Are Artificially Low Interest Rates Producing Artificially High Asset Prices?

The popular media are full of stories about the sins being committed by central banks.  They claim that central banks are keeping interest rates "artificially" low and that is leading to "artificially" high asset prices.  Paul Krugman explains why these claims are nonsense. 

In the first place, the economics profession does not recognize the concept of artificially high interest rates.  It uses the concept of the natural rate of interest which holds that the rate of interest that does not lead to inflation is the natural rate of interest.  Since there is little indication of inflation in nations where central bank policy rates are low, our current interest rates are at the level that we should expect with low inflation.  Central banks have helped to set inflation expectations through their policies and the market expects inflation rates to be low.  Investors are willing to pay higher prices for safe assets as long as they expect inflation to remain low.

Stock prices have also risen during this period of low interest rates and low inflation.  Does that mean that stock prices are "artificially" high?  Corporate profits have also been high and the price to earnings ratio is close to its long term average.  Market fundamentals seem to explain the rise in stock prices.  It does not seem that stock investors have been taking on excessive risks because interest rates are too low.

Currency Depreciation And Slow Export Growth in Japan

Economic theory suggests that a currency devaluation should make a nation's exports more price competitive and stimulate export demand.  The Japanese yen has depreciated by 30% versus the US dollar but Japanese exports to the US has declined modestly during this period.  This study by the Federal Reserve Bank Of New York explains why a substantial currency devaluation has not increased Japanese exports to the US.

Many Japanese firms invoice US importers in US dollars.  That actually increases margins in Japan.  The dollars received in Japan translate into higher yen margins.  Another factor is that Japanese exporters are also large importers of raw materials and energy.  Therefore, their cost of production increases.  Higher product costs limit the advantage gained by currency devaluation.  Japanese firms are also protective of their large market shares in the US market.  They are willing to accept lower prices to maintain market share.

This article does not discuss Japanese competition with foreign competitors in the US market but that may also have contributed to slower growth in exports to the US.  In particular,  firms like Samsung and LG have been successful in the US consumer electronics market.  Hyundai and Kia have also been successful in the US auto market.  They have competed with Japanese products on quality as well as on price.

The Prosecution of European Banks That Violated US Law Shifts To Germany

The US has been investigating the operations of European banks for over a decade.  In 2009 the British bank Lloyds struck an agreement for deferred prosecution.  That was followed by agreements with other major banks in Britain.  HSBC, Standard Chartered and Barclays also struck agreements on the violation US banking laws.  Credit Suisse, the largest bank in Switzerland, and ING a large bank in The Netherlands also accepted deferred prosecution agreements and paid substantial penalties.

The major banks in France have also been under investigation.  Credit Agricole and Societe Generale are under investigation and BNP Paribus agreed to a $8.9 billion penalty and a criminal charge.

The most recent investigation involves Germany's second largest bank Commerzbank.  It is subject to a $500 million penalty.

The European banks were using the NYC offices to funnel dollars on behalf of clients in Iran and Sudan in violation of sanctions imposed on those countries by the US.  The largest US bank Citigroup is also under investigation for laundering money through its Mexican subsidiary for a drug cartel.  JP Morgan Chase also agreed to a $2 billion penalty for aiding and abetting the Madoff Ponzi scheme.

The European and American banks cited in this article risked their reputations in the pursuit of easy profits.  Finding ways to get around US laws has been one of their strategic advantages.  This a sad commentary on the international banking industry.

The Hand Of God And Economic Growth

The upset victory of David Brat over Eric Cantor many be a sign of the future for the Republican Party.  It has been successful as a coalition between those who believe in free markets and Christian fundamentalists.  Brat's electoral success suggests that the future of the Republican Party may be not be a coalition between free marketers and Christian fundamentalists.  Its base may become more like David Brat who believes that the source of economic growth is a free market system operated by virtuous Christians.

David Brat convinced the voters in his district that his opponent was not virtuous.  He accused Eric Cantor of "crony capitalism" by connecting him to Wall Street bankers who supported his campaign.  The bankers failed because they are not virtuous and government efforts to rescue the bankers will not work either.  Free markets do not need government regulation; they work best when the people running them are virtuous.

The business wing of the Republican Party has consistently blamed government for our economic problems.  The economy would work fine as long as we let customers, competition and shareholders provide the required market discipline.  The role of government is to enforce property rights by writing laws and providing resources to defend those rights.  God was not essential in the operation of the economy but it was a good idea to court the Christian fundamentalists who voted for them in elections.  Many of the Tea Partiers who voted for David Brat believe that Christian virtues are an essential ingredient for free market capitalism.

We live in a real world in which bankers continue to act badly and markets also break down when participants are virtuous.  Government cannot provide a substitute for failed virtue.  We need government to make markets work but we also have to find ways to limit the growth in "crony capitalism".  That is, can we build a government that we can trust?

Economics 101 And Recovery From Recession

John Cochrane is a supply side economist.  He and other supply side economists blame our slow recovery from the Great Recession on shocks that cause business investment to decline.  Typically, the shocks to business investment are attributed to government policies that create uncertainty about the future. They also believe that government efforts to stimulate demand will be ineffective or harmful.  Demand side economists have a different perspective on the business cycle.  They believe that recessions are caused by cuts in spending.  Central banks are the first line of defense in a recession. They can cut interest rates which encourage business investment and consumer spending.  However, when interest rates have been cut to zero,  and we still have unemployed resources, demand side economists believe that fiscal policies should be used to stimulate economic activity.  That can be accomplished by increasing government spending and/or by cutting taxes.

Noah Smith understands that there is no simple way to end the debate between supply side and demand side economists that has long history.  In this article, he uses simple supply and demand graphs to illustrate what should happen to prices during a recession.  They show that prices should rise when the supply curve moves to the left.  That is, we should have price inflation.  In fact, supply siders have been forecasting price inflation for last several years and it has not happened.  Instead we have seen a decline in prices.  That is exactly what happens when the demand curve moves to the left following a shock to demand.  Smith argues that this simple illustration shows that demand side explanations are more intuitive than those used by supply siders.  That does not settle the debate, but it does explain why demand siders continue to advocate the use of fiscal policies to stimulate demand.  I suggest a test that anyone can use to test their intuitions about this debate.  Pretend that you are a business person, and consider each of the factors that supply siders use to explain why you are not spending money to increase capacity.  Then ask yourself what you would do if you saw an increase in demand for your products or services. 

When you have finished this task please enjoy the holiday in the US and the world cup matches over the weekend.  

The Long Term Damage From Deep Recessions

Moderate recessions are a part of what economists call the business cycle.  Economies normally recover from recessions without suffering any longer term economic damage.  This time it might be different.  This paper provides data from OECD countries which indicates that the damage from the Great Recession may be more serious.  It argues that the recession has decreased the potential output as well as the growth rate of potential output in many OECD nations.  It also makes an effort to describe the channels by which the potential output has been seriously damaged. 

This article suggests that the damage to potential output is partially explained by public policy decisions.  It shows a positive relationship between the degree of austerity and the decline in potential output.  The damage may not be irreversible.

Economic Warfare And The Value Of Old Ideas

Ezra Klein's blog (Vox) is being criticized by conservatives because it uses "old ideas" from the era of demand side economics to frame policy recommendations.  Paul Krugman finds this rather strange.  Supply side ideas are also very old ideas but conservatives prefer them to demand side ideas.  That would be fine if supply side ideas worked better than demand side ideas.  According to Krugman, demand side explanations for our current economic problems have worked better than old supply side arguments.  The conservative preference for supply side economics is an ideological preference that is insensitive to empirical realities.  In any case, it is foolish for conservatives to argue that one set of old ideas is better than another set of old ideas.  They need to come up with a better argument against Ezra Klein's blog.

Keynes made an interesting comment in his General Theory about economic ideas.  His comment was about the rapid ascendency of David Ricardo's economic ideas in Britain.  Keynes argued that Ricardo's ideas were well received by powerful interests in Britain who benefited from them.  The implication is that economic ideas are not independent from the dominant political culture in a nation.  Economists, and their ideas,  provide the intellectual justification for the existing social order.  Supply side economics, which holds that government efforts to stimulate demand in a recession are counterproductive,  derives its power from sources outside of the academy.  Economists who wish to curry favor with the power elite serve a role similar to the priesthood which made the case for the divine rights of kings in another era.