David Einhorn’s Jelly Donut

The Fed is terribly, horrendously, tragically wrong. Or so says David Einhorn.

According to Einhorn, the economy doesn’t need lower rates, but higher rates. Our current low rate environment encourages future retirees to save more, not save less. Raise rates, raise them now, and in short order we’ll see a surge in spending.

Einhorn, in theory, might well be right. But he might also be wrong. When we enter the realm of expectations, reality becomes blurred. What if, for instance, the mere expectation that higher rates will cause a recession actually causes a recession? What if this is true today but false tomorrow? Perhaps Einhorn is correct this time around, and higher rates will lead to a stronger recovery. But what if the reverse occurs during the next business cycle? How do we know how the economy will respond in all possible situations?

We don’t. And we never will.

It’s because of this dilemma that our current monetary system is so flawed. Today’s central bankers are expected to know the correct policy for any economic environment, but how can they when there’s so much uncertainty? If a plausible argument can be made regarding two conflicting policies – raise rates, lower rates – how can the central bank ever achieve its full employment goal with any consistency?

For this reason, when Miles Kimball states that the system I propose – neutral money – is simply one of many ways to remove the Zero Lower Bound (ZLB), I must respectfully disagree. In a neutral monetary system, the central bank directly controls M, the money supply, and not interest rates. And because V, the velocity of money, is fixed, then spending is equal to M. So if the central bank boosts M by 2%, then nominal spending will increase by 2%. No ifs or buts. In other words, to achieve its full employment goal, all the central bank has to do is ensure M tracks the change in potential output.

While identifying the correct M is still non-trivial, the job is infinitely easier than picking the correct interest rate. Potential output, after all, is not very volatile – this month’s potential GDP won’t deviate much from last month’s. So even if the central bank misses, it should not miss by much. Most important, however, is that the cost of such a miss would be minimal. If the central bank overshoots M by 2%, for instance, we get 2% inflation; if it undershoots M by 2%, we get 2% unemployment. Either way, compared to our current system, this is a vast improvement. Today’s central banks don’t control nominal spending at all. They only control nominal interest rates – and they’re barely in control of those. A misstep on these rates can have disastrous consequences. Set them too high and we’ll have a downward demand spiral. Set them too low and we’ll have runaway inflation. (Or, if you adhere to Einhorn’s view, flip these results around.)

Because of the high level of uncertainty and the high capacity for mistakes, it’s my belief that one day we will simply have to make neutral money work. This doesn’t mean we shouldn’t explore or experiment with ideas that maintain the primacy of the central bank, such as Miles’ system or other proposals to remove the ZLB. But we must acknowledge that these systems are not foolproof the way neutral money is. In our current system, central bankers will simply never find a precise link between spending and interest rates – and without this link, they will flounder.

I write all this in the spirit, not of antagonism, but of openness. We need to be honest and upfront about the potential shortcomings of the changes we propose. Otherwise, if the changes are made and the problems remain unsolved, the reactionaries may well win the day.

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Trackbacks and Pingbacks

[…] As of late, Eric Lonnergan has had negative interest rates in his crosshairs. Helicopter money is a much sounder policy, he says, and goes on to cite a single study “proving” a precise, positive, and unshakable link between tax rebates and spending. The same “proof” is not available for negative interest rates, he says, which will probably reduce demand anyway (see David Einhorn’s Jelly Donut). […]

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