It may be frightening to think the central bankers presiding over the global economy are emperors wearing no clothes, but investors who read James Montier’s argument to this effect can perhaps take comfort in the fact that that the investment exec also argues that monetary policy doesn’t matter.
In a new white paper from the famed institutional fund manager GMO called “The Idolatry of Interest Rates,” the iconoclastic investor takes on the wonkish but ubiquitous subject of the “equilibrium real interest rate” (ERIR).
While the subject — also known as the natural rate or neutral rate — can be abstruse, its importance to policymakers cannot be denied.
Former Federal Reserve Board Chairman Ben Bernanke devoted his first blog post to the subject; his successor, Janet Yellen, is said to have mentioned ERIR 25 times in recent speech; and the president of the Federal Reserve Bank of Cleveland called ERIR “the” pressing issue today, Montier recounts.
Economists Larry Summers and Paul Krugman are among the cognoscenti who have weighed in on ERIR, which posits that there is an inherent rate of interest that is consistent with full employment that policymakers can discover in their efforts to set rates correctly.
While eminent people heatedly take different sides on the issue, along comes Montier to ask why no one questions the framework itself. His answer is that the ERIR debate is an example of groupthink stemming from an economic elite of New Keynesians, “many of whom trained at the same university under the same teacher.”
Like medieval churchmen debating how many angels can dance on the head of pin, however, today’s elite fall into the classic trap of making unfounded assumptions.
Montier notes the classic joke of the engineer, chemist and economist stranded on an island with a can of food but no implements. The engineer rigs a contraption that might open the can, the chemist proposes using salt water to erode it and the economist suggests assuming the existence of a can opener.
The GMO exec, on the other hand, shows a chart of wildly swinging short-term rates over the past 60 years and hypothesizes that the rates are reflective of policy decisions rather than market shifts in response to changing capital conditions.
In other words, rates rose steeply in the early 1980s, not because of a scarcity of real capital, but because then-Fed chairman Paul Volcker was determined to break inflation.
Montier also cites recent econometric research that concludes there is little evidentiary support for the idea that trend rate of economic growth drives ERIR, and he presents a table of widely varying estimates (ranging from -5% to +12%) of what ERIR should be.
“Never ones to be deterred by dubious theory, bound by reality, or flinch in the face of impracticality, many economists have engaged in an exercise of estimating a number that might not even exist. The range of estimates that have been generated should alone give pause for reflection,” he writes.
Further pause should stem from the claim by John Williams — one of the leading theoreticians of ERIR and Yellen’s successor as San Francisco Fed president — that “the natural rate of interest is assumed to change over time due to various unobservable influences.”
As Montier puts it, “how much can you or should you trust a model that essentially uses the trend rate of growth (an empirically invalid input…) plus a bunch of completely ‘unobservable influences’ to guide your decision making?”
It would be an understatement to say that Montier distrusts this model since the econo-clast, to coin a term, goes so far as to deride the importance of monetary policy itself as “the greatest con ever perpetuated.”
Indeed, he likens faith in monetary policy to idolatrous worship:
“There seems to be a perception that central bankers are gods (or at the very least minor deities in some twisted economic pantheon). Coupled with this deification of central bankers is a faith that interest rates are a panacea. Whatever the problem, interest rates can solve it. Inflation too high, simply raise interest rates. Economy too weak, then lower interest rates. A bubble bursts, then slash interest rates, etc., etc.”
Montier goes through a range of claims about monetary policy — for example, the idea that interest rate cuts have an expansionary effect on the economy — and brings various data and charts to contest them.
For example, cutting rates is supposed to stimulate demand through investment, yet Montier shows that “firms generally rely on internal funds to fund investment, rather than borrowing.” His chart shows that “over 100% of gross investment is financed by internal funds.”
Similarly, he cites a survey of CFOs by Duke University asking how a rate cut changed capital spending. “A whopping 81% said there was no change!”
At the consumer level, he posits that rate changes cannot clearly be shown to affect consumer behavior since “many consumers are both debtors and creditors, making it unclear as to the impact of interest rate changes on their behavior.” Indeed, a scatter chart of household savings amid positive and negative rates shows savings behavior all over the map over the past 60-plus years.
While Montier considers monetary policy of dubious value, he suggests there is an effective, if overlooked, alternative: namely, fiscal policy.
While government budgeting decisions have a clear impact on incomes, this arena of policy neglect — which he says he may soon write on at length — is deeply out of vogue for political reasons.
Until the return of fiscal policy that can actually boost today’s persistent low growth, policymakers’ excessive attention to ERIR — “a make-believe concept” — condemns us to combating persistent economic ills “with one arm tied behind our back,” Montier concludes, “with a badly functioning prosthetic being forced to do all of the work.”
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