Bernanke’s First Blog Post
By now it has probably made the rounds that Ben Bernanke has joined the “blogosphere” by beginning to write his own blog at the Brookings Institute. After reading his first post there, we couldn’t resist to comment. The article is entitled “Why are interest rates so low?”. Perhaps not surprisingly, it turns out that it is essentially a long-winded apologia for the Fed’s interventionist policies.
At one point Bernanke e.g. deems it necessary to once again defend himself against a complaint voiced by a legislator, namely that the FOMC has “thrown seniors under the bus” by cutting rates to zero. Bernanke is assuring us that “I was concerned about those seniors as well”. It could be that seniors will be happy to hear it. However, the return they get on their savings remains zilch to this day, so we doubt it will be much of a consolation to them that Bernanke professes to have been concerned. He also tries to refute the fact that the Fed’s interventions are distorting markets (i.e., he refuses to admit that it is blowing one bubble after another).
It is interesting that Bernanke is launching into a justification of Fed policies in his very first post already. Reading it, we felt reminded of one of his previous attempts to exonerate the Fed, when he argued that the housing bubble was the result of “too lax regulations”, and had definitely nothing to do with the Fed’s interest rate policies. Among other things, he neglected to mention in that particular speech that the housing bubble was actually concentrated in one of the most highly regulated sectors of the economy.
Ben Bernanke: honest injun, we’re completely innocent! We only do good manipulations! The markets do the bad stuff all by themselves.
Photo credit: Getty Images
The Natural Interest Rate
Bernanke tries to explain why interest rates are currently so low, and discusses the natural interest rate in this context:
“Except in the short run, real interest rates are determined by a wide range of economic factors, including prospects for economic growth—not by the Fed.
To understand why this is so, it helps to introduce the concept of the equilibrium real interest rate (sometimes called the Wicksellian interest rate, after the late-nineteenth- and early twentieth-century Swedish economist Knut Wicksell). The equilibrium interest rate is the real interest rate consistent with full employment of labor and capital resources, perhaps after some period of adjustment. Many factors affect the equilibrium rate, which can and does change over time. In a rapidly growing, dynamic economy, we would expect the equilibrium interest rate to be high, all else equal, reflecting the high prospective return on capital investments. In a slowly growing or recessionary economy, the equilibrium real rate is likely to be low, since investment opportunities are limited and relatively unprofitable.”
It seems a bit unfortunate that economists are calling it the “equilibrium interest rate”. What Wicksell described was the fact that there exists a time discount, a “natural” or “originary” interest rate, that is independent of the height of market interest rates. Wicksell’s work has been incorporated and refined in the interest theories of later economists, inter alia in the work of Frank Fetter in the US and Ludwig von Mises in Austria (whom we quote at length below).
Human beings have a limited life span, and time only moves in one direction for them. Time is an extremely important factor influencing their choices and actions. All action is future-oriented and aims at attaining satisfaction, or “removing uneasiness” as Mises put it, at some point in the future. Human action is purposive and achieving a goal sooner is always preferred to achieving the same goal later. This is not a philosophical or psychological concept, but rather an essential, inviolable category of action, i.e., it is a praxeological theorem. As Mises explains:
“If any role at all is played by the time element in human life, there cannot be any question of equal valuation of nearer and remoter periods of the same length. Such an equal valuation would mean that people do not care whether success is attained sooner or later. It would be tantamount to a complete elimination of the time element from the process of valuation.”
“[…A]cting man does not appraise time periods merely with regard to their dimension. His choices regarding the removal of future uneasiness are directed by the categories sooner and later. Time for man is not a homogeneous substance of which only length counts. It is not a more or a less in dimension. It is an irreversible flux the fractions of which appear in different perspective according to whether they are nearer to or remoter from the instant of valuation and decision. Satisfaction of a want in the nearer future is, other things being equal, preferred to that in the farther distant future. Present goods are more valuable than future goods.
Time preference is a categorial requisite of human action. No mode of action can be thought of in which satisfaction within a nearer period of the future is not – other things being equal- preferred to that in a later period. The very act of gratifying a desire implies that gratification at the present instant is preferred to that at a later instant. He who consumes a nonperishable good instead of postponing consumption for an indefinite later moment thereby reveals a higher valuation of present satisfaction as compared with later satisfaction. If he were not to prefer satisfaction in a nearer period of the future to that in a remoter period, he would never consume and so satisfy wants. He would always accumulate, he would never consume and enjoy. He would not consume today, but he would not consume tomorrow either, as the morrow would confront him with the same alternative.”
(emphasis added; non-bolded italics in original)
What this in effect means is: The natural interest rate is at its root a non-monetary phenomenon. It describes the discount people apply to future goods (or goals/satisfactions) vs. present ones. These value judgments regarding future in comparison to present satisfaction (called time preference) differ from person to person, depending on individual circumstances. In the market they find expression in the time market for money, i.e., in the interest rate on money loans, but they are actually present in the entire market economy. For instance, if one considers an unchanging economy in equilibrium (which can never exist in real life, but an evenly rotating economy is useful as a mental tool to help with the explanation of economic laws), the rate earned by capitalists in the various stages of production would be exactly equal to the natural interest rate determined by time preferences.
Different people will be either suppliers or demanders of present goods on the market at varying heights of interest, depending on their subjective value scales. Someone holding $30,000 in cash may be prepared to lend out $10,000 for a year at a rate of 4%, and another $10,000 at a rate of 5% (or higher), but he may not wish to lend out the remaining amount regardless of the rate prevailing on the market, because he prefers to hold on to this part of his money stock no matter what. This value judgment depends on the marginal utility these units of money have for him (money serves as the stand-in for present goods, because it can be exchanged immediately for all other goods traded on the market).
One thing should be clear: it is unthinkable that this value judgment will ever reverse, i.e., it is categorically impossible that future goods of the same type and quantity are valued more highly than present ones. As Mises points out above, if that were the case, one would never consume, but instead postpone consumption indefinitely. The moment one does consume something – even if one merely eats a sandwich – this action by itself already reveals the existence of positive time preference, because it was not postponed further.
The exact height of the natural interest rate is not measurable. Gross market interest rates contain additional components, namely a price premium which expresses expectations of the future decline in money’s purchasing power, and a risk premium, which reflects an assessment of the creditworthiness of borrowers and other risks attending a loan (this is also called an entrepreneurial premium, since it produces an entrepreneurial profit for lenders who have estimated and priced this risk correctly). Nevertheless, these components of the gross market rate can of course be differentiated analytically. As an aside, this can also at least partly explain the existence of negative yields-to-maturity on some government bonds: essentially, their risk premium has turned negative – they are believed to be safer than cash deposits held at banks (there is more to it than that, but this aspect plays definitely a role).
The Federal Funds rate these days requires a microscope to become visible – click to enlarge.
Keeping the foregoing in mind, imagine an economy in which there is neither a central bank, nor any credit expansion ex nihilo due to fractional reserve banking. It should be immediately obvious that society-wide time preferences will not only determine the height of interest rates, but at the same time the amount of savings made available for lending in the time market. The lower time preferences, the greater the allocation to savings will be. The interest rate is therefore a signal that so to speak tells entrepreneurs which types of investments can be profitably chosen. Longer production processes that involve additional stages of production will tend to increase output, but can only be undertaken if the required savings are sufficiently large to actually complete the necessary investments. It follows from this, as Mises states:
“Originary interest is not a price determined on the market by the interplay of the demand for and the supply of capital or capital goods. Its height does not depend on the extent of this demand and supply. It is rather the rate of originary interest that determines both the demand for and the supply of capital and capital goods. It determines how much of the available supply of goods is to be devoted to consumption in the immediate future and how much to provision for remoter periods of the future.”
It follows also that contrary to what Bernanke states above, a decline in the natural interest rate is actually the precondition for a progressing, growing economy. If time preferences decline, more savings will be available and can be devoted to investment, which is the sine qua non precondition for growth in future output. High time preferences by contrast mean that relatively more will be consumed rather than saved and invested. The economy’s production structure will accordingly have to be shortened, and hence will become less productive – even though the rate of monetary profit between the stages of production that remain will increase (see also: “The Production Structure”).
Bernanke also asserts (when referring to the savers he has waged war on, especially the contingent of retirees, widows and orphans and the like, all of whom depend on fixed income):
“But if the goal was for retirees to enjoy sustainably higher real returns, then the Fed’s raising interest rates prematurely would have been exactly the wrong thing to do. In the weak (but recovering) economy of the past few years, all indications are that the equilibrium real interest rate has been exceptionally low, probably negative.”
The idea that the natural rate of interest is or was “probably negative” has to our knowledge been first propagated by Larry Summers and was then enthusiastically embraced by Paul Krugman, i.e., the usual Keynesian suspects. Hopefully it was made convincingly clear above why this is actually a literal impossibility. If the natural interest rate had indeed turned negative, we would all have starved to death by now, because all consumption would have ceased. We are happy to report that most people in the developed world continue to look quite well fed, arguably even too well fed in many cases, so we can be sure that this logical impossibility has not magically occurred.
Central Planners Not to Blame for Distorting Markets?
We live in a world in which the supply of credit and money is literally expanded from thin air, and the central bank is at the center of this process (even though in a “normal boom” it will only accommodate the expansion of fiduciary media by commercial banks, whereas in recent years it has pumped trillions of dollars into the economy directly). Obviously, expanding the supply of money will not alter the amount of real capital and resources in the economy. Unfortunately, it does have other effects though, and none of them are good. This brings us to Bernanke’s attempt to deflect blame from the Fed for what it does best, namely distort markets:
“A similarly confused criticism often heard is that the Fed is somehow distorting financial markets and investment decisions by keeping interest rates “artificially low.” Contrary to what sometimes seems to be alleged, the Fed cannot somehow withdraw and leave interest rates to be determined by “the markets.” The Fed’s actions determine the money supply and thus short-term interest rates; it has no choice but to set the short-term interest rate somewhere. So where should that be? The best strategy for the Fed I can think of is to set rates at a level consistent with the healthy operation of the economy over the medium term, that is, at the (today, low) equilibrium rate. There is absolutely nothing artificial about that! Of course, it’s legitimate to argue about where the equilibrium rate actually is at a given time, a debate that Fed policymakers engage in at their every meeting. But that doesn’t seem to be the source of the criticism.”
What can we say, except: wrong on all counts! The first sentence we have highlighted above is an example of circular reasoning; the Fed, or rather its members, may well feel they have “no choice” but to overrule markets, but that presupposes that the institution as such is not surplus to requirements. What Bernanke is implying in this sentence is that the existence of a central planning institution that manipulates the size of the money supply and the price of credit should simply be accepted as a given. Apparently he thinks no further debate on this point is required.
However, if one accepts this premise, then why shouldn’t the government control the price of eggs, or the price of cars as well? If government bureaucrats are wise enough to plan and control the most important price ratio in the economy, then why wouldn’t it be best if they controlled all prices? Similar to most economists, Bernanke would probably agree that it wouldn’t be a good thing if government bureaucrats were indeed controlling all prices. So why exactly should the price of credit be an exception to this rule?
Broad US money supply TMS-2, with the Bernanke era (approx.) highlighted. Even if we didn’t know anything about the theoretical arguments, it would be nigh impossible to believe that markets have not been distorted by this flood of money – click to enlarge.
In the second sentence Bernanke restates something that he already admits further above in his post, namely that it is not possible to actually determine the height of the natural interest rate. He alleges that this is not where critics of the Fed are coming from, but he is wrong about this as well. In fact, this is precisely the essence of the critique. We already discussed this point in some detail in “Central Banks and the Socialist Calculation Problem”. We quoted Jesus Huerta de Soto on the topic, who trenchantly summarizes the problem faced by a central economic planning institution like the Fed:
“Sooner or later the system will inevitably run up against the impossibility of socialist economic calculation, the theorem of which maintains it is impossible to coordinate any sphere of society, especially the financial sphere, via dictatorial mandates, given that the governing body (in this case the central bank) is incapable of obtaining the necessary and relevant information required to do so.”
Even Bernanke essentially admits that it is impossible for the Fed to “obtain the necessary and relevant information” to set the interest rate at the “correct” level. His excuse essentially boils down to: “We have little idea what we are doing, but we must do something; besides, we’re trying to do our best”. So the economy is so-to-speak planned on a best effort basis. We’d rather see no such planning at all.
The problem is that trying to do one’s best simply won’t cut it when attempting to do what is literally impossible. As a result, the rates set by the Fed will always be either too high or too low, and at best coincide with the natural rate for fleeting moments by sheer coincidence. The Fed’s activities are therefore most definitely distorting prices and markets – which is precisely what Bernanke denies.
Given that the Fed per experience tends to err on the side of easy money, we experience asset price bubbles and distortions in relative prices that cause malinvestment and capital consumption (as they make capital investment in long-lived projects in the higher stages of the production structure feasible although they are not). Thus the central bank is directly responsible for the boom-bust cycle. If what Bernanke writes were actually true, we couldn’t possibly have suffered any boom-bust cycles on the Fed’s watch – but we most assuredly have. Since there exist no tenable non-monetary explanations of the business cycle, where else are we supposed to look for its cause?
In his first blog outing, Bernanke attempts to paint the Fed as a benevolent institution that cannot be held responsible for market distortions and economic cycles. It is true that the central bank has no control over the natural interest rate, but its interventions most assuredly do influence market interest rates and with that relative prices in the economy. The attempt to exonerate the Fed therefore fails – regardless of how well-intentioned its members may be, their actions in concert with the fractionally reserved baking cartel are the root cause of the boom-bust cycles that continue to bedevil the economy.
Bubbles and busts in asset prices, as reflected in the US stock market. Guess what comes next.