Central banks don't control interest rates

Apologies for going on and on and on when it comes to this topic, but I think it's important. Central banks set macroeconomic policy, partly through setting a policy rate, and this affects the environment in which the yields on securities, i.e. interest rates, are set. But they do not directly control much except for their own policy rates (in the UK, a discount rate at which it lends to banks and pays on reserves they hold with it; in the US and Eurozone other rates are used in preference to or as well as a discount rate).

I have made various logical and empirical arguments for this claim in the posts I link in the first line; this post was spurred by my discovery of a 2013 paper from Eugene Fama (joint winner of2013's economics Nobel) making the case yet more rigorously. Entitled "Does the Fed Control Interest Rates?" it answers 'probably not':

To what extent does TF, the target Federal funds rate set by the Fed, influence other rates? There is lots of variation in rates unrelated to TF, and any effects of TF on rates dissipate quickly for longer maturities. For short rates, all the tests have interpretations in terms of: (i) a Fed that has the power to control rates and uses it, and (ii) a Fed that has little power over rates or chooses not to exercise its power. In the end, there is no conclusive evidence (here or elsewhere) on the role of the Fed versus market forces in the long-term path of interest rates.

A key piece of evidence is the fact that large spreads often emerge between private securities like commercial paper and the Fed-driven rate (i.e. Banks do not lend at the rate the Fed is targeting, despite its best efforts):

Fama argues that the evidence should be a cautionary tale for those who believe the Fed to have great powers of controlling the economy, making the case instead the market forces are usually the key driver, and I agree with him as far as it goes. But I think that monetary policy doesn't work necessarily by affecting real yields but by devaluing money to clear markets.

I think the central bank's control of the monetary base is what gives it power: it can vary the supply of money elastically (like free banks would) to stop money demand shocks from interacting with sticky wages and causing recessions. What it cannot do is produce any extra prosperity above the amount you get from monetary stability and neutrality.

Economic Nonsense: 5. Taxes should be increased to fund necessary spending

Taxation changes behaviour.  Taxes on goods and services makes them more expensive, and in most cases people buy fewer of them as a result.  Taxation on incomes makes work less attractive, motivating some people to do less of it.  Taxes on business usually fall on those who buy the products of those businesses, often reducing demand to below the level it would reach without taxation.  Taxes that people regard as unfair or oppressive will often lead people to take steps to avoid their burden.  Taxes on inheritance lead people to dissipate their wealth early, or they break up the capital pools that enable heirs to invest. Dynamic models of the economy try to take account of this.  Doubling the tax on tobacco products, for example, does not yield twice the revenue.  It might lead to twice the smuggling, though.  Vast increases in the duty on alcohol does not raise revenue in proportion, thought it does lead some drinkers to move down to cheaper booze.  Some tax increases actually yield less revenue because of the behavioural responses they trigger.

Arthur Laffer famously noted that a 0% tax on incomes yields no revenue, as does a 100% tax.  The graph line that links those two zeros is the Laffer Curve, and it has a peak somewhere whose rate yields the most revenue.  Even this moves as people adjust to the new status quo.  If a 50% rate of income tax is lowered to 40%, it is highly likely that it will soon bring in more revenue.  The rate reduction makes work more attractive, so people do more of it.  It also makes complex and expensive avoidance schemes less necessary, as people opt just to pay the lower rate tax instead.

When the economy in question had adjusted to the 40% top rate, however, more revenue might then be raised by lowering it to 35%.  The optimum revenue-raising rate depends on the status quo to begin with.  In many cases it might be appropriate to lower taxes to raise more revenue, rather than to hike them.  It is never likely that higher rates will yield more revenue in proportion to the increase.

Economic Nonsense: 4. Population growth will involve malnourishment & starvation

Malthus made this mistake.  He thought that food supply could only increase arithmetically, whereas population must increase geometrically.  He thought the result would always be more people than could be fed, with mass starvation and misery resulting. He was wrong about both the food supply and the population, as are present-day alarmists who speak of the future world "drowning in people" and call for urgent steps to limit population.

Humankind's ability to produce food has increased beyond anything Malthus could have envisaged.  Improvements in agriculture, in developing higher yield grains and in better animal husbandry have all enabled more food to be produced per acre.  The Green Revolution saw new crop strains combined with better agricultural management produce a huge increase in yields.  Genetically modified crops now offer the prospect of crops bred to be drought tolerant, salt-water tolerant, pest resistant and self-fertilizing, and offer a second Green Revolution with not only higher yields per acre, but crops that can prosper on previously infertile land.

Far from increasing out of control, population growth is levelling off.  As countries become richer, families do not need as many children to augment the family budget through their work.  As people are able to fund social services, they no longer need children to support them when they grow old.  The emancipation and education of women has played a significant role in this change.  Population growth in rich countries levels off.  In most European countries it is now negative, offset in some like the UK only by immigration.

The world's future population, predicted by some to reach 50 billion within a century, now is on course to level off at about 10 billion, and then to decline.  The combination of more abundant food and a significant reduction in population growth suggests that the latter-day Malthusians and doomsayers are wrong.  Population seems to be levelling off within a limit that modern day technology can provide adequate food for.

More of Will Hutton's whatabouttery

What joy, apparently we're to be treated to another volume of whatabouttery from Will Hutton. Containing such gems as this:

Five million wait to be housed – yet over the last generation, five million council flats have been sold and not replaced.

So? Does Hutton think that council houses are destroyed when they are sold? Or perhaps people actually buy them to live in? Meaning that the existence of one ex-council house means one household that does not require a council house? Well, quite, it's the latter, obviously.

The other of his suggestions that caught our eye was this:

The cornerstone of a new approach to ownership should be a Companies Act for the 21st century. Unlike the existing act, passed in 2006, this would set out unambiguously what society expects from companies in exchange for the privileges they are afforded. The aim is to create purposeful companies with a more just relationship between themselves and the wider society, capable of fostering the trust relationships that are at the heart of high-innovation and high-performance workplaces. Companies would be required to declare their business purpose on incorporation: they should incorporate to deliver particular goods and services that serve a societal or economic need and will need particular capabilities and skills. It is through delivery of their purpose that they should seek to make profits. Most great companies have this purpose at their heart already, even if informally. Unilever famously exists to make the best everyday things for everyday folk – Boeing to build planes that fly furthest safest. This should become the rule, not the exception.

Oh great. We can never remember whether it was Nokia or Ericsson that used to make rubber boots but then switched to mobile phones but this would ban that idea. And Apple moving from computers to smartphones would also be illegal. And this is quite separate from the basic fact that whatever you set up a company to do usually isn't what the company ends up doing. Simply because no business plan ever survives contact with the market.

Hutton's deliberately insisting that we should hobble the flexibility and adaptability of the market system. Said adaptability and flexibility being one of the great points about having a market system in the first place. It fits with his own ideas about how the economy works, this is true. That some small number of the Great and the Good (naturally including one W. Hutton) sit around and plan how the rest of us do everything. But that his actual suggestions are also insane is why we should pay him no heed.

Just to rub the point in, one of the examples of a great company that he uses is Rolls Royce. Which started out to make cars and only later moved into jet engines. A declaration that they only existed to make great cars would have been a bit of a problem for that later development, would it not?

Economic Nonsense: 3. There has to be a winner in every bargain

This is not true, and is based on the false zero sum game fallacy.  The assumption behind it is that value is fixed, so that if someone gains more of it, someone else will obtain less.  People commonly ask who gets the best of a bargain, wrongly assuming that one party gains at the expense of the other. In fact, value is not a fixed property of objects, but something in the mind of those who think about them.  People are different and they value things differently; and value is not fixed or in limited supply.  When a voluntary exchange takes place it is because each party puts greater value on what the other party has than they put upon what they are ready to trade for it.  When the trade takes place, each party acquires something they value more than what they already had.  Both gain in value; this is how wealth is created.

It is not a case of one party winning and the other losing.  Rather is it a win-win situation in which both parties have added value to their lives.

Just as both usually gain in a voluntary bargain between people, so do both sides usually gain in a freely-entered exchange between nations.  People in one country trade what they have in return for what they value more from the other country.  Both become wealthier as a result.  It is trade and exchange that makes countries wealthier, not trying to accumulate precious metals or plundering wealth from others.  When countries abandoned the idea that they could grow rich at the expense of others, the world's wealth began to grow dramatically.  Trade has made everyone winners.

Rare disasters and the efficient markets hypothesis

One common strand in financial economics research is that financial markets are not perfectly efficient, i.e. they do not immediately and consistently incorporate all facts about the world in prices. I have several feeds set up for new papers in the area and at least five new papers come out each week finding that while markets are far more efficient than random, there are a number of departures from perfect efficiency.

I had always wondered why this was true: surely if there really are all these easily-exploitable bets then there would be at least some market participants who would exploit the hell out of them. Markets do not come to rest at the median view of everyone, but the position where no one wants to trade—so it doesn't matter if most people are 'behavioural'.

If the inefficiencies—i.e. prices that differ from fundamental values—cannot be bet on then there's a question of why: if it's down to regulation then that's hardly surprising and doesn't really tell us anything about markets; if it's down to the (non-regulatory) cost of trading then it's not an inefficiency. It's more socially efficient all things considered to not trade on those inefficiencies—i.e. the social benefits of getting to the true price are outweighed by the social costs needed to get there.

Well a new paper seems to give a strong undergirding to my thoughts here. Entitled "Disaster risk and its implications for asset pricing" (pdf) and authored by Jerry Tsai and Jessica Wachter (hat tip to Robin Hanson), it says that most of these inconsistencies are parsimoniously accounted for by the risks of catastrophic disasters like the Great Depression.

These make certain sorts of assets (like stocks) less attractive by dint of the fact there is a very small chance that they might tank a huge amount. Otherwise there seems to be a big puzzle why stocks return so much more than bonds.

After laying dormant for more than two decades, the rare disaster framework has emerged as a leading contender to explain facts about the aggregate market, interest rates, and financial derivatives. In this paper we survey recent models of disaster risk that provide explanations for the equity premium puzzle, the volatility puzzle, return predictability and other features of the aggregate stock market. We show how these models can also explain violations of the expectations hypothesis in bond pricing, and the implied volatility skew in option pricing. We review both modeling techniques and results and consider both endowment and production economies. We show that these models provide a parsimonious and unifying framework for understanding puzzles in asset pricing.

This probably leaves a few market puzzles unexplained—perhaps many—but I expect these may eventually yield simple, plausible and efficiency-preserving explanations. As Eugene Fama points out in a brilliantly clear introduction to and history of the EMH it is very hard to test market efficiency since you must always make assumptions about risk at the same time.

When the typo reveals something of interest

It is, of course, jejeune to mock today's newspapers for having typos in headlines. For while the near total absence of subeditors does lead to such errors things were not so much better in the past. Private Eye has been calling it the Grauniad for years as a result of that paper (and PE does swear that it was true although others are more sceptical) managing to misspell its own masthead one day. But this link to a Boris Johnson column is particularly delicious:

Capitalism can same lives: Ed doesn't get that

By the time you read this we're sure it will have been changed. But the joy of this is that it's exactly capitalism that not only saves lives, as Johnson avers, but also capitalism and its handmaiden, free markets, that vary lives. It's socialism and planning that produces the monotony. Eastern Europe (and parts of the UK sadly) is littered with concrete monstrosities, stack a prole worker flats (panelaki in Czech, Brezneviki in Russian, horrible in every language) where the indistinguishable masses were to live their indistinguishable lives between indistinguishable walls. Venezuela's Bolivarian socialism has brought the monotony of no toilet paper for anyone to all.

That people can make a shilling or two by catering to niche tastes, that a way to make further profits is to slice and dice and vary one's offerings is precisely what does produce the variety that the modern market economy offers. Depending upon who you believe the island of Manhattan currently has 1 billion or 10 billion different items offered for sale, right now. This is a cornucopia of choice that no planned economy has ever managed to produce. And it's also a complexity that no planned economy could ever deal with: there's simply not enough computing power available to us to be able to calculate the interactions between that many items.

As with the phrase in vino veritas, or the way that a slip of the tongue can reveal the inner complexity of thought, so sometimes a typo can be an instructive mistake, making us think about the underlying point. The very joy of capitalism is that it doesn't "same" lives, it's the dead hand of the state that does that.

Economic Nonsense: 2. Some prices should be legally capped

Prices do more than tell us how much we have to pay for things; they also convey important information that motivates people to act.  When prices rise for things in short supply, they tempt producers to bring more supply onto the market, alleviating the shortage.  Prices motivate people to put investment into particular sectors of the market, raising future supply there. Governments since that of Hammurabi over 4,000 years ago have at times sought to fix prices, often in response to political pressures: the Adam Smith Institute's Director, Dr. Eamonn Butler, examined the history of this kind of price fixing in Forty Centuries of Wage and Price Controls.  When prices are fixed, however, their role as conveyors of information is lost, and their ability to motivate people to act is compromised.

If energy prices, for example, were fixed, it would make energy less attractive as an investment, reducing the future supply of it and perhaps leading to blackouts.

Fixing the price of rents is popular with current tenants, but it will limit the future supply of rental property.  Rents set artificially below market rates leads to poor maintenance as landlords no longer have the same incentive to maintain and renovate properties.  Fixed rents attract fewer people to rent out property, and encourage landlords to take properties off the rental market.  The Swedish economist, Assar Lindbeck, famously said  "next to bombing, rent control seems in many cases to be the most efficient technique so far known for destroying cities."  It could be argued that it is more effective, since bombing takes out demand as well as supply.

The market has many self-correcting mechanisms that price controls prevent coming into play.  The high prices caused by shortages tell more producers to enter the market; the low prices caused by gluts lead them to direct their resources elsewhere.  This activity depends on the flow of information that prices generate, a flow that is stopped when prices are fixed by law.

Economic Nonsense: 1. Self-sufficiency and buying locally are beneficial

No, the reverse is true.  Depending on others for some of our needs and having access to goods from distant markets are beneficial, whereas self-sufficiency and localism usually leave people poorer.  When we buy things from others we have access to their skills and specializations, skills that can make goods better and cheaper than we could make ourselves. Households that make their own clothes and pottery are poorer than those that can buy cheaper, mass-produced goods.  It takes them more time and more resources than it takes producers who specialize.  The same is true on a larger scale for communities and nations.  Buying from others and buying from outsiders leaves people richer.

People who can buy from distant sellers can buy more cheaply, and are richer by the money they save.  Requiring people to buy locally often means making them pay more than they would otherwise need to, leaving them less money to spend on other things.

When governments of developing countries impose tariffs and quotas on imported goods in the name of "protecting infant industries" they are making their citizens pay more than they need to.  A prohibitive tariff on imported US tractors, for example, means that farmers have to pay more for locally-produced ones, making their produce more expensive.  The protected local tractor makers benefit, of course, but it is at the expense of local buyers.  The process opens up opportunities for corruption and cronyism as local producers lobby, and occasionally bribe, ministers to impose such "protection."

Wealth is created by trade and exchange, and is increased when they are increased.  Self-sufficiency and buying locally both introduce restraints on trade and exchange and lead to people being poorer than they need to be.  They are not beneficial.

Nominal GDP targeting constituency on the rise

Just as the ASI releases a new paper on the benefits of nominal GDP level targeting over inflation targeting, two economists at the Harvard Kennedy School have a new paper on its benefits in developing countries. They join a chorus saying nominal GDP targeting—stabilising the total amount of spending in the economy instead of an index of prices like we currently do with inflation targeting—may outperform the status quo.

Entitled "Nominal GDP Targeting for Developing Countries", helpfully, and written by Pranjul Bhandari and Jeffrey Frankel, it explains how inflation targeting fares poorly when there are large supply-side shocks.

Interest in nominal GDP (NGDP) targeting has come in the context of large advanced economies. Developing countries are better suited for it, however, in light of big supply shocks and terms of trade shocks, such as monsoon rains and oil import price shocks in the case of India. Under annual inflation targeting (IT), the full impact of adverse supply shocks is felt as lost real GDP. NGDP targeting automatically accommodates such shocks, while retaining the advantage of anchoring expectations. We derive the condition under which NGDP targeting would dominate other regimes such as annual IT, to achieve objectives of output and price stability. We estimate key parameters for the case of India and conclude that the condition may indeed hold.

The paper is mainly a restatement of common points in nominal GDP targeting's favour; indeed it leaves out many of the crucial elements of NGDPLT as I see it—using market measures of expectations, targeting the forecast rather than the out-turn, doing policy more automatically than leaving it down to central bankers.

The real point of interest is just how many papers coming out are considering nominal GDP targeting or advocating for it, compared to inflation targeting or other policy rules. It suggests to me, like Prof. Sumner has been saying, that perhaps we are seeing 'the NGDP moment'.