A Powerful Intellectual Stumbling Block: The Belief that the Market Can Only Be Failed

Over at Project Syndicate: The Trouble with Interest Rates: Of all the strange and novel economic doctrines propounded since 2007, Stanford’s John Taylor has a good claim to propounding the strangest: In his view, the low interest-rate, quantitative-easing, and forward-guidance policies of North Atlantic and Japanese central banks are like:

imposing an interest-rate ceiling on the longer-term market… much like the effect of a price ceiling in a [housing] rental market…. [This] decline in credit availability, reduces aggregate demand, which tends to increase unemployment, a classic unintended consequence…”

When you think about it, this analogy makes no sense at all.

When a government agency imposes a rent-control ceiling, it:

• makes it illegal for renters to pay or landlords to collect more than the ceiling rent;
• thus leaves a number of potential landlords willing but unable to rent apartments and a number of potential renters willing but unable to offer to pay more than the rent-control ceiling.

When a central bank reduces long-term interest rates via current and expected future open-market operations, it:

• does not keep any potential lenders who wish to lend at higher than the current interest rate from offering to do so;
• does not keep any potential borrowers who wish from taking up such an offer;
• it is just that no borrowers wish to do so.

The reason we dislike rent-control ceilings–that it stops transactions both buyers and sellers wish to undertake from taking place–is simply absent.

So why would anyone claim that low interest-rate, quantitative-easing, and forward-guidance policies are like rent control?

I think that the real path of reasoning is this:

1. John Taylor, and the others claiming that central banks are committing unnatural acts by controlling the interest rate, feel a deep sense of wrongness about the current level of interest rates.
2. John Taylor and his allies believe that whenever a price like the interest rate is “wrong”, it must be because the government has done it–that the free market cannot fail, but can only be failed.
3. Thus the task is to solve the intellectual puzzle by figuring out what the government has done to make the current level of the interest rate so wrong.
4. Therefore any argument that government policy is in fact appropriate can only be a red herring.
5. And the analogy to rent control is a possible solution to the intellectual puzzle.

If I am correct here, then the rest of us will never convince John Taylor and company.

Arguments that central banks are doing the best they can in a horrible situation require entertaining the possibility that markets are not perfect and can fail. And that they will never do. We have seen this in action: Five years ago John Taylor and company were certain that Ben Bernanke’s interest-rate, quantitative-easing, and forward-guidance policies risked “currency debasement and inflation”. The failure of those predictions has not led John Taylor or any other of the Republican worthy signatories of their “Open Letter to Ben Bernanke” to rethink and consider that perhaps Bernanke knows something about monetary economics. Instead, they seek another theory–the price-control theory–for why the government is doing it wrong.

Thus all we can do is repeat, over and over again, what both logic and evidence tell us:

• That with the current configuration of fiscal policy, North Atlantic monetary policy is not too loose but if anything too restrictive.
• That as far as the real interest rate is concerned, the “‘natural rate’… that would be ground out by the Walrasian system of general equilibrium equations”, as Milton Freidman would have put it, is lower than the one current monetary policy gives us.
• That our economies’ inertial expectations and contracting structures have combined with monetary policy to give us nominal interest and inflation rates that are distorted, yes–but an interest rate that is too high and an inflation rate that is too low relative to what the economy wants and needs, and what a free-market flexible-price economy in a proper equilibrium would deliver.

Why does the North Atlantic economy right now want and need such a low real interest rate for its proper equilibrium? And for how long will it want and need this anomalous and disturbing interest-rate configuration? These are deep and unsettled questions involving, as Olivier Blanchard puts it, “dark corners” where economists’ writings have so far shed much too little light.

Hold on tight to this: There is a wrongness, but the wrongness is not in what central banks have done, but rather in the situation that has been handed to them for them to deal with.