Tuesday, November 16, 2010

Motes vs. Beams

People, Dean Baker is quite a piece of work. He goes after people hard with what I will charitably describe as less than a fully correct analysis.

Here's another example, a post purporting to explain "Robert Samuelson's confusion on real interest rates:

In an economy operating below capacity, it would be desirably to have very low real interest rates to boost investment. This means that the cost of borrowing is low relative to the return on investment. Because interest rates can't go negative, it is impossible for real interest rates to fall as much as would be desired given the weakness of Japan's economy. It would be ideal if it could keep its nominal rates at their current near zero level, while inflation rose to 3.0 or 4.0 percent.

The other reason why inflation would be desirable is that it would allow homeowners to get out from under their debt burdens. If wages rose 3.0-4.0 percent annually in step with inflation, the burden of a fixed mortgage debt would be eroded through time. Also, if house prices rose in step with inflation, consumers would gain equity in their homes.

Excuse me for a moment.....


Thanks, now I feel a bit better. I think I may even be able to make a couple comments.

First, if the real rate is negative, then investment projects with a negative return may actually be "profitable". If the real rate is -4%, then a project with a -2% return "works". Strange way to rebuild an economy, no?

Second and more importantly, the most widely used model of the real interest rate is the Fisher equation which states that the nominal rate is equal to the required real rate plus a premium for expected inflation. It is beyond bizarre (but sadly not uncommon) to assert that inflation can rise significantly without nominal rates also rising.

Third, if inflation rose in a predictable manner, mortgage interest rates would rise as well (see point two) and there'd be no "savings" on new mortgages.

Fourth, to the extent that inflation was unanticipated, yes, borrowers would gain. But this is a zero sum game. Lenders, who after all are people, consumers, and voters too would lose an equivalent amount.

Fifthly and finally, as for how inflation builds home equity, all I can say there is WTF??? Housing is in the CPI. If all prices go up 3% how is the real value of your home increasing?

People, I am fine with trying a little bit of inflation here in the US of A. There are tons of idle cash sitting around, inflation is a tax on holding money, so maybe peoples will spend more. I don't think QE2 is the first sign of the apocalypse. But, even if it works to the specifications of its most ardent supporters, it's not going to come close to solving our problems.


John Thacker said...

Fifthly and finally, as for how inflation builds home equity, all I can say there is WTF??? Housing is in the CPI. If all prices go up 3% how is the real value of your home increasing?

It's not, but the real value of your equity can, because your debt, unlike the value of the house, doesn't rise with inflation. Simple mathematics.

Suppose you have a mortgage on a house worth $200,000, on which you owe $100,000 on a fixed rate mortgage. You have $100,000 in equity.

If inflation increased by 10%, then your house is worth $220,000. You still owe $100,000. You have $120,000 in equity, which in real terms is like $109090.91 in the old money. Real equity has gone up.

That's what he's saying there.

John Thacker said...

Note that that's separate from the effect that your $100,000 that you owe is a smaller burden (assuming wage inflation as well) regardless of whether your home price goes up.

In short, though he may be wrong on the other issues, I think he's correct here.

People who have fully paid off their mortgage do not gain equity if home prices increase with inflation (and they do worse if home prices don't match), but anyone with a mortgage debt does.

Norman said...

I'm not quite sure about the second point. The Fisher equation isn't a causal theory so much as an accounting identity, right? I think the narrative he had in mind:

The Fed targets the nominal interest rate through activity in the bond market. If it targets the nominal rate at zero, then the Fisher equation says that the real interest rate will be the same as the inflation rate but opposite in sign.

Meanwhile, the quantity theory says that money growth will eventually translate into growth in prices (and if it goes into real growth instead, so much the better?). If the Fed, while continuing to hold nominal rates at zero, finds additional ways to increase money growth, this will increase the inflation rate, which must of necessity decrease the real interest rate.

So if the Fed has a way to set both nominal interest rates and inflation rates, then it's the Fisher equation which says the Fed can therefore set real interest rates.

Of course, if money demand isn't exogenous and highly stable, or if the relationship between the targeted federal funds rate and other nominal rates isn't stable, then this narrative doesn't work too well. But unless I've been miseducated on the matter, I don't think the problem lies with failing to properly interpret the Fisher equation.

Angus said...

Fisher argued that the real rate was independent of expected inflation and that the nominal rate would adjust one to one with changes in expected inflation.

So if the required real rate is 3% and expected inflation is 3%, the nominal rate would be 6%.

The ex-post real rate is often measured as the nominal rate minus expected inflation, but that does not imply that that is how the real rate is actually set.

Another way to think about this is instruments and targets. The Fed has pretty much one macro policy instrument, manipulating reserves. They can use that one instrument to hit one independent target but not two.

I fear that you have indeed been miseducated on this matter.