Friday, April 12, 2013

On Cowen, Andolfatto, Williamson, and flights to quality

There's been a back and forth between Krugman, Cowen, Andolfatto, Williamson, and DeLong on whether interest rates are too high or too low right now. The "too high" answer is the more natural one. When growth and prices are sluggish one has to really do some intellectual backflips to tell a story where interest rates are too low.

The story that Cowen/Andolfatto/Williamson are telling is that:
"In grandma's liquidity trap, the real interest rate is too high because of the zero lower bound. Steve argues that in our current liquidity trap, the real interest rate is too low, reflecting the huge world appetite for relatively safe assets like U.S. treasuries.

If this latter view is correct, then "corrective" measures like expanding G or increasing the inflation target are not addressing the fundamental economic problem: low real interest rates as the byproduct of real economic/political/financial factors."
This is actually fairly sensible as a description. What is less sensible, I think, is the interpretation of what that means for interest rates. Demand for government bonds depresses interest rates. What Williamson and Andolfatto are saying here is that that demand for government bonds pushes interest rates lower than they ought to be. So the disagreement is really over the "ought to be" part, since Krugman and DeLong (and I) agree that a flight to quality is part of the interest rate story.

Again, I think Krugman and DeLong take the far more natural position. To call interest rates "too low" because demand for a particular asset is high is saying that the preferences that drive people to demand those assets are somehow illegitimate or need to be bracketed off in a way that we don't bracket off the demand for other assets. That's an odd position for economists to take, I think - and it confuses the discussion. Obviously Andolfatto and Williamson think some of the demand for treasuries is legitimate and not "too much" demand - so where do we draw the line?

Isn't it better to just say that people demand all sorts of assets for all sorts of reasons. We all agree there are a lot of real economic/political/financial problems right now, and those problems drive the real natural rate of interest very low, so low that the zero lower bound does not allow us to reach the real natural rate.

Another reason to discount the Andolfatto/Williamson story is that the flight to quality and depressed investment demand are not unrelated. So they're not really just bracketing off this one type of asset as being different and "wrong" - people are demanding those assets because they don't want other types of assets, so you're making this judgment call about many more assets than just treasuries.

My perspective is this: we don't pass judgment on what people demand, although it's good to understand why they demand certain things. The demand for treasuries is perfectly rational given the economic environment. If it weren't for the zero lower bound, a natural adjustment to the interest rate consistent with that demand for treasuries wouldn't cause nearly so much problems.

So the "wrong" thing here is the zero lower bound, which keeps rates unnaturally high for no rational economic reason - not a flight to quality which isn't really distortionary in its own right and is completely rational.

1 comment:

  1. I've got no bone in this debate.

    But my reading of Andolfatto/Williamson is a bit different. They're not criticizing people's asset preferences. The problem is that a mispricing has occurred. When an institution's financing costs have been driven far below the return it can enjoy by investing in projects, the institution will issue new debt and invest the proceeds until the gap between financing costs and returns has shrunk.

    The problem is that the government isn't listening to price signals. People desperately want to invest in government debt and this is driving down the government's financing costs relative to its prospective return on projects. But rather than issue more debt so as to arbitrage the differential, like a normal company would, the government is sitting back on its heels.


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