Twisting When We Should Be Shifting

Steven Horwitz

Without directly addressing the slides that Tyler linked to, I want to make a quick comment about the Fed's new Operation Twist.  The idea is to twist long and short rates by buying more long-term securities and paying for them with sales of shorter-term ones.  The hoped-for reduction in long term rates would benefit mortgage holders and others on the consumer side, but also spur investment.

In class this morning, I made two points about this:

1.  The Fed is like one of those movie characters who empties all the bullets in his gun to no avail against an advancing bad guy, leading him to grab anything he can find nearby to use as a weapon:  throw a vase or a bowling ball or a chair, or whatever's to hand to try to fend off the bad guy.  Your normal weaponry does not work. That's where it seems to me the Fed is right now.

2.  More important, if we look at the loanable funds market, we might get a handle on the situation.  If this program is designed to increase investment by driving down rates, it's not going to work if that demand for loanable funds curve is highly inelastic.  Borrowers are just not going respond to the lower interest rate if they have major concerns about the future.  It's worth noting that the slideshow Tyler linked to does not really deal with the question of corporate cash.  Why are they sitting on so much if it's not about some form of uncertainty?  And how will driving the opportunity cost of holding cash even lower get them to get rid of it?

The problem, I would argue, is that we shouldn't be trying to twist the yield curve, but shifting the loanable funds demand curve.  If we want to increase the market-clearing quantity of borrowing/lending taking place, anything that convinced firms that there was sufficient predictability to think they had profitable uses for their existing cash and new funds they might borrow would help.  I suspect that even if recovery really picked up, firms would finance new activity with their own cash before anything else.  But for any of this to happen, we need that change in the demand for loanable funds that would come from less uncertainty, regardless of the source.  Over time, that demand for loanable funds curve might well start to twist in the direction of more elasticity.  That would be a twist worth having!

In other words, we shouldn't be twisting yield curves to increase the quantity of loanable funds demanded, we should be adopting a better policy regime so that the demand for loanable funds increases.  It's Econ 100 folks.

PS:  I'm not persuaded by the slide on capital and software purchases for the same reason as J Oxman - after being so low for a couple of years, it's no surprise that in a rapidly changing area like technology that investment expenditures there are picking up.  I'd be surprised if that sustains unless the environment changes.  And Koppl is correct in noting a tension/contradiction in the argument.

Comments

[Matt Cole]

Mr. Horwitz,

Do you think that the short-term interest rates will/can remain low?

[Don Kirk]

Well, then, where is the graph of "demand for loanable funds"? Where is the graph for "uncertainty"? Where is Northern Trust's graph of lending institution's "concern for capital adequacy"? And where are those three curves on the same graph of historical GDP, times of fiscal demand-side stimulus and fiscal supply-side stimulus, and times of monetary easing or contraction before, during, and after economic recessions?

With such a complete graph then maybe, just maybe, we laymen can get a picture of the 'science' of economics instead of being spoon-fed ideological pap from both the Left and Right. If Austrians cannot do any better than Keynesians in their 'science' in the indisputable prediction and universal duplication of any economy's performance, then no wonder we layman grow an anger, if not a contempt for the self-delusion that economics is a 'science.'

[Troy Camplin]

Don, By your definition, biology is not a science, let alone neurology, or any of the social sciences. Demanding the rules of physics is the problem, not the solution. The economy is a complex science, and pointless, simplistic graphs won't get anyone anywhere.

[anon]

pointless, simplistic graphs won't get anyone anywhere

Really. Is that because the Austrian scientists don't know how to read data and make graphs?

Why are they sitting on so much [cash] if it's not about some form of uncertainty?

What's too much corporate cash? Oh, right, all the unrepatriated corporate cash stashed in Double Irish offshore accounts. Anyways, you need to compare corporate liquid assets to some intertemporal metric to ascertain whether there is too much or too little on the balance sheet relative to trend.

after being so low for a couple of years, it's no surprise that in a rapidly changing area like technology that investment expenditures there are picking up

Is it too much to request that ideologues examine BEA Table 5.5.6 before they pontificate?

There was no statistical decline in real investment in software during the Great Recession.

Do you know what component of equipment was hammered? Autos and light trucks. Just like households.

[Troy Camplin]

Austrians can do all the simplistic nonsense the economic pseudoscientists engage in. But, more importantly, they can engage in the real science necessary to understand complex processes. Can you? I doubt it.