Open Letter to Gregory Mankiw, 7 December

Dear Professor Mankiw:

I am writing in response to your article in the New York Times, “The Puzzle of Low Interest Rates”. I commend you for recognizing two important truths, which are missed by many other observers. One, that there has been a breathtaking drop in the interest rate over 40 years. Too many dismiss this with an airy hand wave, or deny it.

Two, you see that the cause is not the Federal Reserve, at least not directly. As you note, the Fed aims to set the interest rate at levels determined by “deeper market forces.” In my theory of interest and prices, I show how the Fed sets up a dynamic which is bigger than the central bank itself. Once set in motion, this dynamic moves in one direction for a long time, with positive feedback loops that act like a ratchet. Since 1980, we are in a powerful falling trend.

However, you commit some big blunders too. One is that old saw that rates are falling because of falling inflation expectations. If the Treasury had a penny for every time someone repeated this error, it would have enough to pay off the debt (well, it could—if there were a mechanism to extinguish debt using irredeemable currency).

You cite Irving Fisher for this, but Fisher wrote during the gold standard and virtually all of his work was done prior to when FDR made the dollar irredeemable to American citizens. In the gold standard, of course, people may invest their gold if they like the terms (including the interest rate). Or they can choose not to invest. Gold under the mattress is better than gold committed to a long investment at too-low interest rates.

My point is that, under gold, interest rates are modulated by the savers the way that, say, meat prices are modulated by the consumers.

FDR’s move in 1933 was pure (evil) genius. By making the dollar irredeemable, he took away this choice. Even if one hoards paper dollar bills under the mattress, one is still a creditor. One is in fact lending to the Fed, which uses the credit to lend to the government and the banking system. Irredeemable currency disenfranchises the savers. They have no way to opt out. Thus, they can protest the too-low interest rate all they want, but their protestations are toothless. The bond vigilante is a myth, like the dragon and the unicorn.

In any case, there is a relationship between the price of goods and the interest rate. Fisher, Gibson, and Wicksell all saw it but could not explain it. In brief, all yields are tied to the interest rate. Where interest goes, so does return on all forms of capital, and profit margins. When interest drops, every business from hamburger stands to car manufacturers borrows more money to expand production. But the increase in production barely adds to the bottom line, because their competitors are all doing the same thing. Consumers may love the cornucopia of additional hamburgers—just look at the expansion of the average American waistline—and cars, but it is a serious economic problem.

Next, you trot out the tired old slogan of the Fed’s alleged full employment and stable prices (which, in an Orwellian twist, is defined as chronic 2% inflation). The Soviet Union proved decisively that you cannot centrally plan corn. To produce corn, all you need is good soil, rain, and sun. You put the seeds in the ground and wait. Corn is a simple product, and it has a predictable one-year cycle. Yet the Soviets failed so abysmally, that millions died of malnutrition.

Despite this, most economists think that the Fed can centrally plan prices and employment! The error—and the hubris—would almost be funny, if the consequences of this error were not so massive.

You say that economic growth has slowed since the 1970’s, but do not say the growth of precisely which indicator. Certainly, by any measure, technology and the rate of change of how we do business and how we live has accelerated dramatically. Certainly, consumer goods are much more plentiful, and less expensive in real terms.

What has slowed down is the rate of growth of business profits. The rate of business profit is tied to the interest rate.

You claim that new technology is less capital-intensive than railroads. Is it? The cost of opening a new semiconductor fabrication plant is $3 to $4 billion. What is the cost of developing Amazon’s IT infrastructure? Have you looked at startups? Do they raise less money today than they did in 2007, 1997, or 1977?

You reiterate one of the most brazen lies of the economics profession. Yes, I said “lies.” A child knows that it’s bad to owe money that you cannot pay back. But it takes a PhD economist to say no problem—if the interest rate drops. This switcheroo is like a sleight of hand, redirecting attention from the debt to the interest on the debt. If you want to see the problem of debt in perspective, look at a chart of the Marginal Productivity of Debt. This shows how much GDP is added for each fresh, newly borrowed dollar added to the debt. MPoD is in a long-term secular decline.

Interestingly, if you Google this term, my articles are all over the top page of search results. This is not because I am so prominent an economist. It’s because of the professional negligence of the big names in economics, who know (or reasonably ought to know) about MPoD, but don’t write about it because it does not serve their narratives. The fact that we add pennies to GDP for each dollar added to the debt shines a spotlight on the flaw in “counting on strong growth to reduce the debt-to-G.D.P. ratio”.

Seemingly intent on hitting all the frivolous fallacies, you say, “Young families looking to buy homes, for example, benefit from the lower cost of mortgage financing.” The mortgage rate may be lower, but the purchase price is higher! Have you been looking around, recently? Home prices are skyrocketing again, thanks to yet-lower mortgage rates.

Next, we get to your comment about income inequality. Could any article by a Left-leaning economist not somehow weave this in? Perhaps to cover the possibility that falling interest is a bad thing, you suggest that it could be the result of rising income inequality.

There is a connection, but it goes in the other direction. When rates fall, asset prices rise. This is because the net present value of all future cash flows goes up, as the discount factor (which is the market interest rate) falls. Rising asset prices adds to the net worth of those who own the assets. This is especially pronounced for those who buy assets with leverage.

The incomes of CEOs and bankers are tied to asset prices. So falling interest causes rising paychecks for them. At the same time, it puts downward pressure on jobs and wages. I will give you two arguments. One, the lower the interest rate, the greater is the incentive to buy a machine to replace workers.

Two, think of any wage as a cash flow in perpetuity. The net present value of any perpetuity doubles, if the interest rate halves. For four decades, we have doubled, and doubled, and doubled again the burden of paying a wage!

If you care about jobs and wages, you should care about falling interest rates.

There is one more point for which I commend you. You acknowledge the danger that falling interest presents to university endowments. And, though endowments may be nearer and dearer to your heart as a professor, the same problem occurs for pensions, annuities, and insurers. You said retirees will need 19% more savings to retire, but I must wonder more than what? Certainly the return on capital is down by a lot more than that just since 2007. In December of that year, the rate on a 3-month CD was 5.02% according to the St. Louis Fed. As of October, it is down to just 0.12%.

To earn $1,000 in interest, one needed about $20,000 back in December 2007. Today, one needs about $830,000. One does not need 19% more savings, but 4,050% more! Since 2007.

This reflects the staggering collapse in Yield Purchasing Power, about which I have written many articles and given some lectures. The basic idea is that we should look, not at how many groceries we could buy if we liquidate our life savings, but how many groceries we can buy with what we earn on our life savings. This is the purchasing power, not of the capital, but of the interest on the capital.

Keynes called endowment funds, and everyone else who depends on earning a yield, “rentiers”, a term which often carries a pejorative connotation. He certainly wanted to kill them, by driving interest rates to near-zero. We are now at that point. I am glad you recognize it.

Can we agree that this problem should be part of the national conversation?