An unnatural rate of economic ignorance

Having taught modern policy just this week, about inflation targeting and the natural rate of interest, and again while doing it wondering whether such gross stupidity can still persist when it has caused nothing but grief, it was nice to see this in The Australian today, by David Uren, that all is still wrong with the world and economics remains stuck in the same rut it’s been in for thirty years. This is from his article, Stubbornly low inflation tests even RBA’s patience:

When Philip Lowe took up the governorship of the Reserve Bank of Australia a year ago, financial markets were betting he would be cutting rates within six months. Today they are betting he’ll be raising them by May next year.

After Tuesday’s RBA board meeting, Lowe said there would be no change in rates, as he has after every meeting since his first as governor in October last year. . . .

It is as if the economy were stuck in first gear, and the Reserve Bank keeping its foot to the floor is neither making it go any faster nor lifting inflation. Central banking the world over is in ferment as top officials wrestle with the risks created by a decade of ultra-low rates and with their failure to generate the modest inflation required by their formal targets.

The inflation targeting framework that has governed the world of central banking for the past two decades, and that seemed to work so well at taming runaway inflation, is now struggling to deal with price rises chronically undershooting the mandated goals.

The Reserve Bank has been pursuing a target of keeping inflation between 2 per cent and 3 per cent since the early 1990s. The underlying rate of inflation (which strips out volatile movements such as petrol price jumps) has been below 2 per cent since the beginning of last year and the RBA’s projections suggest it doesn’t ­expect a ­return to the desired 2.5 per cent until the middle of the next decade. The same is true the world over, and it is leading central bankers to question whether their explanation of the economy and their impact on it is correct.

In a speech last week, US Federal ­Reserve chairwoman Janet Yellen pondered whether there was a “risk that our framework for understanding inflation dynamics could be misspecified in some fundamental way”. A week earlier, Bank of England governor Mark Carney had claimed globalisation was responsible for weak inflation but said he was not ready to ditch his bank’s inflation target.

The Bank for International Settlements, which is a kind of central bank to the world’s central banks, warns that the inflation targeting framework is fostering a dangerous build-up of risk. Head of its monetary and economic ­department Claudio Borio says central banks must “feel like they have stepped through a mirror”. Having spent their lives struggling to bring inflation down, they now toil to push it up. Where once they feared wage increases, now they urge them on.

Borio challenges the intellectual underpinnings of central banking. For the past century it has been assumed that there is a “natural” (or “neutral”) rate of ­interest that balances the needs of savers and investors. If a central bank sets its policy interest rate below this natural rate, it will ­encourage people to run down their savings and lift spending, pushing inflation higher. If the policy rate is higher than the natural rate, people will save more of their income to take advantage of the higher rates, spending less, and inflation will fall.

The theory runs that while central banks set the short-term rate of interest, long-term bond rates trend ­towards the “natural rate”. But this natural rate of interest is an economists’ hypothesis — it can’t be seen or measured, except by economists’ models. Borio calls it an “abstract, unobservable, model-dependent concept”.

Low interest rates are one of economic theory’s worst ideas ever, a notion once universally understood by all and now understood by none. Economic theory will have to relearn the lessons of the nineteenth century. It is quite quite astonishing to see these errors compound and the undoing of this mess won’t be pleasant. So to the article’s end:

The RBA slashed its cash rate from 4.75 per cent to 1.5 per cent between late 2011 and late last year, triggering a house price boom that pushed up household debts by an average of almost 7 per cent a year.

This week the International Monetary Fund said household debts much above 60 per cent of GDP were a threat to growth and financial stability. The RBA’s measure of the household balance sheet shows debts have soared from 120 per cent of GDP to 137 per cent since 2011, putting them among the highest in the world.

Lowe worries that a small shock could turn into a much lar­ger downturn as households seek to repair their balance sheets. The danger is that debts are already so high that any rise in rates would crunch household spending, while rates are still low enough to make further borrowing attractive. With no path forward, the Reserve Bank is stuck where it is.

As for the theory that explains it, you could go to Keynes, not The General Theory where he abandoned it all, but to his very orthodox 1930 Treatise on Money where he discussed the natural rate of interest in just the way it had been discussed since the end of the nineteenth century. Or you could go to the last two chapters of my Free Market Economics, whether editions one, two or three, since it is the same message in each.

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9 Responses to An unnatural rate of economic ignorance

  1. Mark A

    Steve, I’m not an economist’s bootlace, but when you make a statement like this :
    “Or you could go to the last two chapters of my Free Market Economics, whether editions one, two or three, since it is the same message in each.”

    If you think you are the bees’ knees, then why aren’t you revered and celebrated?
    Serious question, is everyone else out of step?

  2. Ƶĩppʯ (ȊꞪꞨV)

    Central banking the world over is in ferment as top officials wrestle with the risks created by a decade of ultra-low rates and with their failure to generate the modest inflation required by their formal targets.

    The Great Replacement© hasn’t quite been what it was cracked up to be.

  3. Bruce of Newcastle

    Actually the low inflation regime is at least partly a result of a giant Says Law experiment.

    China has been manufacturing stuff like crazy and the manufacturers will try to sell you pretty much anything they can think of. I like walking through dollar shops to see the sheer amount of stuff you can now buy.

    All extremely cheap – I was thinking to myself the other day that the cheap Sanyo vacuum cleaner I bought for $50 thirty years ago (and which still works very well) would be purchasable for $40 or so today. So it has suffered total “inflation” of minus 67% measured against the ATO’s official CPI rate.

    Also the headline rate of interest is not the real rate of interest that mere mortals pay, as anyone in a SME could wincingly tell you. So the real effective business rates of interest are more like the natural interest rate than the surface data suggests. APRA has also been contributing to that by monstering the banks, who’ve used the excuse to raise interest rates where possible in light of competition.

    The upshot is that a lot of natural economics is going on under the surface – which those in control do not actually control – nor measure correctly, in the cases I strongly suspect of both inflation and interest rates.

  4. Tator

    Economic ignorance runs rampant in Australian society.
    As Bruce of Newcastle illustrated and DoomLord posted on with his article on how governments drive inflation and how currently private industry is deflating prices via productivity and economies of scale, we still get leftards discussing how we should give the poor people more of other peoples money via the aged pension or welfare as that will drive up demand because Keynesian dictates that they spend more of their income on consumer goods than wealthy people do. Doesn’t take into account the fact that the wealthy create employment via entrepreneurship and building businesses that value add to wealth.
    On top of that you have the MMT muppets saying the government doesn’t need to balance the budget as they are a sovereign currency issuer and who also say the rich need to pay their way via higher taxes. My understanding is that if you apply MMT, taxes do not pay for anything but just destroy money whilst governments create new money by spending. Thus rendering progressive tax rates into a punitive regime to satisfy politics of envy.
    So many morons, not enough ammo.

  5. mh

    At the next election the Coalition government should run the campaign slogan of John Howard in 2004: Keeping Interest Rates at Record Lows

  6. The Pugilist

    If you think you are the bees’ knees, then why aren’t you revered and celebrated?
    Serious question, is everyone else out of step?

    I’ll tell you why…It’s because to accept Steve’s logic (and the logic of his predecessors), you’d have to pop the bubble (no pun intended) that says that central bankers are these wise all-knowing, all-controlling deities who can control the economy with a tweak of their levers.

    In essence, central bankers are really just central planners in the money market with incomplete information and so, this form of monetary socialism is bound to fail. But anyone who dares question the emperor’s clothes is professionally excommunicated from the high priesthood.

    Just like government’s can’t accept the socialist calculation problem and the concept of emergent order…lest they do themselves out of a job. Economists have lost sight of the fact that they cannot control the economy. They can (or should) only seek to explain it. Politicians feed this egomania…

  7. sdfc

    My understanding is that if you apply MMT, taxes do not pay for anything but just destroy money whilst governments create new money by spending.

    Operationally that’s correct.

  8. H B Bear

    At the next election the Coalition government should run the campaign slogan of John Howard in 2004: Keeping Interest Rates at Record Lows

    Another Lieboral lie. Invites the question, why areinterest rates are now lower than during the GFC?

  9. sdfc

    why are interest rates are now lower than during the GFC?

    Because there is a mountain of household debt hanging over the economy.

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