LARRY SUMMERS: The Wall Street Journal published the 'single most confused analysis' of the Fed I've read this year

Economist fight!

Harvard professor Larry Summers has blasted an op-ed that appeared in The Wall Street Journal on Tuesday criticising the Federal Reserve.

Writing on his blog late Wednesday, Summers said a piece from Michael Spence and Kevin Warsh which asserted that Fed policy has weighed on corporate investment is simply nonsense.

“My friends Mike Spence and Kevin Warsh, writing in [Tuesday’s] Wall Street Journal, have produced what seems to me the single most confused analysis of US monetary policy that I have read this year,” Summers writes.

“Unless I am missing something — which is certainly possible — they make a variety of assertions that are usually exposed as fallacy in introductory economics classes.”

Spence won the 2001 Nobel Prize in economics and Warsh is a former Fed governor.

Neither of these pieces, we’d note, have to do with the Fed’s latest decision on Wednesday to keep interest rates pegged near 0%. The Fed’s announcement, however, did explicitly mention what it would need to see in order to raise interest rates at its December meeting. The Fed has kept rates near 0% since December 2008 and hasn’t
raised rates since July 2006.

In their piece, Spence and Warsh write, “We believe that QE has redirected capital from the real domestic economy to financial assets at home and abroad.”

Spence and Warsh’s critique asserts that the Fed’s quantitative easing program — which involved the outright purchase of Treasury bonds and mortgage-backed securities — effectively created less uncertainty in financial markets while doing nothing to damp down uncertainty in the “real” economy, causing corporate decision makers to balk at spending money on things like employees or equipment given the unknown consequences of this program.

As a result, in Spence and Warsh’s view, this uncertainty has led to the increase in share buybacks that have been roundly criticised as “financial engineering” by critics on both sides of the economics divide.

Standard economic thinking, as Summers hints towards, would say that lower interest rates encourage companies to spend money on things like equipment and labour because not only is it less expensive to borrow money, but saving money earns you nothing.

In other words, low rates are supposed to encourage companies to do something with their cash. Buying back shares, however, is an investment in your company, if not one that really does anything for people other than your shareholders. But recall again, however, that Spence and Warsh think QE is hurting the “real” economy, not the financial one (which is what buybacks are investing in, more or less).

Typically, as Summers notes, critiques of Fed policy center on concerns about runaway inflation (which have proven unfounded to this point), or financial stability. And while Summers disagrees with these attacks, they are at least the sort of accepted way one goes about bashing the Fed.

And so as Summers writes, Spench and Warsh, “assert a proposition that I have not encountered in 40 years as a professional economist — that overly easy monetary policy reduces business investment.”

The short of it, then, is that Summers doesn’t understand where Spence and Warsh get their evidence from, writing, “For now though I would put the Spence-Warsh doctrine that easy money reduces investment in a class of propositions backed by neither logic nor evidence.”

Read the original Spence and Warsh piece in the WSJ here »

And read the full Summers critique here »

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