Easy Money: The Root of all Evil
Longtime financial commentator Edward Chancellor has
written a sweeping socio-economic history of interest rates going back to the
ancient Sumerian civilization of over 4000 years ago and the Code of Hammurabi
up to the present. Chancellor correctly notes that interest rates represent the
“universal price of time” that links the present to the future and is essential
in valuing any asset.
His concern is that when politicians and central
bankers underprice the cost of money all kinds of bad things happen. Those bad
things would include asset bubbles, commodity price inflation, income inequality,
uneconomic investment, the monopolization of the economy and food riots leading
to political destabilization. But what is the correct price? Chancellor relies
on the work of Eugen von Bohm-Bawerk, Irving Fisher, Friedrich Hayek, and Knut
Wicksell. He leaves out the work of my late and great economics professor Jack
Hirshleifer with his “Investment, Interest and Capital.”
Simply put on a micro foundation basis the interest
rate is determined by society’s rate of time preference and its ability to increase
output overtime. Thus, from the point of view of output growth the real
interest rate should equate to the real growth in GDP. However, when money, credit and central
banking are introduced you dramatically increase the likelihood of overshooting
and undershooting the neutral rate of interest.
Chancellor criticizes central bankers for their
seeking economic stability via inflation targeting. Low inflation in product
markets usually makes sense, but sometimes it masks inflation is asset markets
giving rise to bubbles. It here where Chancellor brings in Hyman Minsky’s work
on stability leading to instability. Thus, it was the Great Moderation of
1982-2007 that led to the crash of 2008.
He is especially critical of Fed chairs, Bernanke,
Yellen, and Powell for them violating Bagehot’s rules for acting in a crisis
and for all of them keeping interest rates way to low for way to long which
gave rise to the maladies listed above. With respect to Walter Bagehot, in a
banking crisis the central bank should lend aggressively on good collateral at
a penalty rate. To be sure our central bankers lent aggressively, but not all
on good collateral and certainly not at a penalty rate which opened the gates
to a populist rebellion against the bankers.
By keeping interest rates too low for too long, the
Fed totally distorted the relationship between the present and the future which
made hitherto unprofitable investments lucrative. Thus, instead of investing in
new assets businesses and individuals bid up the price of existing assets to
the detriment of long run productivity. And remember who owns existing assets,
the already wealthy.
What Chancellor gets wrong is that he focuses too much
on the policy rate. The relevant interest rate is the long-term rate which is
tied to the long-term growth in the economy and the long-term rate via the term
premium is usually higher than the policy rate. Further, necessary short-term
reductions in the policy rate to manage a crisis and/or a recession should not
affect long term rates all that much. However, when central banks promise to
keep rates low forever, the long-term rate will converge on the short-term
rate. Thus, the error of the Fed was not to lower the rates in a crisis but
keeping them low well past the crisis.
Edward Chancellor has written an important book that
reflects Austrian economics over Keynesian economics, but I suspect it will
gain popularity overtime as the credibility of our central bankers continues to
erode.
For the full amazon URL see: Easy Money: The Root of all Evil (amazon.com)
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