Attack on Euler equation implies Financial Repression is alive and well
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.
Related articles…
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
While the Euler condition is flawed, this does not mean the relation is causal in the direction you think. If you think higher rates increase consumption you should closely examine Fed behavior under Hoover which indeed did raise rates with disastrous results.
Lord,
The dynamics can flow in either direction, it depends on the economic context. As it is now, Euler is a one-directional equation… it should be a two-directional equation.
The equation should say when higher interest rates lead to more current consumption and when they don’t.
The expectation of increasing interest rates should increase current consumption, and actual higher interest rates change evaluation of spend/borrow/save.
We definitely have a business savings glut right now, but that might have more to do with the desire to manage earnings. Management theory currently claims that managers effectively have more control over a company relative to owners when they capitalize through debt (and as a result, shareholders with MBAs often want a company to be capitalized through debt, in part because they know it is tax preferenced and generates earnings multipliers).
Cost of capital would change if interest rates went up, but for most companies, I wonder if it would even really move the needle. More likely to negatively impact small businesses than large ones. The smaller the business the more likely they would get screwed (ones financing a business via a credit card for instance).
I can’t tell which of many coincident bad things are drivers and which are passengers.
I think I would prefer to not have high interest rates, I’d rather have a change in tax rates and policies to drive business investment via a different route, make companies bleed off cash that way.
J. Goodwin,
OK… You say that if expectation of increasing interest rates increase current consumption, then a rise in interest rates will activate your expectations and you will start to consume. It is like you are waiting for your expectations of higher interest rates to be confirmed.
Higher interest rates don’t matter to large companies according to reports. But all companies are sensitive to changes in demand. The real question coming from this discussion of the Euler equation is whether consumption rises with rising interest rates. Sometimes it does, sometimes it doesn’t.
A change in tax rates and policies would be good. Yet, companies are going to want to hold onto their cash especially now because their risk in the economy still… cash flow risk.
I know a few developers who had their cash flow whacked when the crisis hit. Some had to declare bankruptcy. They are preparing for that not to happen again.
It will be interesting to see how this story of the Euler equation develops in other blog posts.
Corporate world expectations of things like interest rates are almost always based on trend analysis or actual published changes in things (like tax rates are published before they are in effect, so you have that planned in, even if you won’t actually end up paying those amounts in the end) so an actual rise in rates is what creates the expectation for businesses, not a whisper campaign from the fed (which is what affects the world of “investors”).