Thursday, September 8, 2016

What Would It Take to Establish a Truly Free Market Economy?

In the past, I've posted articles on the views of Narayana Kocherlakota, the former President of the Federal Reserve Bank of Minneapolis, professor of economics at the University of Rochester and columnist for Bloomberg View.  In his latest musings, he looks at how the government was responsible for the last recession and lukewarm economic recovery and how the market could truly become "free".

Dr. Kocherlakota opens by noting that, in a truly free market, if everyone suddenly decided that future economic growth would be very slow (actually similar to what it is now), the price of "safe assets" like Treasuries would rise sharply because demand for these assets would rise since the interest income gleaned from such investments is considered iron-clad.  Since bond prices act inversely to interest rates, rising bond prices would push interest rates down just as has happened since 2008 as shown here:

In fact, in a free market, demand for Treasuries could be so high and prices rise so much that bond yields could potentially plunge deeply into negative territory.

Dr. Kocherlakota goes on to note that there are two government mechanisms that interfere with the free market, acting to prevent negative interest rates from falling deeply into negative territory as follows:

1.) Cash - as long as people can hold currency which only loses value at the rate of inflation, they will not purchase assets that yield less.

2.) Central Banks and inflation - central banks have more or less promised to keep inflation low and stable at about 2 percent.

This means that people have no logical reason to hold assets that yield less than negative two or three percent.

Here's a key paragraph from Dr. Kocherlakota's commentary:

"In other words, governments -- by issuing cash and managing inflation -- put a floor on how low interest rates can go and how high asset prices can rise. That's hardly a free market."

I find it fascinating how he blames government intervention for "managing inflation"!  I suppose in a round about way, it is true given that Congress established the statutory objectives for monetary policy, stating that the Federal Reserve is responsible for ensuring that their monetary policies keep prices stable, however, it is the Federal Reserve that has set a 2 percent target.  

So, what is his solution to the problem?

"The right answer is to abolish currency and move completely to electronic cash, an idea suggested at various times by Marvin Goodfriend of Carnegie-Mellon University, Miles Kimball of the University of Colorado and Andrew Haldane of the Bank of England. Because electronic cash can have any yield, interest rates would be able go as far into negative territory as the market required."

Now won't that be fun and games for savers and retirees who are already suffering with generationally low but still slightly positive interest rates?  Fortunately, Dr. Kocherlakota has a solution: he suggests that governments simply redistribute resources to the elderly and the poor by giving them money.

If cash were abolished, the author suggests that two measures must be adopted:

1.) rather than targeting a positive inflation rate like they are now, central banks aim to keep prices constant over time.

2.) governments would have to develop alternatives that allow consumers the same anonymity and privacy that cash currently offers.

Here's his closing paragraph:

"We’ve endured a deep recession and a miserable recovery because the government, through its provision of currency, interferes with the proper functioning of financial markets. Why not ensure that doesn't happen again?"

Given that the number of the world's most influential economies with positive interest rates seems to be dropping on a regular basis, my suspicion is that Dr. Kocherlakota's rather off-the-wall suggestion (at least for an American central banker) of adopting a cashless society to prevent future economic contractions is becoming an increasingly likely scenario given that central banks are pretty much out of ammunition, both conventional and otherwise. 

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