Hey teacher, call on me!

Do you recall that student back in middle school, frantically waving his hand trying to get the teacher to call on him? That’s how I feel when I read the following sort of news story:

As the US economy hums along month after month, minting hundreds of thousands of new jobs and confounding experts who had warned of an imminent downturn, some on Wall Street are starting to entertain a fringe economic theory.

What if, they ask, all those interest-rate hikes the past two years are actually boosting the economy? In other words, maybe the economy isn’t booming despite higher rates but rather because of them.

It’s an idea so radical that in mainstream academic and financial circles, it borders on heresy — the sort of thing that in the past only Turkey’s populist president, Recep Tayyip Erdogan, or the most zealous disciples of Modern Monetary Theory would dare utter publicly.

Most mainstream economists view MMT as a crackpot theory, and they are probably right.  But there’s another “MMT” that actually can explain these recent trends:

But the new converts — along with a handful who confess to being at least curious about the idea — say the economic evidence is becoming impossible to ignore. By some key gauges — GDP, unemployment, corporate profits — the expansion now is as strong or even stronger than it was when the Federal Reserve first began lifting rates.

That MMT is called “market monetarist theory”.  And unlike the other MMT, it is perfectly consistent with mainstream economic theory.  So why does the press do so many stories about the fringe MMT, and almost none about the more reasonable MMT?  I suspect it is because market monetarism doesn’t give easy answers.  Journalists wish to know how to interpret rising interest rates, and we respond that one should not even try to interpret rising interest rates.  To do so would be to engage in the fallacy of reasoning from a price change.

In the fringe MMT, there is no natural rate of interest.  Tomorrow, the Fed could wave a magic wand and set nominal interest rates at zero, without impacting inflation.  It’s simple, easy to explain.

In contrast, we emphasize that central banks usually respond to changes in the natural interest rate.  They are roughly as likely to overreact as they are to underreact to a rise in the natural rate, and thus we should not expect to see any clear correlation between rising rates and changes in aggregate demand.  And we don’t.

In fairness, the trendy new Wall Street theory does have an “it depends” aspect:

This is, the contrarians argue, because the jump in benchmark rates from 0% to over 5% is providing Americans with a significant stream of income from their bond investments and savings accounts for the first time in two decades. . . .

In a typical rate-hiking cycle, the additional spending from this group isn’t nearly enough to match the drop in demand from those who stop borrowing money. That’s what causes the classic Fed-induced downturn (and corresponding decline in inflation).

The fallacy here is pretty obvious.  In terms of the effect on income, interest payments are always a zero sum game.  One person pays money and another person receives money.  It’s true that bondholders are now getting a larger flow of interest income from the government, but that’s always true of higher interest rates (and was even more true in the early 1980s, when much higher interest rates preceded two recessions.)

In contrast, the market monetarist explanation doesn’t rely on any implausible assumptions.  Rather we simply assume that the natural (or equilibrium) interest rate is hard to estimate (a generally accepted claim), and that the Fed will attempt to move interest rate targets to an appropriate level (another generally accepted claim), and that an unbiased central bank will make errors in both directions. Thus, rising interest rates should have no reliable impact on aggregate demand.  

But that’s so much less interesting to journalists than the ideas of MMTers, Turkish political leaders and Wall Street traders dabbling in folk economics.

PS.  Those on the other extreme from MMTers are equally off base:

To be clear, the vast bulk of economists and investors still firmly believe in the age-old principle that higher rates choke off growth. As evidence of this, they point to rising delinquencies on credit cards and auto loans and to the fact that job growth, while still robust, has slowed.

That’s equivalent to saying the vast bulk of economists and investors engage in reasoning from a price change.  Of course job growth has slowed, as unemployment has fallen to the natural rate.  Unlike in 2020-21, we no longer have a vast reserve army of unemployment to hire from. But job growth is still extremely high for a period of sub-4% unemployment.  The economy is still overheated.  We are still waiting for the tight money policy to begin.

HT:  Michael Darda