Noah Smith wrote a GREAT! post about how the data does not support the Euler equation. His post strikes at the heart of why economics and monetary policy is failing. Hopefully, we will see a revolution in thought about interest rates and monetary policy. The one sentence from his post that empowers the rebels is…
“The times when interest rates are high are times when people tend to be consuming more, not less.“
Awesome! … The major implication I see from his statement is that Financial Repression is a reality.
I recently wrote a 5-part series on Financial Repression which said that it has been sneaking into US policy. Financial repression relies on low interest rates to repress consumption with the goal of raising national savings for investment and increased exports. However, the Fed’s low interest rates are meant in part to raise consumption, not repress it. Noah’s post exposes the fundamental error guiding the Fed’s logic.
I posted a model of the money market split into two sectors, one of capital income and one of labor income. Capital income and labor income experience and react to interest rates differently. The model says that raising interest rates would actually raise consumption. For example, if interest rates rise and labor consumes more, capital investment will actually rise in the face of higher interest rates. So, the real key to “fixing” the Euler equation is to split the money market into a capital income sector and a labor income sector. The correct Euler equation will understand this dynamic.
But in the midst of Financial Repression around us, the solution to low consumption is to raise interest rates. Thank you, Noah.
Lambert, Edward. A Tale of two incomes in the money market. Angry Bear blog. October 23, 2013.
Lambert, Edward. A “Weird” case for a higher interest rate. Angry Bear blog. October 24, 2013.
Lambert, Edward. Inflation expectations, income expectations & financial repression. Angry Bear blog. November 27, 2013