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June 13, 2010

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Posted: 12 Jun 2010 11:02 PM PDT

"Strange Arguments For Higher Rates"

Posted: 12 Jun 2010 02:34 PM PDT

Paul Krugman responds to Raghuram Rajan's latest defense of his view that the Fed should raise the target interest rate:

Strange Arguments For Higher Rates, by Paul Krugman: So Raghuram Rajan has posted a further explanation of his case for raising interest rates in the face of very high unemployment, presumably a response to Mark Thoma. It's good to see Rajan put his cards on the table — but what he says only further confirms my sense that we're talking about some kind of psychological desire to be tough...
Rajan's argument boils down to two assertions:
1. Raising rates a bit wouldn't significantly deter investment.
2. "Unnaturally low" interest rates are distorting asset prices.
The first thing to say about these two assertions is that they are essentially contradictory. If the difference between current rates and the rates Rajan wants is trivial — just a wafer thin mint — how can that same difference be leading to a major distortion in financial markets? Are we to believe that an interest rate change that matters not at all to firms making real investments somehow has huge effects on speculators? And actually, don't asset prices themselves matter for real investment?
It might be worth noting, in this context, that just because the interest rate on safe bonds is near zero, that doesn't mean that people making risky investments can borrow at near-zero rates.
Beyond all that, what does Rajan mean by "unnaturally low" rates? What makes them unnatural?
My take on the current economic situation is quite simple... Right now, we clearly don't have enough demand to make full use of the economy's productive capacity. This means that the real interest rate is too high. And so the "natural" thing is for the real rate to fall. Yes, that would mean a negative real rate. So?
The trouble is that getting that negative real rate isn't easy, because the nominal rate can't go below zero, and there's no easy way to create expected inflation. If you ask what would happen if prices were completely flexible, the answer, as I figured out long ago, is that prices would fall so far now that people would expect them to rise in the future, creating expected inflation. Bur prices aren't that flexible, which is why we turn to quantitative easing, fiscal policy, and more.
Surely, though, we want to get rates as close to their appropriate level as possible — which means a zero nominal rate. There's nothing "unnatural" about it. On the contrary, the "natural rate of interest", as Wicksell defined it, is clearly negative right now.
So why does Rajan feel that there must be something wrong with low rates (and he's not alone)? I think his language, with its odd moral tone, is the giveaway: it's the sense that economic policy is supposed to involve being tough on people, not giving money away cheap.
I actually understand the seductiveness of that posture; I can sort of understand how economists succumb to it. But right now, with the world desperately in need of clear thinking, is no time to give in to the subtle allure of inflicting economic pain.

I had the same response. If raising rates doesn't change investment, how does raising rates choke off risky (and distorted) financial investment which ultimately depends upon real investment activity?

(There is also an argument that high rates, not low rates, cause an increase in the proportion of investors taking high risks. When rates are high, only the riskiest, highest expected return projects will have a chance of being profitable, so these are the only projects that are pursued. In this case higher rates, not lower rates, lead to an increase in the fraction of risky investment. This is where Krugman's point that the interest rates people making risky investments actually face are not zero, and increasing these rates by another 2 to 2.5 percent, as recommended, will raise them even higher and potentially induce more risk-taking behavior. This doesn't directly overturn the argument the arguments Rajan is making, but it is a potential countervailing force.)

Let me also address this part of Raghu Rajan's response, which I assume is directed at the title and content of this post ("The Fed Should Raise Rates Because Brazil has Low Unemployment?"):

If the Federal Reserve were to accept the responsibilities of its role as central banker to much of the world, it would have to admit that its policy rates are too accommodative for the world as a whole. Does the Fed have responsibility to help the world while hurting its own economy (or as one commentator put it, am I advocating that the U.S. raise rates because Brazil is overheating)? Of course not! But when the benefits to its own economy are dubious, it should also give some thought to the global effects of its policies. For eventually, the consequences of its policies will come back to haunt it if they precipitate crises elsewhere.

That the benefits of low rates are dubious is an assertion, not a demonstrated fact. Rajan's post attempts to make the case that low rates have costs that exceed the benefits, i.e. that the net benefits are "dubious," but here he is assuming he has already proven his case. So, yes, if you assume that there is no cost to raising rates (which is what the debate is all about, so clearly I disagree with this assumption), assume that low rates will cause a crisis in Brazil or somewhere else (the argument is that these countries need to raise rates, but low rates in the US prevent them from doing so), and assume that a crisis in one of these countries will cause a crisis in the US (or at least significant troubles), then yes, I suppose we should take this into account. But it takes quite a few "dubious" assumptions to come to this conclusion, the contradictory "it won't change investment" among them, so I am not at all convinced by this argument.

"The Simple Economics of Broadband Regulation"

Posted: 12 Jun 2010 12:15 PM PDT

Shane Greenstein discusses "The Simple Economics of Broadband Regulation." The discussion (from mid May) comes in response to a court ruling in the Comcast v. FCC case. Here's how the FCC describes the regulatory problems caused by the ruling in the Comcast case:

A month ago, the United States Court of Appeals for the D.C. Circuit issued an opinion...  [in] Comcast v. FCC, the so-called Comcast/BitTorrent case.  The case began in 2007, when Internet users discovered that Comcast was secretly degrading its customers' lawful use of BitTorrent and other peer-to-peer applications.  In 2008, the FCC issued an order finding Comcast in violation of federal Internet policy as stated in various provisions of the Communications Act and prior Commission decisions.
The D.C. Circuit held that the Commission's 2008 order lacked a sufficient statutory basis ... because the Commission, in 2002, classified cable modem offerings entirely as "information services" (a category not subject to any specific statutory rules...), it could not, in 2008, enforce ... nondiscrimination and consumer protection principles in the cable modem context. ...
[U]nder Comcast, the FCC's 2002 classification decision greatly hampers its ability to accomplish a task the Commission unanimously endorsed in 2005:  "ensur[ing] that broadband networks are widely deployed, open, affordable, and accessible to all consumers." 

The court ruled that the FCC did not have the authority to stop Comcast from limiting the services of applications that flow over its network (i.e. the ruling allowed net non-neutrality). In response, the FCC reclassified the cable carriers so as to reestablish their regulatory authority. What are the economics behind the FCC's response (the original post has quite a bit more detail)?:

The Simple Economics of broadband regulation, bu Shane Greenstein: There is a simple economic rationale behind the FCC's recent announcement, made last week by Chairman Julius Genachowski, on May 6th.The FCC had to act. The costs of not acting were too great. Here is why. Broadband carriers have strong economic incentives to provide services that compete with the applications of others. Yet, those same broadband carriers carry the data of all those applications. These carriers face what is often called "mixed incentives", and until recently all carriers were forbidden from acting on them. Genchowski wanted to keep things that way, but an appellate court made that hard to do.
Let me make the issue concrete. Just ask your neighbor what they would think of the following: Would they be angry if Comcast blocked Skype from operating and told all users they had to go through an approved vendor of IP telephony? Would your neighbor be unhappy if Google slowed down when the search concerned local car dealers because AT&T broadband had a local search service on which local car dealers advertised? Would your neighbor be frustrated if they could not go to Hulu, but instead had to go to the approved TV distributor who worked with Verizon?
Look, none of that has happened yet, but that is because it was forbidden by regulators until a few weeks ago. It is not anymore, and that illustrates what any sensible regulator should fear. ... Households have gotten used to having unrestricted choice online of innovative services, and there would be a minor revolt if narrow firm self-interest got in the way of that.
I have no axe to grind with carriers, so let me say that more positively. The ... present limitations have fostered an innovative ecosystem. Software vendors and Internet hosting companies have developed a range of innovative services in anticipation of (1) better infrastructure on which to run it, and (2) sending their applications across broadband lines that behave the same way everywhere.
In other words, application vendors do not worry about which carrier delivers the data to which homes because carriers are not allowed to act on their mixed incentives. Knowing that, application developers innovate in all sorts of ways that users enjoy.
Those simple economics explains quite a bit of regulatory action..., it is not surprising the FCC feared what would happen if it permitted no legal restraint on carrier action. ...
There were two economic reasons to take action, and both point towards limiting mixed incentives. One has to do with the incentives to act on mixed incentives today, and the other has to do with the long term trends of the evolutions of the network, which reinforces incentives to act on mixed incentives tomorrow...
I am not saying anything that many other analysts have not noticed. Comcast's management is ambitious. So is AT&T's, and so is Verizon's. They must be considering how a carrier can develop its own television service (instead of relying on Hulu), or get a piece of revenue from selling online movies (instead of letting Netflix collect all the revenue), or get a piece of online advertising for local services (instead of letting Google collect all the revenue).
This is an old lesson in regulatory economics. Commercial ambition from a dominant firm is a good thing when it fuels competitive conduct, innovative services, and invading of new service territories. Ambition from dominant firms is usually not such a good thing when it motivates such those firms to block a rival's access to channels, when it leads dominant firms to refuse to deal with potential rivals, and when it leads dominant firms to raise a rival's cost. ...
Mixed incentives are a very old problem in communications access regulation, and easily understood by every regulator on the planet. Every regulator can sense the danger of letting carriers move down the slippery slope of not cooperating with another participant in the Internet ecosystem. That bright line had to be protected, if only for the sake of preserving the innovative ecosystem that has driven the Internet forward in these last two decades.
Let's hope the ecosystem continues to be innovative in the next decade with these new set of rules.

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