Greg Ip is the Chief Economics Commentator of the Wall Street Journal. He writes about US and global economic developments and policy in the Weekly Capital Account Column, and on Real Time Economics, the Wall Street Journal's economic blog. Greg joins David to discuss his book, “Foolproof: How Safety Can Be Dangerous and How Danger Makes Us Safe.” In addition, David and Greg discuss how perceptions of risk, safety, and moral hazard impact the way economists confront contemporary policy problems.
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David Beckworth: Greg, welcome to the show.
Greg Ip: Thanks for having me, David.
Beckworth: Well, thank you for being here. I'd like to begin by asking how did you get into macroeconomic journalism?
Ip: Well, I actually came about it honestly because I got it from my upbringing. My mother was a working economist who worked in an investment bank, later on she actually worked at the Bank of Canada. But she liked to try and apply economics to child rearing. And so, she decided that we were more likely to do chores if we're properly incentivized. So, she would pay us to do our weekend chores and would pay us for the chores that were less pleasant. I like to say I was the only kid that I knew whose weekly allowance was indexed to the consumer price index. That's a true story, by the way.
Ip: When it came to time to choosing my college career, I knew that I liked to write, I liked to write short stories and so on, but I also knew that I needed a viable way to make money. In college, I took economics and I took journalism and I thought, "Well, if I can't make a go of it in journalism, I can become an economist." And I didn't really think that I would actually end up being an economics journalist, but that's what I started as, and that's where I am now. I managed to combine my two great loves, economics and writing.
Beckworth: Wow. That's an interesting story. You went to Carlton University, is that right?
Ip: That's right. In Ottawa, Canada.
Beckworth: And did you by chance have Nick Rowe as a professor?
Ip: I had Nick Rowe as a professor. He was actually my honors advisor.
Beckworth: No kidding.
Ip: No kidding at all.
Beckworth: So, you were probably pleasantly surprised to see him when he started blogging about some of the crisis.
Ip: That's right. I remember him actually telling his followers something very nice. He said, "Well, Greg is smart because he got economics at Carlton, and because his mother is an economist."
Beckworth: That's neat, small world. Hopefully Nick is listening and can weigh in on this at some point. All right, let's talk about your book, your most recent one, Foolproof: How Safety can be Dangerous and How Dangerous Makes us Safe. Why don't you summarize your arguments in there and bring up the key points that you think are important.
How Safety can be Dangerous and Dangerous Makes us Safe
Ip: Sure, let me actually segue to it from a little bit about my career because I graduated from Carlton in 1989, and I immediately found jobs writing about economics in Canadian newspapers. In '95, '96, I should say, I moved to the United States. So, about 20 years, actually between graduating and 2008, I was writing about economics in one way, shape or form. So, that was 20 years in the business. And frankly, by that point I had come to believe that I understood how economics worked. And I actually had learned a lot of faith in central banks and our economic overseers. It really felt to me like Alan Greenspan and Ben Bernanke had it all figured out. They had given us the Great Moderation, this amazing 20 year period of declining unemployment, stable inflation, just two very mild recessions, ever rising asset prices, and it was very hard for me to imagine how all of this could go wrong because they had really had it figured out.
Ip: Only later on after the disaster did I stumble across Hyman Minsky and realized that the very mechanism of stability I had so much faith in, was in fact encouraging complacency among many people. With me, for example, but also with Ben Bernanke and other people who felt that they had actually solved the problem of macroeconomic instability. I wrote this book as kind of a mea culpa, to try and figure out what is it about our way of thinking about the world that tripped us up. And what I discovered in the reporting of my book is that this belief in safety trips us up in many worlds. It's not just in economics and finance, it's even in things like natural disaster, where building levees next to rivers makes us feel safe, but it just means that there's more damage when the levees fail. It even happens in things as routine as like raising our children or playing football.
Ip: It turns out that one of the reasons concussions are such a problem in football is because players wear hard helmets that enable them to hit each other harder. What I tried to do, explore this very sort of tenancy as we as human beings, for basically since the beginning of civilization to make our world safer is by and large been a very successful effort. We live longer and healthier lives, but periodically we have these disasters, whether it's the financial crisis, whether it's the Euro zone crisis, whether it's Super-storm Sandy or Katrina that expose to us just how our hubris about trying to design these well controlled engineered systems is actually embedded risk on all sorts of levels.
Beckworth: Okay. You speak in that book to the financial crisis quite in depth, but what were some of the problems and issues that you saw that could have been done different maybe had we had a better approach. You talk about the engineers versus the ecologists and I guess, economists, the people you had faith in, would be the engineers.
Ip: That's right.
Beckworth: Okay, so we're guilty of being engineers. How could we have done things a little better, I guess, to be more cautious?
Ip: Let me explain my engineers versus ecologists distinction. To me, an engineer is somebody who basically says, "We have this body of knowledge about how economies or biological systems work, let's use that knowledge to actually prevent disaster, whether it's forest fires, epidemics or financial crisis." An ecologist says, "That sounds all well and good, but we know that these systems are adaptive and that once you try and change them in one way, something else is going to change." That's what I think happened in our economy in a couple of ways.
Ip: First of all, the great moderation was about defeating inflation and ironing out financial instability. Now I know you David, are a big believer that a central bank, if it chooses the right target, whether it's nominal income or whatever, it can actually essentially abolish the recession problem. But I would argue, and I think Hyman Minsky would argue the opposite. They would say, "No, the more success you have in fooling us, and I think the recessions have been avoided, the more risk you have. Defeating inflation actually had the perverse effect of convincing people that interest rates wouldn't shoot up, you wouldn't have a bad recession. So, it was okay to take on more debt. It was okay for banks to have more leverage. It was okay for home owners to pay higher prices for houses." And so, this actually created the debt financed bubble that helped bring us down.
Ip: There was another effect here, and this was much more subtle and it came in the world of regulation. One of our responses to early banking crisis in the '70s and '80s was to require banks to have more capital and to regulate them better. It did work, banks actually had a lot more capital in 2008 than they did 20 years earlier. But by making banking more safe, it also made them less profitable. And so, a lot of the risk migrated out of the banking system to other places, and it ended up in places like money market, mutual funds or repo loans. And we thought that was a good thing because we said, "Well, money market funds and repo loans aren't part of the banking system." It's okay if there's problems there. But what we didn't realize was they had actually fueled a whole shadow banking system of risk.
Ip: One of the lessons I think is that you shouldn't try too hard to regulate your way out of future problems, and you should, to a certain extent, accept the fact that you will have bank failures and you'll have periodic disruptions and possibly recessions. And it may actually be better to have lots of small financial disruptions than one big financial disruption.
Beckworth: I remember watching House of Cards in a CNBC special, looking back on the crisis and they interviewed Alan Greenspan. And they asked him, "Weren't you aware of what was going on during the housing boom? Where were the regulators? Where was monetary policy?" And he responded by saying, "Did you want a recession in 2003? Did you want?" And I think what you're suggesting is maybe a smaller, milder downturn back then would have been better than the big blowup we had several years later.
Ip: Right. Now, one of the things I do in my book, is I have a whole chapter describing how, if you're the person who has to make the decision about whether to let a bank fail, perhaps allow the recession to happen, it's a very tough position to be in. I draw the analogy to forest fires. We know that if you suppress too many fires, you actually allow more fuel to build up and you get bigger fires in the end. In fact, that's one of the reasons why we've had such severe fire seasons in the United States and Canada. But to be in the position of actually allowing that fire to burn, you end up with like Yellowstone in 1988. And in fact, I interviewed the guy who was in charge of Yellowstone and made the decision to let those fires burn. It ended up being a total disaster.
Ip: In '91, Bank of New England was on the verge of... it actually did fail and the government had to make the decision, do we bail out the uninsured depositors, and there was a big argument between people at the Treasury and people at the Fed. The Fed said, "Well, if you let the uninsured depositors fail, there will be runs on banks everywhere in Europe and North America on Monday morning." The Treasury said, "We don't want that, and they bailed them out." But that, of course, inculcated the entire sense of moral hazard and risk. That's kind of what Alan Greenspan was getting at. Where in this process did you want us to basically step back and allow market forces to play out.
Beckworth: All right, let's move on to maybe a template episode of engineering by economists and that's recently there's been increased discussion of helicopter drops as a way to solve the doldrums of the global economy. The US is doing relatively well. There's some issues that you've shown in your writing, but in Europe and other places where they are really struggling, there is more and more people calling for helicopter drops and you had a call on March 21st, Time and Place for Helicopter Drops. Tell us, what is a helicopter drop? How is it different than QE? Because as you well know, I mean, Ben Bernanke has been labeled, Helicopter Ben, because of QE. How are helicopter drops different than QE?
Difference Between QE and Helicopter Drops
Ip: Let's just do a little bit of monetary policy 101 here. Central banks, as you know, their job is to raise and lower interest rates in order to adjust the ups and downs of the economy. Now, as a practical matter from day to day, the way they do that is they buy and sell small amounts of government securities and by increasing and decreasing the amount of money in the banking system, they cause interest rates to go up or down.
Ip: In 2008, interest rates in most countries including the United States went to zero because that's how bad the economy was. Having lost a traditional tool of adjusting the economy, they turned to quantitative easing. Instead of working on short term rates, they decided to work on long term bond yields and this involved going out into the market and buying literally trillions of dollars worth of bonds.
Ip: Now, if you and I had to go out and buy bonds, we'd actually have to come up with money to do it, but the great thing about being a central bank is you just print the money. You press a key and it just appears magically. That's quantitative easing.
Ip: Now, the difference between quantitative easing and helicopter money is as follows. With quantitative easing, all you're really doing is taking a bond away from the public and giving them $20 bills. You actually haven't altered the demand for goods and services, which is what economic growth is really about. You're hoping that those people with the $20 bills will decide, "Well, I don't want to just hold cash, I'm going to go invest that in something more interesting like a building or a business." And that will create demand, but there is no guarantee.
Ip: So, how do you get around that problem? How do you actually cause money printing to force people to spend money? You team up with the government. The government says, "We're going to run a big deficit and we're going to slash taxes, or we're going to spend a whole lot of money sending checks out to people. And you Federal Reserve, you're going to actually help us by simply printing the money that we need." That's what we call a helicopter drop of money, because it's like dropping money on people from helicopters. And it's pretty much guaranteed to produce higher spending and ultimately higher inflation.
Ip: The question that I want, and you're hearing a lot about it these days, because in a lot of countries, whether it's Japan, or the United States or the Euro-zone, central banks are just not very happy with the results they've had with traditional policy of lower short term interest rates and the unconventional policies of quantitative easing, going out in the market and buying bonds. They say, "We need better results, inflation is too low, it's below 2%. We want it higher than that. Economic growth is too low." So, they are casting around saying what tools are available to do a better job than what we have. Now, I would characterize this as the ultimate in economic engineering.
Ip: In other words, we're not satisfied with the results we have in the broad economy. We have to come up with even more elaborate schemes to try and force employment higher. And this is where I think you need to start worrying about unintended consequences. The first question I think you have to ask is, is it really needed? The global economy for all the gloom, it's not really the disaster zone that everybody seems to make it out to be. And the first statistic I would point out to people is the unemployment rate. It's 5%, in the United States, a lot of people think there's full employment.
Ip: Now, I'll recognize there might be a lot of hidden unemployed. So, let's say that real unemployment is 6%. Well, that's still pretty close to healthy economy. In Japan, the unemployment rate is the lowest since the 1990s. The reason economic growth is so weak is because it's an old society, the number of people in the workforce is declining. As your colleague Scott Sumner has said, "An economy with declining employment is going to have a very low growth rate. And they're going to have a lot of recessions just by virtue of the fact that your growth is fluctuating around zero all the time."
Ip: Even in Europe, which is still a mess, their unemployment rate has been steadily dropping by two percentage points. The first point I like to say is, don't assume that the policies we have in place right now aren't working. If you look at the unemployment rate, they are working. The second point I want to raise David, is, are we actually overreaching here? Are we now trying to load so much responsibility onto macroeconomic policy that we are going to recreate some of the problems that I've talked about through history, unintended consequences? We've already seen that when central banks work so hard to create full employment with low interest rates, they can create asset bubbles.
Ip: We had an asset bubble in the 90s. It burst, the response to it was low interest rates. We got the housing bubble, it burst, the response is low interest rates, and we got a commodity bubble. People may not put two and two together, but the fact there so much money poured into shale oil, so much money poured into emerging markets and commodity economies was partly a response of our central banks working very hard to boost growth with zero interest rates. If you go the next step with helicopter money, what unintended consequences are you going to end up with? Will we get higher growth? Maybe. Is that a benefit that's worth the price of paying a potentially more instability?
Ip: If this was the Great Depression with 25% unemployment rates? I would say, "Go for it." Today, I just don't think that it meets the cost benefit test.
Beckworth: Okay. You think the costs are too high to engage in more unconventional practices? Well, I want to go back to the basics you're outlining before quantitative easing. And in the article, you wrote that I mentioned the time and place for helicopter drops, it's really good reading. I encourage the listeners to go take a look at it. I just want to mention an excerpt from your article, you say, "Unlike with QE, the Fed promises never to sell the bonds or withdraw from circulation the money it created when it bought those securities. It returns the interest earned on the bonds to the government. That means households won't expect their taxes to go up to repay the bonds. It also means they should expect prices eventually to rise."
Beckworth: And so, you point out and I think that's a key part of what makes the helicopter drop work if it's done right, if you're going to do it, is that the Fed promises never to sell the bonds or withdraw the money from circulation. This is a point I've stressed many times, it has to be a permanent injection of the monetary base. And so, my question is, so let's put aside the issue whether it's a good idea or not right now, let's just say for the sake of argument, it is. Let's say it's Europe, maybe better case will be made there. I have a hard time believing, I want to hear what your thoughts are, that the ECB or the Fed could even do it if they wanted to, and here's why.
Beckworth: They seem to be so wedded to low inflation, and it's just not them. I would argue it's the body politic. It's Congress, it's European Parliament, that anything above 2% is just unorthodox, heads will be chopped off. I mean, it's a very dangerous area in terms of most serious people thinking that 2% is the norm you can't deviate from that. But if you go to a helicopter drop and you permanently inject money, yes, it will raise aggregate demand, it will raise inflation but it might temporarily push it above two. And so, I don't see how you could ever use a helicopter drop.
Beckworth: I think many observers, when the advocates of helicopter drops, to me they miss this institutional constraint called this inflation target we have, you'd have to change the inflation target. Does that seem reasonable?
Ip: I think you're absolutely right. In fact, let's go back a little bit earlier to the point you're asking about the difference between QE and a helicopter drop. And this is important, because in the markets, there's a lot of confusion here, a lot of people will say, "Well, the government's running a deficit, and the Federal Reserve is buying bonds. So, isn't that a helicopter drop?" Well, no, it's not because it's not coordinated. Why does that matter? Well, in the old courtroom dramas where the prosecutor was being asked to explain why they're bringing certain evidence, it goes to motive, Your Honor, you have to look at the motives of the federal government issuing those bonds and the Federal Reserve buying those bonds.
Ip: The difference between QE when those two are acting separately, is that under a helicopter drop the actually coordinate them. When the government issues bonds on its own something called as you know, well, the Ricardian equivalence kicks in, or at least in theory it does. People say, "The government's borrowing all that money today, but they're going to ask us to pay it back one day. So, I'm going to save more today to prepare it for those higher taxes." That actually blunts the impact of the fiscal stimulus. Similarly, when the Federal Reserve buys bonds, but then repeats over and over again, we're going to one day sell them back, we want our balance sheet to go down to normal size, it actually blends the effect on people's expectations. They don't tend to have, translate the Feds actions into expecting for higher prices all along.
Ip: And that is by design, because exactly as you're saying, today's central banks have bread in the bone, there's fixation on 2% inflation. Now, we've come some ways. There is no longer the mistake among central bankers thinking that 1% is better than 2% and deflation is not a problem. They recognize that's a problem, but they still cannot get themselves around the possibility of 3% should be okay, and 4% should be okay. And they know that helicopter drops are inevitably driving towards that world where inflation has to go above 2%. And even among people advocating helicopter drops, by the way, I don't think fully appreciate this fact.
Ip: If you were to try and finance a fiscal deficit of let's say 5% of GDP, then the central bank basically has to buy bonds and print money equal to 5% of GDP. Well, the monetary base, in a good year is around 10% of GDP. So, you're basically asking the Fed to permanently increase the monetary base by 50%. That means in the long run, GDP will also have to be 50% higher, unless you're expected some miraculous increase in productivity, a lot of that is going to come through in prices. And indeed, that is precisely what we saw the last time this country tried helicopter money, which was during World War Two.
Ip: From 1942 to 1951, the Fed promised to buy as many bonds as needed so that the federal government could finance the war. They ended up buying bonds equal to around 9% of GDP, and most of those purchase proved to be permanent. And the price level rose by an average of 7% a year over period. Now, I don't think that's a very high price to pay to escape the depression, and number two defeat Japan and Nazi Germany, that's a pretty good price to pay. And as Bob Gordon points out, in his recent book, “The Rise and Fall of American Growth,” a lot of the real output gains in that period proved to be permanent.
Ip: I have a lot of questions about whether we expect the same benefits today. But irrespective, I don't think there's a central banker alive who thinks that at a 7% inflation is a price worth paying for whatever benefits helicopter money could bring.
Beckworth: Right. And that's why people like Scott Sumner, myself are advocates of level targeting because level targeting whether it's a price level target or it's nominal GDP level targeting, which is what we advocate, would allow a temporary departure. Now we're not advocating helicopter drops, but level targeting would do what helicopter advocates want to be done. That is to have this temporary burst of spending inflation. So, level target would allow maybe 3%, 4% inflation in the short run until you got back on track if you fall below that path. But this is, in my mind, a political economy story, you'd have to have consensus from Congress and everybody else, and it's not clear that that's going to easily happen.
Ip: But I have another question about that David. And you and Scott have actually done a lot to actually illuminate this issue. And so, I think you've really done economics world a favor in this respect by moving that the front of like, cutting edge macroeconomic issues. But my question has always been, what's the mechanism since central banks are struggling to even meet their inflation targets today? What are the tools available to them to achieve this higher price level that you and Scott think would work?
Beckworth: Well, I have a proposal and since you've asked, to make it credible, I would actually call for a treasury backed nominal GDP level targeted. So, here's how it would work, that they'd I would announce some path. Now again, I think right now, I think you're right, we could probably start from where we are and not worry about it. But there's 2009. Let's say it's 2009, and this summer we're going to return back to the nominal GDP growth path, what would happen is, the Treasury would say, "Look, we'll do whatever it takes to get there." And if that's not enough, as you suggested it might be, then what would happen is the Treasury would every year, would have to step in and provide a backstop. They would literally monetize the debt.
Beckworth: Treasury would say, "Look, we're going to do what it takes to guarantee that this happens." Now, that would be a huge change in policy as well as I recognize, but what I envision is it would be a systematic, I'll be very clear here, a systematic kind of like a big automatic stabilizer. Because the danger is once you get fiscal policy Treasury tinkering, the danger is politicians want to play, the next is the danger that helicopter drops in general. But I would like to see an automatic kind of Treasury backstop to what the Fed would do with the level targets. I wrote a post where Nick Rowe, your former teacher often compare central bankers to Chuck Norris.
Beckworth: Chuck Norris walks into a room and says, "Get out." We don't argue with Chuck Norris, even at this age. You get out but what if Chuck Norris walked to the room with Jean-Claude Van Damme, with him, but that's, he's treasury secretary, Chuck Norris is a central banker and they say, "Get out." You get out. The market, they listen. If you knew, I mean, level targeting tells you that they're going to do this reflation if needed, and the treasure is there to kind of back it up. But again in a very systematic rules based approach, because the danger is if you do a discretionary and this is where I get very nervous, you can return to the 70s pretty quickly.
Beckworth: But I do agree there needs to be some kind of commitment. I mean, at the end of the day to get aggravate man growth, what we're talking about, a helicopter drop is saying we're going to commit the consolidated balance sheet of the government, both the treasuries balance sheet and the Fed's balance sheet to doing whatever is necessary to get there. But you want to do it in a very careful little space manner. But enough about me, let's get back to you. You're the interesting person here we have on the show today. I want to get your sense since I think you've got your ear to the ground, you know what's going on probably better than many people. Is this discussion of helicopter drops, is it really gaining ground? Or is just a bunch of bloggers or journalists academics beating their drums? I mean, is anyone really taking it seriously? I guess, is my question.
Ip: Well, right now, nobody in the central banking world is talking about it seriously. I remember I had an interview with Haruhiko Kuroda, the Governor, the Bank of Japan a few weeks ago, and I put the question to him, "Well, should we do helicopter money?" And I remember him just like, smiled at me and he started spinning his hands around his head said, "No, no." And I said, "Why not?" And he says, "Because there's a division of authorities here, the government, the parliament does fiscal policy, the central bank does monetary policy." It was obvious in his immediate and visceral response to that, that to the division, that the blurring of the line between fiscal and monetary policy that helicopter money requires is way beyond what he's prepared to accept right now.
Ip: And then he went on to make that point that he said, what the Bank of Japan is doing right now is, it's close to helicopter money because they're buying bonds that are equal to twice the size of the government's borrowing this year. But I don't think that really sort of answered the problem that the absence of coordination might be one of the reasons the Bank of Japan is really getting expectations to change. But so, the short answer to your question is no, nobody's ready to go there. I think it's just too big an issue. It's too big a step.
Ip: That said, I would say that a lot of things that sounded radical at first began in the blogosphere, or began with academics and they eventually found their way into actual economic policy. So, I'm kind of glad that this ideas is out there. I mean, things like honestly, like you and Scott and a few other people have actually put price level targeting, sorry, nominal GDP targeting out there as an issue to be discussed. We know from the minutes that it came up at a Federal Open Market Committee meeting. Now, as you know, they didn't adopt it, but you take the little victories where you can get them.
Beckworth: Yeah, I was talking to a regional Fed President just last week about nominal GDP target, and it happened in the place where he was. I wasn't pushing it, but we were talking and his biggest beef with it, he liked the idea, was the data revisions and this measurement issues. I think we have some hurdles to clear, but I think people are talking about it, and that there was hope.
Beckworth: Let's move on to another hot topic. And that's negative interest rates. And they've been increasingly used a number of central banks around the World Bank, I think the ECB was the first one to do it, I'm not mistaken, the Bank of Japan, there's Swiss National Bank, the Swedish Central Bank, Denmark, are all doing negative interest rates. The Fed said it was off the table agenda, Janet Yellen said it was off the table, I believe she said that, for now. What is the idea behind that? What do you think that these, I'm sorry, what these other central banks are trying to do with negative interest rates?
The Rationale of Negative Interest Rates
Ip: Well, really, the distinction between very low positive rates and negative rates is really not that large because in economics, we know that it's not the nominal interest rate, what you get on your bank account that matters, it's the real interest rate. What's the difference between the interest rate and the rate of which your purchasing power declines, I just say the inflation rate. There's no difference between a 3% inflation rate and a 1% nominal interest rate, which is a negative 2% real rate, and between a 1% inflation rate and a minus 1% nominal interest rate, they both equate to a minus 2% interest rate.
Ip: In theory, there should be nothing special about going from slightly positive to slightly negative interest rates. In practice there is because first of all, people actually have an option, they can take their money out of the bank to avoid these negative interest rates and hoard cash. Now, it turns out to be very costly and dangerous to hoard very large amounts of cash, you generally don't want the world to know that you're doing this.
Ip: People will probably accept the certain negative interest rate just to avoid the security risk and the inconvenience of holding large amounts of cash, and that number could be anywhere from minus one to minus 4%. We've realized that the zero bound isn't quite as binding as we thought it was. And you have seen central banks, as you mentioned in Europe and Japan actually explore how far below zero they can go, because they're not satisfied with the results they've had.
Ip: The biggest negative consequence has been, first of all, on the banking system where banks are already squeezed because banks make a lot of money on the difference between what they earn on loans and what they pay out in deposits. Well, it turns out, they're having a lot of trouble forcing their depositors to accept negative interest rates, they get really upset, but no business likes having upset customers. Generally, even when the central bank is digging commercial banks for the money they have on deposit at the Central Bank, the commercial banks are unable to pass that cost on to their depositors. Negative interest rates is squeezing profitability of banking and weak banks are not generally something that helps economic growth.
Ip: At the end of a larger level, we go back to that point that I raised with respect to helicopter money is the cost benefit analysis. Are we really sure that things are so bad, that we hit negative interest rates, and I'm not so sure that they are, as I said before, the unemployment rates come down a lot in this country, we're getting very close to full employment. I fully recognize that real economic growth and real wages have been very poor. And I think it's about time we started looking at supply side explanations for that, the demographics which have given us very low new growth in the labor force. And the fact that productivity growth is the worst we've seen in about 30 years.
Beckworth: What about Europe? I mean, Europe has far more anemic growth, the periphery. I guess we could speak to the flawed nature of the currency in itself is maybe more fundamental than using negative rates. But do you think negative rates is appropriate now for the ECB?
Ip: Yeah, although remember, one of the reasons ECB is using negative rates is that they fully recognize that one of the channels of transmission is to get the Euro down, not because they're essentially trying to beggar thy neighbor. They're not necessarily trying to steal exports from the United States or other countries, but they recognize that in terms of getting inflation from around 1%, where it is now on a core basis, back to 2% something that's going to have to come through the tradable side by getting the exchange rate lower. And I have some sympathy for that. And I think the United States has some sympathy for that, which is why they're basically allowing the European Central Bank and the Bank of Japan to not so subtly employ negative rates as a way to get their exchange rates lower.
Ip: So yeah, I think the case is clearly stronger for Europe and Japan to use negative rates. They're just in a cyclically different position. But that said, again, I would question whether things were even as bad in those economies as people make them out to be, as I pointed, unemployment is actually coming down in both those countries, that region. Japan actually does have a positive inflation rate consistently for the first time in quite a few decades. It's not 2% where they would like it to be, but it's a lot better than the negative numbers that they had become used to. And we have seen signs, for example, in manufacturing activity surveys, that economic growth in Europe is starting to pick up.
Beckworth: One of the arguments for negative rates, I mean, you brought up a practical point that it's not that different than being at 25 basis points or 0%. But kind of the theoretical argument for it is there's this thing called the natural interest rate or where it's the market clearing rate, the level where rates would need to be in order for the economy to back at full employment. And in a depressed economy, it's negative, we're not sure exactly where there's these estimates of it, but it's negative.
Beckworth: All we're doing is the Fed or the ECB is trying to track that. In an ideal world kind of new Keynesian model, ideal world, when rates are positive even central banks should align their target rate with the natural rate. And I guess my question, unless you go all Miles Kimball and take his full approach, which I don't think several banks are doing yet. It's going to be difficult to align those two, because of what you said the cash problem, right? If you start going down deep enough into negative territory, at some point it becomes worthwhile to hoard cash. It depends, I guess how far down the natural rate is, but it seems to me that this exercise is fraught with challenges because as long as you got physical cash out there, you're never going to be able to do what you really need to do with negative interest rates.
Ip: I agree to that challenge there, but I don't think that's the immediate challenge facing the central bank. Because the point you raised, what is the natural interest rate? And just for listeners out there by natural interest rate, we believe that there's an interest rate out there that perfectly balances the supply and demand for savings in the economy, that if we could get the interest rate to this natural rate, all the savings in the world would be perfectly matched by all the investment in the world and we would be at full employment.
Ip: Now, when you look at how low bond yields are around the world, even in countries that aren't doing things like QE, they're very low that tells us that whatever that natural interest rate is, it's probably very low, because for whatever reason, there's a lot of saving and very much an investment going on. So, the challenge facing the Central Bank of actually getting their own policy rate to match that natural rate is one that exists irrespective of whether that attribute is a positive number, or if it's negative number. I don't think that's really the question. But I think the bigger meta-question that you're getting at here, is why is the natural rate so low, whether that's a very low positive number or even a negative number?
Ip: Larry Summers, as you know, has argued that we're facing a situation of secular stagnation, where desired savings systematically exceeds desired investment. And we simply are unable to get back to full employment because we can't get the natural interest rate negative enough. It's an intriguing theory. And there's a lot of stuff out there that suggests that he's right. I mean, you could look at the fact that China runs a basically a mercantile economic model that involves generating very large savings that it exports to the world that puts downward the pressure on interest rates around the world. You could point to efforts by Europe to bring budgets back into a line that subtracts from borrowing demand, that pushes down natural interest rates.
Ip: You can look at the growth of income inequality around the world, we know that the rich tend to save more than the poor. As more of our nation's income goes towards the rich, that too generates extra savings, all these things could be conspiring to push down the natural interest rate and make it harder to get back to full employment. Larry's solution for this is that if the private sector insist on saving so much, the public sector has to borrow more. That's another way of saying we need to have larger budget deficits. And that in some sense, I think is actually the next frontier of this debate.
Ip: I think there's a growing belief, and maybe you don't share this, David. But I think there's a growing belief among other people that central banks have been largely exhausted at sources of incremental demand, and we need to look at things that like fiscal policy. That's why there's talk about helicopter money, which is really an amalgam of fiscal and monetary policy. It's why the International Monetary Fund and the G20 are going around asking all countries to rely less monetary policy. Everybody was cheering because little Canada, my home country, brought out a budget that was essentially unabashedly Keynesian in his approach, we're going to borrow more and do more infrastructure.
Beckworth: The Prime Minister-
Ip: … do more social transfers. That's right. The Bank of Canada said, "That's great. Now, we don't have to cut interest rates as much." And the Canadian dollar immediately went up. And I don't think Canadians realizes, but they were doing the rest of the world a bigger favor than they were doing for themselves. But we can come back to that political economy problem that you're discussing before, is that no individual country has a strong incentive to pursue that degree of aggressive fiscal policy, knowing that a lot of the benefits are going to spill over to their partners. So, it's almost like a collective action problem where you have to get every country to get together.
Beckworth: Absolutely. And that leads us to the safe asset problem. Before I do that, I want to, one more thought on the low rates. And I'd love to hear your thoughts on this. But over the past seven years rates have been low in the US, elsewhere. The US was active in QE. So, many people, many of my friends on the right, my neighbors, people I go to church with they'd come to me, "Ah, the Fed is artificially distorting interest rates." And I said, "No, no, not quite the Fed's following that natural rate down." I mean, had there been no Fed, rates would have been low anyways because of weak economic conditions.
Beckworth: And how have you seen this disconnect between many people who think in central bank, for example, the negative interest rates that we just talked about, I see that as central bank's kind of groping in the dark trying to get at this the safe asset shortage problem, the weak growth problem, because the natural it's already down there. It's not that they're pushing it down there. They're trying to find their way down there. But for many politicians, I mean, you probably see this the coverage of Federal Reserve and government, they look at the central banks. And so, either we're not communicating clearly what's going on, or it's just so confusing that most people don't get it. But what is your take on that communication issue?
The Safe Assets Problem
Ip: Well, first, let's talk about the safe assets question for a moment because there might be listeners out there who aren't sure what we're talking about. Safe asset, essentially in economics, when talk about... you can buy a lot of assets with your money, you can buy a house, you can investment in a small business, you could buy stocks, you could buy a corporate bond, all those assets are risky to some extent, the house might go down in value, the business might fail, the corporation might default on its bond. Safe assets or assets that don't have that problem there things like treasury bills or cash, because you are guaranteed to always get back 100 cents on the dollar of a safe asset.
Ip: One of the problems the world has right now is there's a lot of fear and risk aversion out there. People would rather not invest in risky things, they'd rather hold things that are perfectly safe, whether that's cash or government treasury bills. And that indeed, might be one of the reasons why interest rates on government bonds today are as low as they are. And so, one of the ways that there's confusion about why interest rates manifests itself, is that people who are trying to buy safe assets really don't understand that there's a price for safety, like there is a price for everything else.
Ip: I'll give you an example. My mother, this former central bank economist, she's now retired, and she complains to me incessantly about the low interest rates on her savings and so on. You can guarantee that if my mother who's a very accomplished economist is complaining about this, there's a lot of people who really aren't quite like with the program here, but in reality, the price that you can get for your savings is not that different from let's say, the price that a farmer gets for his corn. If it's a bumper crop that year, and there's a lot of corn produce, the price of corn is going to go down. And similarly, there's a lot of savings out there, if there's a lot of people who want to generate the savings, then what you're going to get return on your savings, it's not going to be very high.
Ip: Similarly, if the world decides they don't want to eat corn, because popcorn is uncool now, then the demand for corn is going to go down and there's not much you can do about that. If the world doesn't want to invest, you as a saver have to accept the fact that there's fewer people who want to take your savings from you and they're going to pay a lower interest rate for it. Central banks out there, when they're lowering the interest rate, they're not trying to deprive savers of some income. They're trying to find out where that magical number is that actually brings this new balance of investment and savings back together.
Ip: If farmers complain to the government and said the price of corn is too low, and the government said, "You're right. We're going to artificially jack the price of corn." What would happen? First of all, there'd be a lot of extra corn that people don't want produced. And there'll be a lot of uneven corn piling up. In fact, demand would decline, it would in the end be very bad for the economy. And it would probably be bad for farmers. If the central bank would go out today and say, "You're right savers, let's get the interest rate up." They wouldn't actually end up doing any help, they would actually end up hurting investment even more than it is now because they forced the price of saving up to a level that the market just can't sustain.
Beckworth: Let's dig a little deeper into the safe assets shortage problem that you outline there. So, we have this safe asset shortage phenomenon. And there's been a lot of people who've talked about it. Richard Caballero has written about it. A number of other folks have done it. I've looked at myself some and you had this piece in The Economist bond shelter, where you talked about it. And I just want to step back and think about it. So, they're these assets as you mentioned treasuries, commercial paper, highly liquid. There's the publicly provided ones, the treasuries the GSE, Government's Sponsored Entities like Fannie and Freddie. And they're also what we thought were safe assets prior to the crisis, triple A rated mortgage backed securities.
Beckworth: Interestingly, I just read, there's only two corporations now that have triple A rated status at this point. And that blew me away. It's only two corporations that have that status now. Any event, these triple A rated securities effectively function as money for institutional investors. So, you mentioned the shadow banking system earlier. Gary Gordon in some really good work has outlined how, and the repos you talked about, they effectively were backed up by collateral which were these triple A rated securities or the private kind or the treasuries. And there was a run on the shadow banking system.
Beckworth: So, to me as the monetary cost is fascinating, there's big similarity between the great recession and a great depression. The negatives are very different, but there was a banking run in both cases. There's also a money supply collapse. If you look at him too, you'll say, "Where's the money supply collapse?" Well, you don't see it those are retail money assets. But if you look at a broader measure of money that includes institutional money assets, there's this huge drop. So, there are places that collect this. There's an informed measure put out by the Center for Financial Stability in New York, this divisia m4. Gary Gordon’ own measure, safe assets you see this sharp decline 2000 that really still hasn't fully recovered. And some of that may be because of risk aversion. But you also mentioned maybe over regulation that they're not able to supply, there's some kind of a supply side issue as well.
Ip: Let me talk about this because it's actually an issue that I address at some length in my book. And I think that one of the points I try to make is that the purpose of financial systems going back hundreds of years, the first banks, was essentially a form of alchemy. It was to transform unsafe assets like loans, to safe assets like deposits. That is really all that a bank does. It takes my money and says, "Here's your deposit, you get back 100 times in $1." And then it goes in lends it out. But the people that it lends it out to cannot provide 100 cents on the dollar back to the bank on a moment's notice.
Ip: That business of actually juggling my desires a deposit to have a safe asset. And the fact that the loan on the other side is not a safe asset. That's what bankers do for a living. And most of the time, it works pretty good. Banks keep a little bit of money in reserve so that when I ask for my money back, they can give it to me. And they try to keep some capital so that if some of their borrowers don't pay their loans back, that doesn't have to impinge on their ability to repay my deposits.
Ip: But as we know, from time immemorial, if for some reason every depositor asks for their money back, no bank can do that. And that's why banks fail. And Gary Gordon, who you talked about a moment ago, has actually spent his career studying bank panics through history. As essentially this problem of everybody wanting this banks providing a lot of safe assets and being unable to redeem them on demand.
Ip: Before the Federal Reserve, the business of creating money was actually a private activity. That's one of the great acts of socialism was that we essentially nationalized the act of issuing banknotes. Before the Federal Reserve came along private bank would issue their own bank notes, it worked fine until everybody said no banks aren't safe, I want my money back and banks couldn't provide it. So, banks would fail. And that's why we'd have periodic banking panics. So, everything we did 100 years ago to create the Federal Reserve, and then the 1930s, Federal Deposit Insurance was a way of solving the problem of how people would suddenly all ask for their safe assets back.
Ip: A bank cannot suddenly give all my deposits back at once. So, we're going to create a Federal Reserve that is able to print money, to be a lender of the last resort so the bank won't fail. It can borrow from the Fed, the money it needs to pay me the depositor back. And we're going to create deposit insurance so that I won't want my money back in the first place, because frankly, with the federal government standing behind, it's as safe as treasury bills. So, de facto, those acts, the creation of the Federal Reserve, and deposit insurance transformed all the deposits in the banking system into a form of safe assets. And this was a great social good, it provided everybody with this form of safety. You know what I mean, I would sort of like equate this to everybody feeling they had some antibiotics in their closet, they could reach anytime they wanted to solve any problem. And it's great for your peace of mind to know that the world's going to hell and you really don't have to worry.
Beckworth: So it deposits back?
Ip: It does your deposit. This like you're hearing about anthrax attacks and you don't have to worry because you've got your antibiotics in the closet. It fulfills the same purpose. Well, as Gary Gordon now knows, one of the problems, or one of the features of history is that eventually, as financial systems grow, the demand for safe assets exceeds supply of those safe assets. Under the gold standard, the supply was fixed because there was only so much gold to go around. And so, the financial system became very adept at creating new kinds of safe assets to meet that demand.
Ip: In the 1860s, it was checking accounts, didn't think that as financial innovation now, but in the 1860s, that was the financial innovation of the day. And then bank failures started happening when people ask for their money back in their checking accounts and banks couldn't actually redeem that money. In the early 1980s, we'd had a spate of bank near bank failures. And so, the federal government responded by forcing banks to hold more capital, and more liquidity and so forth. And this did indeed make bank safer. But as we were discussing earlier, it also made bank loans more expensive. And so, a lot of this process of gathering up people's money and transforming them into form of safe assets that could be then repurposed to make loans, it moved into what became known as a shadow banking system. And I'll give you a very simple example the money market mutual fund, do you have a money market fund? Yeah, so do I.
Ip: You probably never thought of that as a bank account, or as some kind of a safe asset, you'd probably never think of it as a bank. But that's really all it is. Money market funds were invented in the 70s as a form of regulatory arbitrage. Banks won't give you a high interest rate, give me your money, all invested in high quality short-term loans, and it'll be a saves bank deposit and you'll get a higher return. That's really what a bank does, but it's not called a bank. It doesn't have deposit insurance, and it doesn't have the Federal Reserve as lender of last resort.
Ip: In the 1990s and the 2000s, as a demand for safe assets grew, some of that demand was met by money market funds, people would put their money market funds, money market funds would turn around, invest that money in commercial paper and subprime mortgage backed securities. Sounds like a good idea, until those securities or the poor Lehman Brothers whose paper was also one of the things money market funds invested in turned out to be bad. And so, when people heard that Lehman Brothers had failed, they asked for the money back from their money market funds, and the money market funds couldn't give them their money back, or this couldn't give them back 100 cents on the dollar.
Ip: And so, there was a run on money market funds. As Gary Gordon can tell you, it was exactly like a run on the bank in the 1860s. Except it wasn't a bank, it was a shadow bank. Now, as I discussed in my book, Gary Gordon himself was a bit of a victim of this business, because he was an advisor to AIG, which is big insurance company. And one of the things AIG was doing, is it was taking risky assets, like subprime mortgage backed securities and transforming them into safe assets by selling insurance on them. AIG was a de facto deposit insurance corporation, only for non deposit type stuff. And Gary had been writing these models to explain how unlikely it was that these mortgages would fail, because they were triple A, and home prices never collapsed by 20%, but as I talked about it in my book, it was a very belief that you would never have a home price collapse of 20% that fueled all the money pouring into the mortgage market, which fueled the housing bubble, and basically guaranteed that you would have housing bubble collapse.
Ip: That guaranteed these mortgages would go bad, and that guaranteed that AIG would be forced to pay up, whereas all the models told them they would never have to pay up, and that created the bank run. So as long, with David saying that our belief in the safety of all the innovations we had come up with, the shadow banking innovations brought about the disaster.
Beckworth: A couple of questions, first, has that safety been extended to the shadow banking system implicitly, because during the crisis, we saw the government stepped in. We saw all these lending agencies, all these money market facilities that were extended. And I wonder now if these same parts of shadow banking system seen that in the past. I mean the flip side of the safety is it's moral hazard, right? And I wonder now if they look forward to any future crisis with the belief that once things are bad enough, they'll step in and the government backup money market accounts again.
Addressing Concerns over Moral Hazard
Ip: I want to say a thing or two about moral hazard because I think moral hazard gets a bad name, because moral hazard really isn't a bad thing. And Lawrence Summers makes this point, I talked about in my book, all moral hazard means is this something that encourage you to take risks that you would not otherwise take, but let's remember that that's actually what we want to happen. We know that moral hazard exists with deposit insurance. We want that to happen so that banks have a stable funding base, not because we like banks or bankers, but because we want banks to make loans, and making loans enables people to make investments which has our economy grow over time.
Ip: Moral hazard is about making people more comfortable taking risk. And risk taking is so vital to so many things that we don't even realize are vital to life. I mean, if you were risk averse would you have ever asked your wife out on your first date? Maybe not, and you would have denied you and your wife a lot of happiness. I mean, if you were risk averse, would you ever let your kid actually like play on a swing set with the possibility I might fall off? No, but you deprive them of all sorts of happiness.
Ip: If we were truly risk averse, we wanted to risk as a finance system that would never fail. We would require banks only to invest in government bonds. And a lot of businesses would never start up and our economy wouldn't grow very fast. Compare the experience of a country like Thailand, with a country like India. From 1980 to 2008, India had a very repressed financial system, banks were either owned by the government or so tightly regulated by the government. They really couldn't lend to very many businesses, and India never had a financial crisis. But Thailand had kind of a more freewheeling financial system. Banks were not that regulated. They could lend almost anybody, and they ended up with the mother of all crises in 1998. And yet at the end of that period Thailand still grew a lot faster than India did.
Ip: I'm trying to say this not the way we're saying we should welcome financial crises, but we should accept the fact that risk and yes, moral hazard sometimes create financial crisis, but they also create the conditions for investment in economic growth and make us all richer in the long end, in the long run. Let's bring that discussion to what we've done with regulation since the crisis. In my view, we have become so afraid, first of all of crises, and afraid of moral hazard that we've actually gone too far in the opposite direction.
Ip: Now, the first thing that we've done is appropriately in my view required the very large banks to hold so much capital that they're very unlikely to fail. The purpose here is to make them unprofitable, I hate to say it, but the purpose of here is to take away any profit that they may have been earning from the fact they were thought to be too big to fail. As an economist, I don't want banks to earn that kind of unfair subsidy because it gives them an advantage over smaller banks, and I think it basically is a subsidy from the taxpayer.
Ip: But at the same time, another thing we've done is try and weigh them, and the entire financial system has so many new rules that we can never have another financial crisis. I mean, Obama says this all the time, we must make sure, through laws like the Dodd-Frank law, that we can never have another financial crisis like that again.
Ip: Well, first of all, you can't make that promise. We are going to have another financial crisis. I don't know when it'll be. And I don't know what it'll look like. But it is sure thing, we're going to have another financial crisis. And as I talked about, in my book, our efforts to prevent forest fires mean that we have bigger forest fires in the end. And I think they're trying too hard to prevent financial crises, means that we have larger crises in the end.
Ip: I'll give you one very simple example. And this brings together our fear of moral hazard interfere of crises. During the crisis, when they were run on all these banks, some were run on the shadow banks, cash was very limited in supply. We created central banks for exactly this problem. When everybody wants cash and nobody wants to take risk. The only entity out there that can create cash out of thin air is the central bank. That is its job. And Gosh, it's a great job to have it, it's a great public good that the central bank provides. But since the crisis, we said, "Oh, that's an unfair subsidy, when banks and money market funds know that the Fed is out there able to provide this lender of last resort function, that'll tell them to take more risks. That's moral hazard, that'll bring into crisis, we can't have that."
Ip: And so, they've come up with things like the liquidity coverage ratio, which require banks to hold a very large amount of their assets not as business loans but as really safe cash, government bonds. And this is a bad thing for two reasons. First of all, as we've just been discussing, everybody wants to own government bonds right now, people are so risk versus a real shortage of those truly safe assets. When you have basically instructed all these banks that they must, as a matter of law, hold all these safe assets, you're creating an artificial shortage of other people to hold the safe asset, you're actually worse in this problem of pushing down, safe interest rates.
Ip: The other problems, you are going to have a perverse effect in the next crisis, which is that at this time, you want banks to actually be lending to risky people because it's a panic and good after being thrown at the door along with the bad assets. One of the jobs of banks is to actually enable people to avoid those fire sales, but they won't, because they're too afraid of lending out that money. And the final this is it's doing, is that it's creating, I think it's aggravating the problem of risk aversion, which I think is holding down investment, and is one of the reasons why we have poor productivity growth right now.
Beckworth: Yeah, I think you're right. I think we've swung too far the other direction, that pendulum, and it's both individual level, governance level, and it's slowing down recovery. We're all running out of time here, but I have one last question for you. We're going to switch gears, and I want to ask you to give advice to a budding young macro journalist, what would you tell them to do? What path to take to become the future Greg Ip?
Advice for the Young Macroeconomist
Ip: Well, both economics and journalism, both changed a lot since I studied it back at Carleton with Nigro and other people. First of all, as we've seen in this crisis, a lot of things that we thought about were economics just aren't true. On the other hand, things that we thought weren't true any longer like the IS-LM diagram. Nick, if you're out there listening, that's you I'm talking about. Nick, you remind us of those-
Beckworth: He will be on the show in the future date.
Ip: That's right. Those things still do matter. Economics has changed, journalism has changed. Frankly, I'll be quite honest David, it's hard to make a living in journalism than it used to be. Our business has been heavily disrupted by the internet. This is a great thing if you're a consumer of news, you can get vast amounts of news at the touch of a button for a very low price, and you get great analysis and thought provoking commentary from people like you, and Tyler Cowen and Paul Krugman and Scott Sumner on the internet for free.
Ip: In the old days, you had to pay to read that on the op-ed page of my newspaper, The Wall Street Journal. So, it's a tough time if you're a supplier of news, it's a great time you're a consumer of news. I'd say though, that if that you are brave enough to want to go into this area, you need to think more broadly about what it is to be a journalist. It's not necessarily working at The Economist magazine, or The Wall Street Journal, you might be working at an online publication like the Huffington Post, or like real clear markets. It might be being a blogger, an economist by day like you, and a blogger by night.
Ip: There's a quite a variety of venues out there to work that weren't possible before. Next face you're going to have to be pretty savvy. One of the interesting things about the digital world out there for those of us who work in the journalism profession, so we have much more granular information about what people are reading and what they like. My colleagues can now show me a spreadsheet that tells me how many people read my articles, where they came from, how many minutes they spent on that article, at what paragraph they stopped reading, little bit of frightening, it's a little bit … sometimes I got to tell you David, I wouldn't recommend doing that unless you have a very strong sense of your self esteem.
Ip: But, so you can craft what you do, on the other hand, if you really want to be somebody is encratic. The barriers to entry are so low that you can produce interesting commentary and so forth that weren't there. And the world of economics, you and I mostly write about fascinating macro-economic questions out there, like what should interest rates be, what should be the role of government? How do we prevent recessions in the future?
Ip: But economics is a vast field. And there have been tremendous advances in areas like behavioral economics, and the application of economics in everyday life. Why do we buy lottery tickets? Why do we buy insurance? How do we deal with problems like racial discrimination and segregation and so forth? Economics has a lot of interesting lessons to bring to these questions. Companies like Google and Uber, employ economists now to help them make their search algorithms better. They help us learn things from search algorithms that we couldn't before.
Ip: Finance is a very interesting field. Finance got us into a lot of trouble. We had probably too much of it in 2006, 2008. But finance is still ultimately a general purpose technology that helps make the world a richer place because that basically sweeps up all the world's savings and allows them to be deployed into efficient new ways to invest. And as long as we believe that finances has a value that will need five financial experts and economists and journalists to write about what the financial markets are doing.
Ip: If you're interested in this area, I would advise you to be broad in your interest, to be prepared to write about quite a few different things. I have found that with each passing year, I'm more interested and more excited by the things I come across. I'd like to say that being a journalist is a license to be nosy, a licensed to start every day by asking a new question. Just going out there to find out what the answer is. And I might find the answer on David Beckworth blog, or I might find the answer somewhere else altogether different. And I kind of love that about my job.
Beckworth: All right. Well, thank you. Our guest today has been Greg Ip. Greg, thanks for being a part of the show.
Ip: Thanks for having me.
Beckworth: Macro Musings is produced by the Mercatus Center at George Mason University. If you haven't already, please subscribe via iTunes or your favorite podcast app. And while you're there, please consider rating us and leaving a review. This helps other thoughtful people like you find the podcast thanks for listening.