Matthew Yglesias on how the Federal Reserve works

January 9, 2012 10:17 PM

Fed Up. Matthew Yglesias explains how the Federal Reserve System works, and why progressives should care. A more recent column: What is "Austrian economics"? (And why is Ron Paul obsessed with it?) And the Economist has a roundup of heterodox economic theories: Austrian economics, neo-chartalism/MMT (previously), and market monetarism.
posted by russilwvong (34 comments total)

heterodox economic theories: Austrian economics, neo-chartalism/MMT

I read that as neo-charlatanism and for a moment thought that someone really understood the economy.
posted by twoleftfeet at 10:28 PM on January 9 [33 favorites]

Thomas Woods responded (sort of) to that Yglesias piece.
posted by resurrexit at 10:55 PM on January 9

So there's this economic model that seems counter-intuitive from the start. It doesn't really make sense to experts from the field. Yet it is aggressively implemented anyway and, in consequence, is proven wrong over and over again for decades with disasterous results.

There should eventually be a time when we dismiss this model as at best an error, more likely a fraud.
posted by patrick54 at 12:02 AM on January 10 [15 favorites]

proven wrong over and over again for decades with disasterous results. There should eventually be a time when we dismiss this model as at best an error, more likely a fraud.

Before one tosses a model - one should understand if the model name matches the actual non-working system about to be tossed.

So what is the actual model in place in the US of A? Not what the faceplate says - based on how things work - what model best matches how things are really done.
posted by rough ashlar at 3:55 AM on January 10 [1 favorite]

[One reform] would be to take away the regional bank presidents’ rotating seats on the Open Market Committee, cutting them out of any role in making monetary policy. This would limit them to conducting the business of regional banking services and economic research, leaving monetary policy in the hands of the Board of Governors, with the aim of removing FOMC from under the thumb of the structural interests of the banking industry.

And thus, by limiting the members of FOMC to Presidential appointees, the influence of bankers and Wall Street over America's monetary policy was forever ended.

[Alternatively,] Class A and Class B board members could be selected by the governors of the states within a bank’s jurisdiction. Or instead of governors, responsibility could be vested with senators or state legislatures.

Because these evil banks would never think to try to meddle and get their desired outcome in mere State issues, would they?

More seriously, neither of these proposals to tinker with the voting structure of 5/12ths of the FOMC seats would do anything towards removing the interchange between high finance and government.

Central banks and monetary policy are the primary determinant of short-term economic conditions—of the unemployment rate, and thus of workers’ ability to bargain for wages.

Indeed, the heroic way in which FOMC prevented a substantial rise in the unemployment figures by aggressively slashing the target rate in 2008 brings a tear to my eye. Mostly because it means my tragic brain disorder, which causes me to fantasise about a recent past which didn't happen, hasn't been cured.

the vast majority of recessions are fought primarily with monetary tools rather than fiscal ones.

Be the best progressive you can be, and agree with Milton Friedman!
posted by kithrater at 3:55 AM on January 10 [3 favorites]

It so happens that Rollback contains a chapter on the Fed that smashes to smithereens pretty much everything Yglesias has ever written about central banking.

Wood sounded like he was really going to go somewhere here but then he pulled out his Yglesias-smashing-to-smithereens hammer and it turns out that it is "Statistics. Buy my book!" How can you argue with that?

If you want to argue that the Fed is best summarized by William S. Burroughs, I'd be pretty receptive. If you want to not look like the Time Cube guy dropping some of the "Yglesias is a moron! Neener neenner neener!" crap and elucidating a little bit would probably be helpful.

Of course, a lot of the flaws Yglasias points out in the "Austrian economics" model should work equally well at dissuading people from loosing lots of money at casinos, but people still loose a lot of money in casinos.
posted by Kid Charlemagne at 4:14 AM on January 10 [2 favorites]

"The economist can never refute the economic cranks and quacks in the way in which the doctor refutes the medicine man and the charlatan."

///

The flowering of human society depends on two factors: the intellectual power of outstanding men to conceive sound social and economic theories, and the ability of these or other men to make these ideologies palatable to the majority.


From Human Action by Ludwig von Mises.
posted by chavenet at 4:16 AM on January 10

As best I can tell Yglesias is considered a progressive for his appreciation of indie rock.
posted by ennui.bz at 4:23 AM on January 10 [5 favorites]

what model best matches how things are really done.

Feudalism.
posted by DU at 4:56 AM on January 10 [7 favorites]

Central banks and monetary policy are the primary determinant of short-term economic conditions—of the unemployment rate, and thus of workers’ ability to bargain for wages.

I think this is where he is incorrect. The market determines these things, and a central bank's "meddling" can only dampen the effects of what all the people in the economy are trying to do. No amount of low interest rates can force people to build factories when they don't see a demand for the product. High interest rates aren't going to stop anyone from investing in sure-things. As he said earlier in the piece, the Fed doesn't really do all the heavy lifting; people in the marketplace trade bonds and make loans based on the demand they see, and the Fed's interest rate targets are just one component of that demand. The Fed's actions move the margins.

Car analogy: if the economy is a bunch of cars on a road, the Fed is the road builder. They can build less road to slow things down, but the cars will just seek other routes. They can build more road, but that does very little if the cars don't need it.

Where he is right is that there is little to stop an incompetent Fed from doing its job poorly. But I'm not sure his solutions will make much meaningful difference.

One theory of the 2008 recession and housing/finance bust is that the Fed kept interest rates too low in the early 2000s, because of the goal of maintaining full employment. They should have made money more expensive, but that could have been seen as failing to maintain full employment.

So if there is a change to be made, it would be for the Fed to simply focus on a stable dollar. I think that the idea the Fed's actions have anything to do with employment is mostly confirmation bias anyway.
posted by gjc at 5:57 AM on January 10

The market determines these things, and a central bank's "meddling" can only dampen the effects of what all the people in the economy are trying to do. No amount of low interest rates can force people to build factories when they don't see a demand for the product.

It sounds like you are saying that printing extra money will not spur investment.
posted by goethean at 6:22 AM on January 10

...it became clear that Republicans were genuinely moving toward a critique of the whole idea of stimulative monetary policy. This was striking because stimulative monetary policy had been since Milton Friedman’s day the main conservative alternative to Keynesian fiscal stimulus.

Shocked... shocked I tell you.

It's amazing that Yglesias can spend as much time in DC as he has and not see the overton window shifting. Friedmann's work, as much as it may be good economics, has always been about creating a political wedge against direct government intervention in the US economy ala the New Deal. Once the wedge is inserted and you have people like Yglesias, nominally on the left, nattering on about the ideal monetary policy, you can push your actual agenda: rolling back economic/political conditions to the late 19th century.

Of course re: Yglesisa, there's always the Sinclair quote: "It is difficult to get a man to understand something, when his salary depends upon his not understanding it!"
posted by ennui.bz at 6:23 AM on January 10 [2 favorites]

"The economist can never refute the economic cranks and quacks in the way in which the doctor refutes the medicine man and the charlatan."

That quote and its context are especially curious given Mises' declaration that "there is and must be an aprioristic theory of human action" and his accompanying opposition not only to empiricism, but to aprioristic theories of human action different from his own. Essentially, history must be read through his lens; therefore, if you read history and see results in conflict with the lens, you must be reading history wrong.

Mises is like a mad monk: one who is convinced that a million angels are precisely the maximum able to dance on the head of a pin, and who exasperates of his seeming inability to prove this ironclad theory to those heretical clods who have come to different conclusions on the pin-dancing question.
posted by Sticherbeast at 6:29 AM on January 10 [4 favorites]

Milton Friedman’s day the main conservative alternative to Keynesian fiscal stimulus.

This "Keynesian" modelspace - is that the actual active model?
posted by rough ashlar at 6:29 AM on January 10

As Yglesias says, a gold standard is "neither necessary nor sufficient".

It is not necessary, because you can already own gold or gold certificates (e.g. government-backed Perth Mint certificates), which represent a fixed amount of gold. Investors are free to make gold as big a part of their portfolio as they wish. For the most part, they also seem to want some fiat currency in their portfolio. An American gold standard won't change that.

It is not sufficient, because it is literally impossible for Congress to permanently fix the price of a certain amount of gold to the dollar. A gold standard would probably be done through legislation, which a future Congress would be free to modify or overturn at its convenience. In theory it could be done through a constitutional amendment, but realistically the states could not be made to agree. And even an amendment could be overturned when judged necessary. None of these things provide reliable ownership of a fixed amount of gold, compared to the already available options of owning gold, gold certificates, or ETFs.

So the gold standard is a joke, even before you get into the messy question of what effect it would have on the economy.
posted by East Manitoba Regional Junior Kabaddi Champion '94 at 6:32 AM on January 10 [4 favorites]

Also, Austrian economics. I think it is pretty obvious that government intervention CAN cause booms and busts, and the Austrians are right about that. But where they are wrong is the corollary of that, which says that booms and busts can ONLY be caused by government intervention.

(I'm not even sure that's what the actual Austrian school says, but that's what it has come to mean.)

From the Austrian link:

It may seem “obvious” that the decline in housing activity caused the current recession, in line with the Austrian view, but in fact fixed residential investment turned negative in 2006. It stayed negative for more than a year before the recession began, and then continued negative for a couple more quarters before it turned severe. People spent less on home-building and renovation and more on other things. If investment spending in general declines, you would expect spending on consumer goods to rise to offset it. In practice, this doesn’t always happen and you get a recession. It’s this anomalous collapse in overall spending that needs explaining, and describing some of the past spending as “malinvestment” doesn’t help you understand it.

The mistake there is in assuming that everything happens all at once. When you poke a balloon with a needle, it will deflect for a little while until it can't withstand the pressure anymore, and then it pops. That there is a time delay in some purported effect does not mean the effect isn't there.

Nothing in economics is just first-order effect. Money taxed does not just disappear. Spending that slows in one sector of the economy doesn't just make a graph start to go downward and everyone buys iPods instead. When housing spending started to decline, profits turned into losses which turned into layoffs which turned into reduced spending in other sectors, and so on and so on.

In any economy more advanced than trading chickens for yarn, everything depends on leverage and support. If the levee starts leaking, everyone is screwed if it doesn't get fixed. Austrians would say that people are smart and self-interested enough to realize that and pay someone to get it fixed without anyone forcing them to. That's not always going to happen, and the people who were willing to pay their fair share of the repairs will get just as flooded as those who weren't.
posted by gjc at 6:35 AM on January 10 [1 favorite]

Austrians would say that people are smart and self-interested enough to realize that and pay someone to get it fixed without anyone forcing them to.

Yeah, this is sort of their major failing. They have an unwavering faith not only in the primacy of the invisible hand, but also an even more religious faith in the idea of the invisible hand as being this speedy, all-knowing cybernetic wonder. The levee gets fixed before it becomes an even worse problem because that's what makes perfect sense on paper, despite what experience may have repeatedly taught us about the nature and speed of de-centralized group decision-making.

Football ran Austrian-style would have begin and end with the coach hiring the best possible players, and then figuring that the ball would already be in the goal from the very beginning. And every time all the other teams won, the coach would assume it was because his players weren't strong enough and that he, as a coach, had given still too much input.
posted by Sticherbeast at 6:43 AM on January 10 [9 favorites]

The market determines these things, and a central bank's "meddling" can only dampen the effects of what all the people in the economy are trying to do. No amount of low interest rates can force people to build factories when they don't see a demand for the product.

It sounds like you are saying that printing extra money will not spur investment.

Not necessarily, no. Printing more money only solves the problem when the problem is not enough money. Beyond that point, it is at best useless and at worst inflationary.

This is evidenced by the current economic climate: QE and low interest rates aren't spurring investment, they are just pumping cash into bank accounts. Business isn't investing it, they are saving/hoarding it. Not only are they not inspired to invest with the temptation of low, low rates, they aren't even investing the zero-interest cash they have.
posted by gjc at 6:58 AM on January 10

They have an unwavering faith not only in the primacy of the invisible hand, but also an even more religious faith in the idea of the invisible hand as being this speedy, all-knowing cybernetic wonder.

Oh, wait, you weren't talking about the government.

Carry on then.
posted by quintessencesluglord at 7:04 AM on January 10

WHAAA! No Schumpeter, Blasphemy? =(

You know... one of the big differences between Keynes and Schumpeter was the basic premise of whether or not a healthy economy should either a) be in static equilibrium or b) not be in static equilibrium (via creative destruction). Keynes being all about healthy equilibrium and Schumpeter being all about creative destruction and the importance of the entrepreneur.

Check out Schumpeter if you've never looked into him.... He and Keynes were contemporaries that respected each other and referenced each other.

As a side note Schumpeter thought that the final evolution of capitalism would result in socialism... which is interesting.
posted by khappucino at 7:48 AM on January 10 [1 favorite]

Here is where the problem is:

The point, in any case, should be to ensure that public power is accountable to public officials who, in turn, are accountable to the voters rather than to private firms who are accountable to shareholders.

From the Constitutional Convention debates to the Federalist Papers and unambiguously through the entire history of the United States, the idea that the voters are too stupid to be trusted with big decisions prevails, and when this fact is discussed it's mostly obscured.
posted by bukvich at 8:38 AM on January 10 [2 favorites]

This is evidenced by the current economic climate: QE and low interest rates aren't spurring investment, they are just pumping cash into bank accounts. Business isn't investing it, they are saving/hoarding it. Not only are they not inspired to invest with the temptation of low, low rates, they aren't even investing the zero-interest cash they have.

To be fair the other half of the "QE/0%" solution isn't being implemented like it should due to political obstructionism. The fed can only do so much. Short of them starting to buy construction companies directly and shoveling cash at them to employ people to rebuild our infrastructure the rest comes down to the legislature providing some demand for private services.
posted by Talez at 9:32 AM on January 10

Talez: "The fed can only do so much."

They could stop paying interest on reserves. In normal circumstances excess reserves would be fine. The best explanation I can come up with is that the Fed is using this as a backdoor method of recapitalizing the banks.
posted by pwnguin at 10:11 AM on January 10

This "Keynesian" modelspace - is that the actual active model?

If you ask me, the last true Keynesian in the WH was Nixon. And I don't just mean by his own admission.
posted by dhartung at 10:50 AM on January 10

Great post! Without knowing it, I've been looking for a place to summarize some of these things for me.
posted by Edgewise at 10:52 AM on January 10

I don't understand the Fed haters. It's easy to think that a cabal of evil bankers is ruining the economy, but this is my opinion:

1) The Fed's quick action saved us from a true depression with a capital D.
2) In order to do this, the Fed had to put money into the economy and recapitalize. The Fed had to give money to banks.
3) The Fed was able to save us in part because it isn't run by political prostitutes. In particular, it has very smart economists - actual experts in the field - working to figure out what is best, not what is popular. These economists often don't agree. But, with their relatively large salaries and professional freedoms they are not beholden to other interests, which is not true of pretty much every other politician and bureaucrat.

For all this talk about Fed giving money away and giving a free ride to the banks, I would point to the significant debate early on in the financial crisis about moral hazard and the Fed doing too much.

Finally, for all this talk about the Fed not doing enough, I would point to the too-small fiscal stimulus and general weakness of the Federal government to make any strong actions during or after the financial crisis.

If I were to grade every economic actor over the last 5 years, I would give the Fed a B and everybody else a D/F.
posted by The Ted at 11:15 AM on January 10

I think it is pretty obvious that government intervention CAN cause booms and busts, and the Austrians are right about that. But where they are wrong is the corollary of that, which says that booms and busts can ONLY be caused by government intervention.

Interesting parallel to another popular libertarian concept: the state is coercive, so if we dismantle the state, then we will be free of coercion.
posted by weston at 11:27 AM on January 10

As Yglesias says, a gold standard is "neither necessary nor sufficient".

To be fair, not all Austrians argue that an elimination of fractional-reserve banking has to be accompanied by a return to the gold standard. The implementation problems of full-reserve banking dwarf those of the gold standard, though.

The fed can only do so much.

Yglesias' argument is that progressives should care about the Fed because monetary policy is the primary tool in fighting the negative effects of recession. While I try to avoid pea-and-thimble games of definition, this doesn't sound particularly "progressive". See pushing on a string for a perhaps more traditional progressive view on the limits of monetary policy.

At the end of the day, it is certainly not a bad thing to encourage people to become more familiar with the machinery of governance.

For all this talk about Fed giving money away and giving a free ride to the banks, I would point to the significant debate early on in the financial crisis about moral hazard and the Fed doing too much.

So despite all this talk about the Fed fostering moral hazard, we shouldn't worry about it because there's a lot of talk about the Fed fostering moral hazard?

Finally, for all this talk about the Fed not doing enough, I would point to the too-small fiscal stimulus and general weakness of the Federal government to make any strong actions during or after the financial crisis.

Again, I'm not sure I follow : the Fed isn't do enough but that's OK because neither is the Government?
posted by kithrater at 4:35 PM on January 10

This "Keynesian" modelspace - is that the actual active model?

At least to the extent that we tend to base almost all finance and economics on seeking equilibrium.
This shows up pretty much all over the place... micro/macro. The alternative is that the natural state is persistant instability.
posted by khappucino at 7:52 PM on January 10

They could stop paying interest on reserves. In normal circumstances excess reserves would be fine. The best explanation I can come up with is that the Fed is using this as a backdoor method of recapitalizing the banks.

The problem with the banks, as I understand it, was that mortgages have traditionally been "good as gold" as reserves. If a bank needs $X in reserves, it could make and hold mortgages which would count for some of those reserves. And mortgage backed securities were considered just as good. Which they are, in theory.

The problem is that when the housing industry crashed, they were caught holding paper that wasn't worth as much as they thought it should be. So they might have $1b in mortgages fulfilling their reserve obligations on paper, the values dropped such that maybe they only really had $800m in viable assets, and they had to come up with $200m in cash, RIGHT NOW, to keep their reserve requirement fulfilled. Which caused a credit crisis, because few other banks had the cash to spare, and even those that did weren't willing to lend it out to some bank whose books weren't balanced.

So yes, I think paying higher interest on reserves probably was meant to help feed some money in, but I suspect it was also a bit of a test to see which banks were and weren't healthy. A sick bank has no reserves to dump into their Fed account to take advantage of the payout.
posted by gjc at 9:06 PM on January 10

The problem with the banks, as I understand it, was that mortgages have traditionally been "good as gold" as reserves. If a bank needs $X in reserves, it could make and hold mortgages which would count for some of those reserves. And mortgage backed securities were considered just as good. Which they are, in theory.

This is incorrect. A bank's reserve requirement ratio has to be met from a combination of vault cash (physical currency, also known as Federal Reserve Notes), and the balance of their master account at their regional Federal Reserve Bank. The purpose of the reserve requirement ratio is to prevent a depositor-led bank run.

In a simple model, when you sell something to the Fed's trading desk, they increase the reserve balance of your master account. When you buy something from the Fed, they decrease the reserve balance of your master account.

In reality, what goes on is mostly repurchasement agreements, or repo, where banks sell thngs to Fed with a promise to buy it back shortly with interest.

Which caused a credit crisis, because few other banks had the cash to spare, and even those that did weren't willing to lend it out to some bank whose books weren't balanced.

It was, ironically, during the darkest days of the credit crunch that the Fed started accepting any old garbage, such as hundreds of billions of dollars worth of still-having-a-high-face-value-but-otherwise-worthless mortgage CDOs, as collateral for overnight repo to allow banks to pay off their other obligations.
posted by kithrater at 11:53 PM on January 10

Maybe this is what I was thinking of?
posted by gjc at 8:26 PM on January 11

Sounds like it: capital adequacy ratio vs reserve requirement ratio. You don't need the value of your mortgage-backed-security to fall to worsen your capital adequacy - an increase in the acknowledged riskiness of said security does the same thing.
posted by kithrater at 10:11 PM on January 11

Sorry, in my post I should probably have said something about orthodox macroeconomics as well. These are generally based on mathematical models. Greg Mankiw provides an excellent description of the intellectual history in The macroeconomist as scientist and engineer (PDF).

Saltwater/Keynesian: both monetary policy (lowering interest rates) and fiscal policy (borrowing and spending money) are useful in stabilizing the economy. It's the view most commonly held by policymakers and central bankers. I'd describe it as technocratic rather than politically left (held by Republican technocrats like Greg Mankiw and Ben Bernanke). A sample technical article by Paul Krugman on the IS-LM model: There's something about macro. For an introduction, see an introductory economics text, or check out Krugman's older papers on his MIT page.

Freshwater/University of Chicago/"new classical": opposed to counter-cyclical fiscal policy. This is not a crank school of thought: it's prominent in academia, and several leading members have won the Nobel Prize in economics. Paul Krugman has been arguing that the Real Business Cycle theory of the freshwater school is an intellectual dead end. Greg Mankiw is more sympathetic, but his conclusion isn't much different. New Yorker: The Chicago school and the financial crisis.

(Summary of the heterodox schools of thought: Austrians are opposed to both monetary and fiscal policy. MMT advocates argue for unrestrained fiscal policy. Market monetarists argue that monetary policy is always sufficient to stabilize the economy, e.g. through NGDP targeting. It's less cranky/taken more seriously than the others; besides Scott Sumner, see Nick Rowe at Worthwhile Canadian Initiative.)
posted by russilwvong at 9:19 AM on January 12 [1 favorite]