I’m very reluctant to criticize Raghuram Rajan, as he’s been a careful and brilliant economist over the years who has voiced prescient warnings about our current financial crisis.
But he’s been lately arguing some odd ideas unsupported by very much evidence. In his latest piece, he argues that currently lax monetary policy is a durable threat to the economy. Low interest rates encourage borrowers to take on risky and speculative investments, while piling on debt.
Scott Sumner takes down this argument fairly effectively. But there is another reason it’s wrong—interest rates aren’t low.
Check out this graph from Robert Hall:
The chart shows interest rates on various forms of investments. Ideally, once the recession began, we should observe that looser monetary policy (or other stimulus measures) should work to reduce interest rates across all asset categories—this is, after all, what Rajan and others argue happened when interest rates were too low from 2002-2004.
Instead, monetary stimulus has had a limited effect on interest rates. You see lower rates in Treasury bills (where the Fed has indeed purchased many T bills as a part of conventional policy), as well as for mortgage-backed assets (where the Fed has purchased over a trillion dollars of GSE-insured assets). But you don't see it in other asset categories.
In fact, government policy is pushing in the opposite direction in the case of credit cards. In the first part of 2009, interest rates on credit cards shot up. This is directly attributable to credit card legislation which made it much more difficult for credit card companies to adjust rates in the future. Unsurprisingly, they all raised rates immediately while cutting credit lines—sparking a credit crunch which made the recovery much harder. Thank you, Elizabeth Warren.
It’s unclear why monetary policy is doing so poorly in this case. Presumably, problems in the financial system are clogging the system, so to speak, limiting the ability of stimulus measures to impact the real economy. A big part of this is probably due to the Fed’s decision to start paying out interest on bank reserves in 2008. In a single stroke, the Fed managed to devastate the monetary base by converting non-interest bearing reserves—which are interchangable with currency—into an interest bearing security. This massively tightened monetary policy in a critical period; has made measures of the monetary base unreliable as estimates of the stance of monetary policy; and has made banks entirely unwilling to lend money as long as they have the option of keeping it at the Fed.
So we need very different monetary policy. Aside from changing the policy of paying out interest to banks to charging banks for the money they store as reserves--one option would be to alter the Fed’s charter to allow it to engage in more robust monetary policy. As far as I know—the Fed can only purchase assets under government guarantee (ie, Treasury bills and GSE-insured assets). It would be simple enough to allow the Fed to also purchase all sorts of assets as long as they are under a credit default guarantee. This would dramatically improve the ability of the Fed to alter monetary policy, completely eliminate any need for fiscal stimulus, and finally lower interest rates. And then Rajan’s complaints would at least respond to ongoing events.