Don’t Pay Any Attention to Interest Rates

Pay attention to the things that cause interest rates to change.

This post was inspired by a Tyler Cowen post entitled “Don’t obsess about interest rates.”  I agree, and will stake out an even more extreme position.

Before doing so, I’d like to talk a bit about the identification problem in another area—wages.  Suppose someone argued that rich country workers can’t compete with low wage countries like China.  The counterargument would be that Germany has led the world in exports for most of the past decade, and they have some of the highest wages in the world.  Bangladesh has a much bigger population, but puny exports.  The counter-counterargument is that Germany’s high wages are caused by their high productivity, and that high wages are still a disadvantage in trade, holding other things constant.  In the end, the debate is sterile unless we understand all of the underlying fundamentals, in which case wages are superfluous.

Here’s better analogy.  Massachusetts saw a big loss in jobs in industries like shoes and textiles during the 1980s.  Was the job loss due to high wages?  If so, then why didn’t Massachusetts see a higher unemployment rate?  Economists would use the good old comparative advantage model.  The booming high tech, health care, and finance sectors created lots of high paying jobs.  This raised the cost of living here, and drove out the low paying jobs.  Thus our low wage jobs weren’t stolen by cheaper labor in Mexico or China, they were literally pushed out (or crowded out) by higher paying jobs in other industries.  That’s creative destruction.

Now let’s consider the role of wages.  Although they weren’t the root cause, it is true that high wages were a sort of transmission mechanism between the high tech boom and the loss of low wage jobs.  So why do I object to people saying high wages drove out those older industries?  Because wages change for many different reasons.  They might change because the shoe industry became highly unionized and drove up wages, despite weakness in other areas of the economy.  Or they might change because of the creative destruction process I just described—a high tech boom pushing up the overall wage rate around here.  It makes a big difference which factor is behind the wage change.  You haven’t really described the reason why shoe-making jobs left the state unless you can explain why wages rose.

Here’s how this relates to interest rates.  Tyler Cowen links to a study by Glaeser, Gottlieb, and Gyourko (GGG), which finds that only about 20% of the housing price boom was due to low interest rates.  I don’t wish to contest that study, rather I want to warn people to be careful interpreting the findings.  For instance, interest rates might have fallen because the popping of the high tech bubble in 2001 led to a big drop in business investment.  With lower demand for credit, interest rates (real and nominal) would naturally be expected to fall.  Or the Fed might have cut interest rates.  Or saving rates might have risen in Asia.  If the housing industry was not directly hit by any unusual shocks, these outside factors affecting interest rates would be expected to increase housing demand, prices, and output.  The GGG study is essentially saying that 80% of the rise in housing prices was due to non-interest rate factors, i.e. factors directly affecting the housing market.  I suppose these could be changes in regulation, financial innovation, banks taking greater risks, GSEs, etc.

So why don’t I like hearing people talking about the portion of the housing boom that was due to low interest rates?  The problem is that many listeners subconsciously connect low interest rates with “easy money.”  They assume it is the Fed’s “fault.”  To their credit GGG avoid this error, referring instead to “easy credit,” i.e. low real interest rates.

Economists generally accept the idea that the Fed only affects real interest rates in the short run.  (Or at least I thought this was generally accepted, the last two years have caused me to reconsider everything that I assumed was generally accepted by economists.)  The standard view is that the so-called liquidity effect only impacts real interest rates for a few years.  In the long run, easy money will leave real interest rates unchanged, and raise nominal rates.  For instance, compare the 1970s to the 2000s.  The 1970s saw higher and higher nominal rates, culminating in 20% rates by 1980.  The 2000s saw much lower interest rates, which ended up near 0% by 2010.  The man on the street would assume that money was much tighter in the 1970s.  But economists know that this is wrong, because the 1970s saw high and rising inflation, and the 2000s saw low inflation.

So here is my suggestion.  Never reason from a price change.  Don’t ever say “oil prices will be high next year; hence I expect oil consumption to decline.”  That’s bad reasoning.  And don’t ever talk about high or low interest rates causing some sort of change in the economy.   Instead say something like ”I believe the high tech bust helped boost the housing industry.”  That sort of reasoning is consistent with the central idea of economics—scarcity.  If less resources are devoted to making one type of capital good, then you’d expect more resources to be devoted to making other types of capital goods.  Interest rates are merely the transmission mechanism that facilitates the “recalculation.”

Of course I am not suggesting that the tech bubble bursting caused the housing boom.  GGG find only about 20% of the boom is explainable via interest rates, and the tech bubble bursting is just one of many variables that can affect real interest rates.  High Asian savings rates are another factor, and Fed policy is a third. However, the liquidity effect is less significant than usually assumed, as interest rate changes far more often reflect economic conditions than exogenous changes in Fed policy.  So even if low interest rates had caused the housing boom, you would still not be able to claim that a Fed easy money policy contributed to the housing boom.

PS.  BTW, also avoid talk about disinflation/deflation, which could be due to either less AD or more AS.  If you are worried about too little AD, then talk directly about falling NGDP.  And yes, I am at fault here as well, as Bill Woolsey has noted on occasion.

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