Inflation Causes High Interest Rates

I was at a church one time, and the preacher read a verse from 1 Samuel about Saul the king. Then he started talking about the Saul of the New Testament who later became known as Paul the Apostle. This preacher had no clue what he was talking about. 

A recent column at National Review Online http://tinyurl.com/ygz58ym reminded me of that preacher. Larry Kudlow starts off with the claim that people in the “money business” generally believe that government deficits drive up interest rates. Kudlow takes the position that this belief is wrong. It’s really inflation that causes higher interest rates, he claims. Are you laughing yet? Economists believe that budget deficits can cause an increase in “real” interest rates. Kudlow’s inflation causing interest rate increases are “nominal” interest rates. He’s really that clueless to not comprehend the difference.

That inflation causes an increase in nominal interest rates is embraced by all. There’s really no reason to discuss it. But Kudlow addresses it in the column as if he’s presenting some new cutting edge economic principle that no one has thought of before. But with respect to budget deficits not affecting interest rates, Kudlow makes three amateur mistakes.

We had a pool, and in the winter it iced over. My science teacher said that a solid would turn to liquid when its temperature increased. When it got warmer, he said, the ice would melt. The temperature was about 7 degrees. It rose to 10 degrees, but the water didn’t melt. Then it rose to 14 degrees, twice as high as the original 7 degrees, but the ice still didn’t melt. Then it rose to 20 degrees. Then 25 degrees, but the water never melted. Therefore, it is false the theory that a solid will melt as its temperature increases. But that’s not true.

But that’s what Kudlow would have you believe. Kudlow argues that because relatively small Federal deficits in the United States didn’t result in measurable changes in interest rates, interest rates aren’t affected by budget deficits. It’s not a straight line relationship. There is a melting point, or a boiling point. No, small deficits of a few percentage points of GDP are not going to have much of an effect on real interest rates. But if the deficits build up the national debt to an extent where lenders may question the certainty of repayment, then the real interest rates will be affected. Has the United States reached that point yet? No.

But other countries have. Kudlow’s narrow view of economics does not permit him to consider the experiences of other countries. Argentina, Venezuela, and other countries have run government deficits for so long and built up their national debt so high that lenders were reluctant to invest in those countries. As a result, real interest rates skyrocketed. Kudlow’s ignorance of economic events outside of the U.S. leaves him ignorant of much economic data.

Many applauded as the New Orleans Saints won the Super Bowl. Many jokingly expressed belief that it was Kim Kardashian’s big behind on the sidelines that caused the victory. Others, also jokingly, suggested that Jessica Simpson was bad luck for the Dallas Cowboys. Primitive societies performed rain dances and even human sacrifices believing that it will improve their lives. Every time we do a rain dance, it rains sooner or later so we’ve gotta keep doing these rain dances every spring. Some might chuckle at this failure to consider other factors in determine the cause of events. But this same “post hoc ergo propter hoc” fallacy is still embraced today among some.

Which leads us to Kudlow’s third error: failing to consider other factors. In his assessment of the effects of deficits on interest rates, he examines the data as if there are no other factors affecting interest rates. During the past decade investors from Japan, China, Europe and other countries have been putting their money in the U.S. economy. This influx of investment from abroad is what many believe has helped keep interest rates so low over the past decade. And don’t forget The Fed. The Federal Reserve has maintained a low interest rate policy for decades now.

Kudlow and his ilk have been preaching their “Deficits Don’t Matter” mantra for decades now. Like Kudlow, many of them do not have degrees in economics but are merely hacks. Some politicians have used their advice as a green light to be fiscally irresponsible and are destroying this nation. And they’re still preaching their nonsense.        

The Efficient Market Hypothesis

For the past few decades, the field of economics has embraced the “efficient-market hypothesis” which claims that financial markets price assets at their intrinsic worth given all publicly available information. For example, the price of a company’s stock always accurately reflects the company’s value given the information available on the company’s earnings, its business prospects and so on.

Lawrence Kudlow, Jerry Bowyers and other popular pseudo-economists have promulgated the theory to the general public and continue to embrace the theory to this day. They argue that the minds of millions of investors, all acting in their own best interests, are smarter than the minds of a handful of economists and government officials. Therefore, the pricing of the market is accurate. They consider the performance of the markets to be the most reliable economic indicators.

The theory is so infused into economists’ minds that few pay attention to dissent. Alan Greenspan himself rejected recommendations to rein in subprime lending or address the housing bubble on the belief of this theory.   In the late 00s, suggestions that the financial system was taking on potentially dangerous levels of risk were mocked and considered misguided.

This theory was so universally accepted that when the housing bubble burst, an oft-used phrase became “nobody could have predicted it.”  But it was, however, predicted. Case In Point: The Housing Bubble. Among others, Dean Baker of the Center for Economic Policy Research predicted the housing bubble years before it collapsed. But he was ignored.

The main limitation of the theory is “paper speculation”. Many investors are investing, not in a business or real estate, but in the potential profit they anticipate receiving from reselling the security in the future. The basis for the selling price is not the intrinsic value of the business or property but the price that the speculator thinks he can get at some future date. This theory explains the stock market bubble of the 90s as well as the housing bubble of the 00s.

Another limitation is withheld information.  Insiders may have information that would cause the price of a security to decline, but they intentionally withhold this information. This took place in the Enron scandal, the housing bubble (mortgage brokers granting loans to borrowers who were unable to repay and then selling the loans to unknowing investors) and most recently Greece trying to cover up the extent of its debt.

If the economics profession is to redeem itself, it will have to abandon the assumption that everyone is rational and markets work perfectly.

"A Trade Deficit Is Good"

One of the examples of the short-sightedness of American economists is their focus on numbers, the main number being Gross Domestic Product (“GDP”).  If GDP goes up, then that’s good; if GDP goes down, that’s bad irrespective of other occurrences in the economy.  

Most people see a trade deficit as money leaving the nation.  We buy more than we sell thereby resulting in a deficit.  But there are two sides to every equation.  The other side is the capital side.  What happens to the money that we spend?  It’s invested right back in our economy, in theory.  They either invest in dollars, or debt (i.e. they loan us the money that we use to buy their products) or in capital (i.e. they buy stocks or other assets in our economy).

Economists interpret a trade deficit not as us consuming more than we produce but as foreign investors investing in our economy.  If investors want to invest in our economy rather than anywhere else in the world, then that’s a sure sign that we have a healthy economy.  And it’s true.  Despite the recent short-term fluctuation, our economy has been very healthy, and investors have been investing here and making good profits.

Investment is good.  A worker with a shovel can dig a hole faster and accomplish more than a worker digging with his hands.  On a broader scale, a manufacturing plant in Tennessee can produce more cars than no manufacturing plant.  It provides jobs for Americans, and our GDP goes up.  Usually, investment is generated by savings.  Instead of going out to dinner or taking an expensive vacation, consumers save, pool their savings and use the money to build a manufacturing plant.  They get jobs and reap the profits.  If Japan decides to invest in a manufacturing plant in the U.S., then the result will be that the U.S. will produce more thereby increasing GDP.  U.S. workers get jobs, and Japan gets a profit at the end of the year.  Everyone benefits.

But common sense tells us that if you're consuming more than you're producing, then sooner or later you're going to end up bankrupt.  If you buy more than you sell, then you have to use your savings, and after your savings is expired, then you have to sell assets or borrow.  Imagine a family consuming in excess of its income.  If the trend continues for long enough, then the family's financial position will deteriorate.  If the family borrows to invest in a college education or a business, then yes, in the long run their income will increase and the trend will be reversed.  But if the family's borrowings don't result in increased income over time, then their financial position is worse.

While a trade deficit is a sign that the economy is good, I disagree that large trade deficits over the long term are good.  After three decades, the U.S. has gone from the largest creditor nation to the largest debtor nation in the world.  We often hear about the "national debt" which represents borrowings by the Federal Government.  But consumer debt and corporate debt are also so high that it's hard to fathom.  And yes, all this is due to the trade deficit, decades of consuming more than we produce.

And investment from abroad was not in addition to our savings, it replaced it.  We have not generated savings.  The consumer savings rate has been embarrassingly low over the past decades.  And with the money from abroad, we have not invested enough in productive assets.  The government itself wastes billions per year.  Much of its budget is in the form of outlays for Social Security and Medicare that make neither businesses nor workers more productive.  Bridges collapse.  A levy can't protect a city.  Dams are aging and in danger of collapse.  Consumers have borrowed to buy luxury automobiles, big screen TVs, vacations and houses they can't afford.  Had we used the investment from abroad in productive means, then we would have been better off.  But we're not

We misspent the money.  Not just Congress.  Not just the President.  WE DID IT!  You've got your Xbox and big screen TV, a big house, a BMW and nice clothes.  And you've got debt that you and your children and grandchildren will be paying off your entire lives.

Economists have used consumer spending as the engine of the economy for decades.  Consumers spend, business profit.  The more consumers spend, the more profits.  So policies have been created to encourage consumers to spend more.  Attracting foreign investment to replace the lack of domestic savings is only one method.  Another is Social Security.  Promise consumers a monthly annuity at retirement so they don’t have to save as much thereby creating incentives to spend.  Low interest rates made housing more affordable as well as credit cards.  Consumers are so burdened with debt and government obligations that it will take more than one generation to correct it.  The party is over.

A Strange Welcome to the Free Market

While I was looking over the menu at a restaurant while on a business trip last year, I noticed that basa was on the menu.  I love catfish so I ordered both an appetizer with basa and a main dish.  My co-workers were curious as to why I seemed so enamored with something they'd never heard of.  "It's catfish," I said.  I went on to explain that a law requires catfish from Vietnam to be labeled as "basa".

Catfish farming is relatively new to the agricultural industry.  Farmers developed methods to breed and grow channel catfish in ponds and distribute the delicious fish to grocery stores, fish markets and restaurants throughout the country.  It's been a lucrative industry.  Like all money making industries, catfish farming has attracted new businesses both at home and abroad who wish to get a piece of the lucrative market.  And like fruit, sugar, cotton and other products, producers have strived to impede the competition.

Like its neighbor to the north, the once communist Vietnam has been softening up its trade policies and slowly dabbling in free market capitalism.  One of the markets they tried to enter is the U.S. catfish market.  The Mekong Delta turns out to be a great place to breed and grow catfish.  Rather than growing the fish in ponds, the farmers build cages in the river itself.  It's a lower cost means of production, and Vietnamese catfish usually goes for about $1/pound less than U.S. catfish.  With the Vietnamese competition taking a piece of the market and cutting profits, U.S. producers sought out on a mission to stop the competition.

The best way to stop the competition is to lobby Congress.  Because of international trade agreements, their options were limited.  In 2002 they came up with the idea that Vietnamese catfish wasn't real catfish.  There are various breeds of catfish: channel catfish, bullheads, flatheads, blue catfish, the little inch-long catfish you can put in your aquarium...  Different breeds of catfish can be found in rivers throughout the world.  The warm rivers of South East Asia provide a good habitat for catfish.  They're all catfish.  But U.S. catfish producers managed to convince Congress and the Bush administration that catfish from Vietnam shall not be called "catfish" but "basa".  Any catfish from Vietnam must be labeled as "basa" in the U.S.  You won't find it in your local grocery store.  It's mostly served in restaurants.

But the catfish lobby kept pressing for more.  In 2008 they convinced Congress and the Bush administration that Vietnamese catfish posed a health risk.  About 3% of salmonella deaths each year are attributed to fish.  No death in the U.S. has ever been attributed to Vietnamese catfish.  Nevertheless, U.S. catfish producers convinced the government that Vietnamese catfish posed an elevated risk and needed to be subjected to an enhanced inspection process.

Catfish producers from Vietnam say the rules do not allow sufficient time for foreign producers to convert from the Food and Drug Administration inspection process. Under the 2008 farm bill, catfish inspections are to move to the USDA.  Foreign importers say, the program would effectively ban their product.  Welcome to the free market, Vietnam.

And this is why I was so eager to eat the basa at that restaurant.  Knowing the underhanded trade practices of the U.S. catfish industry, I hadn't had an appetite for catfish for years.  As I saw it in the supermarket, I just passed it by.  When I saw it on that menu, it was not only a chance to eat the catfish that I love so much, it was also a chance to thumb my nose at immoral trade practices.  And it was just as delicious as any catfish I ever had.

Kudlow vs. Bernanke

http://tinyurl.com/yj6znpm History major Lawrence Kudlow has been writing criticisms of Ben Bernanke at the National Review dot com website for months now.  His recent column posted at Townhall.com is very critical of Bernanke and suggests that Bernanke should withdraw his name from consideration of a second term as Fed Chair based on popular opinion.

Kudlow writes that Bernanke "cut is academic teeth studying the Great Depression".  That's not true.  Bernanke was valedictorian of his high school, scored a 1590 out of 1600 on the SAT test, obtained an undergraduate degree in economics and went on to earn a PhD in economics.  He's been an educator, an adviser to a president and a member of the Board for years.  Kudlow is a history major, has no post-graduate degree and is known for hosting a talk show.

Kudlow's Townhall column starts by saying that Bernanke's credibility could be undermined if he doesn't obtain wide support from the U.S. Senate, which is made up of career politicians, lawyers and people with a sole objective of getting elected in the next election cycle.  Kudlow writes that Barnanke's main detractors are critical of him because of their desire to continue Reaganesque policies of low taxes and easy money.

Kudlow agrees with Bernanke's detractors.  Kudlow believes that Bernanke should continue the policies of his predecessor, the policies that created this mess: the strong dollar.  It is true that Bernanke had studies the Great Depression.  But he studied it from an academic point of view, not a political point of view.  For example, tax cut fanatics want to blame the Great Depression on high taxes; anti-immigration fanatics want to blame it on immigration.  Bernanke studied it from an objective point of view.  One effect that worsened the Great Depression and made recovery more difficult was the shrinking of the money supply, i.e. deflation.  When banks lend, it results in an increase in the money supply.  During the Great Depression, banks were reluctant to make loans thereby causing a decrease in the money supply.  The same thing is happening today.  Banks are reluctant to make loans in an atmosphere of uncertainty and a high rate of business failure.  Bernanke's policies seek to counter this effect.

Bernanke's policy is a response to desperate times, a severe economic decline with a threat of a long term depression.  Kudlow disagrees with this.  He thinks that the threat of deflation is passed.  Kudlow goes on to say that the majority of the public do not support Bernanke's reappointment and that therefore Bernanke will be "totally ineffective" as Fed Chair.  Without the support of the lawyers and politicians in the Senate and without the support of the general public (most of whom have absolutely no education at all with respect to macroeconomics or monetary policy), he should withdraw his name from consideration.

What should he do?  Should a well educated genius withdraw his name from consideration so someone more popular can be appointed?  Maybe Miley would be willing to serve.  It's ridiculous.  We are in a very dangerous point in our short-term economy.  Should decisions be made based on what is popular?

The fact is that the Fed has to make tough decision that might not always be popular.  That's the very reason why the Fed was designed as a non-political entity.  Yes, the Board is appointed by politicians, but the Fed is not elected and operates independently of the government and for good reason.  To suggest that the Fed governors be appointed based on popular opinion provide incentive for the Fed to base policy decisions based on popular opinion.  What Kudlow is proposing could lead to a catastrophe.