Pushing Down Interest Rates in a Boom
By Pierre Lemieux
Standard Keynesian theory claims that the government should stimulate the economy during a slump and cool it during a boom. Many objections exist to this interventionism, but there is apparently a new kind of interventionism concocted in the White House: stimulate the economy during a boom. Would this imply slowing it down during a recession?
In Keynesian theory, one way to stimulate the economy is to lower interest rates by increasing the money supply. John Maynard Keynes himself, however, did not trust monetary policy and preferred increasing government expenditures and the budget deficit. Later Keynesians reclaimed monetary policy and the idea of pushing down interest rates during a slump. The current administration apparently wants both higher budget deficits (which it has been achieving with enthusiasm) and lower interest rates. It’s the total Keynes, but at the wrong stage of the cycle: they want stimulus in a context of full employment and an economic boom, which is arguably where the American economy now stands.
Echoing his boss after a Labor Department’s announcement that employment has continued to expand last month, Vice-President Mike Pence declared yesterday (“Pence Doubles Down on Trump’s Call to Turbo-Charge the US Economy,” CNN, May 3, 2019):
The economy is roaring. This is exactly the time not only to not raise interest rates, but we ought to consider cutting them.
Assuming there is some validity in Keynesian remedies, the question is, what will the Fed do when a recession hits and interest rates are already low? Continue to stimulate with still more government deficits and quantitative easing? How long? Until the Fed owns the whole economy? This would be Marx’s revenge.
Note that it is questionable that the Fed can manipulate interest rates, especially long-term rates, at will; on this, see Jeffrey Hummel, “Central Bank Control over Interest Rates: The Myth and the Reality” (Mercatus Working Paper, 2017). Some epistemic and interventionist humility is required.
The White House wizards justify their stimulus desire with the argument that “potential output,” or the production possibility frontier (PPF), has expanded under the adroit economic management of the current president and that, therefore, pushing up interest rates is no longer necessary to cool down the boom. In other words, they claim that the American economy is not at full employment. The Wall Street Journal writes (“White House Escalates Feud With Fed,” March 3, 2019):
White House officials say the administration’s tax cuts and deregulatory moves have expanded the economy’s potential output, meaning there is room to cut rates to boost growth, wages and employment without risking a sharp increase in inflation.
If that were true, prices should be falling. A non-big increase in the price level (what we are now seeing, that is, between 1.5% and 2%) is not the same as a decrease. One could claim that the Fed’s policy has remained expansionary and barely contained deflation. But this looks like a very hypothetical claim.
In the CNN report, Pence says that Trump is “committed to the free market.” Let’s just say that it is not obvious. But if it is true and if it is also true that the PPF has shifted up, why doesn’t the administration simply propose a free-market solution: that the Fed stop trying to interfere with interest rates and instead let markets determine them? A period of expansion is the right time to start such a reform.
This reform would be consistent with the observation that the financial future is always clouded in fundamental uncertainty and that government intervention can only, as it has generally done, increase economic volatility and fuel economic crises. In his short book Finance and Philosophy (Paul Dry Books, 2018), Alex J. Pollock shows how dangerous is the Fed’s power to manage the economy. (I will review the book at Law & Liberty.) But the power taken out of the Fed’s hands should not be transferred to politicos or to other bureaucrats. “Managing the economy” is the problem.
There are many reasons to think that a laissez-faire solution is foreign or simply unknown to the sages in DC. It looks obvious that the only reason for the administration to want further stimulus is to temporarily boost the economy and the electoral prospects of Trump and the Republicans at the cost of future inflation and financial crash, just as Richard Nixon did in the early 1970s.
Nick Timiraos of the Wall Street Journal (“Trump Repeats Calls for Fed to Stimulate Growth,” April 30, 2019) reminded us of the evidence, which is available in many forms on the web:
Before he became president, Mr. Trump repeatedly criticized such bond buying [quantitative easing by the Fed] as a dangerous experiment, and he warned that low interest rates risked inflating financial bubbles. Since entering the White House, however, he has called on the Fed to stop raising rates and to resume its bond-buying program.