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Weekly Economic Commentary

 
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We Are All Keynesians Now - Except Me

November 22, 2011

Download PDF version

If you want federal debt reduction, you are going to get it Super-Committee “failure” or not. The recent debt-ceiling legislation calls for $1.0 trillion less-than-otherwise federal spending over the next 10 years. The “trigger” calls for $1.2 trillion less-than-otherwise federal spending over the next 10 years. And, with the return to the Clinton-era personal tax rates for all household income groups on January 1, 2013, revenues will increase by $3.5 trillion more-than-otherwise over the next 10 years. So, that is $5.7 trillion of less federal debt issuance than otherwise over the next 10 years. Now, that’s what I would call a grand bargain. And don’t forget, unless Congress acts before yearend 2011, an extra $168 billion of federal debt that otherwise would have been issued won’t be because of an expiring FICA tax “holiday” (just in time for the holidays?) and the expiration of extended unemployment insurance benefits. The U.S. as the next Greece? I beg your pardon. Try Canada, eh?

But most economists are not celebrating this significant prospective slower growth in federal debt. Rather, this dismal lot is busy marking down their real GDP forecasts. Why? Because they are partial-equilibrium Keynesians. Allow me to explain why I think they are too quick to reduce their forecasts of economic activity.

If the government borrows less than otherwise, then, all else the same, the demand for credit, at the margin, will have fallen. Entities that had intended to restrain their current spending in order to transfer that spending power to the government now find themselves with more spendable funds than planned. They may be able to entice someone else to borrow and spend if the interest rate at which they are willing to lend is lowered marginally. And/or, at a lower interest rate level, these lenders may decide to become spenders themselves. So, with the government demanding less credit over the next 10 years, private borrowers will step up to absorb the “excess” offered credit and/or lenders will become spenders themselves. So, why mark down your GDP forecast?

It could be a bit more complicated if we take into consideration Fed policy and banking system credit creation. And, this is where some markdown in the GDP forecast could be appropriate. Suppose the Fed is targeting the level of the federal funds rate when the government’s demand for credit is increasing more slowly. As I indicated, this weaker demand for credit would result in a decline in the interest-rate structure, all else the same. But all else is not the same if the Fed is targeting the level of the federal funds rate. If the Fed maintains the same target level of the federal funds rate in the face of weaker overall credit demand, then the interest-rate structure will not be permitted to fall fully to its new lower equilibrium level.

How does the Fed maintain the same level of the federal funds rate in the face of weaker overall credit demand? By draining cash reserves from the banking system. What happens to bank credit growth under these circumstances? It slows. Why? With the interest rate structure not being allowed to decline to its new lower equilibrium level, the quantity demanded of nongovernment credit (a movement along the credit demand curve) will not increase enough to offset the decline in the demand for government credit (shift back in the credit demand curve). Some of the credit demand that banks were providing is now being accommodated by the entities who were formerly lending to the government. Hence, with overall credit demand growing more slowly, bank credit growth slows. Why don’t banks lower their loan rates more to restore their loan growth? Because banks’ marginal cost of funds, the federal funds rate, has not declined even as their loan rates have. In effect, banks’ marginal return on capital has declined.

In this case, the slower growth in the demand for government credit will lead to a decline in the growth of bank credit. Remember, banking system credit, along with Fed credit, is credit created “out of thin air.” An increase in the growth of “thin air” credit results in a net increase in the growth in spending in the economy. Conversely, a decrease in the growth of “thin air” credit results in a net decrease in the growth in spending in the economy. Thus, to the extent that weaker growth in government credit demand results in weaker growth in bank credit, then the GDP forecast should be marked down. But because the decline in the dollar change in bank credit is likely to be of a smaller magnitude than the decline in the dollar change in government credit demand, the markdown in GDP growth would be much smaller than the Keynesian forecasters are contemplating.

If the Federal Reserve were targeting a rate of growth in bank credit (or even more radical, targeting a rate of growth in the sum of bank and Fed credit), then, in the face of weaker growth in government credit, the Fed would operate so as to maintain the growth rate in bank credit rather than passively allowing it to slow. In this case, weaker growth in government credit demand would not result in weaker bank credit growth. Thus, there is no reason to markdown one’s GDP forecast.

So, in my non-Keynesian (lonely) world, whether slower growth in government credit demand leads to slower growth in overall economic activity depends critically on the behavior of bank credit growth. If the Fed is targeting the federal funds rate, which it normally does, and does not lower its target rate so as to maintain the growth in bank credit, then the pace of future economic activity likely will be slower, but not nearly as slow as the Keynesians argue.

Note: The comments above are dedicated to the memory of Robert (Bob) Laurent, Milton Friedman’s most brilliant student (in my opinion) and my most brilliant “teacher.” If only Bob were here, someone would understand these comments. I miss you, man.

Are We about to Find Out that the Fed “Has no Clothes?”

From the minutes of the November 1-2 FOMC meeting, we learn that the Committee had an in depth discussion about policy communication. (I wonder if they brought in consultants and engaged in role playing.) As usual, no decisions on changing the FOMC’s communications policy were made. Below is a passage that caught my attention:

"More broadly, a majority of participants agreed that it could be beneficial to formulate and publish a statement that would elucidate the Committee's policy approach, and participants generally expressed interest in providing additional information to the public about the likely future path of the target federal funds rate. The Chairman asked the subcommittee on communications to give consideration to a possible statement of the Committee’s longer-run goals and policy strategy, and he also encouraged the subcommittee to explore potential approaches for incorporating information about participants’ assessments of appropriate monetary policy into the Summary of Economic Projections."

The first rule of economic forecasting is never give a date along with a numerical forecast for GDP/inflation/unemployment. The second rule of forecasting is that if you violate the first rule, never give a fed funds rate forecast with your GDP/inflation/unemployment forecast. This is sure to embarrass you if anyone keeps a record. Now, just after I read this passage from the FOMC minutes, I happened to catch this Reuters News headline:

“[Minneapolis Fed President] Kocherlakota [says] FOMC Forecasts Do Not Reveal ‘Special Information’ About Economy.”

Talk about an understatement! If the FOMC begins to lay out a federal funds rate forecast that it thinks is consistent with its economic forecast, the public is going to find out, indeed, that the FOMC has no “special information.” At a time when the American people are losing confidence in so many of our institutions, is wise for the Fed to expose itself to such public scrutiny?

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The opinions expressed herein are those of the author and do not necessarily represent the views of The Northern Trust Company. The Northern Trust Company does not warrant the accuracy or completeness of information contained herein, such information is subject to change and is not intended to influence your investment decisions.
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