monetary policy – J. W. Mason

At The International Economy: A Global Debt Crisis?

(I am an occasional contributor to roundtables of economists in the magazine The International Economy. The topic of this month’s roundtable was: Is a serious global debt crisis possible?)

As Hyman Minsky famously described, when market participants believe that crises are possible, they behave in ways that make the system relatively robust. Only when the chance of a crisis is deemed very low, or forgotten entirely, do financial markets accept the degree of leverage and illiquid commitments that make a crisis possible.

This means, among other things, that crises are inherently difficult if not impossible to predict. A predicted crisis is a crisis that does not occur.

So to the question of whether a serious crisis is likely in the near future, the sensible answers range from “maybe” to “I don’t know.”

There are other questions we have a better chance of answering. First, are the authorities able to handle a crisis if one does occur? And second, what kind of spillovers will a financial crisis have for the rest of the economy?

On both questions, the answers would seem to be reasonably encouraging for the rich countries, less so for the developing world.

The 2007-2009 financial crisis and the 2020 pandemic were very different events in many ways. But one thing they had in common, is that both demonstrated the awesome power of a committed central bank to overcome almost any kind of disruption to the financial system. The Fed, in particular, was willing to buy a much wider range of assets, and intervene in a wider range of markets, than almost anyone would have previously predicted. Today there can be little doubt that the Fed can stem the contagion from even the biggest bank failure or sovereign default, if it wishes to.

That last caveat is worth emphasizing. The decade after 2007 saw a sharp divergence between the US and Europe. While the Fed moved aggressively to repair the financial system, the ECB moved more slowly — in part because of tighter institutional constraints, but also, it’s now clear, because decision makers at the ECB saw the crisis as a chance to push through a broader set of policy changes. Not only Greece but also Spain, Italy and Ireland were in effect held hostage by the ECB, which refused to restore liquidity to their banking systems until they accepted various structural reforms.

This divergence suggests that, in the rich countries, the question may be less what central banks are able to do in response to a banking crisis, and more what they are willing to do.

As for the second question, it’s worth maintaining a bit of skepticism that finance is as important to the rest of us as it appears in its own eyes. In retrospect, it seems clear that the long-term damage to the US economy after the 2007 crash had more to do with the collapse of housing market — a pillar of the real economy — than with the the financial aftershocks that got so much attention at the time. When we think about the dangers of a financial crisis today, we should ask not only what are the chances of bank failures and asset market disruptions, but how important those markets are for real activity. Mortgages and cryptocurrencies are very different in this respect.

For the developing world, unfortunately, such a relatively sanguine view is harder to sustain. Central banks are much less powerful in countries where a large fraction of domestic obligations involve foreign currencies, and where financial conditions are largely determined beyond the borders. Serious spillovers to the real economy are more likely in this case. If there is a crisis in the near future, it may finally teach the lesson that the world has been slowly learning: Outside the core of the world economy, an essential requirement for any kind of macroeconomic management is a degree of financial delinking.

At The International Economy: Low Interest Rates Were OK

(I am an occasional contributor to roundtables of economists in the magazine The International Economy. This month’s roundtable was on concerns that ultra-low interest rates after the 2007-2009 financial crisis contributed to rising inequality and asset bubbles, and asked contributors to grade post-2007 monetary policy on a scale of A to F.)

Overall, I give the negative interest rate experiment a grade of B. The costs of negative rates have been greatly exaggerated. But so have the benefits. The main lesson is that conventional monetary policy is surprisingly weak in a depressed economy, even when carried to extremes. The next time we need stimulus, greater weight should be put on fiscal policy.

The case against ultra-low rates on distribution grounds is not very strong, in my view. Yes, low rates do tend to raise asset values, and it’s the rich who own most of the assets. But we should not make the mistake so many people do, and confuse a change in the present value of future income streams with a change in those streams themselves. Low rates, for example, imply a greater present value of the same future dividend payments, and thus higher stock prices. But that has no effect on income distribution — the owners of the stock are receiving the same payments as they were before.

The bigger criticism of ultra-low rates is that they didn’t have much effect one way or another. Did 20 years of zero nominal rates in Japan significantly boost demand and growth? It doesn’t seem like it.

At the same time, we should be careful of language like “distortion,” which suggests that there is some true, natural level of interest rates and investment. Whether high or low, interest rates are always set by policy. And this always involves tradeoffs between competing social goals.

Whether ultra-low rates contribute to bubbles is debatable. Many of the world’s great bubbles — from the 1920s in the US to the 1990s in Sweden — have occurred in environments of high interest rates. But let’s say for the sake of argument that cryptocurrency is socially useless, and that it would never have taken off if rates were higher. Is this a problem with negative rates? Or is it a problem with the financial system? The reason we have so many well-educated, well-compensated people working in finance is that they are supposed to direct credit to the best opportunities. If cheap money leads them to invest in projects that are worthless, or worse, rather than ones with moderate returns, they’re not doing their jobs.

If jet fuel were free, we would all probably fly more. But if planes kept crashing into the ocean, we’d blame the airlines, not the cheap fuel.

Speaking of airlines, it’s easy in retrospect to see the subsidized loans to them and other pandemic-hit industries as excessive. But we don’t know what the counterfactual is — it’s possible that without public support, they would have collapsed into bankruptcy, leading to a much slower recovery. Certainly we couldn’t be sure at the time. Under the extraordinary circumstances of the pandemic, there was no safe course, only a balance of risks. The high inflation of 2021-2022 was unfortunate; a prolonged depression would have been much worse. Perhaps next time — and climate change ensures that there will be a next time — we will strike a better balance. But it seems to me that under the circumstances, policymakers did pretty well.

That’s what I wrote for the symposium. Let me add a couple of things here.

First, this is not a new debate. Many of the same arguments were being made immediately after the global financial crisis, and even before it in the mid-2000s, in the context of the supposed global savings glut. At that time, the idea was that the volume of excess savings in Asia were too great to be absorbed by productive investment in the US and elsewhere, leading to downward pressure on interest rates and an excess of speculative investment, in housing especially.

It’s progress, I suppose, that the more recent period of low interest rates is attributed straightforwardly to central banks, as opposed to an imagined excess of “saving.” (For a critique of the savings-glut story, you can’t do better than Jörg Bibow’s excellent work.) But the more fundamental problem remains that the savings-glut/too-low-for-too-long stories never explain how they coexist with all the other economic stories in which more abundant financing is unambigously a good thing. As I wrote a dozen years ago¹:

the savings glut hypothesis fails to answer two central, related questions: Why was there a lack of productive investments available to be financed, and why did the financial system fail to channel the inflow of savings in a sustainable way? From a Keynesian perspective, there is nothing strange about the idea of a world where savings rates are chronically too high, so that output is demand-constrained; but this is not the perspective from which the savings-glut hypothesisers are arguing. In other contexts, they take it for granted that an increase in the savings rate will result in greater investment and faster growth.

In particular, as I pointed out there, many of the same people arguing for these stories also think that it is very desirable to reduce government budget deficits. But if you ask any economist what is the economic benefit of moving the government balance toward surplus, their answer will be that it frees up saving for the private sector; that is, lower interest rates.²

Second. Returning to the International Economy roundtable, it’s striking how many of the contributors shared my basic analysis³ — ultra-low rates didn’t achieve very much, but they were better than nothing given the failure of the budget authorities to undertake adequate stimulus. It’s interesting is that people with this same analysis — and who also reject the idea that the low rates of the 2010s are to blame for the inflation of the early 2020s — give such different responses on the grading component. I agree with everything that Jamie Galbraith writes, and especially appreciate his points that hardly any private borrowers ever faced zero (let alone negative) rates, and that higher rates do not seem to have done much to curb speculative excess. (Just look at “AI”.) I also agree with everything Heiner Flassbeck says (especially the underappreciated point that we’ve also had a decisive test of the benefits of wage flexibility, with negative results) and with almost everything Brigitte Granville says. Yet two of us give As and Bs, and two give Ds and Fs. It’s the difference between comparing monetary policy’s actual performance to what it reasonably could have accomplished, and to what it promised, perhaps.

Finally. It might seem strange to see me speaking so positively about macroeconomic policy over the past decade. Aren’t I supposed to be a radical of some sort?⁴ It was even a bit disconcerting to me to see I typed those words a few months ago (there’s a bit of turnaround time with these things), given that my main feelings about Western governments these days tend toward rage and disgust.

But the point here is important. It’s important to remember that the central macroeconomic problem in recent years has been insufficient demand.⁵ It’s important to remind people of the overwhelming evidence, and the quite broad consensus, that the economic problem over the past 15 years has not been a lack of real resources, but a lack of spending — of demand. (A world in which over-low interest rates could even be a concern, is not a world where the central economic problem is scarcity.) And I think that it’s true, and important, that the institutions — at least in the US and Western Europe — that were consistently trying to address this problem, were the central banks.

Even today, while we can certainly argue that central banks raised rates too aggressively, the main contractionary pressure is coming from elected governments. This is most obvious in Europe, but in the US, it seems to me, the withdrawal of pandemic unemployment benefits and the child tax credit have done more harm than anything the Fed has done. There’s an old idea that elected governments are structurally biased toward deficits and generous social benefits.⁶ But it’s clear this is no longer true, if it ever was.

Against this background, I think both the broader recognition of hysteresis and chronic demand shortfalls in the 2010s, and the aggressive response to the pandemic in this decade, are positive lessons that need to be preserved and defended and built upon. It’s very challenging to separate this positive record on domestic economic policy from the increasingly horrifying treatment of the rest of the world that we have seen from the same governments. (I make this argument in the context of industrial policy in a forthcoming piece in Dissent.) But I think it’s vitally important, both politically and analytically, that we continue to try to do so.

Inflation Came Down, and Team Transitory Was Right

Line goes down, and up. Last week, I wrote out a post arguing that the inflation problem is largely over, and the Fed had little to do with it. Yesterday, the new CPI numbers were released and they showed a sharp rise in inflation — a 4 percent rate over the past three months, compared with 2 percent when I wrote the piece.

Obviously, I’m not thrilled about this. It would be easier to make the arguments I would like to make if inflation were still coming down. But it doesn’t really change the story. Given that the spike last month is entirely energy, with growth in other prices continuing to slow, almost everyone seems to agree that it has nothing to do with demand conditions in the US, or anything the Fed has been doing or ought to do.

Here is an updated version of the main figure from the piece. You can see the spike at the far right – that’s the numbers released yesterday. You can also see that it is all energy costs (the pink bar). Everything else is still coming down.

Here is a table presenting the same data, but now comparing the high inflation of June 2021-June2022 with the lower inflation of the past yer. The last column shows how much each category has contributed to the change in inflation between the two periods. As you can see, the fall in inflation is all about goods, especially energy and cars. Services, which is where you’d expect to see any effects of a softening labor market, have not so far contributed to disinflation.

One thing the figure brings out is that we have not simply had a rise and then fall in inflation over the past couple of years. We’ve had several distinct episodes of rising prices. The first, in the second half of 2020, was clearly driven by reopening and pandemic-related shifts in spending. (One point Arjun and I make in our supply-constraints article is that big shifts in the composition of spending lead to higher prices on average.) The next episode, in the second half of 2021, was all about motor vehicles. The third episode, in the first half of 2022, was energy and food prices, presumably connected to the war in Ukraine. Finally, in later 2022 and early this year, measured inflation was all driven by rising housing costs.

Even though they may all show up as increases in the CPI, these are really four distinct phenomena. And none of them looks like the kind of inflation the Fed claims to be fighting. Energy prices may continue to rise, or they may not — I really have no idea. But either way, that’s not a sign of an overheated economy.

It’s the supply side. Of course I am not the only one making this point. Andrew Elrod had a nice piece in Jacobin recently, making many of the same arguments. I especially like his conclusion, which emphasizes that this is not just a debate about inflation and monetary policy. If you accept the premise that spending in the economy has been too high, and workers have too much bargaining power, that rules out vast swathes of the progressive political program. This is something I also have written about.

Mike Konczal makes a similar argument in a new issue brief, “Inflation is Down. It’s a Supply-Side Story.” He looks at two pieces of evidence on this: different regression estimates of the Phillips curve relationship between unemployment and inflation, and second, expenditure and price changes across various categories of spending. I admit I don’t find the regression analysis very compelling. What it says is that a model that used past inflation to predict future inflation fit the data pretty well for 2020-2022, but over predicted inflation this year. I’m not sure this tells us much except that inflation was rising in the first period and falling in the second.

The more interesting part, to me, is the figure below. This shows quantities and prices for a bunch of different categories of spending. What’s striking about this is the negative relationship for goods (which, remember, is where the disinflation has come from.)

It is literally economics 101 that when prices and quantities move together, that implies a shift in demand; when they move in opposite directions, that implies a shift in supply. To put it more simply, if auto prices are falling even while people are buying more automobiles, as they have been, then reduced demand cannot be the reason for the price fall.

Larry Summers, in a different time, called this an “elementary signal identification point”: the sign the price increases are driven by demand is that “output and inflation together are above” their trend or previous levels. (My emphasis.) Summers’ point in that 2012 article (coauthored with Brad DeLong) was that lower output could not, in itself, be taken as a sign of a fall in potential. But the exact same logic says that a rise in prices cannot, by itself, be attributed to faster demand growth. The demand story requires that rising prices be accompanied by rising spending. As Mike shows, the opposite is the case.

In principle, one might think that the effect of monetary policy on inflation would come through the exchange rate. In this story, higher interest rates make a country’s assets more attractive to foreign investors, who bid up the price of its currency. A stronger currency makes import prices cheaper in terms of the domestic currency, and this will lower measured inflation. This is not a crazy story in principle, and it does fit a pattern of disinflation concentrated in traded goods rather than services. As Rémi Darfeuil points out in comments, some people have been crediting the Fed with US disinflation via this channel. The problem for this story is that the dollar is up only about 4 percent since the Fed started hiking — hardly enough to explain the scale of disinflation. The deceleration in import prices is clearly a matter of global supply conditions — it is also seen in countries whose currencies have gotten weaker (as the linked figure itself shows).

Roaring out of recession. I’ve given a couple video presentations on these questions recently. One, last Friday, was for Senate staffers. Amusingly —to me anyway — the person they had to speak on this topic last year was Jason Furman. Who I imagine had a rather different take. The on Monday I was on a panel organized by the Groundwork Collaborative, comparing the economic response to the pandemic to the response to the financial crisis a decade ago. That one is available on zoom, if you are interested. The first part is a presenation by Heather Boushey of the Council of Economic Advisors (and an old acquaintance of mine from grad school). The panel itself begins about half an hour in, though Heather’s presentation is of course also worth listening to.

[Thanks to Caleb Crain for pointing out a mistake in an earlier version of this post.]

At Barron’s: Inflation Is Falling. Don’t Thank the Fed

(I write a monthly opinion piece for Barron’s. This one was published there in September. My previous pieces are here.)

You wouldn’t necessarily guess it from the headlines, but we may soon be talking about inflation in the past tense. After peaking at close to 10% in the summer of 2022, inflation has fallen even faster than it rose. Over the past three months inflation, as measured by the CPI, has been slightly below the Federal Reserve’s 2% target. Nearly every other measure tells a similar story.

Predicting the future is always risky. But right now, it seems like the conversation about how to fix the inflation problem is nearing its end. Soon, we’ll be having a new debate: Who, or what, should get credit for solving it?

The Fed is the most obvious candidate. Plenty of commentators are already giving it at least tentative credit for delivering that elusive soft landing. And why not? Inflation goes up. The central bank raises interest rates. Inflation goes back down. Isn’t that how it’s supposed to work?

The problem is, monetary policy does not work through magic. The Fed doesn’t simply tell private businesses how much to charge. Higher interest rates lead to lower prices only by reducing demand. And so far, that doesn’t seem to have happened – certainly not on a scale that could explain how much inflation has come down.

In the textbook story, interest rates affect prices via labor costs. The idea is that businesses normally set prices as a markup over production costs, which consist primarily of wages. When the Fed raises rates, it discourages investment spending — home construction and business spending on plant and equipment — which is normally financed with credit. Less investment means less demand for labor, which means higher unemployment and more labor market slack generally. As unemployment rises, workers, with less bargaining power vis-a-vis employers, must accept lower wages. And those lower wages get passed on to prices.

Of course this is not the only possible story. Another point of view is that tighter credit affects prices through the demand side. In this story, rather than businesses producing as much as they can sell at given costs, there is a maximum amount they can produce, often described as potential output. When demand rises above this ceiling, that’s when prices rise.

Either way, the key point — which should be obvious, but somehow gets lost in macro debates — is that prices are determined by real conditions in individual markets. The only way for higher rates to slow down rising prices, is if they curtail someone’s spending, and thereby production and employment. No business — whether it’s selling semiconductors or hamburgers — says “interest rates are going up, so I guess I’ll charge less.” If interest rates change their pricing decisions, it has to be through some combination of fall in demand for their product, or in the wages they pay.

Over the past 18 months, the Fed has overseen one of the fast increases in short-term interest rates on record. We might expect that to lead to much weaker demand and labor markets, which would explain the fall in inflation. But has it?

The Fed’s rate increases have likely had some effect. In a world where the Federal Funds rate was still at zero, employment and output might well be somewhat higher than they are in reality. Believers in monetary-policy orthodoxy can certainly find signs of a gently slowing economy to credit the Fed with. The moderately weaker employment and wage growth of recent months is, from this point of view, evidence that the Fed is succeeding.

One problem with pointing to weaker labor markets as a success story, is that workers’ bargaining power matters for more than wages and prices. As I’ve noted before, when workers have relatively more freedom to pick and choose between jobs, that affects everything from employment discrimination to productivity growth. The same tight labor markets that have delivered rapid wage growth, have also, for example, encouraged employers to offer flexible hours and other accommodations to working parents — which has in turn contributed to women’s rapid post-pandemic return to the workplace.

A more basic problem is that, whether or not you think a weaker labor market would be a good thing on balance, the labor market has not, in fact, gotten much weaker.

At 3.8%, the unemployment rate is essentially unchanged from where it was when at the peak of the inflation in June 2022. It’s well below where it was when inflation started to rise in late 2020. It’s true that quits and job vacancy rates, which many people look to as alternative measures of labor-market conditions, have come down a bit over the past year. But they still are extremely high by historical standards. The prime-age employment-population ratio, another popular measure of labor-market conditions, has continued to rise over the past year, and is now at its highest level in more than 20 years.

Overall, if the labor market looks a bit softer compared with a year ago, it remains extremely tight by any other comparison. Certainly there is nothing in these indicators to explain why prices were rising at an annual rate of over 10% in mid-2022, compared with just 2% today.

On the demand side, the case is, if anything, even weaker. As Employ America notes in its excellent overview, real gross domestic product growth has accelerated during the same period that inflation has come down. The Bureau of Economic Analysis’s measure of the output gap similarly shows that spending has risen relative to potential output over the past year. For the demand story to work, it should have fallen. It’s hard to see how rate hikes could be responsible for lower inflation during a period in which people’s spending has actually picked up.

It is true that higher rates do seem to have discouraged new housing construction. But even here, the pace of new housing starts today remains higher than at any time between 2007 and the pandemic.

Business investment, meanwhile, is surging. Growth in nonresidential investment has accelerated steadily over the past year and a half, even as inflation has fallen. The U.S. is currently seeing a historic factory boom — spending on new manufacturing construction has nearly doubled over the past year, with electric vehicles, solar panels and semiconductors leading the way. That this is happening while interest rates are rising sharply should raise doubts, again, about how important rates really are for business investment. In any case, no story about interest rates that depends on their effects on investment spending can explain the recent fall in inflation.

A more disaggregated look at inflation confirms this impression. If we look at price increases over the past three months compared with the period of high inflation in 2021-2022, we see that inflation has slowed across most of the economy, but much more so in some areas than others.

Of the seven-point fall in inflation, nearly half is accounted for by energy, which makes up less than a tenth of the consumption basket. Most of the rest of the fall is from manufactured goods. Non-energy services, meanwhile, saw only a very modest slowing of prices; while they account for about 60% of the consumption basket, they contributed only about a tenth of the fall in inflation. Housing costs are notoriously tricky; but as measured by the shelter component of the Bureau of Labor Statistics, they are rising as fast now as when inflation was at its peak.

Most services are not traded, and are relatively labor-intensive; those should be the prices most sensitive to conditions in U.S. product and labor markets. Manufactured goods and especially energy, on the other hand, trade in very internationalized markets and have been subject to well-publicized supply disruptions. These are exactly the prices we might expect to fall for reasons having nothing to do with the Fed. The distribution of price changes, in other words, suggests that slowing inflation has little to do with macroeconomic conditions within the US, whether due to Fed action or otherwise.

If the Fed didn’t bring down inflation, what did? The biggest factor may be the fall in energy prices. It’s presumably not a coincidence that global oil prices peaked simultaneously with U.S. inflation. Durable-goods prices have also fallen, probably reflecting the gradual healing of pandemic-disrupted supply chains. A harder question is whether the supply-side measures of the past few years played a role. The IRA and CHIPS Act have certainly contributed to the boom in manufacturing investment, which will raise productive capacity in the future. It’s less clear, at least to me, how much policy contributed to the recovery in supply that has brought inflation down.

But that’s a topic for another time. For now it’s enough to say: Don’t thank the Fed.

(Note: Barron’s, like most publications I’ve worked with, prefers to use graphics produced by their own team. For this post, I’ve swapped out theirs for my original versions.)

At Barron’s: Who Is Winning the Inflation Debate?

(I write a monthly opinion piece for Barron’s. This one was published there in July. My previous pieces are here.)

Is inflation fundamentally a macroeconomic problem – a sign of an overheated economy, an excess of aggregate demand over supply? Or is it – at least sometimes – better understood in microeconomic terms, as the result of producers in various markets setting higher prices for their own reasons?

Not long ago, almost all economists would have picked door No. 1. But in the postpandemic world the choice isn’t so clear.

The answer matters for policy. If the problem is too much spending, then the solution is to bring spending down — and it doesn’t matter which spending. This is what interest rate hikes are intended to do. And since wages are both the largest source of demand and the biggest single component of costs, bringing down spending entails higher unemployment and slower wage growth. Larry Summers – perhaps the most prominent spokesman for macroeconomic orthodoxy – predicted that it would take five years of above-5% unemployment to get inflation under control. He was widely criticized for it. But he was just giving the textbook view.

If inflation is driven by dynamics in particular markets, on the other hand, then an across-the-board reduction in demand isn’t necessary, and may not even be helpful. Better to address the specific factors driving price increases in those markets – ideally through relieving supply constraints, otherwise through targeted subsidies or administrative limits on price increases. The last option, though much maligned as “price controls,” can make sense in cases where supply or demand are particularly inelastic. If producers simply cannot increase output (think, automakers facing a critical chip shortage) then prices have little value as a signal, so there’s not much cost to controlling them.

The debate between these perspectives has been simmering for some time. But it’s reached a boil around Isabella Weber, a leading exponent of the microeconomic perspective. Her recent work explores the disproportionate importance of a few strategic sectors for inflation. Weber has probably done more than any other economist to bring price controls into the inflation-policy conversation.

A recent profile of Weber in the New Yorker describes how she has become a lightning rod for arguments about unconventional inflation policy, with some of her critics going well beyond the norms of scholarly debate.

This backlash probably owes something to the fact that Weber is, biographically, a sort of anti-Summers. While he is a former Treasury secretary and Harvard president who comes from academic royalty (two of his uncles won economics Nobels), she is young, female, and teaches at the University of Massachusetts, Amherst, a department best-known for harboring heterodox, even radical, thinkers. (Full disclosure: I got my own economics doctorate there, though well before Weber was hired.) Some prominent economists embarrassed themselves in their rather obvious professional jealousy, as the New Yorker recounts.

But even more than jealousy, what may explain the ferocity of the response is the not unjustified sense that the heterodox side is winning.

Yes, central banks around the world are hiking interest rates – the textbook response to rising prices. But the debate about inflation policy is much broader than it used to be, in both the U.S. and Europe.

Weber herself served on the committee in Germany that devised the country’s “price brake” for natural gas, which is intended to shield consumers and the broader economy from rising energy prices while preserving incentives to reduce consumption. In the wake of the New Yorker piece, there was a furious but inconclusive debate about whether a “brake” is the same as a “control.” But this misses the point. The key thing is that policy is targeted at prices in a particular market rather than at demand in general.

Such targeted anti-inflation measures have been adopted throughout Europe. In France, after President Emmanuel Macron pledged to do “whatever it takes” to bring down inflation, the country effectively froze the energy prices facing households and businesses through a mix of direct controls and subsidies. Admittedly, such an approach is easier in France because a very large share of the energy sector is publicly owned. In effect, the French measures shifted the burden of higher energy costs from households and businesses to the government. The critical point, though, is that measures like this don’t make sense as inflation control unless you see rising prices as coming specifically from a specific sector (energy in this case), as opposed to an economy-wide excess of demand over supply.

Even economists at the International Monetary Fund – historically the world’s biggest cheerleader for high rates and austerity in response to inflation – acknowledge that these unconventional policies appear to have significantly reduced inflation in Europe. This is so even though they have boosted fiscal deficits and GDP, which by orthodox logic should have had the opposite effect.

The poster child for the “whatever it takes” approach to inflation is probably Spain, which over the past two years has adopted a whole raft of unconventional measures to limit price increases. Since June 2022, there has been a hard cap on prices in the wholesale electricity market; this “Iberian exception” effectively decouples electricity prices in Spain from the international gas market. Spain has also adopted limits on energy price increases to retail customers, increased electricity subsidies for low-income households, reduced the value-added tax for energy, and instituted a windfall profits tax on energy producers. While the focus has been on energy prices (not surprisingly, given the central role of energy in European inflation) they have also sought to protect households from broader price increases with measures like rent control and reduced transit fares. Free rail tickets aren’t the first thing that comes to mind when you think of anti-inflation policy, but it makes sense if the goal is to shift demand away from scarce fossil fuels.

This everything-plus-the-kitchen-sink approach to inflation is a vivid illustration of why it’s so unhelpful to frame the debate in terms of conventional policy versus price controls. While some of the Spanish measures clearly fit that description, many others do not. A more accurate, if clunkier, term might be “targeted price policy,” covering all kinds of measures that seek to influence prices in particular markets rather than the economy-wide balance of supply and demand.

More important than what we call it is the fact that it seems to be working. Through most of the postpandemic recovery, inflation in Spain was running somewhat above the euro-area average. But since summer 2022 – when the most stringent energy-price measures went into effect – it has been significantly below it. Last month, Spain saw inflation fall below 2%, the first major European country to do so.

Here in the U.S., direct limits on price rises are less common. But it’s not hard to find examples of targeted price policy. The more active use of the Strategic Petroleum Reserve, for example, is a step toward managing energy prices more directly, rather than via economy-wide spending. The Russian sanctions regime — though adopted, obviously, for other reasons — also has a significant element of price regulation.

The Inflation Reduction Act is often lampooned as having nothing to do with its name, but that’s not quite right. Instead, it reflects a very different vision of inflation control than what you’d get from the textbooks. Rather than seeking to reduce aggregate demand through fiscal contraction, it envisions massive new public outlays to address problems on the supply side. It’s a sign of the times that a closely divided Congress could pass a vast expansion in federal spending as an anti-inflation measure.

Meanwhile, there’s growing skepticism about how much rate hikes have actually achieved. Inflation has declined steeply without Summers’ prescribed three years of over-5% unemployment, or indeed any noticeable rise in unemployment at all. By connventional measures, demand is no weaker than it was a year ago. If it’s interest rates that brought down inflation, how exactly did they do so?

To be sure, hardly anyone in either camp correctly predicted the 2021 surge in inflation, or its equally dramatic decline over the past year. So it’s too soon to declare victory yet. But for the moment, it’s Team Weber and not Team Summers that seems to be gaining ground.

At Barron’s: Are Low Rates to Blame for Bubbles?

(I write a monthly opinion piece for Barron’s. These sometimes run in the print edition, which I appreciate — it’s a vote of confidence from the editors, and means more readers. It does impose a tighter word count limit, though. The text below is the longer version I originally submitted. The version that was published is here. All of my previous Barron’s pieces are here.)

The past year has seen a parade of financial failures and asset crashes. Silicon Valley bank was the first bank failure since 2020, and the biggest since 2008. Before that came the collapse of FTX, and of much of the larger crypto ecosystem. Corporate bankruptcies are coming faster than at any time since 2011. Even luxury watches are in freefall.

The proximate cause of much of this turmoil is the rise in interest rates. So it’s natural to ask if the converse is true. Is the overvaluing of so many worthless assets – whether through bubbles or fraud – the fault of a decade-plus of low rates? For those who believe this, the long period of low rates following the global financial crisis fueled an “everything bubble”, just as the earlier period of low rates fueled the housing boom of the 2000s. The rise of fragile or fraudulent institutions, which float up on easy credit before inevitably crashing back to earth, is a sign that monetary policy should never have been so loose. As journalist Rana Foorohar put it in a much-discussed article, “Keeping rates too low for too long encourages speculation and debt bubbles.”

You can find versions of this argument being made by prominent Keynesians, as well as by economists of a more conservative bent. At the Bank for International Settlements “too low for too long” is practically a mantra. But, does the story make sense?

Yes, low interest rates are associated mean high asset prices. But that’s not the same as a bubble.To the extent an asset represents a stream of future payments, a low discount rate should raise its value.

On the other hand, asset prices are not just about discounted future income streams; they also incorporate a bet on the future price of the asset itself. If a fall in interest rates leads to a rise in asset prices, market participants may mistakenly expect that rise to continue. That could lead to assets being overvalued even relative to the current low rates.

Another argument one sometimes hears for why low rates lead to bubbles is that when income from safe assets is low, investors will “reach for yield” by taking on more risk, bidding up the price of more speculative assets. Investors’ own liabilities also matter. When it’s cheap and easy to borrow, an asset may be attractive that wouldn’t be if financing were harder to come by.

But if low interest rates make acquiring risky assets more attractive, is that a problem? After all, that’s how monetary policy is supposed to work. The goal of rate cuts is precisely to encourage investment spending that wouldn’t happen if rates were higher. As I argued recently, it’s not clear that most business investment is very responsive to interest rates. But whether the effect on the economy is strong or weak, “low interest rates cause people to buy assets they otherwise wouldn’t” is just monetary policy working as intended.

Still, intended results may have unintended consequences. When people are reaching for yield, the argument goes, they are more likely to buy into projects that turn out to be driven by fraud, hype or fantasy.

Arguments for the dangers of low rates tend to take this last step for granted. But it’s not obvious why an environment of low yields should be more favorable to frauds. Projects with modest expected returns are, after all, much more common than projects with very high ones; when risk-free returns are very low, there should be more legitimate higher-yielding alternatives, and less need for risky long shots. Conversely, it is the projects that promise very high returns that are most likely to be frauds — and that are viable at very high rates.

Certainly this was Adam Smith’s view. For him, the danger of speculation and fraud was not an argument for high interest rates, but the opposite. If legal interest rates were “so high as 8 or 10 percent,” he believed, then “the greater part of the money which was to be lent would be lent to prodigals and projectors, who alone would be willing to give this high interest. Sober people … would not venture into the competition.”

The FTX saga is an excellent example. At one point, Sam Bankman-Fried—a projector and prodigal if ever there was one—offered as much as 20% on new loans to his hedge fund, Alameda, according to The Wall Street Journal. It wouldn’t take low rates to make that attractive — if he was good for it. But, of course, he was not. And that is the crux of the problem. Someone like Bankman-Fried is not offering a product with low but positive returns, that would be attractive only when rates are low but not when they were high. He was offering a product with an expected return that, in retrospect, was in the vicinity of -100 percent. Giving him your money to him would be a bad idea at any interest rate.

We can debate what it would take to prevent fraud-fueled bubbles in assets like cryptocurrency. Perhaps it calls for tighter restrictions on the kinds of products that can be offered for sale, or more stringent rules on the choices of retail investors. Or perhaps, given crypto’s isolation from the broader financial system, this is a case where it’s ok to just let the buyer beware. In any case, the problem was not that crypto offered higher returns than the alternative. The problem was that people believed the returns in crypto were much higher than they actually were. Is this a problem that interest rates can solve?

Let’s suppose for the sake of argument that it is. Suppose that without the option of risk-free returns of 3 or 4 or 5 percent, people will throw their money away on crazy longshots and obvious frauds. If you take this idea seriously, it has some funny implications. Normally, when we ask why asset owners are entitled to their income in the first place, the answer is that it’s an incentive to pick out the projects with the highest returns. (Hopefully these are also the most socially useful ones.) The “too low for too long” argument turns this logic on its head. It says that asset owners need to be guaranteed high returns because they can’t tell a good project from a bad one.

That said, there is one convincing version of this story. For all the reasons above, it does not make sense to think of ordinary investors being driven toward dangerous speculation by low interest rates. Institutions like insurance and pension funds are a different matter. They have long-term liabilities that are more or less fixed and, critically, independent of interest rates. Their long investment horizons mean their loss of income from lower rates will normally outweigh their capital gains when they fall. (This is one thing the BIS surely gets right.) When the alternative is insolvency, it can make sense to choose a project where the expected return is negative, if it offers a chance of getting out of the hole. That’s a common explanation for the seemingly irresponsible loans made by many Savings & Loans in the 1980s—faced with bankruptcy, they “gambled for resurrection.” One can imagine other institutions making a similar choice.

What broke the S&Ls in was high rates, not low ones. But there is a common thread. A structure set up when interest rates are in a certain range may not work when they move outside of it. A balance sheet set up on the basis of interest rates in some range will have problems if they move outside it.

Modern economies depend on a vast web of payment expectations and commitments stretching far into the future. Changes in interest rates modify many change of those future payments; whether upward or downward, this means disappointed expectations and broken commitments.

If the recent period of low rates was financially destabilizing, then, the problem wasn’t the not low rates in themselves. It was that they weren’t what was planned on. If the Fed is going to draw general lessons from the bubbles that are now popping, it should not be about the dangers of low rates, but that of drastic and unexpected moves in either direction.

At Barron’s: Do Interest Rates Really Drive the Economy?

(I write a more-or-less monthly opinion piece for Barron’s. This is my contribution for March 2023; you can find the earlier ones here.)

When interest rates go up, businesses spend less on new buildings and equipment. Right?

That’s how it’s supposed to work, anyway. To be worth doing, after all, a project has to return more than the cost of financing it. Since capital expenditure is often funded with debt, the hurdle rate, or minimum return, for capital spending ought to go up and down with the interest rate. In textbook accounts of monetary policy, this is a critical step in turning rate increases into slower activity.

Real economies don’t always match the textbook, though. One problem: market interest rates don’t always follow the Federal Reserve. Another, perhaps even more serious problem, is that changes in interest rates may not matter much for capital spending.

A fascinating new study raises new doubts about how much of a role interest rates play in business investment.

To clarify the interest-investment link, Niels Gormsen and Kilian Huber — both professors at the University of Chicago Booth School of Business — did something unusual for economists. Instead of relying on economic theory, they listened to what businesses themselves say. Specifically, they (or their research assistants) went through the transcripts of thousands of earnings calls with analysts, and flagged any mention of the hurdle rate or required return on new capital projects.

What they found was that quoted hurdle rates were consistently quite high — typically in the 15-20% range, and often higher. They also bore no relationship to current interest rates. The federal funds rate fell from 5.25% in mid-2007 to zero by the end of 2008, and remained there through 2015. But you’d never guess it from the hurdle rates reported to analysts. Required returns on new projects were sharply elevated over 2008-2011 (while the Fed’s rate was already at zero) and remained above their mid-2000s level as late as 2015. The same lack of relationship between interest rates and investment spending is found at the level of individual firms, suggesting, in Gormsen and Huber’s words, that “fluctuations in the financial cost of capital are largely irrelevant for [business] investment.”

While this picture offers a striking rejection of the conventional view of interest rates and investment spending, it’s consistent with other research on how managers make investment decisions. These typically find that changes in the interest rate play little or no role in capital spending.

If businesses don’t look at interest rates when making investment decisions, what do they look at? The obvious answer is demand. After all, low interest rates are not much of an incentive to increase capacity if existing capacity is not being used. In practice, business investment seems to depend much more on demand growth than on the cost of capital.

(The big exception is housing. Demand matters here too, of course, but interest rates also have a clear and direct effect, both because the ultimate buyers of the house will need a mortgage, and because builders themselves are more dependent on debt financing than most businesses are. If the Fed set the total number of housing permits to be issued across the country instead of a benchmark interest rate, the effects of routine monetary policy might not look that different.)

If business investment spending is insensitive to interest rates, but does respond to demand, that has implications for more than the transmission of monetary policy. It helps explain both why growth is so steady most of the time, and why it can abruptly stall out.

As long as demand is growing, business investment spending won’t be very sensitive to interest rates or other prices. And that spending in turn sustains demand. When one business carries out a capital project, that creates demand for other businesses, encouraging them to expand as well. This creates further demand growth in turn, and more capital spending. This virtuous cycle helps explain why economic booms can continue in the face of all kinds of adverse shocks — including, sometimes, efforts by the Fed to cut them off.

On the other hand, once demand falls, investment spending will fall even more steeply. Then the virtuous cycle turns into a vicious one. It’s hard to convince businesses to resume capital spending when existing capacity is sitting idle. Each choice to hold back on investment, while individually rational, contributes to an environment where investment looks like a bad idea.

This interplay between business investment and demand was an important part of Joseph Schumpeter’s theory of business cycles. It played a critical role in John Maynard Keynes’ analysis of the Great Depression. Under the label multiplier-accelerator models, it was developed by economists in the decades after World War II. (The multiplier is the link from investment to demand, while the accelerator is the link from demand growth to investment.) These theories have since fallen out of fashion among economists. But as the Gormsen and Huber study suggests, they may fit the facts better than today’s models that give decisive importance to the interest rate controlled by the Fed.

Indeed, we may have exaggerated the role played in business cycles not just of monetary policy, but of money and finance in general. The instability that matters most may be in the real economy. The Fed worries a great deal about the danger that expectations of higher inflation may become self-confirming. But expectations about real activity can also become unanchored, with even greater consequences. Just look at the “jobless recoveries” that followed each of the three pre-pandemic recessions. Weak demand remained stubbornly locked in place, even as the Fed did everything it could to reignite growth.

In the exceptionally strong post-pandemic recovery, the Fed has so far been unable to disrupt the positive feedback between rising incomes and capital spending. Despite the rate hikes, labor markets remain tighter than any time in the past 20 years, if not the past 50. Growth in nonresidential investment remains fairly strong. Housing starts have fallen sharply since rates began rising, but construction employment has not – at least not yet. The National Federation of Independent Business’s survey of small business owners gives a sharply contradictory picture. Most of the respondents describe this as a very poor moment for expansion, yet a large proportion say that they themselves plan to expand and increase hiring. Presumably at some point this gap between what business owners are saying and what they are doing is going to close – one way or the other.

If investment responded strongly to interest rates, it might be possible for the Fed to precisely steer the economy, boosting demand a little when it’s weak, cooling it off when it gets too hot. But in a world where investment and demand respond mainly to each other, there’s less room for fine-tuning. Rather than a thermostat that can be turned up or down a degree or two, it might be closer to the truth to say that the economy has just two settings: boom and bust.

At its most recent meeting, the Fed’s forecast was for the unemployment rate to rise one point over the next year, and then stabilize. Anything is possible, of course. But in the seven decades since World War Two, there is no precedent for this. Every increase in the unemployment rate of a half a point has been followed by a substantial further rise, usually of two points or more, and a recession. (A version of this pattern is known as the Sahm rule.) Maybe we will have a soft landing this time. But it would be the first one.

At Barron’s: The Fed’s View of the Economy Matters for More than Monetary Policy

(I write a monthly opinion piece for Barron’s. This is the most recent one; you can find earlier ones here.)

Has the inflationary fever broken at last? The headline Consumer Price Index, which was rising at a 17 percent annual rate last June, actually fell in December. Other measures show a similar, if less dramatic, slowing of price growth. But before we all start congratulating the Federal Reserve, we should think carefully about what else we’re signing up for.

For Fed Chair Jerome Powell, it’s clear that slower price growth is not enough. Inflation may be coming down, but labor markets are still much too tight. “Nominal wages have been growing at a pace well above what would be consistent with 2 percent inflation over time,” he said recently, so “another condition we are looking for is the restoration of balance between supply and demand in the labor market.”

The model of the economy that the Fed is working with looks something like this: most prices are, at the end of the day, set as a markup over wages. Wage increases depend on the relative bargaining power of workers and employers, and that in turn depends on labor market tightness. Labor market tightness depends on aggregate demand, which the Fed can influence through interest rates. Yes, there are other influences on inflation; but it’s clear that for the Fed this story is central. Indeed, we might call it the Federal Reserve View.

Is this story a fair description of the real world? Yes and no.

A useful rule to remember is that the rise in average wages must equal the rise in the price of domestically-produced goods, plus productivity growth, plus the share of income going to workers. All else equal, higher wages mean higher prices. But all else is not always equal. It’s possible to have faster wage growth and stable inflation if profit margins are falling, or if productivity is rising, or if import prices are falling.

In the short run, these other factors can easily outweigh wage growth. Just look at the 10 years prior to the pandemic. Hourly wages grew almost twice as fast in the second half of the decade as in the first half — nearly 4 percent annually, versus 2 percent. Yet inflation as measured by the CPI was no higher over 2015-2019 than over 2010-2014. That was thanks to productivity growth, which accelerated significantly, and import prices, which declined. (Workers’ share of national income did not change significantly.)

On the other hand, there is a limit to how fast productivity can rise, or profit margins or import prices can fall. No one doubts that if wages were to rise by, say, 10 percent year after year, inflation would eventually rise.

Critics of the Fed have questioned whether these long-run relationships tell us much about the inflation we are seeing now. There are plenty of things that cannot go on forever but can, and should, go on for a while. Rapid wage gains might be one of them. While Powell clearly still sees wage growth as excessive, others might look at the latest Employment Cost Index—less than 1% growth, compared with 1.4% at the start of 2022—and see a problem taking care of itself.

The Fed’s current plan is to increase unemployment by 1 percent over the next year, throwing 1.6 million people out of work. If the link between labor market conditions and prices is not as tight as they think, that’s a lot of suffering being inflicted for no reason.

But there’s an even bigger problem with the Federal Reserve View: what else follows once you accept it. If price stability requires a weaker labor market – one in which employers have an easier time finding workers, and workers have a harder time finding jobs – that has implications that go far beyond monetary policy.

Take the Fair Trade Commission’s recent ban on non-compete clauses in employment contracts. When President Biden issued the executive order that led to this action, he explicitly framed it as a way of shifting bargaining power to workers and allowing them to demand higher pay. “If your employer wants to keep you,” he said, “he or she should have to make it worth your while to stay.”

This sounds like good news for workers. But here’s the problem: from the Fed’s point of view, businesses are already paying too much to hold onto their employees. As Powell has said repeatedly over the past year, there is currently a “real imbalance in wage negotiating” in favor of workers. He wants to make it harder for people to switch jobs, not easier. So if the non-compete ban delivers what the President promised, that will just mean that rates have to go up by more.

Or think about minimum wage laws. Thanks to widespread indexing, nearly half the states saw significant increases in their minimum wages at the start of this year. Others, like New York, are moving in this direction. For many people the case for indexing is obvious: It makes sure that the incomes of low-wage workers in retail, fast food and other services keep pace with rising prices. But for the Fed, these are exactly the wages that are already rising too fast. Higher minimum wages, from the Fed’s point of view, call for higher interest rates and unemployment.

There’s nothing new or secret about this. In a typical macroeconomics textbook, the first example of something that raises the “natural rate” of unemployment (the one the central bank targets) is more generous unemployment benefits, which encourage workers to hold out for higher wages.

Publicly, the Fed disavows any responsibility for labor market policy. But obviously, if your goal is to maintain a certain balance of power between workers and employers, anything that shifts that balance is going to concern you.

This problem had dropped from view in recent years, when the Fed was struggling to get inflation up to its target. But historically, there’s been a clear conflict between protecting workers and keeping unemployment low. Under Alan Greenspan, Fed officials often worried that any revival of organized labor could make the job of inflation control harder. Treasury Secretary Yellen made a version of this argument early on in her career at the Fed, observing that “lower unemployment benefits or decreased unionization could … result in a decline in workers’ bargaining power.” This, she explained, could be a positive development, since it would imply “a permanent reduction in the natural rate of unemployment.”

Unfortunately, the same logic works the other way too. Stronger unions, higher minimum wages, and other protections for workers must, if you accept the Federal Reserve View, result in a higher natural rate of unemployment — which means more restrictive monetary policy to bring it about.

It’s easy to understand why administration officials would say they trust the Fed to manage inflation, while they focus on being the most-pro-labor administration in history. Unfortunately, dividing things up this way may not be as simple as it sounds. If that’s what they think their job is, they may have to challenge how the Fed thinks about its own.

At Barron’s: Rate Hikes Are the Wrong Cure for Rising Housing Costs

(I write a monthly opinion piece for Barron’s. This is my contribution for November 2022.)

How much of our inflation problem is really a housing-cost problem?

During the first half of 2021, vehicle prices accounted for almost the whole rise in inflation. For much of this year, it was mostly energy prices.

But today, the prices of automobiles and other manufactured goods have stabilized, while energy prices are falling. It is rents that are rising rapidly. Over the past three months, housing costs accounted for a full two-thirds of the inflation in excess of the Federal Reserve’s 2% target.

Since most Americans don’t rent their homes, the main way that rents enter the inflation statistics is through owners’ equivalent rent—the government’s estimate of how much owner-occupied homes would rent for. The big cost that homeowners actually pay is debt service on their mortgage, which the Fed is currently pushing up. There is something perverse about responding to an increase in a hypothetical price of housing by making actual housing more expensive.

Still, the housing cost problem is real. Market rents are up by over 10% in the past year, according to Zillow. While homeownership rates have recovered somewhat, they are still well below where they were in the mid-2000s. And with vacancy rates for both rental and owner-occupied homes at their lowest levels in 40 years, the housing shortage is likely to get worse.

Housing is unlike most other goods in the economy because it is tied to a specific long-lived asset. The supply of haircuts or child care depends on how much of society’s resources we can devote to producing them today. The supply of housing depends on how much of it we built in the past.

This means that conventional monetary policy is ill-suited to tackle rising housing prices. Because the housing stock adjusts slowly, housing costs may rise even when there is substantial slack in the economy. And because production of housing is dependent on credit, that’s where higher interest rates have their biggest effects. Housing starts are already down 20% since the start of this year. This will have only a modest effect on current demand, but a big effect on the supply of housing in future years. Economics 101 should tell you that if efforts to reduce demand are also reducing supply, prices won’t come down much. They might even rise.

What should we be doing instead?

First, we need to address the constraints on new housing construction. In a number of metropolitan areas, home values may be double the cost of construction. When something is worth more than it costs to produce, normally we make more of it. So, if the value of a property comes mostly from the land under it, that’s a sign that construction is falling far short of demand. The problem we need to solve isn’t that people will pay so much to live in New York or Los Angeles or Boston or Boulder, Colo. It’s that it is so difficult to add housing there.

Land-use rules are set by thousands of jurisdictions. Changing them will not happen overnight. But there are steps that can be taken now. For example, the federal government could tie transportation funding to allowing higher-density development near transit.

Second, we need more public investment. Government support—whether through direct ownership or subsidies—is critical for affordable housing, which markets won’t deliver even with relaxed land-use rules. But government’s role needn’t be limited to the low-income segment. The public sector, with its long time horizons, low borrowing costs, and ability to internalize externalities, has major advantages in building and financing middle-class housing as well.

If we look around the world, it isn’t hard to find examples of governments successfully taking a central role in housing development. In Singapore, which is hardly hostile to private business, the majority of new housing is built by the public Housing Development Board. The apartment buildings built by Vienna’s government between the world wars still provide a large share of the city’s housing. Before the privatizations under Prime Minister Margaret Thatcher, some 30% of English families lived in publicly owned housing.

In the U.S., public housing has fallen out of favor. But governments at all levels continue to support the construction of affordable housing through subsidies and incentives. Some public developers, like the Housing Production Fund of Montgomery County, Md., are finding that with cheap financing and no need to deliver returns to investors, they can compete with private developers for mixed-income housing as well. The important thing is to channel new public money to development, rather than vouchers for tenants. The latter may just bid up the price of existing housing.

Third, we should revisit rent regulation. The argument against rent control is supposed to be that it discourages new construction. But empirical studies have repeatedly failed to find any such effect. This shouldn’t be surprising. The high-rent areas where controls get adopted are precisely those where new housing construction is already tightly constrained. If not much is getting built in any case, rent regulation merely prevents the owners of existing housing from claiming windfall gains from surging demand.

No, rent control won’t boost the supply of housing. But it can limit the rise in prices until new supply comes on-line. And it’s a much bettertargeted response to rising housing costs than the policy-induced recession we are currently headed for.

At Barron’s: Americans Owe Less Than They Used To. Will the Fed Change That?

(I write a monthly opinion piece for Barron’s. This one was published there in September.)

Almost everyone, it seems, now agrees that higher interest rates mean economic pain. This pain is usually thought of in terms of lost jobs and shuttered businesses. Those costs are very real. But there’s another cost of rate increases that is less discussed: their effect on balance sheets.

Economists tend to frame the effects of interest rates in terms of incentives for new borrowing. As with (almost) anything else, if loans cost more, people will take less of them. But interest rates don’t matter only for new borrowers, they also affect people who borrowed in the past. As debt rolls over, higher or lower current rates get passed on to the servicing costs of existing debt. The effect of interest rate changes on the burden of existing debt can dwarf their effect on new borrowing—especially when debt is already high.

Let’s step back for a moment from current debates. One of the central macroeconomic stories of recent decades is the rise in household debt. In 1984, it was a bit over 60% of disposable income, a ratio that had hardly changed since 1960. But over the next quarter-century, debt-income ratios would double, reaching 130%. This rise in household debt was the background of the worldwide financial crisis of 2007-2008, and made household debt a live political question for the first time in modern American history.

Household debt peaked in 2008; it has since fallen almost as quickly as it rose. On the eve of the pandemic, the aggregate household debt-income ratio stood at 92%—still high, by historical standards, but far lower than a decade before.

These dramatic swings are often explained in terms of household behavior. For some on the political right, rising debt in the 1984-2008 period was the result of misguided government programs that encouraged excessive borrowing, and perhaps also a symptom of cultural shifts that undermined responsible financial management. On the political left, it was more likely to be seen as the result of financial deregulation that encouraged irresponsible lending, along with income inequality that pushed those lower down the income ladder to spend beyond their means.

Perhaps the one thing these two sides would agree on is that a higher debt burden is the result of more borrowing.

But as economist Arjun Jayadev and I have shown in a series of papers, this isn’t necessarily so. During much of the period of rising debt, households borrowed less on average than during the 1960s and 1970s. Not more. So what changed? In the earlier period, low interest rates and faster nominal income growth meant that a higher level of debt-financed expenditure was consistent with stable debt-income ratios.

The rise in debt ratios between 1984 and 2008, we found, was not mainly a story of people borrowing more. Rather, it was a shift in macroeconomic conditions that meant that the same level of borrowing that had been sustainable in a high-growth, low-interest era was unsustainable in the higher-interest environment that followed the steep rate hikes under Federal Reserve Chair Paul Volcker. With higher rates, a level of spending on houses, cars, education and other debt-financed assets that would previously have been consistent with a constant debt-income ratio, now led to a rising one.

(Yes, there would later be a big rise in borrowing during the housing boom of the 2000s. But this is not the whole story, or even the biggest part of it.)

Similarly, the fall in debt after 2008 in part reflects sharply reduced borrowing in the wake of the crisis—but only in part. Defaults, which resulted in the writing-off of about 10% of household debt over 2008-2012, also played a role. More important were the low interest rates of these years. Thanks to low rates, the overall debt burden continued to fall even as households began to borrow again.

In effect, low rates mean that the same fraction of income devoted to debt service leads to a larger fall in principal—a dynamic any homeowner can understand.

The figure nearby illustrates the relative contributions of low rates and reduced borrowing to the fall in debt ratios after 2008. The heavy black line is the actual path of the aggregate household debt-income ratio. The red line shows the path it would have followed if households had not reduced their borrowing after 2008, but instead had continued to take on the same amount of new debt (as a share of their income) as they did on average during the previous 25 years of rising debt. The blue line shows what would have happened to the debt ratio if households had borrowed as much as they actually did, but had faced the average effective interest rate of that earlier period.

As you can see, both reduced borrowing and lower rates were necessary for household debt to fall. Hold either one constant at its earlier level, and household debt would today be approaching 150% of disposable income. Note also that households were paying down debt mainly during the crisis itself and its immediate aftermath—that’s where the red and black lines diverge sharply. Since 2014, as household spending has picked up again, it’s only thanks to low rates that debt burdens have continued to fall.

(Yes, most household debt is in the form of fixed-rate mortgages. But over time, as families move homes or refinance, the effective interest rate on their debt tends to follow the rate set by the Fed.)

The rebuilding of household finances is an important but seldom-acknowledged benefit of the decade of ultra-low rates after 2007. It’s a big reason why the U.S. economy weathered the pandemic with relatively little damage, and why it’s growing so resiliently today.

And that brings us back to the present. If low rates relieved the burden of debt on American families, will rate hikes put them back on an unsustainable path?

The danger is certainly real. While almost all the discussion of rate hikes focuses on their effects on new borrowing, their effects on the burden of existing debt are arguably more important. The 1980s—often seen as an inflation-control success story—are a cautionary tale in this respect. Even though household borrowing fell in the 1980s, debt burdens still rose. The developing world—where foreign borrowing had soared in response to the oil shock—fared much worse.

Yes, with higher rates people will borrow less. But it’s unlikely they will borrow enough less to offset the increased burden of the debt they already have. The main assets financed by credit—houses, cars, and college degrees—are deeply woven into American life, and can’t be easily foregone. It’s a safe bet that a prolonged period of high rates will result in families carrying more debt, not less.

That said, there are reasons for optimism. Interest rates are still low by historical standards. The improvement in household finances during the post-2008 decade was reinforced by the substantial income-support programs in the relief packages Congress passed in response to the pandemic; this will not be reversed quickly. Continued strong growth in employment means rising household incomes, which, mechanically, pushes down the debt-income ratio.

Student debt cancellation is also well-timed in this respect. Despite the fears of some, debt forgiveness will not boost current demand—no interest has been paid on this debt since March 2020, so the immediate effect on spending will be minimal. But forgiveness will improve household balance sheets, offsetting some of the effect of interest rate hikes and encouraging spending in the future, when the economy may be struggling with too little demand rather than (arguably) too much.

Reducing the burden of debt is also one of the few silver linings of inflation. It’s often assumed that if people’s incomes are rising at the same pace as the prices of the things they buy, they are no better off. But strictly speaking, this isn’t true—income is used for servicing debt as well as for buying things. Even if real incomes are stagnant or falling, rising nominal incomes reduce the burden of existing debt. This is not an argument that high inflation is a good thing. But even bad things can have benefits as well as costs.

Will we look back on this moment as the beginning of a new era of financial instability, as families, businesses, and governments find themselves unable to keep up with the rising costs of servicing their debt? Or will the Fed be able to declare victory before it has done too much damage? At this point, it’s hard to say.

Either way we should focus less on how monetary policy affects incentives, and more time on how it affects the existing structure of assets and liabilities. The Fed’s ability to steer real variables like GDP and employment in real time has, I think, been greatly exaggerated. Its long-run influence over the financial system is a different story entirely.