Krugman Perpetuates Myth of the Zero Lower Bound

Professor Paul Krugman

Professor Krugman just published a column where he deserves kudos for sticking his neck on the line and predicting that the Bernanke Fed is not creating a bubble in bonds, and "probably not" in stocks either.

While the argument on whether or not Bernanke is blowing bubbles is interesting and worthy of discussion (although only time will tell for sure), that's not what this post is about.

In the column Krugman makes a somewhat tangential comment about what economists often refer to as the 'zero lower bound problem' on where a central bank can set interest rates. Here's Krugman's quote:

"True, it (the Fed) can’t cut rates any further because they’re already near zero and can’t go lower. (Otherwise investors would just sit on cash.)"

Krugman's statement is problematic for several reasons:

First, it's misleading and patently false of Dr. K to say that the Fed "can’t cut rates any further" when in fact it can. There is no economic or natural law which prevents the Fed from setting nominal rates at exactly zero, or at a negative rate.

Whether they should be set at zero or negative is another question. In short, Dr. K needs to replace "can't" with something like "could but shouldn't because...".

Second, I suggest that it would be helpful if Dr. K was a little more precise so that people understand why the Fed "can't" (shouldn't) set zero or negative rates but Denmark's central bank can set a negative deposit rate, and now Drahgi at the ECB is openly discussing this as well.

To be clear, I'm not endorsing negative rates. I'm only saying that negative rates are possible and that some central banks are experimenting with negative rates as a policy tool.

And finally, yes, perhaps if the Fed were the only central bank to pursue a negative rate policy then investors may sit on cash, move their money elsewhere, etc. But if enough central banks around the world kept driving rates further and further into negative territory then it would be very surprising if this didn't help generate inflation, in which case people would probably not be sitting on cash as Dr. K suggests but rather spending it before money lost its purchasing power.

The long perpetuated myth of the zero lower bound is starting to be challenged more and more, and for a more detailed academic discussion of the zero lower bound myth see here. 

Guest Post: Investing Simplified for Senior Citizens

Investments for senior citizens are no different than those made by a person of any age; however, it may be in their best interest to make investments with low risks since many are retired and are on a fixed income.  Here are some typical investments:

Stock Investments- You buy an equity ownership interest in a publicly traded companies. The price of a stock can fluctuates; as it fluctuates investors either make or lose money on their initial investment.  Stock prices can be unpredictable and risky but has the potential for very high returns if you invest smartly. Some stocks also pay dividends, although the amount of the dividend can be changed by the company.

Stock Mutual Fund Investments- You choose a manger and they invest your money into diversified set of assets. Mutual funds are available for stocks, bonds, short-term money market instruments, and other securities. A mutual fund can less risky than investing in a single or small number of companies due to diversification. However, fund fees can reduce the total investment return.

Savings Deposit Investments- Deposits you make into your savings account with your bank.  Money must be moved into your checking account for use.  While in your savings account, your bank pays you interest based on current interest rates and your money is insured by the FDIC up to $250,000 per despositor, per insured bank.

Certificate of Deposit Investments (CD)- You deposit a fixed amount of money for a fixed amount of time into account with a bank or thrift institution.  Once the maturity date is met, your bank pays you back your initial investment plus any interest you accrued. Bank CDs are also often covered by FDIC insurance.

Treasury Bill Investments (T-Bills)- Short-term debt sold by the U.S. Treasury, usually at a discount from the par amount, i.e. amount the bill will be worth upon maturity. For example, you might buy multiple bills for $98 and get $100 for each when the bills mature at a later date; the lowest bill you can buy is worth $100 upon maturity. Treasury Bonds are longer-term debt sold by the U.S. Treasury for periods up to 30 years. The Treasury also sells Treasury Inflation Protected Securities (TIPS) which have feature and adjustable coupon payment based on the changes to Consumer Price Index.

Money Market Account (MMA) or Money Market Deposit Account (MMDA) Investments- A deposit account offered by banks.  Upon deposit, your bank will invest your money into government and corporate securities. You will be paid interest based on current money market rates of interest.

Money Market Mutual Fund Investments- A deposit fund offered by brokers who invest your money in short-term government and corporate debt securities. This investment is very similar to MMAs except that they are through a broker and not insured; they are more risky than MMAs, but you may receive a higher rate of return on your investment.

Below is an easy to read chart for senior citizens; it lists general details about these investment types.

Shannon Paley is a guest post and article writer bringing to us her simplified explanations on investments for senior citizens. She writes about nursing home abuse for nursinghomeabuse.net.


Note: please see the Disclaimer on the right side of this website. Before considering any investment you are encouraged to consult with a professional investment advisor.

Recommended links

1. Why is Greece turning down the “bailout” (Tyler Cowen)

2. Circular commitments lead to a Ponzi economy (Letter to the FT). Here's the key quote:

If governments stand behind banks and banks stand behind governments and the central bank lends freely to both and also underwrites financial markets, then financial asset prices become completely detached from economic reality. In this “system”, the central bank implementing more quantitative easing is no different, in economic terms, from Bernie Madoff marking up his client accounts every month.

3. The Bailout That Busted China's Banks (WSJ)

4. Mr. Hoenig Goes to Washington (Simon Johnson)

5. Bond Dealers See Fed Holding Rate Near 0% at Least Through First Half of 2013 (WSJ)

6. Papandreou Is Right to Let the Greeks Decide (Spiegel)

7. Live European debt crisis coverage (BBC) and (Telegraph)

Video: Pimco's El-Erian Explains Financial Repression

Video: Carmen Reinhart on a Decade of Debt

Here is a link to audio only versions of Carmen's presentation and the Q&A.

Reinhart and Rogoff on Why Heavily Indebted Economies Can't Grow

Coinciding with Moody's placing the U.S. debt rating on negative review, Carmen Reinhart and Ken Rogofff remind us that country's will high debt levels often struggle to grow (attention Paul Krugman, they're talking to you!):

Our empirical research on the history of financial crises and the relationship between growth and public liabilities supports the view that current debt trajectories are a risk to long-term growth and stability, with many advanced economies already reaching or exceeding the important marker of 90 percent of GDP. Nevertheless, many prominent public intellectuals continue to argue that debt phobia is wildly overblown. Countries such as the U.S., Japan and the U.K. aren’t like Greece, nor does the market treat them as such. 

Indeed, there is a growing perception that today’s low interest rates for the debt of advanced economies offer a compelling reason to begin another round of massive fiscal stimulus. If Asian nations are spinning off huge excess savings partly as a byproduct of measures that effectively force low- income savers to put their money in bank accounts with low government-imposed interest-rate ceilings -- why not take advantage of the cheap money? 

Although we agree that governments must exercise caution in gradually reducing crisis-response spending, we think it would be folly to take comfort in today’s low borrowing costs, much less to interpret them as an “all clear” signal for a further explosion of debt. 

Several studies of financial crises show that interest rates seldom indicate problems long in advance. In fact, we should probably be particularly concerned today because a growing share of advanced country debt is held by official creditors whose current willingness to forego short-term returns doesn’t guarantee there will be a captive audience for debt in perpetuity. 

Those who would point to low servicing costs should remember that market interest rates can change like the weather. Debt levels, by contrast, can’t be brought down quickly. Even though politicians everywhere like to argue that their country will expand its way out of debt, our historical research suggests that growth alone is rarely enough to achieve that with the debt levels we are experiencing today. 

The full Reinhart and Rogoff article can be found here.

Bill Gross Harps on Financial Repression

Picking up right where he left off last month, the Bond King's latest letter sounds-off on how financial repression is a bad deal for U.S. treasury investors.

Video: Bill Gross on U.S. Financial Repression

What is Financial Repression and How Investors Can Protect Themselves

Carmen Reinhart

Financial repression, a subject last widely studied in development economics circles in the 1970s-80s, appears to be making a comeback. Bill Gross dedicated his May investment letter to financial repression, and an article by the FT's Gillian Tett describes how both policymakers and investors are having to refamiliarze themselves with its tenets.

Just what exactly is the ominous sounding 'financial repression'? Below is an abridged definition from Reinhart & Rogoff's This Time is Different:

Banks are vehicles that allow governments to squeeze more indirect tax revenue from citizens by monopolizing the entire savings and payment system. Governments force local residents to save in banks by giving them few, if any, other options. 

They then stuff debt into the banks via reserve requirements and other devices. This allows the government to finance a part of its debt at a very low interest rate; financial repression thus constitutes a form oftaxation. Governments frequently can and do make the financial repression tax even larger by maintaining interest rate caps while creating inflation.

The 'Era of Financial Repression'

Carmen Reinhart and M. Belen Sbrancia recently published a paper which analyses the extent of financial repression among advanced economies in the post-World War II period. Here's Reinhart's and Sbrancia's updated definition of financial repression, which now includes pension funds along with banks in their list of domestic captives:

A subtle type of debt restructuring takes the form of “financial repression.” Financial repression includes directed lending to government by captive domestic audiences (such as pension funds), explicit or implicit caps on interest rates, regulation of cross-border capital movements, and (generally) a tighter connection between government and banks.

They studied the post-WWII period:

In the heavily regulated financial markets of the Bretton Woods system, several restrictions facilitated a sharp and rapid reduction in public debt/GDP ratios from the late 1940s to the 1970s. Low nominal interest rates help reduce debt servicing costs while a high incidence of negative real interest rates liquidates or erodes the real value of government debt. 

And their key finding which has PIMCO's Bond King in a tizzy:

Continue reading the full article at SeekingAlpha here.

The Buck Stops Here: Housing Price Trends and the Economic Outlook

Is the time finally right to get back into the residential real estate game? And what are the broader implications of trends in housing on the overall economy and financial markets? Let's take a look at the arguments and data.

The Case for Investing in Housing

Mortgage interest rates have come up some recently but are still near historic lows and appear attractive.

U.S. 30-Year Mortgage Interest Rates

Note: chart data only runs through early 2010; if updated through 2011
 the chart would show a recent increase in interest rates to around 5%.

We're also entering the comparatively slow home buying season and prices, after a post-bubble popping uptick, have been retreating recently.  There may be some sweet deals to be had over the next several months.

And perhaps most importantly are the following two considerations: a) the overall economy is showing increasing signs of life and b) the risk of deflation appears to be subsiding as commodity (e.g., oil) and food price inflation is taking off globally. Real estate has historically been considered one of the best ways to protect oneself against broad inflation.

Add it all up and it would appear that housing could in fact be a prudent investment right now. What would be reasons for holding off?

Continue reading the full article published on SeekingAlpha here.