My First Comment From Someone I Don’t Actually Know!

by robekulick

This is a very exciting day for my blog since I got a comment on my blog from someone I don’t know, and also got a different person I don’t know as a twitter follower. Before I respond to the comment, I just want to say how much I appreciate people’s interest in this blog. I very my encourage people to comment often and as much as they like, even if it is just to submit an idea for an entry. I take requests.

Anyway, Georgia writes about my colloquy with Kevin:

“Gentleman, I just found this discussion and I must say that I am intrigued a bit, and also sceptical.  I do not believe at this time Bernake can do much more, since the banks are already very liquid and are just not willing to make loans at this time.  The reality is the only people who can get loans at this time are those who can prove they do not need the loans!  My small business friends who have great ideas for new products and services are simply not willing to take the chance given the fact that they have a partner who takes 50% of their earnings without regard to their will as to how the profits should be spent.”

This is an excellent post because it raises a number of issues about monetary theory, why this economic slump has continued for so long, and makes a very important point about small businesses.

The first point I want to discuss is that Georgia is absolutely correct, the problem in our economy is not a lack of potential for innovation or productivity increases. That actually is a major reason why I think all the talk about the end of US influence in the world is overblown.

Georgia is also correct that a major problem is that banks are sitting on stockpiles of money instead of lending it. The question is can monetary policy do anything about this problem? I believe the answer is yes.

To paraphrase what I think Georgia is saying, she is skeptical that increased liquidity from the Federal reserve will do anything at this point, especially since rates are already near zero. This notion is known as a “liquidity trap.”

I’m very excited at this point, because at this point I get to invoke my favorite economist, Milton Friedman, to explain the flaw in this logic. In an interview  with David Laidler in 2000 Milton Friedman said the following in the context of Japan:

“David Laidler: Many commentators are claiming that, in Japan, with short interest rates essentially at zero,  monetary policy is as expansionary as it can get, but has had no stimulative effect on the economy. Do you have a view on this issue?

Milton Friedman: Yes, indeed. As far as Japan is concerned, the situation is very clear. And it’s a good example. I’m glad you brought it up, because it shows how unreliable interest rates can be as an indicator of appropriate monetary policy.

During the 1970s, you had the bubble period. Monetary growth was very high. There was a so-called speculative bubble in the stock market. In 1989, the Bank of Japan stepped on the brakes very hard and brought money supply down to negative rates for a while. The stock market broke. The economy went into a recession, and it’s been in a state of quasi recession ever since. Monetary growth has been too low. Now, the Bank of Japan’s argument is, “Oh well, we’ve got the interest rate down to zero; what more can we do?”

It’s very simple. They can buy long-term government securities, and they can keep buying them and providing high-powered money until the high powered money starts getting the economy in an expansion. What Japan needs is a more expansive domestic monetary policy.

The Japanese bank has supposedly had, until very recently, a zero interest rate policy. Yet that zero interest rate policy was evidence of an extremely tight monetary policy. Essentially, you had deflation. The real interest rate was positive; it was not negative. What you needed in Japan was more liquidity.”

So there are two essential points here. First, low interest rates are not evidence of loose policy. In fact, they can be evidence of tight monetary policy. So what can the Fed to to simulate monetary expansion? It can start to buy long-term government debt and focus on long-term inflationary expectations. Furthermore, the Fed can also print money and buy assets directly from banks.

Now, why should this increase lending and economic activity in general? Two reasons:

First, by indicating future inflation, the penalty for holding dollars will increase, inducing spending, investment, and lending activity.

Furthermore, by decreasing the debt burden on people and by acquiring risky assets the market does not want to hold, the Fed helps to restore bank balance sheets to a level where they are again willing to take risks and personal balance sheets to a point where consumers are willing to spend.

A more detailed explanation of what can be done with monetary policy is contained here in Scott Sumner’s excellent blog:

Now, I’m assuming that what she means by the “50%” comment, is that high tax rates discourage innovation. Kevin would probably be less likely to agree with you on that, but I very much do.

In an article for the economist, Scott Sumner explains how a policy of monetary easing and supply-side reform, can address both the demand-side and supply-side problems in the economy:

(Btw, I think Scott Sumner is taking up Milton Friedman’s mantle, and I’m very happy to see that).

Thanks for reading! I hope you comment again soon!