The Wisdom of David Einhorn’s Jelly Donuts
Earlier this week, Greenlight Capital President David Einhorn compared the Federal Reserve's monetary policy to force-feeding someone too many jelly donuts.
A Jelly Donut is a yummy mid-afternoon energy boost.
Two Jelly Donuts are an indulgent breakfast.
Three Jelly Donuts may induce a tummy ache.
Six Jelly Donuts — that's an eating disorder.
Twelve Jelly Donuts is fraternity pledge hazing.
My point is that you can have too much of a good thing and overdoses are destructive. Chairman Bernanke is presently force-feeding us what seems like the 36th Jelly Donut of easy money and wondering why it isn't giving us energy or making us feel better. Instead of a robust recovery, the economy continues to be sluggish.
That’s just one of a bunch of colorful passages in Einhorn’s long Huffington Post essay. He goes on to imagine the effect of Fed policy on Homer Simpon’s family and compares the Fed’s current monetary stance to “Walmart’s Everyday Low Pricing.”
But what seems to have escaped many readers—perhaps distracted by all the talk about Simpsons and donuts—is that Einhorn is essentially right. Monetary policy has become largely ineffective and potentially counter-productive.
Quantitative easing—or even the expectation of more QE—seems to boost asset prices but the rest of the economy is still sluggish.
Einhorn points out that rate cuts hurt the ability of retirees to save and can therefore lead to contraction rather than expansion.
“Those who have given up on earning more will have to save more and spend less. This is the antithesis of a wealth effect, and their reduced spending is a drag on the economy,” Einhorn writes.
Basically, he adopts an argument made by Warren Mosler on NetNet back in January:
It would serve public purpose if the Fed made it clear that in today's rate environment, what's called 'quantitative easing' in fact removes interest income from the private sector, thereby functioning much like a tax and a source of what's called fiscal drag, as it takes net dollars out of the economy as it reduces the federal deficit.
Furthermore, all the evidence so far indicates this source of fiscal drag may be at least offsetting any positive effects of lower interest rates on aggregate demand.
This brings up my second criticism with regards to the interest income channel. Lowering rates in general in the first instance merely shifts interest income from 'savers' to borrowers. And with the federal government a net payer of interest to the economy, lowering rates reduces interest income for the economy.
The only way a rate cut could add to aggregate demand would be if, in aggregate, the propensities to consume of borrowers was higher than savers. But fed studies have shown the propensities are about the same, and, again, so does the actual empirical evidence of the last several years.
And further detail on this interest income channel shows that while income for savers dropped by nearly the full amount of the rate cuts, costs for borrowers haven't fallen that much, with the difference going to net interest margins of lenders. And with lenders having a near zero propensity to consume from interest income, versus savers who have a much higher propensity to consume, this particular aspect of the institutional structure has caused rate reductions to be a contractionary and deflationary bias.
I’d go even further than Einhorn or Mosler. With interest income contracting, people have a propensity to save more—diminishing aggregate demand in the economy. This applies not only to retired people but to younger people, too. They see that the savings of their parents and grandparents are inadequate so they “tighten their belts.”
No amount of further easing will push households who are in belt-tightening, balance-sheet repair mode further out on the risk curve. In this atmosphere, businesses also don’t expand in reaction to lower rates—they pay down debt and “hoard” cash. It’s a classic example of the balance-sheet recession described by Nomura economist Richard Koo in his book, “The Holy Grail of Macroeconomics.” (Here’s a recent Koo presentation on the ineffectiveness of QE2.)
Even Koo’s book inadequately describes the situation. We’re not only in a private sector balance sheet recession. We’re in a public-sector balance sheet recession, with local and national governments the world over “tightening” their belts, reducing deficits, and hoarding tax income. This means that there is no expansionary fiscal policy to accompany monetary expansion, which undermines the effectiveness of monetary expansion.
The Fed has been contributing to deficit reduction. Profits from its securities purchases during easing operations are assets removed from the private sector and paid into the U.S. Treasury. Since this extra income is not accompanied by spending increases or tax cuts, it means that the economy needs to slow down or actually shrink to accompany this monetary contraction. (See my piece on Quantitative Easing as a tax.)
Einhorn proposes a rate increase as a way out of this trap.
“I know this isn't conventional thinking, and it certainly isn't the way the Fed looks at it, but I believe that raising short rates — not to a high level, but to a still-low level of 2 or 3 percent — would be much more conducive to both growth and stability,” he writes.
But I’m not sure this is possible without serious pro-rate intervention by the Fed. That is, the Fed would have to undertake open market operations to push up interest rates by selling its securities.
The natural rate of interest is almost certainly below 3 percent.
A far more productive approach, however, would be cutting taxes. This would result in an immediate increase in incomes, almost across the board. Increased incomes would enable more spending, faster balance sheet repair, and require less “manipulation” of rates by the Federal Reserve.
Unfortunately, even the Republicans are in belt-tightening mode these days and don’t seem to have much of an appetite for tax cuts.
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