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JakilaTheHun (99.94)

Applying the Mankiw Rule to the Eurozone

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June 28, 2011 – Comments (19) | RELATED TICKERS: FXE , FEZ

The lack of independent monetary policy within the Eurozone is one of the more economically destructive aspects of the system.  Every individual nation in the 17-member grouping is forced to adopt a common monetary policy; even while they all continue to function as sovereign nations otherwise.  The result is that money supply in each individual nation cannot be adjusted for the observed market conditions.   In my view, this is the Euro’s biggest flaw.

As a little experiment, I wanted to try to determine what sort of monetary policy the Eurozone nations should be running right now.  I’ve decided to take the Mankiw Rule in order to try to predict what the short-term interest rates should be in each individual nation.

Background on Mankiw Rule

There are two primary monetary policy rules that I am aware of:  the Taylor Rule and the Mankiw Rule.  Both provide a soft recommendation for short-term interest rates in the United States.

The two rules are fairly similar in terms of results, but the inputs are slightly different.  The Taylor Rule emphasizes the output/inflationary gap and uses raw CPI in order to calculate an optimal Federal funds rate.  The Mankiw Rule, on the other hand, uses core CPI, which is CPI excluding food and energy.  Mankiw also factors unemployment into the equation.  The formula for the Mankiw Rule is below:

Federal funds rate = 8.5 + 1.4 (Core inflation – Unemployment)

I’ve decided to use the Mankiw Rule, not because I have an overwhelming preference for one rule over the other, but because Mankiw will be easier to calculate with the data I can acquire quickly.  While there will be minor differences between the two rules, we’re not focusing on precision here, so much as direction and degree.

With that, let’s jump to the results.  I will deal with some of the flaws with this methodology afterwards.

Eurozone Mankiw Rule

There was one significant issue in calculating this data.  It was far simpler to find raw CPI Eurozone data in wholesale fashion; whereas, I would’ve had to have spent more time digging up core CPI for each nation.  While this should slightly alter our data, it won’t destroy its validity, so much as require us to compensate for it.

The Eurozone equivalent of the Federal funds rate is the marginal lending rate for main refinancing operations.  This is currently set at 1.25% as a reference point.

All 17 Eurozone member states are in the table below:


As you can see from the chart above, it suggests that monetary policy is too loose in the “Northern Block” of Eurozone nations, which includes Germany, Luxembourg, the Netherlands, and Austria.    Austria and Luxembourgh, in particular, appear to have very loose monetary policy due to the Eurozone’s structural flaws.

On the other end of the spectrum, we see that Estonia, Ireland, Greece, Spain, Portugal, and Slovakia all have tight monetary policy, with Spain and Ireland falling into the “very tight” categorization.

Since I used raw CPI rather than core CPI, I tried to make adjustments for the more troubled block of nations, commonly known as the PIGS:  Portugal, Ireland, Greece, and Spain.   In the chart below, for the first result, I adjusted raw CPI to estimate core CPI.  This was not a scientific calculation; I merely based it off of what I’ve observed with CPI data over the past six months in most nations.  In most cases, this means that CPI was lowered between 100 to 200 basis points.

For the second adjustments, I attempted to factor housing prices into CPI.  For Spain, I assumed that housing would get a 25% weighting and prices had fallen 7.5% in the past year.   This was based on some analysis I have read elsewhere and seems to be a reasonable estimate.  For Greece, Ireland, and Portugal, I merely assumed a 5% decline in real estate values and a 25% weighting.  This is merely a guess and may not be accurate at all.

The results are below:

With these adjustments, monetary policy in all of these nations looks extremely tight.  Keynesian economic theory would suggest that fiscal policy should be used to compensate for this disparity, but the problem is that the precise opposite result is taking place, with all four nations implementing austerity measures:  higher taxes and lower spending.   This has the affect of constricting money supply even further below its optimal level.

In my view, this is precisely the same situation that played out during the Great Depression.  Nations could not increase money supply as necessary due to the gold standard.   Except, this is even worse in a sense, because at least gold can be mined and supply increased; whereas, the PIGS are essentially stuck in their predicament with very few options, unless they abandon the Euro.

Flaws with this Methodology

There are, of course, some flaws with using this methodology (the Mankiw Rule) and applying it to Eurozone member states in the manner I did.  As mentioned earlier, I used raw CPI data in the first table as opposed to core CPI.  Because I wanted to do this wholesale and finding the core CPI rates would have taken a lot more digging, I decided to live with this limitation.  In practice, food and energy prices are causing CPI inflation to be significantly higher, so a nation with 3.5% inflation might only have 1.5% core inflation.  My second chart attempts to accommodate for this shortcoming for the four “troubled nations” (Mankiw Rule Modified #1).

Another problem, in my view, is that CPI does not account for housing prices in most nations.  Personally, I believe this is a huge mistake and that fixed asset prices are one of the most important considerations in monetary policy.  If the US had accounted for fixed asset prices during the ‘00s, we would have likely clamped down during the housing boom, and it would have never become quite so out of control.  However, it’s important to note that this is a flaw with both the Mankiw Rule and the Taylor Rule and applies to the US, as well.  As mentioned already, I tried to accommodate for this in the second chart, as well (Mankiw Rule Modified #2).

The final flaw here is that the Mankiw Rule was meant to predict an appropriate level for the Federal funds rate in the United States.  It’s not completely clear how well it will carry over to various Eurozone nations.  Some nations might have different long-term optimal unemployment rates, so that could make this rule somewhat off.   It was more difficult to compensate for this potential shortcoming.

Even with the flaws, however, I believe this analysis shows why the problems in the Eurozone are so severe.   Without independent monetary policy, Portugal, Ireland, Spain, and Greece are essentially unable to adjust their money supply in an adequate fashion.   Iceland, which does have independent monetary policy, is now starting to recover some from its financial meltdown; while none of the Eurozone nations have seen anything other than further problems.

Conclusion

From this data, I would suggest that Portugal, Ireland, Spain, Greece, Estonia, and Slovakia would all be better off exiting the Eurozone.   A tight centralized monetary policy that does not account for the unique needs of these nations’ economies only exacerbates current issues.

Meanwhile, it would appear that Austria, the Netherlands, Luxembourg, and Germany are benefitting from loose monetary policy and an artificially weak currency.  If several of the weaker states were to split off from the Euro, it would cause the Euro to strengthen and interest rates to rise, thereby weakening exports.  If this downturn were combined with a banking crisis, initiated by sovereign debt restructurings, we could have a major Eurozone crisis on our hands.

There are several solutions to these problems, but in its simplest form, the Eurozone should either break up or enact reforms that make it more like a “United States of Europe”, rather than a dysfunctional conglomeration of independent states lacking independent monetary policy.   Until Eurozone policymakers are willing to take one of these actions, the economic problems of the Eurozone will likely continue.

19 Comments – Post Your Own

#1) On June 28, 2011 at 11:14 PM, rfaramir (29.27) wrote:

"Federal funds rate = 8.5 + 1.4 (Core inflation – Unemployment)...some flaws with using this methodology"

I'll say. 8 of the 17 nations 'should' be paying people to take out loans, since the formula gives them a negative interest rate! What a farce!

"unable to adjust their money supply in an adequate fashion... lacking independent monetary policy"

Inability to adjust the money supply is a good thing. To 'adjust' it is to defraud people by printing more unbacked currency. It is to spit on the concepts of private property and responsibility. To have an "independent monetary policy" is to be a tyrant over those forced to use your currency ('your' people).

The one good aspect of the Euro (beyond the simple convenience of a common currency) is that it vaguely functions as a gold standard for those countries on the margin, forcing them to come to grips with their overspending. They cannot just debase their people's currency since they don't control it. They are forced to spend less or tax more, especially as they are soon going to be unable to borrow more.

The only "optimal level" of money supply is the current level. A money is most useful when its amount is constant. To be a store of value, you cannot have other people coming up with more of it (at least not without a lot of effort for a small additional amount, like gold miners). Lowering the level (deflation) is rare, only occuring when industry uses up gold or silver in a non-recoverable manner. And since it only makes the money you have left more valuable, no one complains about it. Raising the level (inflation) is what central banks do. It's about all they can do; they are one-trick ponies. And it is equivalent to theft.

Widescale theft never helped an economy (broken window fallacy). Advocating it is foolish and not supportable with real economics.

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#2) On June 28, 2011 at 11:28 PM, whereaminow (< 20) wrote:

You do a lot of great positivist research. 

Where do you get that the gold standard prevented nations from exercising loose monetary policy in the Great Depression?  Every Western nation was off the gold standard in 1914 (US in 1917).  Not a single one ever went back on it 100%. 

So if you can just let go of the lies you've been told regarding economic and monetary history, you might actually become a decent economist.

The Great Depression was caused by wars, inflation, and dirty scumbag politicians.  It had nothing to do with the Gold Standard.

David in Qatar

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#3) On June 28, 2011 at 11:28 PM, JakilaTheHun (99.94) wrote:

I'll say. 8 of the 17 nations 'should' be paying people to take out loans, since the formula gives them a negative interest rate! What a farce!

That's why monetary policy becomes ineffective at that level.  But the bigger point is that this resulted from years under the flawed system. 

 

Your views on money supply are absolute rubbish.  If money supply stayed constant, the economy would always be in a depression.  Population grows and wealth grows in a healthy economy, so money supply would need to increase as well.  Keeping it constant in spite of the fact that market signals suggesting it be increased is a receipe for disaster. That's not "sound money."  It's simply poor economics. 

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#4) On June 28, 2011 at 11:38 PM, whereaminow (< 20) wrote:

If money supply stayed constant, the economy would always be in a depression

Just because you've never heard the idea before doesn't make it rubbish.  

You talked a big game in your last post about understanding Austrian theory.  Have you read Mises' Theory of Money and Credit or any significant Austrian work, Mr. Gold Standard Caused the Great Depression?

David in Qatar

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#5) On June 29, 2011 at 1:28 PM, rfaramir (29.27) wrote:

While I won't back down on the correctness of the Austrian position, I will first apologize for my tone. Specifically, "to spit on the concepts of private property and responsibility" and "What a farce!" are a bit emotional and may get in the way of a valuable discussion.

"If money supply stayed constant, the economy would always be in a depression."

No. With a constant money supply, as the goods and services increased (the usual case in absence of war with growing industrialization and accumulating capital) prices would gradually fall. It is axiomatic that constant dollars bidding for increasing goods would have to bid lower over time. Confusingly for non-Austrians, this is not a problem. Holders of money get wealthier (in real terms) because their purchasing power grows.This is a good thing. Everyone likes it when the prices of things they buy go down. Increased wealth is also the natural result of higher productivity.

If you could list the reasons why this seems to be a problem to you, we (David and I, at least) could probably answer each one. I could guess at your objections ahead of time, but that might devolve into me creating straw men and blowing them away. If they aren't your objections, then I wouldn't be helping you.

I'll start with your first objection already mentioned, but I'm sure there's more:

"Population grows and wealth grows in a healthy economy, so money supply would need to increase as well."

No. I've mentioned why this is not the case, but I can go into more detail. One of the attributes of a good money is infinite and linear divisibility. By 'infinite' we really only mean as far as we need to go, not necessarily that we will go beyond individual atoms and beyond. By 'linear' we mean that when we subdivide a money, the value of the sum of the broken pieces is the same as the original whole. A large diamond, for example, is worth more whole than the sum of its pieces once cut into smaller diamonds. Eggs, seashells, cows, and many other things are similarly non-linear when subdivided. Gold, silver, (all PMs, all metals), salt, sand, tobacco, corn and wheat (so long as you don't mind meal/flour instead of kernels) are all pretty linear. Once you recognize that there is no problem subdividing the money, you can see that there is no problem of having a fixed amount divided amongst the community. There is no such thing as a shortage or surplus (of money or goods) in a free market, only prices which need to adjust. With linear, infinite divisibility the money can be stretched over as many goods as could ever be produced, so prices can adjust infinitely to accomodate changes in supply.

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#6) On June 29, 2011 at 1:42 PM, PeteysTired (< 20) wrote:

If we had a stable money supply wouldn't prices adjust due to production efficiencies and competition?  Even with increases in population money would be more valuable and prices would go down as more people would seek constant dollars?  What am I missing?

It seems with inflation there is a game of who gets the money first.  I wonder what life would be like..hmm

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#7) On June 29, 2011 at 2:04 PM, PeteysTired (< 20) wrote:

Oops it appears I typed while rfaramir was typing and posting.

My questions above are for JakilaTheHun

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#8) On June 29, 2011 at 2:35 PM, JakilaTheHun (99.94) wrote:

You're missing how the real world operates.  In particular, deflationary bias means an ever increasing debt load for debtors.  Debtors, unable to deal with a constantly increasing debt load, are more likely to default.  This is more likely to lead to banking crises.  Which is more likely to lead to subpar economic growth over the long-term. 

Moreover, there's less incentive to invest with a constant deflationary bias.  Why would I invest in a project that yields a 4% real return with some risk, when I could hold onto cash and earn a 4% real return with no risk?  Indeed, there are very few reasons for one to ever invest with constant deflation.  Which defeats the very purpose of having money. 

Money is meant to be a medium of exchange to allow people to more easily transfer goods and services.  Once it becomes an investment with an appreciating real return, it can no longer serve its purpose efficiently. 

Price stability is also absolutely essentially for debtors and lenders.  Once the status quo is upset by either high inflation or significant deflation, it creates problems.  High inflation means that lenders make negative real returns.  High defation means debtors have a constantly increasing debt load and are more likely to default. 

 

Honestly, I don't get why Austrians often adamently defend the gold standard.  It's the precise opposite of a free market system. You are essentially requiring the government to fix the price of a commodity to its currency.   This dictates that wealth can not increase unless the supply of gold increases at an equal rate.  Yet, gold is a scarce commodity that has absolutely nothing to do with increases in wealth. 

 

I think convincing yourself that gold is a "free market currency" is the biggest mistake possible.  And it doesn't achieve "sound money" any more than the "Drug War" stops kids from doing drugs. 

In truth, gold creates a non-market based system for currency that is very arbitrary and inefficient.   Once a financial crisis hits and a nation is caught in a deflationary spiral, what is more likely to happen is that the government than arbitrarily moves the gold peg in order to avoid "default."  

I would rather have a market-based system than one where the government arbitrarily changes the value of the currency when problems arise. 

While you might accuse the current system of being "arbitrary", it's not really. It's true that the Federal Reserve could inflate the money supply --- but the market can also react to such a move. If the Feds really inflate the money supply, the currency will slowly lose its value in a predictable fashion.  

Is this a good result?  No.  But it's better than the arbitrary devaluation with a currency peg.  And gold doesn't force governments to spend soundly, as they'll simply change the rules whenever it's in the way. 

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#9) On June 29, 2011 at 3:17 PM, whereaminow (< 20) wrote:

Price stability is also absolutely essentially for debtors and lenders.

There is absolutely no evidence that centrally managed fiat money provides price stability.

What is even more silly is the idea that a simple equation can set monetary policy (and the price of money through the interest rate) that will reflect the subjective values of hundreds of millions of market actors.  The equations are so crude and barbaric when I study them that I cannot believe so many academics are enthralled with them.

David in Qatar

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#10) On June 29, 2011 at 3:44 PM, PeteysTired (< 20) wrote:

This dictates that wealth can not increase unless the supply of gold increases at an equal rate. 

Why does this dictate?

If I have $10 and prices go down or stay the same do I have more wealth?

If I have $10 and prices go up (inflation) then do I have more wealth?

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#11) On June 29, 2011 at 4:13 PM, rfaramir (29.27) wrote:

"Indeed, there are very few reasons for one to ever invest with constant deflation.  Which defeats the very purpose of having money."

No, it doesn't. You contradict yourself with your very next sentence giving the purpose of money (note the lack of investing):

"Money is meant to be a medium of exchange to allow people to more easily transfer goods and services."

But even if it were true that "there are very few reasons for one to ever invest with constant deflation", the fact that there is deflation indicates that peopel are investing. The extra productivity that capital investments make possible is where the extra wealth comes from which causes the general lowering of prices. So investing is definitely happening. But perhaps you mean it gets harder over time as all possible inventions get discovered and implemented? That's a problem? That sounds like Nirvana: every possible improvement realized! From then on, investment is indeed impossible, and you can go back to just spending your money on all the things that investment has made possible and not investing any further.

I'm really not worried about the lack of need for investment in Heaven, LOL.

Investing is an exchange like all others that money makes easier, but is a little special in that it is an exchange for a future good. More literally, it is an exchange for a claim to a good in the future, say 20 oz gold now for a claim to 21 oz gold next year. This is 5% interest nominally. If there is deflation, the real rate is even higher, as that each oz gold I get next year can buy more than an oz gold could right now.

"High defation means debtors have a constantly increasing debt load and are more likely to default."

True. It makes entrepreneurs more discriminating in what they invest in because it requires their project to net a higher nominal rate of return to pay back the debt. This is a good thing, actually. The reverse is artificially low rates of interest (the current climate caused by the Fed printing money to lower the rate), which tempt entrepreneurs to invest unwisely in anything that might have a net gain of a few percent. These end up being malinvestments that have to be liquidated later, causing great distress in the economy.

But really, if entrepreneurs are having a hard time finding good new ways to create capital improvements, they will borrow less, which will lower interest rates. A free market always clears, so you don't have to worry about high or low rates of interest, they will be the "right level" on a free market. You only have to worry about the freedom of the market, which is what Austrians focus on.

"why Austrians often adamently defend the gold standard.  It's the precise opposite of a free market system. You are essentially requiring the government to fix the price of a commodity to its currency."

No. A gold standard is not a government activity, actually. It is government *refraining* from interfering with the free market participants who chose gold (or silver or anything else) as their money and making them use something else over which the government has complete control.

Under a gold standard, people really use gold. If a bank accepts gold deposits and issues redemption tickets, and people start trading the tickets as a money, they are still essentially using gold so long as those tickets are completely equivalent to gold because they are redeemable on demand for gold, i.e., so long as the bank is not committing the fraud of issuing more tickets than it has gold to exchange for the tickets. These are, strictly speaking, money substitutes and are often more convenient than coins or bullion, but only when redeemable in them.

If a government issues a gold-based currency, then of course it has to play by the same rules as any bank, goldsmith, vault-owner, or any other market participant. It cannot issue more paper tickets for gold than it has gold to redeem. Creating two indistinguishable claims to the same deposit is fraud.

"requiring the government to fix the price of a commodity to its currency"

This is an odd way to say the same thing. Yes, a currency ticket that says 'redeemable for 3 grams gold' should always be redeemable for 3 grams gold. Not 2 or 1 or a half gram, if the government (or vault-owner, whether goldsmith or bank or other person) later decides. It legally represents ownership of what is in the vault, which is why it can be used in trade for goods and services. That is its value. Changing the value after giving it out is as fraudulent as changing the terms of a contract after it is signed. Calling it "fixing the price" is an emotionally charged equivalent. If you have a signed quote for a quantity of goods at a "fixed price", you are happy, so long as the other guy doesn't later un-fix the price in his favor.

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#12) On June 29, 2011 at 4:27 PM, whereaminow (< 20) wrote:

Ah yes, the old Gold standard is price fixing!! argument. It shows such a poor understanding of property rights.

When you check your coat at the restaurant or club, they hand you a claim check. Do you berate them for fixing the price of your coat to 1 claim check?  ROFL, I hope not.

Likewise, when you deposit gold at a money warehouse and they give you a claim check, they are not fixing the price.  It is a receipt for your property.

The statist academics have done a wonderful job confusing people about property rights.  

David in Qatar

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#13) On June 29, 2011 at 5:48 PM, rfaramir (29.27) wrote:

David,

"Ah yes, the old Gold standard is price fixing!! argument. It shows such a poor understanding of property rights."

I think it is both worse than that and not so bad. Not so bad since, acutally, Jakilla, no doubt, understands property rights, when he knows that that's what being talked about. Worse, because it's not just "poor understanding," he has been deliberately misled.

"The statist academics have done a wonderful job confusing people about property rights."

Exactly! He and others following the statists have been miseducated about money so they don't think about it in terms of property rights. Except in so far as he's responsible for listening to them, it's their fault, not his.

And why do they do that? So that the state that they worship can steal us blind by controlling the supply of the money they force us to use. If we even occasionally redeemed notes in coin or bullion money (specie), it would keep them honest by making it as plain as a hat-check claim. By never redeeming them, they mentally move money out of the category of regular property, leaving them mere tokens that of course the government can do anything they want with, and we have to adjust ourselves to it.

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#14) On June 29, 2011 at 6:54 PM, whereaminow (< 20) wrote:

By never redeeming them, they mentally move money out of the category of regular property, leaving them mere tokens that of course the government can do anything they want with, and we have to adjust ourselves to it.

Bang!  Right on brother!

A while back, Ron Paul asked Ben Bernanke to define the dollar. At first, it appeared that Ben didn't understand the question (scary) or he was just being coy (arrogant academic).  Then Bernanke stated that a dollar was defined as the goods and services it can purchase.

But, big Ben... that means the definition of a dollar changes constantly.  How is that a definition?  In fact, since the subjective value scales of millions of market actors are constantly adjusting, Ben's definition of a dollar changed while he was completing his sentence telling us what the definition is!

Yet, according to statist academics, Ron is the nutjob.

David in Qatar

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#15) On June 29, 2011 at 7:55 PM, ajm101 (32.67) wrote:

Jakila, one of the better posts here in a while.  Thanks.

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#16) On June 29, 2011 at 9:54 PM, dbjella (< 20) wrote:

I liked the discussion.  I wish Jakila was able to respond.  I still think inflation is not good and I have yet to read an argument that makes sense to me.  I want my dollars to be worth something, but sadly this is not what has happened in my lifetime.  Instead, I like most everyone else move most of my savings to investing.  It shouldn't be this way.  I suppose some of you will say that nobody is stopping me from saving, but sadly, I wish it was different.

Oh well, I have dabbled in gold and silver that has done wonderfully to protect me :) 

 

 

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#17) On July 06, 2011 at 11:14 AM, ikkyu2 (99.18) wrote:

Negative interest rates are not a farce, of course; the explicit goal of QE1 was to create an effective interest rate of -5.5%.

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#18) On July 06, 2011 at 1:46 PM, rfaramir (29.27) wrote:

Not a farce for the central planner, maybe, who wants to steal your purchasing power for his god the State.

But no investor wants to use a currency whose value continuously erodes. It is not in his interest to do so. For us, holding fiats is a farce, because of negative real interest rates.

I didn't mean to imply they didn't or couldn't exist, just that they make obvious how ridiculous it would be to use a currency whose issuer followed these monetarist rules.

Demand the freedom to trade using the currency of your choice! End the Fed!

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#19) On July 09, 2011 at 6:00 PM, ikkyu2 (99.18) wrote:

Er, holding cash and cash equivalents is beneficial when real rates are negative.  So is doing nearly anything but holding bonds or CDs or savings accounts.

Rates have to be correlated to the money supply to avoid all kinds of bad incentives; when the money supply shrinks by 30% per annum as it was doing in 2008 and part of 2009, negative real rates are essential if capital is going to continue to be deployed on capital investment type projects - you know the ones I mean: the ones that make paying jobs.

The Fed is not a government organ; it is an association of banks, very wealthy and powerful ones.  They do not stop existing or making the rules you and I must play by, just because you or I think they should. 

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