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Thursday, November 20, 2008

Mainstream economists just don't GET it

Mankiw is finally pointing out that the Fed pumping money into the economy isn't working. Duh. Been there, discussed that.

The sad thing is, he still doesn't get WHY. As is typical of his more classical perspective, he is focusing on inflation expectations being the culprit. It's not the big problem. It is true that with little wiggle room in nominal rates, and with prices falling and expected to fall further, that real rates should rise - which is problematic for the Fed (ie. there is a nominal liquidity trap, which people have been noting for months now will be a problem).

But that's just one small part of the problem. The BIG problem is the overall market uncertainty and consumer confidence drop. Banks, business, people are hoarding their money, reducing credit usage etc and pulling funds from their 401K's and stock market etc. All this means money demand is rocketing up - raising interest rates. And it's not just general market uncertainty, but also INFLATION uncertainty. Yes, deflation is likely in the short-run, but keep in mind that just a few months ago we were all concerned about stagflation. To the extent that is a longer-term concern, inflation uncertainty is higher now. This contributes to hoarding or lack of lending and borrowing --- people are taking a wait-and-see approach.

So, the Fed can announce a price target all they want, but the Fed only has so much control. They can't control inflation uncertainty due to supply-side effects, nor can they control general market uncertainty in times where aggregate demand is free-falling. Further, to the degree that the Fed can't control the money supply in times of crisis (ie. money is endogenous and led by demand for funds), this further limits the Fed's ability to effect the market. I am therefore skeptical that even an announced price target would have much of an effect given the current malaise.

As a matter of fact, Mankiw's very prescription would likely cause inflation uncertainty to skyrocket as X number of people would find the Fed action credible, Y number would not, and Z number would see the current economic crisis making it moot! That could mean an even bigger credit crunch!

Focus needs to be on 2 areas:

1. Quicker use of that $700 billion to buy equity in banks etc to get interbank funds flowing and to try to reduce uncertainty (which is the main culprit).

2. Government spending stimulus of a large-order - a new New Deal.

....Abandon Fed Funds targeting - it's not effective and actually can be doing more harm than good because if interest rates on riskier savings is unaffected by the Fed such that those rates keep rising due to uncertainty, but the Fed keeps trying to push it's interest rate on T-bills down further, all that does is INCREASE demand for hoarding.

I think monetary theory will be completely revamped after this crisis is over with, because I am becoming more and more convinced that the traditional idea that decreasing Fed Funds rate can stimulate the economy is outdated in times like these --- in normal times yes, but not now.

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