"Should the Fed raise interest rates?"

Willem Buiter, the London School of Economics political economy professor who blogs at the Financial Times, asks the provocative question in the headline above, and after a very length discussion, that they probably shouldn’t yet, but they most assuredly should not cut rates.

But what is more interesting about this post, and I’ve excerpted those sections, is Buiter’s stinging attack on the excessive weight given to protecting financial institutions, and on the Fed’s disfunctional communications strategy and decision-making processes.

Buiter’s discussion of the merits of a rate raise is a mixed bag, a case study of how someone too rooted in theory can sometimes fail to connect the dots.

His post starts off well:

The US economy grew at an unsustainable 4.9 percent rate in the third quarter of 2007, which includes almost two months since the ‘official’ start of the financial crisis on August 9. Admittedly almost a full percentage worth of this growth was inventory accumulation. If his was unplanned, it may predict future planned inventory decumulation. Even 3.9 percent GDP growth, though, is still well above the Fed’s estimate of the growth rate of US potential output …

It’s true that the US housing market is a little shop of horrors, with further horrors to come…Domestic inflationary pressures coming from a growing output gap are reinforced by the decline in the US dollar and the increase in the dollar price of oil and gas….

The rising inflationary pressures are reflected in elevated inflation expectations. On Thursday November 29, US break even inflation (calculated from nominal and index-linked bond yields) were 2.32 at a 2-year horizon and 2.51 at a twenty-year maturity.

He goes into a grating discussion. Buiter asserts that the fall in housing values will have no effect on wealth. Tell that to the editorial pages of the Wall Street Journal, which have used apprecaiting house prices and the state of the consumer balance sheet to argue that the low US savings rate is fine, since housing price gains are a form of saving. His view assumes that “house ownership” comes in only one size and has a stable relationship to rentals. Neither is true. Homeowners can trade out of appreciated houses into smaller ones in the same market or cheaper houses in markets showing lower gains. Similarly, some markets, particularly San Francisco, have exhibited ownership cost on recent purchases greatly in excess of rentals. He does acknowledge, though, that lower housing prices mean less collateral for borrowings that support consumer spending.

But then we get to the fun bit. It’s hard to know whether Buiter believes everything he is saying, or is deliberately overstating his case to shake up the hidebound:

Judging from the noise, moans and calls for policy relief coming from the financial sector, one could be forgiven for believing that the end of the world is neigh. It’s not. There used to be a time when most financial institutions were intermediating directly between the ultimate private spending units in the economy – households and non-financial corporations. Most financial markets also had either households (or their direct representatives – institutional investors like pension funds or insurance companies) or non-financial corporates or the state as participants. No longer. Many, perhaps most, financial institutions are involved only very indirectly and peripherally with the intermediation between ultimate savers and ultimate investors or with the management of portfolios of ‘outside’ assets. Their counterparties are other financial institutions. Both sides of their balance sheets include mainly ‘inside’ financial instruments.

This layering or pyramiding of financial institutions and the explosion of new financial instruments created by them was to a significant degree driven by the twin motives of regulatory avoidance and tax avoidance. Part of it reflected genuine institutional and technical innovation not driven by regulatory and tax efficiency. This may well have contributed to more efficient risk trading during normal times and under orderly market conditions. These developments also make abnormal times and disorderly market conditions more likely and the associated financial crises deeper. The failure of regulators to keep up with the proliferation of instruments and institutions, the lack of transparency of many of the new instruments and institutions (negligible reporting obligations, mysterious governance practices) has reinforced the periodic eruptions of euphoria and hubris that are inherent in financial capitalism.

The good news in all this is that much of the financial sector has become quite detached from the real economy. The implosion of much of this formerly privately profitable but never socially productive financial intermediation will have little if any adverse macroeconomic effect. Many, perhaps most, financial institutions today are engaged in a gigantic, worldwide game of musical chairs in which vast fortunes are won and lost every day, but nothing of macroeconomic significance happens. Much recent financial intermediation amounts to the creation of vast artificial lotteries that are used not to hedge previously unhedgeable and non-diversifiable fundamental risk, but rather to allow the taking of larger unhedged positions by speculators with more resources (mostly other people’s money) than sense. Imagine, for instance, a world without hedge funds, SIVs and conduits. That world would be somewhat more stable and transparent than the one we have now, but not significantly different.

All the Sturm und Drang in the financial sector today only matters from a macroeconomic perspective, if it has a material effect on household consumption and on household and corporate investment. In my view, rather little of it does.

I’m as big a fan as anyone of moral hazard and letting financial miscreants fail, but one has to wonder what Buiter is smoking. His belief in the disconnect between the financial markets and the real economy is allegedly proven by the robust 3rd quarter GDP stats, but I am not alone in taking them with a handful of salt.

Unfortunately, precisely due to the power of the markets, corporation have kept profits high rather than sharing the gains of growth with labor via hiring increases and pay rises, as in every other previous postwar expansion. Instead, consumers have gotten ever-more hooked on debt, which ties their fate more closely to the health of asset and debt markets.

I wish we could let entire sectors of the financial services industry go up in flames. The Fed is way way too afraid of letting there be financial failures. Had Countrywide been allowed to fail, and had England had a proper deposit insurance regime in place so it could let Northern Rock collapse, we’d all be better off now. You wouldn’t see institutions like Citi going to the officialdom for support, which is an admission of serious weakness. Instead, they’d tough it out if they could at all for fear of provoking an adverse market reaction.

Back to Buiter:

Throughout the crisis, the Fed’s communication policy with the markets has been atrocious. My fear is that this communication policy mess reflects a deeper confusion/disagreement in the Fed about how to respond to the crisis, and about both the ultimate and the proximate objectives of monetary policy.

The speeches by Vice Chairman Donald L. Kohn on November 28 and by Chairman Ben S. Bernanke on November 29 had as their sole purpose to clean up the mess left by careless speeches earlier in November by assorted FOMC members who had left the impression that it would take a miracle (or a disaster) for the Fed to cut rates at the December 11 meeting. The self-evident superiority of a strategy where FOMC members say nothing in public that in anyway anticipates future Fed rate decisions has obviously not occurred to anyone. The Fed’s monetary policy actions (decisions on the Federal Funds target rate) and its liquidity policy actions (decisions on the discount rate, on eligible discount window collateral policy, on eligible discount window counterparties and on its open market operations, both through repos and through outright purchases) speak louder than any words. The written statements released following FOMC meetings and other policy actions fill the rest of the information gap. Anything else is, at best, cheap talk. At worst, it confuses the markets and puts the Fed in the awkward position it has found itself in so many times recently. Too often, ambiguous signals extracted from unnecessary speeches by FOMC members force the Fed to choose between appearing to be a captive of the markets (by validating the markets’ expectations – which tend to be very close to the markets’ wishes – regardless of whether these expectations make any sense) or appearing to be desperate to re-establish its operational independence and room for manoevre by deliberately surprising the markets – ‘teaching them a lesson’.

I’ve been stunned by the Fed’s failure to communicate effectively; it seems Greenspan’s opaqueness has been misconstrued as a virtue. But Buiter is correct; past Fed chairmen and presidents have been more taciturn. Perhaps my memory is faulty, but I can’t recall Volcker tipping his hand during his nerve-wracking monetary supply clampdown. But everyone on Wall Street stopped cold on Thursday at 4:00 PM to get the weekly monetary supply figures. That told them what they needed to know about Fed policy.

Buiter again:

There obviously are deeper divisions among the Board members and in the FOMC as a whole, than I have ever witnessed before. The Vice Chairman, Kohn, is an unreconstructed anti-inflation targeting old-style dual mandate man. Mishkin believes in inflation targeting and appears to be genuinely convinced of the merits of the dual mandate. Bernanke is an inflation targeter who can live with the dual mandate, but only because he believes that the best, or even the only possible, way to stabilise the real economy is to pursue a low and stable rate of inflation in the medium term. Several of the Regional Fed Governors only pay lip service to the dual mandate and are lexicographic price stability targeters at heart. Janet Yellen, however, is a committed dual mandate proponent.

What is equally striking as the disagreement about the operational mandate is the fear of the financial markets among key Board members, regardless of their view on the Fed’s mandate. They fear a large fall in the stock market; they fear financial market turmoil; and they can be moved to cut rates if there is a sufficient crescendo of anguished voices from the financial markets and money centre banks. We all know that the Great Depression of the 1930s started with a stock market collapse and was aggravated by bank runs and a misguided monetary policy. The collapse of the multilateral trading system was the final nail in the coffin. Perhaps our central bankers have studied the 1930s too much.


Financial markets and private financial institutions deserve the attention of the policy makers. They are an important part of the transmission mechanism of monetary policy and an important source of shocks that could have implications for systemic stability; the information conveyed by asset prices and other market indicators must be monitored carefully and interpreted thoughtfully. But they only matter to the extent that they impact on the real economy. Today’s overgrown, bloated and highly vocal financial markets and institutions are getting more attention than they deserve.

The Fed and other US policy makers appear to be constitutionally incapable of taking the long view. Instead they are flailing about in a desperate attempt to minimize any short-run economic pain. By doing this, they also prevent necessary and unavoidable medium-term and long-term adjustment. This institutionalisation of myopia and resistance to change may well be an accurate expression of the unwillingness and inability of the US polity and public to take the long view in virtually any area that matters, be it monetary policy, fiscal policy, infrastructure investment, energy pricing and security or global warming. It is probably the clearest evidence that we can expect an accelerated decline in the global role of the US.

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  1. minka

    “This institutionalisation of myopia and resistance to change may well be an accurate expression of the unwillingness and inability of the US polity and public to take the long view in virtually any area that matters, be it monetary policy, fiscal policy, infrastructure investment, energy pricing and security or global warming.”

    Sad but true. Our paralyzed and partisan political system, primarily the product of the Republican swing to the far right, seems to be simply incapable of dealing with any serious problem. Insight is nonexistent. Policy is nothing more than a thuggish grasping for advantage. When I was younger there was a public discourse that was dumbed down for the public, but serious folks who knew what they were doing were in charge.

    Simply amazing.

  2. Yves Smith

    Agreed. I don’t know how this sorry state of affairs has come to pass. While it has become grotesque with this Administration, I have the feeling that there was a less obvious erosion that made it possible.

    And the worst is that we won’t be the only ones to suffer the consequences of our shortsightedness.

  3. Anonymous

    Lets see. 1967 and rate of nonfinancial corporate profit turned over, falling steeply into the mid 1970s. 1970 – 75 and nonfinancial profit as share of total national income fell away. Growth rate began a decade by decade slowing, unemployment and underemployment escalated, productivity diminished… By almost all measures, the long postwar ‘Golden Age’ had come to an end.

    Well, that would be the beginning of a true tale, to include business’ normal responses such as a turn to speculative gains as overaccumulation blocked sufficient rate of return from productive enterprise. In this case though, a ‘turn’ given additional impetus via state policies and the foolish, fully bipartisan, attempts to substitute financial for real. I believe one can understand this to have effected socio-temporal horizons, to have shortened them.

    Where we are today has much to do with where we were and reaction — current financial hypertrophy grew out of earlier industrial weakening, the two motions have been one.

  4. James

    Wealthy baby boomers are not going to change anything. I know because my parents are in great shape. Its only going to change when others gain control over the political system

  5. E. Cartman

    While I overwhelmingly agree with Buiter’s overall point, I disagree with the assertion that the Fed is “constitutionally incapable of taking the long view.” Bill Martin was ok. Volcker was excellent. Greenspan, at least in his first couple of terms, was ok, as far as I know. The academics Burns and Bernanke, however, have been terrible.

    What Buiter is referring to by that quote is, presumably, the Fed “mandate” of full employment, as specified by the 1978 Humphrey-Hawkins Act. That mandate is extremely subjective. For example, 1% higher employment today in exchange for 10% lower employment tomorrow, as a result of capital depreciation from a weak dollar, is obviously a much bigger long-run violation of the Fed mandate than it is a fulfillment of the short-run mandate, and as such would be a blatant violation of an intertemporal reading of the Humphrey-Hawkins Act.

    What I am trying to say is that “full employment” is totally at the Fed’s discretion. It is no pretext for pathetically myopic, short-term monetary policy.

  6. Anonymous

    Debt is like chewing gum for the soul, may feel good but no nourishment there. That nourishment is what has fueled the consumer binge and the capital markets have been its conduit. That eviscerates the point about real economy and the financial markets dichotomy. That is not to say his point about the financial economy papering over a hollow real economy is illegitimate. The two are complimentary, in a parasitic way.

    The real economy is inextricably linked to the Fed, like a junkie. This Fellow needs to comb through the flow of funds data (FED release) and take a look at the asset and liability side of the consumer balance sheet. It may come as a shock to him that virtually all the wealth of Americans is tied up in houses and equities. Walla, the Fed has been playing a dangerous game of toggling back and forth between the two in order to preserve the wealth “effect.” Effect is the wrong word: affectation is better. Can you dispute that the Fed (in a nod to the sixties era self indulgence that is its #1 constituency and peer group by the way) has effected a massive wealth generation transfer from using the housing bubble as a conduit. No wonder Gen-x is almost unanimous in its belief that they will be worse off than their parents! Now it is probably to sinister and devious to have been planned by government, but the fact that the there are exploding entitlement programs , a pruned economy and virtually no savings, makes it both convenient and not coincidental. Also consider for a moment what would happen if the gov’t reported actual inflation in terms of its floating rate liabilities in the the form of bonds and entitlements? I haven’t done the math, but not inconsequential when you consider the compound effect.

    Oh, but the bond market knows better as that sophomoric Steve Liesman of CNBC likes to say (an economist with a journalism degree, really, even if it is from my Alma mater)? The fact is the bond market is a worse bubble than housing. Gee wiz, Alan Greenspan the maestro himself has said the long bond will eventually have a handle north of 7. The broken and dissolving Bretton Woods 2 system is in triage – See brad sester. Get out the paddles, fast.

    The US economy is for all intensive purposes the automotive industry. The Fed’d rate cutting agenda is the equivalent of the zero percent financing seven years ago. The Fed is following the same death by a thousand cuts approach that will eventually snow over the auto companies.

  7. Anonymous

    The most recent administration is guilty of shortsightedness all around, but let’s be clear, they are just showing the lesions of a core that rotted long ago. What amazes me as a patriot is just how much success we have had in spite of ourselves. That gives me confidence that it is not to late to turn around the ship, though it is a aging and unbalanced tanker.

    The malicious rot began with the self important self loathing the snowballed after world war II. In the wake of the cold war, when the US found itself adrift, the “enlightened” establishment – it State, Intel, bureaucracy generally etc… – finally jettison its reactionary posture and seized its “real” mission of civilizing. The last two decades have been spent squandering our competitive advantages with irrelevant free trade deals, educational subsidies and retrograde thinking about both economics and policy. Make no mistake the free trade lobby in this country is about two things: (1) cheap labor to protect eroding margins otherwise and (2) socialist evangelicals keen to lift the world out of poverty. Both may be noble goals. But both are not necessarily in our national interest.

    Sadly this will not end well. Whether it is ten or twenty years, the United States as it so likes to view itself is a mere shadow of itself and that shadow is growing fainter and fainter. The system is too big and the system is simply not built to resit the internal socialist elements or compete with the bear knuckle capitalism as practiced by the emerging mercantilism authoritarians.

    The government knows it the Fed knows it, the rest of the world senses it, but as usual the American people will be last to know. Here’s hoping they can turn it around, but from this vantage it looks like the rout is set to escalate. We need a new playbook fast. Unfortunately, America doesn’t make those anymore either.

  8. Peter Principle

    Buiter: “The good news in all this is that much of the financial sector has become quite detached from the real economy. The implosion of much of this formerly privately profitable but never socially productive financial intermediation will have little if any adverse macroeconomic effect.”

    This may be too mordant a historical analogy, but similar arguments were made about the U.S. stock market after the Great Crash. Or as Herbert Hoover put it the day after Black Tuesday:

    “The fundamental business of the country, that is the production and distribution of commodities, is on a sound and prosperous basis.”

    The implosion of what Buiter dismissed as “formerly profitable but never socially productive financial intermediation” involves the destruction of paper asset values on a grand scale. We’ve had enough experience since ’29 with debt-deflation spirals to think that Buiter might be a little less flip about dismissing the risk — even if he didn’t have the current example of the U.S. mortgage-backed securities market right in front of him.

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