the Fed’s aggressive response, and preferred a more conservative approach. This comparison represents an interesting case study. What would you have expected in each region?
In the late 1990s, Milton Friedman told us what he would have expected. Friedman argued that the ultra low interest rates in Japan were a sign that money had actually been quite restrictive in the past:
Low interest rates are generally a sign that money has been tight, as in Japan; high interest rates, that money has been easy.
. . .
After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die.
The Europeans thought Friedman was wrong. Let’s see how each view holds up, a decade after the 2008-09 recession. If Friedman was right, then the tighter monetary policy in the Eurozone (which was initially associated with higher interest rates) would eventually lead to lower interest rates than in America. And that’s exactly what happened:
(Ben Bernanke must smile every time he sees this graph, thinking about the criticism he got back in 2009.)
Hardly a day goes by where I do not encounter at least one article that misunderstands this basic point. Thus a recent Bloomberg article on Fed policy and inequality is based on the premise that low interest rates represent an expansionary monetary policy:
If the recession-fighting techniques of the last decade are responsible for widening inequality, central banks will need a new set of tools soon or risk not only widening the wealth gap but also eroding confidence in their ability to set monetary policy. And there is emerging evidence that could be the case.
A new paper from economists Ernest Liu, Atif Mian and Amir Sufi suggests the reason the recession didn’t put a dent in inequality may very well be the Fed’s fault. Low interest rates, particularly when they get to close to zero, tend to increase inequality, even as they revive the economy, the economists argue.
In the short term that can be true. But inequality is a long-term problem, and the long run correlation between the stance of monetary policy and interest rates is exactly the opposite of the short run correlation.
If you are worried that low interest rates worsen inequality (I don’t believe they do so), then you should favor an easy money policy during recessions, as in the long run this will lead to higher interest rates. A tight money policy will leave rates close to zero for decades on end, as we’ve seen in Japan and are beginning to see in Europe.
I also question the claim that low interest rates lead to higher inequality, as that is an example of reasoning from a price change. Low rates might be caused by a deep depression, as in the 1930s. In that case, inequality fell sharply. Alternatively, low rates might reflect a long-term decline in the natural rate of interest, as we’ve seen since 1980. In that case, it may lead to higher asset prices and more inequality. In neither case did the change in rates reflect the short run impact of monetary policy.
If rates are reduced as part of an easy money policy (the so-called “liquidity effect”) then it tends to helps those at the top (stock investors) and also those at the bottom (the unemployed) and hurts some of those in the middle with secure jobs (teachers, nurses, etc.) Overall, most people are probably helped by an easy money policy adopted during a recession, regardless of the impact on inequality. But those are merely short run effects.
In any case, inequality is a long-term issue that is unaffected by monetary policy, which is neutral in the long run. Confusing the secular decline in the natural rate of interest since 1980 with “easy money” will lead to bad monetary policy in the future, hurting those at the bottom of society. Even worse, a relatively tight money policy won’t even deliver the higher interest rates that its proponents assume it will produce. Just look at Europe.
HT: Stephen Kirchner