Should the Federal Reserve Play Mind Games to Stimulate the Economy?

The Federal Reserve has two jobs: maintain the value of the dollar and maximize employment. In a very interesting article from the NY Times , the author Adam Davidson points out that Janet Yellen, who is currently in charge of setting the interest rates at the Reserve, has been maintaining the dollars’ value so well that it is actually impeding the development of new jobs. US citizens have become so comfortable in the stable value of their money that they are less likely to take the risks that coincide with the creation of jobs such as entrepreneurship and venture capitalism. Adam Posen, the man who once set the interest rates for the Bank of England, stated that if Janet Yellen were to simply suggest that the long run interest levels may be higher than previously considered acceptable she might scare people into investing their money in riskier ways to ensure they can beat the inflation curve, thereby creating more jobs.

Giffen goods, items that result in a rightward shift in demand as the price increases, were mentioned in an earlier post. My understanding of Giffen goods in lay-mans terms is that they are items that people are willing to pay or do more to obtain as the price increases. Giffen goods tend to be durable commodities, items that we use regularly that can be bought in advance and saved for later. Based on the information above, would it be appropriate to categorize the US dollar itself as a Giffen good? As interest rates rise, the cost of each dollar also rises. To offset its devaluation, people want more dollars and more willing to take part in riskier investments to gain them.

I would like to know your thoughts on whether the Giffen good concept applies to the US dollar and whether you think the suggestion made by Adam Posen is a good idea.


Dave Tufte said...

This is Dr. Tufte: I cleaned up Lacey's post from below. She couldn't get her link to work, and there are obvious formatting problems.

I suspect this was from writing the post in some other software, and having too much of the default formatting of that software copied over into Blogger before posting.

Dave Tufte said...

Lacey: 94/100 (you mean "layman's" not "lay-mans").

I found the source article puzzling. I am somewhat familiar with Adam Davidson's work through NPR. And yet I found the article ... kind of weird ... in the same way as if someone announced that aliens were coming to Earth so we'd better put out clean towels in the guest bathroom. Maybe "ungrounded" is the word I'm looking for. The whole San Francisco earthquake through Morgan's role in the Panic of 1907 story just begins the weirdness.

Lacey is paraphrasing Davidson's statement that part of the Fed' job is to "... Keep the dollar’s value stable ...". Then Davidson goes on to conflate two ideas that are only sometimes related: keeping inflation low, and maintaining exchange rates near recent levels. He focuses on the latter, but it's only the first one that's part of the mandate he mentions. So I kind of wonder what he's actually getting at, you know?

One detail to correct in Lacey's post is that Janet Yellen isn't in charge of setting the interest rate. She's the Chair (of the Board of Governors of the) Federal Reserve System. That's a really big deal, and makes her the most important person for setting interest rates, but not the person.

Then there's the contention, half from the source and then echoed by Lacey, that it's the stable value of the dollar that's causing people not to invest. That again seems oddly backwards, and conflates low inflation with value, and then blames both for lack of productive investments. It seems to me that if investors aren't taking risks it's because the returns to those risks are too low. The Fed contributes to that, but it's not like rates aren't low all over the world.

Now, Adam Posen's ideas are not ridiculous. Central banks in developed countries, including our Fed, are on new ground. They've greatly increased the size of their balance sheets with quantitative easing, and we're just not sure how they're going to unwind those positions gracefully. Big reactions to uncareful statements by Janet Yellen certainly seem possible.


The discussion of Giffen goods is a bit different.

Let me reiterate that Giffen goods are fun to think about, but just not that common.

Lacey "reasons from a price change" — which isn't a good strategy — by saying that there's a "... Rightward shift in demand as the price increases ...". Where does the price increase come from? It's got to be supply shifting left, which in turn causes the demand of some goods to shift right, increasing their price even further.

Giffen goods (if they exist) would not be durable goods. Instead, they would need to be very inferior goods (think Ramen). Durables don't ever tend to be inferior.

So, is the U.S. dollar a Giffen good? I don't think so. In fact, I think the story here is very much like the self-fulfilling expectations story for ammunition. When world financial markets appear risky, liquid assets flee towards what seems like the safest investment: U.S. Treasury bills. That transfer makes other places look riskier, and the U.S. look safer, which confirms the initial notion that global markets were risky.

Pedro said...

Dr. Tufte, it seems like you have predicted the future in the last paragraph of your comment on quantitative easing. Over the past week the Fed has made comments about raising interest rates and the reaction has been an up and down (mostly down) market. Another point that needs to be considered is mentioned in Dr. Tufte's comment and that is we are dealing with a global economy. Just because dollars are not being invested here in the US does not mean that they are not being used abroad, which makes more sense when they are worth more other places. Especially now the ECB is implementing a quantitative easing plan and the strong dollar is almost equal with the euro.

Dr. Tufte said...

Pedro: 50/50

You make it sound like I'm brilliant when you say this: "Dr. Tufte, it seems like you have predicted the future in the last paragraph of your comment on quantitative easing." I'm not.

All I was doing there was calling them like I see them. But I've been doing this with Fed policy for 30 years now, so I'm pretty good at it. Lots of people can do what I did.

But, what we can't do is figure out how the unwinding of quantitative easing is going to work. We've never seen this before, so we're all watching closely.