Two Can Play That Game

Paul Krugman criticizes the case made by Raghu Rajan for Fed interest rate hikes. Krugman falsely asserts that Rajan's case only rests on two arguments (as you can see if you read Rajan's article it contains more arguments) and that these arguments are self-contradictory:

"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?"

But first of all, it is not necessarily the case that "real" investment movements mirror asset price movements exactly. Obviously the former is influenced by the latter, but because of various considerations including the volatility of asset price movements relative to the partly irreversible nature of many "real investments", the correlation of the magnitude of these two phenonemoms are unlikely to be perfect.

Because of their higher volatility and more easily reversible nature, asset prices are likely to fluctuate more than "real" investments.

And secondly, if we for the sake of the argument assume that the correlation is perfect, then this destroys Krugman's argument that monetary policy can be used to stabilize the "real economy" without creating asset bubbles, an argument he has frequently made when defending the low interest rate policy of the Fed in 2001-05.