I’m currently reading The Death of Money: The Coming Collapse of the International Monetary System, by James Rickards and the book is pretty bad. My current impression is that Rickards is a stereotypical “heterodox” economist/analyst that doesn’t actually understand basic economic theory. He constantly makes sweeping assertions about economists he hasn’t read. His scenarios on financial warfare seem really far fetched. His pretentious writing doesn’t help either.
Instead of complaining, I thought I would do something a little more constructive. As I continue to read the book, I’ll critique the parts that bug me. I probably won’t cover the stuff about financial warfare, as I don’t know if his concerns are real or not. I will cover the sections on economic theory, an area that I’m a little more comfortable with.
James Rickards, like many critics of QE and Federal Reserve Policy, thinks that Fed officials are obsessed with the “wealth effect”:
Policy makers respond to economic distress by pursuing policies designed to improve the data. After a while that data themselves may come to reflect not fundamental economic reality but a cosmetically induced policy result. If these data then guide the next dose of policy, the central banker has entered a wilderness of mirrors in which false signals induce policy, which induces more false signals and more policy manipulation and so on, in a feedback loop that diverges further from reality until it crashes against a steel wall of data that cannot easily be manipulated, such as real income and output. A case in point is the so-called wealth effect. (Rickards 2014: 72)
For those unfamiliar, the wealth effect says that an increase in the value of household financial and non-financial assets will bring about an increase in aggregate expenditure. So for every dollar in asset appreciation, the owner of that asset will spend a part of that dollar. Advocates of the wealth effect say that as stock prices and housing prices go up, consumers will feel more confident about their financial position and start to spend more.
I haven’t read much literature on the wealth effect, so I have no idea if Rickards’ critique addresses the most recent empirical research (I will say that the little research I have read is more tentative than Rickards and other critics would have you believe). But let’s ignore that and assume he is correct. It turns out that the connection between assets and consumption is tenuous. And to be fair to Rickards, a lot of respectable analysts take issue with the wealth effect. It’s also true that several Federal Reserve officials have talked about wealth effect. Everybody loves to cite this Greenspan quote:
A substantial part of the excess growth of demand over potential supply owes to a wealth effect, induced by the rising asset prices that have accompanied the run-up in potential rates of return on new and existing capital. The rise in stock prices, as well as in the capital gains on homes, has created a marked increase in purchasing power without providing an equivalent and immediate expansion in the supply of goods and services. That expansion in supply will occur only over time.
Ben Bernanke has talked about the wealth effect, albeit very briefly in an op-ed piece:
Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.
So Rickards and the critics may have a point. However, one thing I noticed when I read all these pieces is that they reference the same three or four quotes. In my search for Bernanke quotes on the wealth effect, I could literally only find one. It’s the one I’ve quoted above, a brief off-hand sentence in an op-ed piece. If he talks about it anywhere else, a Fed speech or a paper, I’d love to see it. But citing this op-ed as if it’s representative of Bernanke’s thoughts on monetary policy is just silly. The thing about monetary policy is that it works through lots of channels. Ben Bernanke, being a central banker and knowledgeable economist, knows this (he’s even written about it before). Most economists know this. Heck, even I know this. Just look at this picture from Frederick Mishkin’s extremely popular undergraduate textbook on money and banking:
As you can see, there’s a lot of channels that monetary policy can work through. In fact, the most commonly cited channel that QE is supposed to work through is interest rates which in turn affects investments. Here’s a newsletter from the St. Louis Fed explaining the process:
QE affects the economy through changes in interest rates on long-term Treasury securities and other financial instruments (e.g., corporate bonds). To have an appreciable impact on interest rates, QE requires large-scale asset purchases. When the Fed makes such purchases of, for example, Treasury securities, the result is an increased demand for those securities, which in turn raises their prices. Treasury prices and yields (interest rates) are inversely related: As prices increase, interest rates fall. As interest rates fall, the cost to businesses for financing capital investments, such as new equipment, decreases. Over time, new business investments should bolster economic activity, create new jobs, and reduce the unemployment rate. QE is not a new approach; it was used by the Fed in the 1930s, the Bank of Japan in 2001, and more recently by the Bank of England.
This is especially funny when you consider that Rickards writes an entire paragraph on the importance of investment in GDP:
Investment is one of the four fundamentals components of GDP, along with consumption, government spending, and net exports. Of these components, investment may be the most important because it drives GDP not only when the investment is made, but in future years through a payoff of improved productivity. Investment in new enterprise can also be a catalyst for hiring, which can then boost consumption through wage payments from investment profits. Any impediments to investment will have a deleterious effect on the growth of the overall economy. (Rickards 2014: 84)
Now I’m not defending QE and other Fed policies, but these criticisms by Rickards and others are unconvincing. Rickards does talk about how the Federal Reserve is distorting incentives through other channels* but he puts a lot of focus on the wealth effect (he has a whole section titled “The Wealth Effect”). In doing this, he commits a common mistake that critics of the Fed and Federal Reserve policy commit, i.e. only looking at one channel of monetary policy, declaring it useless, and pronouncing that the Fed is impotent. This is nonsense. You need to take a detailed look at all monetary policy channels and go from there. Some critics** do this, most don’t. Rickards definitely falls in the later category.
*He does it in an confusing and incoherent fashion, but I’ll get to that in another post
**One exceptional critic of QE and FED policy is Frances Coppola
1. Bernanke, Ben S., and Mark Gertler. “Inside the Black Box: The Credit Channel of Monetary Policy Transmission.” Journal of Economic Perspectives 9.4 (1995): 27-48. Web.
2. Matteo Iacoviello, 2011. “Housing wealth and consumption,” International Finance Discussion Papers 1027, Board of Governors of the Federal Reserve System (U.S.)
3. Sydney Ludvigson & Charles Steindel, 1999. “How important is the stock market effect on consumption?,” Economic Policy Review, Federal Reserve Bank of New York, issue Jul, pages 29-51.