The Undeserved Adulation for “Mainstream” Economists

The New York Times published an op-ed on April 18 that frankly, should embarrass anyone who agrees with it. Gregory Mankiw is a Harvard economist, author of my Microeconomics 101 textbook here at W&J, and was an advisor to President George W. Bush.

The article typifies the problems with modern economists in academia. Their ranks are full of bright minds that can create statistical models and theories to explain or direct a myriad of policies yet all do great harm to the economy if/when implemented. Mankiw’s latest offering is suggesting the Federal Reserve cut interest rates below zero, into negative territory. I wish I could make this up:

Recessions result from an insufficient demand for goods and services – and so, the thinking goes, our central bank can remedy this deficiency by cutting interest rates…

The problem today … is that the Federal Reserve has done just about as much interest rate cutting as it can. Its target for the federal funds rate is about zero…

So why shouldn’t the Fed just keep cutting interest rates? Why not lower the target interest rate to, say, negative 3 percent?
At that interest rate, you could borrow and spend $100 and repay $97 next year. This opportunity would surely generate more borrowing and aggregate demand.

The problem with negative interest rates, however, is quickly apparent: nobody would lend on those terms. Rather than giving your money to a borrower who promises a negative return, it would be better to stick the cash in your mattress. Because holding money promises a return of exactly zero, lenders cannot offer less.

Unless, that is, we figure out a way to make holding money less attractive.

At one of my recent Harvard seminars, a graduate student proposed a clever scheme to do exactly that…. Imagine that the Fed were to announce that, a year from today, it would pick a digit from zero to 9 out of a hat. All currency with a serial number ending in that digit would no longer be legal tender. Suddenly, the expected return to holding currency would become negative 10 percent.

That move would free the Fed to cut interest rates below zero. People would be delighted to lend money at negative 3 percent, since losing 3 percent is better than losing 10. …

If all of this seems too outlandish, there is a more prosaic way of obtaining negative interest rates: through inflation. Suppose that, looking ahead, the Fed commits itself to producing significant inflation. In this case, while nominal interest rates could remain at zero, real interest rates – interest rates measured in purchasing power – could become negative. If people were confident that they could repay their zero-interest loans in devalued dollars, they would have significant incentive to borrow and spend.

This man should be fired.

In Keynesian theory (of which Mankiw subscribes), aggregate-demand is the single defining factor for all economic decisions. Rising unemployment? Cut the funds rate to get people spending again so companies can hire. In reality, the rates work over time to allocate spending. Remember, saving money is still spending, albeit by someone else.

Efficient allocation is particularly skewed in certain sectors by interest rate manipulation. When the rates drop, what do people look to buy? Homes, cars, long-term property and equipment. Durable goods become cheaper than their true values.

Artificially low interest rates from Alan Greenspan encouraged home buying and propped up prices and demand. Now why in the world would Greenspan have done something so reckless? He was operating under the belief that the way to get out of a recession – caused by the dot-com crash at the time – was to slash interest rates to get businesses and consumers to spend more.

In other words, we are in our current mess because of the very same “medicine” that Mankiw, Krugman, and other mainstream economists propose.

In the onset of a financial panic – where liquidity is at a premium – short-term interest rates need to rise dramatically. It is analogous to the prices of flashlights and canned food during a hurricane that knocks down power lines. The price needs to shoot up in order to ration the available units to those who need them the most.

The price of renting a generator goes up during a hurricane, and the price of renting cash ought to go up during a financial panic.

Probably the worst part of Mankiw’s article is the absurd suggestion from his grad student. Developing an economic model that literally suggests burning a tenth of the currency should result in a lobotomy. Never mind the fact that all cash transactions would come to a screeching halt and coins would be hoarded; the lost productivity by analyzing serial numbers and the fraud potential in the inevitable derivatives market that springs up would cripple an already ailing economy.

Because Gregory Mankiw subscribes to the basic Keynesian framework shared by all mainstream economists, he doesn’t recognize the horrible implications of his proposals. It is fine for a grad student to toy with crazy ideas like destroying a random segment of the currency. But a serious economist who actually influences policy debates at the national level should know better and be out of a job.


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