At Barron’s: Are Low Rates to Blame for Bubbles?

(I write a monthly opinion piece for Barron’s. These sometimes run in the print edition, which I appreciate — it’s a vote of confidence from the editors, and means more readers. It does impose a tighter word count limit, though. The text below is the longer version I originally submitted. The version that was published is here. All of my previous Barron’s pieces are here.)

The past year has seen a parade of financial failures and asset crashes. Silicon Valley bank was the first bank failure since 2020, and the biggest since 2008. Before that came the collapse of FTX, and of much of the larger crypto ecosystem. Corporate bankruptcies are coming faster than at any time since 2011.  Even luxury watches are in freefall. 

The proximate cause of much of this turmoil is the rise in interest rates. So it’s natural to ask if the converse is true. Is the overvaluing of so many worthless assets  – whether through bubbles or fraud – the fault of a decade-plus of low rates? For those who believe this, the long period of low rates following the global financial crisis fueled an “everything bubble”, just as the earlier period of low rates fueled the housing boom of the 2000s. The rise of fragile or fraudulent institutions, which float up on easy credit before inevitably crashing back to earth, is a sign that monetary policy should never have been so loose. As journalist Rana Foorohar put it in a much-discussed article, “Keeping rates too low for too long encourages speculation and debt bubbles.”

You can find versions of this argument being made by  prominent Keynesians, as well as by economists of a more conservative bent. At the Bank for International Settlements “too low for too long” is practically a mantra. But, does the story make sense?

Yes, low interest rates are associated mean high asset prices. But that’s not the same as a bubble.To the extent an asset represents a stream of future payments, a low discount rate should raise its value. 

On the other hand, asset prices are not just about discounted future income streams; they also incorporate a bet on the future price of the asset itself. If a fall in interest rates leads to a rise in asset prices, market participants may mistakenly expect that rise to continue. That could lead to assets being overvalued even relative to the current low rates.

Another argument one sometimes hears for why low rates lead to bubbles is that when income from safe assets is low, investors will “reach for yield” by taking on more risk, bidding up the price of more speculative assets. Investors’ own liabilities also matter. When it’s cheap and easy to borrow, an asset may be attractive that wouldn’t be if financing were harder to come by.

But if low interest rates make acquiring risky assets more attractive, is that a problem? After all, that’s how monetary policy is supposed to work. The goal of rate cuts is precisely to encourage investment spending that wouldn’t happen if rates were higher.  As I argued recently, it’s not clear that most business investment is very responsive to interest rates. But whether the effect on the economy is strong or weak,  “low interest rates cause people to buy assets they otherwise wouldn’t” is just monetary policy working as intended.

Still, intended results may have unintended consequences. When people are reaching for yield, the argument goes, they are more likely to buy into projects that turn out to be driven by fraud, hype or fantasy.

Arguments for the dangers of low rates tend to take this last step for granted. But it’s not obvious why an environment of low yields should be more favorable to frauds. Projects with modest expected returns are, after all, much more common than projects with very high ones; when risk-free returns are very low, there should be more legitimate higher-yielding alternatives, and less need for risky long shots. Conversely, it is the projects that promise very high returns that are most likely to be frauds  — and that are viable at very high rates.

Certainly this was Adam Smith’s view. For him, the danger of speculation and fraud was not an argument for high interest rates, but the opposite. If legal interest rates were “so high as 8 or 10 percent,” he believed, then “the greater part of the money which was to be lent would be lent to prodigals and projectors, who alone would be willing to give this high interest. Sober people … would not venture into the competition.” 

The FTX saga is an excellent example. At one point, Sam Bankman-Fried—a projector and prodigal if ever there was one—offered as much as 20% on new loans to his hedge fund, Alameda, according to The Wall Street Journal. It wouldn’t take low rates to make that attractive — if he was good for it. But, of course, he was not. And that is the crux of the problem. Someone like Bankman-Fried is not offering a product with low but positive returns, that would be attractive only when rates are low but not when they were high. He was offering a product with an expected return that, in retrospect, was in the vicinity of -100 percent. Giving  him your money to him would be a bad idea at any interest rate. 

We can debate what it would take to prevent fraud-fueled bubbles in assets like cryptocurrency. Perhaps it calls for tighter restrictions on the kinds of products that can be offered for sale, or more stringent rules on the choices of retail investors. Or perhaps, given crypto’s isolation from the broader financial system, this is a case where it’s ok to just let the buyer beware. In any case, the problem was not that crypto offered higher returns than the alternative. The problem was that people believed the returns in crypto were much higher than they actually were. Is this a problem that interest rates can solve?

Let’s suppose for the sake of argument that it is. Suppose that without the option of risk-free returns of 3 or 4 or 5 percent, people will throw their money away on crazy longshots and obvious frauds. If you take this idea seriously, it has some funny implications. Normally, when we ask why asset owners are entitled to their income in the first place, the answer is that it’s an incentive to pick out the projects with the highest returns. (Hopefully these are also the most socially useful ones.) The “too low for too long” argument turns this logic on its head. It says that asset owners need to be guaranteed high returns because they can’t tell a good project from a bad one.

That said, there is one convincing version of this story. For all the reasons above, it does not make sense to think of ordinary investors being driven toward dangerous speculation by low interest rates. Institutions like insurance and pension funds are a different matter. They have long-term liabilities that are more or less fixed and, critically, independent of interest rates. Their long investment horizons mean their loss of income from lower rates will normally outweigh their capital gains when they fall. (This is one thing the BIS surely gets right.) When the alternative is insolvency, it can make sense to choose a project where the expected return is negative, if it offers a chance of getting out of the hole. That’s a common explanation for the seemingly irresponsible loans made by many Savings & Loans in the 1980s—faced with bankruptcy, they “gambled for resurrection.” One can imagine other institutions making a similar choice.

What broke the S&Ls in was high rates, not low ones. But there is a common thread. A structure set up when interest rates are in a certain range may not work when they move outside of it. A balance sheet set up on the basis of interest rates in some range will have problems if they move outside it. 

Modern economies depend on a vast web of payment expectations and commitments stretching far into the future. Changes in interest rates modify many change of those future payments; whether upward or downward, this means disappointed expectations and broken commitments. 

If the recent period of low rates was financially destabilizing,  then, the problem wasn’t the not low rates in themselves. It was that they weren’t what was planned on. If the Fed is going to draw general lessons from the bubbles that are now popping, it should not be about the dangers of low rates, but that of drastic and unexpected moves in either direction. 

At Barron’s: Americans Owe Less Than They Used To. Will the Fed Change That?

(I write a monthly opinion piece for Barron’s. This one was published there in September.)

Almost everyone, it seems, now agrees that higher interest rates mean economic pain. This pain is usually thought of in terms of lost jobs and shuttered businesses. Those costs are very real. But there’s another cost of rate increases that is less discussed: their effect on balance sheets.

Economists tend to frame the effects of interest rates in terms of incentives for new borrowing. As with (almost) anything else, if loans cost more, people will take less of them. But interest rates don’t matter only for new borrowers, they also affect people who borrowed in the past. As debt rolls over, higher or lower current rates get passed on to the servicing costs of existing debt. The effect of interest rate changes on the burden of existing debt can dwarf their effect on new borrowing—especially when debt is already high.

Let’s step back for a moment from current debates. One of the central macroeconomic stories of recent decades is the rise in household debt. In 1984, it was a bit over 60% of disposable income, a ratio that had hardly changed since 1960. But over the next quarter-century, debt-income ratios would double, reaching 130%. This rise in household debt was the background of the worldwide financial crisis of 2007-2008, and made household debt a live political question for the first time in modern American history.

Household debt peaked in 2008; it has since fallen almost as quickly as it rose. On the eve of the pandemic, the aggregate household debt-income ratio stood at 92%—still high, by historical standards, but far lower than a decade before.

These dramatic swings are often explained in terms of household behavior. For some on the political right, rising debt in the 1984-2008 period was the result of misguided government programs that encouraged excessive borrowing, and perhaps also a symptom of cultural shifts that undermined responsible financial management. On the political left, it was more likely to be seen as the result of financial deregulation that encouraged irresponsible lending, along with income inequality that pushed those lower down the income ladder to spend beyond their means.

Perhaps the one thing these two sides would agree on is that a higher debt burden is the result of more borrowing.

But as economist Arjun Jayadev and I have shown in a series of papers, this isn’t necessarily so. During much of the period of rising debt, households borrowed less on average than during the 1960s and 1970s. Not more. So what changed? In the earlier period, low interest rates and faster nominal income growth meant that a higher level of debt-financed expenditure was consistent with stable debt-income ratios.

The rise in debt ratios between 1984 and 2008, we found, was not mainly a story of people borrowing more. Rather, it was a shift in macroeconomic conditions that meant that the same level of borrowing that had been sustainable in a high-growth, low-interest era was unsustainable in the higher-interest environment that followed the steep rate hikes under Federal Reserve Chair Paul Volcker. With higher rates, a level of spending on houses, cars, education and other debt-financed assets that would previously have been consistent with a constant debt-income ratio, now led to a rising one.

(Yes, there would later be a big rise in borrowing during the housing boom of the 2000s. But this is not the whole story, or even the biggest part of it.)

Similarly, the fall in debt after 2008 in part reflects sharply reduced borrowing in the wake of the crisis—but only in part. Defaults, which resulted in the writing-off of about 10% of household debt over 2008-2012, also played a role. More important were the low interest rates of these years. Thanks to low rates, the overall debt burden continued to fall even as households began to borrow again.

In effect, low rates mean that the same fraction of income devoted to debt service leads to a larger fall in principal—a dynamic any homeowner can understand.

The figure nearby illustrates the relative contributions of low rates and reduced borrowing to the fall in debt ratios after 2008. The heavy black line is the actual path of the aggregate household debt-income ratio. The red line shows the path it would have followed if households had not reduced their borrowing after 2008, but instead had continued to take on the same amount of new debt (as a share of their income) as they did on average during the previous 25 years of rising debt. The blue line shows what would have happened to the debt ratio if households had borrowed as much as they actually did, but had faced the average effective interest rate of that earlier period.

As you can see, both reduced borrowing and lower rates were necessary for household debt to fall. Hold either one constant at its earlier level, and household debt would today be approaching 150% of disposable income. Note also that households were paying down debt mainly during the crisis itself and its immediate aftermath—that’s where the red and black lines diverge sharply. Since 2014, as household spending has picked up again, it’s only thanks to low rates that debt burdens have continued to fall.

(Yes, most household debt is in the form of fixed-rate mortgages. But over time, as families move homes or refinance, the effective interest rate on their debt tends to follow the rate set by the Fed.)

The rebuilding of household finances is an important but seldom-acknowledged benefit of the decade of ultra-low rates after 2007. It’s a big reason why the U.S. economy weathered the pandemic with relatively little damage, and why it’s growing so resiliently today.

And that brings us back to the present. If low rates relieved the burden of debt on American families, will rate hikes put them back on an unsustainable path?

The danger is certainly real. While almost all the discussion of rate hikes focuses on their effects on new borrowing, their effects on the burden of existing debt are arguably more important. The 1980s—often seen as an inflation-control success story—are a cautionary tale in this respect. Even though household borrowing fell in the 1980s, debt burdens still rose. The developing world—where foreign borrowing had soared in response to the oil shock—fared much worse.

Yes, with higher rates people will borrow less. But it’s unlikely they will borrow enough less to offset the increased burden of the debt they already have. The main assets financed by credit—houses, cars, and college degrees—are deeply woven into American life, and can’t be easily foregone. It’s a safe bet that a prolonged period of high rates will result in families carrying more debt, not less.

That said, there are reasons for optimism. Interest rates are still low by historical standards. The improvement in household finances during the post-2008 decade was reinforced by the substantial income-support programs in the relief packages Congress passed in response to the pandemic; this will not be reversed quickly. Continued strong growth in employment means rising household incomes, which, mechanically, pushes down the debt-income ratio.

Student debt cancellation is also well-timed in this respect. Despite the fears of some, debt forgiveness will not boost  current demand—no interest has been paid on this debt since March 2020, so the immediate effect on spending will be minimal. But forgiveness will improve household balance sheets, offsetting some of the effect of interest rate hikes and encouraging spending in the future, when the economy may be struggling with too little demand rather than (arguably) too much.

Reducing the burden of debt is also one of the few silver linings of inflation. It’s often assumed that if people’s incomes are rising at the same pace as the prices of the things they buy, they are no better off. But strictly speaking, this isn’t true—income is used for servicing debt as well as for buying things. Even if real incomes are stagnant or falling, rising nominal incomes reduce the burden of existing debt. This is not an argument that high inflation is a good thing. But even bad things can have benefits as well as costs.

Will we look back on this moment as the beginning of a new era of financial instability, as families, businesses, and governments find themselves unable to keep up with the rising costs of servicing their debt? Or will the Fed be able to declare victory before it has done too much damage? At this point, it’s hard to say.

Either way we should focus less on how monetary policy affects incentives, and more time on how it affects the existing structure of assets and liabilities. The Fed’s ability to steer real variables like GDP and employment in real time has, I think, been greatly exaggerated. Its long-run influence over the financial system is a different story entirely.

Fisher Dynamics Revisited

Back in the 2010s, Arjun Jayadev and I wrote a pair of papers (one, two) on the evolution of debt-income ratios for US households. This post updates a couple key findings from those papers. (The new stuff begins at the table below.)

Rather than econometric exercises, the papers were based on a historical accounting decomposition —  an approach that I think could be used much more widely. We separated changes in the debt-income ratio into six components — the primary deficit (borrowing net of debt service payments); interest payments; real income growth; inflation; and write downs of debt through default — and calculated the contribution of each to the change in debt ratios over various periods. This is something that is sometimes done for sovereign debt but, as far as I know, we were the first to do it for private debt-income ratios.

We referred to the contributions of the non-borrowing components as “Fisher dynamics,” in honor of Irving Fisher’s seminal paper on depressions as “debt deflations.” A key aspect of the debt-deflation story was that when nominal incomes fell, the burden of debt could rise even as debtors sharply reduced new borrowing and devoted a greater share of their income to paying down existing debt. In Fisher’s view, this was one of the central dynamics of the Great Depression. Our argument was that something like a slow-motion version of this took place in the US (and perhaps elsewhere) in recent decades.

The logic here is that the change in debt-income ratios is a function not only of new borrowing but also of the effects of interest, inflation and (real) income growth on the existing debt ratio, as well as of charge offs due to defaults.

Imagine you have a mortgage equal to double your annual income. That ratio can go down if your current spending is less than your income, so that you can devote part of your income to paying off the principal. Or it can go down if your income rises, i.e. by raising the denominator rather than lowering the numerator. It can also go down if you refinance at a lower interest rate; then the same fraction of your income devoted to debt service will pay down the principal faster. Our of course it can go down if some or all of it is written off in bankruptcy.

It is possible to decompose actual historical changes in debt-income ratios for any economic unit or sector into these various factors. The details are in either of the papers linked above. One critical point to note: The contributions of debt and income growth are proportional to the existing debt ratio, so the higher it already is, the more important these factors are relative to the current surplus or deficit.

Breaking out changes in debt ratios into these components was what we did in the two papers. (The second paper also explored alternative decompositions to look at the relationship been debt ratio changes and new demand from the household sector.) The thing we wanted to explain was why some periods saw rising debt-income ratios while others saw stable or falling ones.

While debt–income ratios were roughly stable for the household sector in the 1960s and 1970s, they rose sharply starting in the early 1980s. The rise in household leverage after 1980 is normally explained in terms of higher household borrowing. But increased household borrowing cannot explain the rise in household debt after 1980, as the net flow of funds to households through credit markets was substantially lower in this period than in earlier postwar decades. During the housing boom period of 2000–2007, there was indeed a large increase in household borrowing. But this is not the case for the earlier rise in household leverage in 1983–1990, when the debt– income ratios rose by 20 points despite a sharp fall in new borrowing by households.

As we explained:

For both the 1980s episode of rising leverage and for the post-1980 period as a whole, the entire rise in debt–income ratios is explained by the rise in nominal interest rates relative to nominal income growth. Unlike the debt deflation of the 1930s, this ‘debt disinflation’ has received little attention from economists or in policy discussions.

Over the full 1984–2011 period, the household sector debt–income ratio almost exactly doubled… Over the preceding 20 years, debt–income ratios were essentially constant. Yet households ran cumulative primary deficits equal to just 3 percent of income over 1984–2012 (compared to 20 percent in the preceding period). The entire growth of household debt after 1983 is explained by the combination of higher interest payments, which contributed an additional 3.3 points per year to leverage after 1983 compared with the prior period, and lower inflation, which reduced leverage by 1.3 points per year less.

We concluded:

From a policy standpoint, the most important implication of this analysis is that in an environment where leverage is already high and interest rates significantly exceed growth rates, a sustained reduction in household debt–income ratios probably cannot be brought about solely or mainly via reduced expenditure relative to income. …There is an additional challenge, not discussed in this paper, but central to both Fisher’s original account and more recent discussions of ‘balance sheet recessions’: reduced expenditure by one sector must be balanced by increased expenditure by another, or it will simply result in lower incomes and/or prices, potentially increasing leverage rather than decreasing it. To the extent that households have been able to run primary surpluses since 2008, it has been due mainly to large federal deficits and improvement in US net exports.

We conclude that if reducing private leverage is a policy objective, it will require some combination of higher growth, higher inflation, lower interest rates, and higher rates of debt chargeoffs. In the absence of income growth well above historical averages, lower nominal interest rates and/or higher inflation will be essential. … Deleveraging via low interest rates …  implies a fundamental shift in monetary policy. If interest-rate policy is guided by the desired trajectory of debt ratios, it no longer can be the primary instrument assigned to managing aggregate demand. This probably also implies a broader array of interventions to hold down market rates beyond traditional open market operations, policies sometimes referred to as ‘financial repression.’ Historically, policies of financial repression have been central to almost all episodes where private (or public) leverage was reduced without either high inflation or large-scale repudiation.

These papers only went through 2011. I’ve thought for a while it would be interesting to revisit this analysis for the more recent period of falling household debt ratios. 

With the help of Arjun’s student Advait Moharir, we’ve now brought the same analysis forward to the end of 2019. Stopping there was partly a matter of data availability — the BEA series on interest payments we use is published with a considerable lag. But it’s also a logical period to look at, since it brings us up to the start of the pandemic, which one would want to split off anyway.

The table below is a reworked version of tables in the two papers, updated through 2019. (I’ve also adjusted the periodization slightly.) 

Due to …
Period Annual PP Change in Debt Ratio Primary Deficit Interest Growth Inflation Defaults
1929 – 1931 3.7 -5.5 2.9 2.8 2.9 *
1932 – 1939 -1.2 -1.5 2.4 -1.6 -0.7 *
1940 – 1944 -3.8 -1.6 1.3 -2.5 -1.9 *
1945 – 1963 2.6 2.5 2.6 -1.5 -0.8 *
1964 – 1983 0.0 0.8 5.1 -2.4 -3.5 *
1984 – 1999 1.7 -0.3 7.5 -2.9 -2.1 -0.4
2000 – 2008 4.5 2.4 7.2 -1.7 -2.5 -0.8
2009 – 2013 -5.4 -3.7 5.8 -3.1 -2.3 -2.4
2014 – 2019 -2.0 -1.4 4.6 -3.4 -1.3 -0.6

Again, our central finding in the earlier papers was that if we compare the 1984-2008 period of rising debt ratios to the previous two decades of stable debt ratios, there was no rise in the primary deficit. For 1984-2008 as a whole, annual new borrowing exceeded debt service payments by 0.7 percent of income on average, almost exactly the same as during the 1964-1983 period. (That’s the weighted average of the two sub-periods shown in the table.) Even during the housing boom period, when new borrowing did significantly exceed debt service, this explained barely a third of the difference in annual debt-ratio growth (1.6 out of 4.5 points).

The question now is, what has happened since 2008? What has driven the fall in debt ratios from 130 percent of household income in 2008 to 92 percent on the eve of the pandemic?

In the immediate aftermath of the crisis, sharply reduced borrowing was indeed the main story. Of the 10-point swing in annual debt-ratio growth (from positive 4.5 points per year to negative 5.4), 6 points is accounted for by the fall in net borrowing (plus another 1.5 points from higher defaults). But for the 2014-2019 period, the picture is more mixed. Comparing those six years to the whole 1984-2008 period of rising debt, we have a 4.7 point shift in debt ratio growth, from positive 2.7 to negative 2. Of that, 2.1 points is explained by lower net borrowing, while almost 3 points is explained by lower interest. (The contribution of nominal income growth was similar in the two periods.) So if we ask why household debt ratios continued to fall over the past decade, rather than resuming their rise after the immediate crisis period, sustained low interest rates are at least as important as household spending decisions. 

Another way to see this is in the following graph, which compares three trajectories: The actual one in black, and two counterfactuals in red and blue. The red counterfactual is constructed by combining the average 1984-2008 level of net borrowing as a fraction of income to the actual historical rates of interest, nominal income growth and defaults. The blue counterfactual is similarly constructed by combining the average 1984-2008 effective interest rate with historical levels of net borrowing, nominal income growth and defaults. In other words, the red line shows what would have happened in a world where households had continued to borrow as much after 2008 as in the earlier period, while the blue line shows what would have happened if households had faced the same interest rates after 2008 as before. 

As the figure shows, over the 2008-2019 period as a whole, the influence of the two factors is similar — both lines end up in the same place. But the timing of their impact is different. In the immediate wake of the crisis, the fall in new borrowing was decisive — that’s why the red and black lines diverge so sharply. But in the later part of the decade, as household borrowing moved back toward positive territory and interest rates continued to fall, the more favorable interest environment became more important. That’s why the blue line starts rising after 2012 — if interest rates had been at their earlier level, the borrowing we actually saw in the late 2010s would have implied rising debt ratios. 

As with the similar figures in the papers, this figure was constructed by using the law of motion for debt ratios:

where b is the debt-income ratio, d is the primary deficit, is the effective interest rate (i.e. total interest payments divided by the stock of debt), g is income growth adjusted for inflation, π is the inflation rate, and sfa is a stock-flow adjustment term, in this case the reduction of debt due to defaults. The exact sources and definitions for the various variables can be found in the papers. (One note: We do not have a direct measurement of the fraction of household debt written off by default for the more recent period, only the fraction of such debt written down by commercial banks. So we assumed that the ratio of commercial bank writeoffs of household debt to total writeoffs was the same for the most recent period as for the period in which we have data for both.)

Starting from the actual debt-ratio in the baseline year (in this case, 2007), each year’s ending debt-income ratio is calculated using the primary deficit (i.e. borrowing net of debt service payments), the share of debt written off in default, nominal income growth and the interest rate. All but one of these variables are the actual historical values; for one, I instead use the average value for 1984-2007. This shows what the path of the debt ratio would have been if that variable had been fixed at its earlier level while the others evolved as they did historically.  In effect, the difference between these counterfactual lines and the historical one shows the contribution of that variable to the difference between the two periods.

Note that the interest rate here is not the current market rate, but the effective or average rate, that is, total interest payments divided by the stock of debt. For US households, this fell from around 6 percent in 2007 to 4.4 percent by 2019 — less than the policy rate did, but still enough to create a very different trajectory, especially given the compounding effect of interest on debt over time. So while expansionary monetary policy is not the whole story of falling debt ratios since 2008, it was an important part of it. As I recently argued in Barrons, the deleveraging of US households is unimportant and under appreciated benefit of the decade of low interest rates after the crisis.

 

At Barron’s: What We Don’t Talk About When We Talk About Inflation

(I am now writing a monthly opinion piece for Barron’s. This one was published there in July.)

To listen to economic policy debates today, you would think the U.S. economy has just one problem: inflation. When Federal Reserve Chairman Jerome Powell was asked at his last press conference if there was a danger in going too far in the fight against inflation, his answer was unequivocal: “The worst mistake we could make is to fail—it’s not an option. We have to restore price stability…because [it’s] everything, it’s the bedrock of the economy. If you don’t have price stability, the economy’s really not going to work.”

Few would dispute that rising prices are a serious problem. But are they everything?

The exclusive focus on inflation acts like a lens on our view of the economy—sharpening our attention on some parts of the picture, but blurring, distorting, and hiding from view many others.

In the wake of the Great Recession, there was a broadening of macroeconomic debates. Economists and policy makers shifted away from textbook truisms toward a more nuanced and realistic view of the economy. Today, this wide-ranging conversation has given way to panic over rising prices. But the realities that prompted those debates have not gone away.

In the clamor over inflation, we’re losing sight of at least four big macroeconomic questions.

First, does the familiar distinction between supply and demand really make sense at the level of the economy as a whole? In the textbooks, supply means the maximum level of production in the economy, labeled “full employment” or “potential output,” while demand means total spending. The two are supposed to be independent—changes in spending don’t affect how much the economy can produce, and vice versa. This is why we are used to thinking of business cycles and growth as two separate problems.

But in the real world, supply often responds to demand—more spending calls forth more investment and draws people into the labor force. This phenomenon, known by the unlovely name “hysteresis,” was clearly visible in the slowdown of labor force and productivity growth after the Great Recession, and their recovery when demand picked up in the years before the pandemic. The key lesson of this experience—in danger of being forgotten in today’s inflation panic—was that downturns are even more costly than we thought, since they not only imply lost output today but reduced capacity in the future.

Hysteresis is usually discussed at the level of the economy as a whole, but it also exists in individual markets and industries. For example, one reason airfares are high today is that airlines, anticipating a more sustained fall in demand for air travel, offered early retirement to thousands of senior pilots in the early stages of the pandemic. Recruiting and training new pilots is a slow process, one airlines will avoid unless it’s clear that strong demand is here to stay. So while conventional wisdom says that rising prices mean that we have too much spending and have to reduce it, in a world with hysteresis a better solution may be to maintain strong demand, so that supply can rise to meet it. In the textbook, we can restore price stability via lower demand with no long-run costs to growth. But are we sure things work so nicely in the real world?

The second big question is about the labor market. Here the textbook view is that there is a unique level of unemployment that allows wages to grow in line with productivity. When unemployment is lower than this “natural rate,” faster wage growth will be passed on to rising prices, until policy makers take action to force unemployment back up. But in the years before the pandemic, it was becoming clear that this picture is too simplistic. Rising wages don’t have to be passed on to higher prices—they may also come at the expense of profits, or spur faster productivity growth. And not all wages are equally responsive to unemployment. Younger, less-educated, and lower-wage workers are more dependent on tight labor markets to find work and get raises, while the incomes of workers with experience and credentials rise more steadily regardless of macroeconomic conditions. This means that—as Powell has acknowledged—macroeconomic policy has unavoidable distributional consequences.

In his classic essay “Political Aspects of Full Employment,” the great Polish economist Michal Kalecki argued that even if it were economically feasible to eliminate unemployment, this would be unsustainable, since employers’ authority in the workplace depends on “the threat of the sack.” Similar arguments have been made by central bank chiefs such as Alan Greenspan, who suggested that low unemployment was sustainable in the 1990s only because workers had been traumatized by the deep recession of the decade before.

Some would argue that it’s unnecessarily wasteful and cruel to maintain labor discipline and price stability by denying millions of people the chance to do useful work—especially given that, prior to the pandemic, unemployment had fallen well below earlier estimates of the “natural rate” with no sign of accelerating inflation. But if we wish to have a permanent full-employment economy, we need to answer a difficult question: How should we manage distributional conflicts between workers and owners (and among workers), and motivate people to work when they have little to fear from losing their job?

A third set of questions concerns globalization. There are widespread fears that renewed Covid lockdowns in China may limit exports to the U.S. and elsewhere. Seen through the inflation lens, this looks like a source of rising prices and a further argument for monetary tightening. But if we take a step back, we might ask whether it is wise to organize the global economy in such a way that lockdowns in China, a war in Ukraine, or even a factory fire in Japan leave people all over the world unable to meet their basic needs. The deepening of trade and financial links across borders is sometimes presented as a fact of nature. But in reality it reflects policy choices that allowed global production of all kinds of goods—from semiconductors to Christmas decorations and latex gloves—to be concentrated in a handful of locations. In some cases, this concentration is motivated by genuine technical advantages of larger-scale production, in others by the pursuit of low wages. But either way, it reflects a prioritization of cost minimization over flexibility and resiliency. Whatever happens with inflation, this is a trade-off that will have to be revisited in coming years, as climate change makes further disruptions in global supply chains all but inevitable.

Then there is climate change. Here, the inflation lens doesn’t just recolor the picture but practically reverses it. Until recently, the conventional wisdom was that a carbon tax was the key policy tool for addressing climate. An Obama-era economist once quipped that the big question on climate was whether a carbon tax was 80% of the solution, or 100%. A carbon tax would increase the prices of energy, which still mainly comes from fossil fuels, and of travel by private car. As it happens, this is exactly what we have seen: Autos and energy have increased much faster than other prices, to the point that these two categories account for a majority of the excess inflation over the past year. In effect, we’ve seen something like a global carbon tax. But far from welcoming the disproportionate rise in the prices of carbon-intensive goods as a silver lining of inflation, both policy makers and the public see it as an urgent problem to be solved.

To be clear, people are not wrong to be unhappy at the rising cost of cars and energy. In the absence of practical alternatives, these high prices inflict real hardship without necessarily doing much to speed the transition from carbon. One reasonable lesson, then, is that a carbon tax high enough to substantially reduce emissions will be politically intolerable. And indeed, before the pandemic, many economists were already shifting away from a carbon-price-focused approach to climate policy toward an investment-centered approach.

Whether via carbon prices or investment, the only way to reduce carbon emissions is to leave fossil fuels in the ground. Yet an increasing swath of the policy conversation is focused on how to encourage more drilling by oil-and-gas companies, not just today but into the indefinite future. As a response to today’s rising energy prices, this is understandable, given the genuine limitations of renewable energy. But how can measures to boost the supply of fossil fuels be consistent with a longer-term program of decarbonization?

None of these questions have easy answers. But the danger of focusing too single-mindedly on inflation is that we may not even try to answer them.

No Maestros: Further Thoughts

One of the things we see in the questions of monetary policy transmission discussed in my Barron’s piece is the real cost of an orthodox economics education. If your vision of the economy is shaped by mainstream theory, it is impossible to think about what central banks actually do.

The models taught in graduate economics classes feature an “interest rate” that is the price of goods today in terms of identical goods in the future. Agents in these models are assumed to be able to freely trade off consumption today against consumption at any point in the future, and to distribute income from any time in the future over their lifetime as they see fit, subject only to the “no Ponzi” condition that over infinite time their spending must equal their income. This is a world, in other words, of infinite liquidity. There are no credit markets as such, only real goods at different dates.1

Monetary policy in this framework is then thought of in terms of changing the terms at which goods today trade for goods tomorrow, with the goal of keeping it at some “natural” level. It’s not at all clear how the central bank is supposed to set the terms of all these different transactions, or what frictions cause the time premium to deviate from the natural level, or whether the existence of those frictions might have broader consequences. 2 But there’s no reason to get distracted by this imaginary world, because it has nothing at all to do with what real central banks do.

In the real world, there are not, in general, markets where goods today trade for identical goods at some future date. But there are credit markets, which is where the price we call “the interest rate” is found. The typical transaction in a credit market is a loan — for example, a mortgage. A mortgage does not involve any trading-off of future against present income. Rather, it is income-positive for both parties in every period.

The borrower is getting a flow of housing services and making a flow of mortgage payments, both of which are the same in every period. Presumably they are getting more/better housing services for their mortgage payment than they would for an equivalent rental payment in every period (otherwise, they wouldn’t be buying the house.) Far from getting present consumption at the expense of future consumption, the borrower probably expects to benefit more from owning the house in the future, when rents will be higher but the mortgage payment is the same.

The bank, meanwhile, is getting more income in every period from the mortgage loan than it is paying to the holder of the newly-created deposit. No one associated with the bank is giving up any present consumption — the loan just involves creating two offsetting entries on the bank’s books. Both parties to the transaction are getting higher income over the whole life of the mortgage.

So no one, in the mortgage transaction, is trading off the present against the future. The transaction will raise the income of both sides in every period. So why not make more mortgages to infinity? Because what both parties are giving up in exchange for the higher income is liquidity. For the homeowner, the mortgage payments yield more housing services than equivalent rent payments, but they are also harder to adjust if circumstances change. Renting gives you less housing for your buck, but it’s easier to move if it turns out you’d rather live somewhere else. For the bank, the mortgage loan (its asset) carries a higher interest rate than the deposit (its liability), but involves the risk that the borrower will not repay, and also the risk that, in a crisis, ownership of the mortgage cannot be turned into immediate cashflows while the deposit is payable on demand.

In short, the fundamental tradeoff in credit markets – what the interest rate is the price of – is not less now versus more later, but income versus liquidity and safety.3

Money and credit are hierarchical. Bank deposits are an asset for us – they are money – but are a liability for banks. They must settle their own transactions with a different asset, which is a liability for the higher level of the system. The Fed sits at the top of this hierarchy. That is what makes its actions effective. It’s not that it can magically change the terms of every transaction that involves things happening at different dates. It’s that, because its liabilities are what banks use to settle their obligations to each other, it can influence how easy or difficult they find it to settle those liabilities and hence, how willing they are to take on the risk of expanding their balance sheets.

So when we think about the transmission of monetary policy, we have to think about two fundamental questions. First, how much do central bank actions change liquidity conditions within the financial system? And second, how much does real activity depends on the terms on which credit is available?

We might gloss this as supply and demand for credit. The mortgage, however, is typical of credit transactions in another way: It involves a change in ownership of an existing asset rather than the current production of goods and services. This is by far the most common case. So some large part of monetary policy transmission is presumably via changes in prices of assets rather than directly via credit-financed current production. 4 There are only small parts of the economy where production is directly sensitive to credit conditions.

One area where current production does seem to be sensitive to interest rates is housing construction. This is, I suppose, because on the one hand developers are not large corporations that can finance investment spending internally, and on the other hand land and buildings are better collateral than other capital goods. My impression – tho I’m getting well outside my area of expertise here – is that some significant part of construction finance is shorter maturity loans, where rates will be more closely linked to the policy rate. And then of course the sale price of the buildings will be influenced by prevailing interest rates as well. As a first approximation you could argue that this is the channel by which Fed actions influence the real economy. Or as this older but still compelling article puts it, “Housing IS the business cycle.

Of course there are other possible channels. For instance, it’s sometimes argued that during the middle third of the 20th century, when reserve requirements really bound, changes in the quantity of reserves had a direct quantitative effect on the overall volume of lending, without the interest rate playing a central role one way or the other. I’m not sure how true this is — it’s something I’d like to understand better — but in any case it’s not relevant to monetary policy today. Robert Triffin argued that inventories of raw materials and imported commodities were likely to be financed with short term debt, so higher interest rates would put downward pressure on their prices specifically. This also is probably only of historical interest.

The point is, deciding how much, how quickly and how reliably changes in the central bank’s policy rate will affect real activity (and then, perhaps, inflation) would seem to require a fairly fine-grained institutional knowledge about the financial system and the financing needs of real activity. The models taught in graduate macroeconomics are entirely useless for this purpose. Even for people not immersed in academic macro, the fixation on “the” interest rate as opposed to credit conditions broadly is a real problem.

These are not new debates, of course. I’ve linked before to Juan Acosta’s fascinating article about the 1950s debates between Paul Samuelson and various economists associated with the Fed.5 The lines of debate then were a bit different from now, with the academic economists more skeptical of monetary policy’s ability to influence real economic outcomes. What Fed economist Robert Roosa seems to have eventually convinced Samuelson of, is that monetary policy works not so much through the interest rate — which then as now didn’t seem to have big effect on investment decision. It works rather by changing the willingness of banks to lend — what was then known as “the availability doctrine.” This is reflected in later editions of his textbook, which added an explanation of monetary policy in terms of credit rationing.

Even if a lender should make little or no change in the rate of interest that he advertises to his customers, there may probably still be the following important effect of “easy money.” …  the lender will now be rationing out credit much more liberally than would be the case if the money market were very tight and interest rates were tending to rise. … Whenever in what follows I speak of a lowering of interest rates, I shall also have in mind the equally important relaxation of the rationing of credit and general increase in the availability of equity and loan capital to business.

The idea that “the interest rate” is a metaphor or synecdoche for a broader easing of credit conditions is important step toward realism. But as so often happens, the nuance has gotten lost and the metaphor gets taken literally.

At Barron’s: There Are No Maestros

(A week ago, I had an opinion piece in Barron’s, which I am belatedly posting here. I talk a bit more about this topic in the following post.)

In today’s often acrimonious economic debates, one of the few common grounds is reverence for the Fed. Consider Jay Powell: First nominated to the Fed’s board of governors by President Obama, he was elevated to FOMC chair by Trump and renominated by Biden His predecessors Bernanke, Greenspan and Volcker were similarly first appointed by a president from one party, then reappointed by a president from the other. Politics stops at Maiden Lane.

There are disagreements about what the Fed should be doing — tightening policy to rein in inflation, or holding back to allow for a faster recovery. But few doubt that it’s the Fed’s job to make the choice, and that once they do, they can carry it out.

Perhaps, though, we should take a step back and ask if the Fed is really all-powerful. You might like to see inflation come down; I’d like to see stronger labor markets. But can the Fed give either of us what we want?

During the so-called Great Moderation, it was easy to have faith in the Fed. In the US, as in most rich countries, governments had largely turned over the job of macroeconomic management to independent central banks, and were enjoying an era of stable growth with low inflation. Magazine covers could, without irony, feature the Fed chair as  “Pope Greenspan and His College of Cardinals,” or (when the waters got choppier) the central figure in the “committee to save the world.”

Respectable opinion of the 1990s and 2000s was captured in a speech by Christina Romer (soon to be Obama’s chief economist), declaring that “the Federal Reserve, is directly responsible for the low inflation and the virtual disappearance of the business cycle in the last 25 years. …The story of stabilization policy of the last quarter century is one of amazing success.”

Romer delivered those words in late 2007. At almost exactly that moment, the US was entering its then-deepest recession since World War II.

The housing bubble and financial crisis raised some doubts about whether that success had been so amazing after all. The subsequent decade of slow growth and high unemployment, in the face of a Fed Funds rate of zero and multiple rounds of QE, should have raised more. Evidently the old medicine was no longer working – or perhaps had never worked as well as we thought.

In truth, there were always reasons for doubt.

One is that, as Milton Friedman famously observed, monetary policy acts with long and variable lags. A common  estimate is that the peak impact of monetary policy changes comes 18 to 24 months later, which is cripplingly slow for managing business cycles. Many people – including at the Fed – believe that today’s inflation is the transitory result of the pandemic. When the main effects of today’s tightening are felt two years from now, how confident are we that inflation will still be too high?

More fundamentally, there’s the question of what links monetary policy to inflation in the first place. Prices are, after all, set by private businesses; if they think it makes sense to raise prices, the Fed has no mind-control ray to convince them otherwise.

In the textbook story, changes in the Federal funds rate are passed through to other interest rates. A higher cost of borrowing discourages investment spending, reducing demand, employment and wages, which in turn puts downward pressure on prices. This was always a bit roundabout; today, it’s not clear that critical links in the chain function at all.

Business investment is financed with long-term debt; the average maturity of a corporate bond is about 13 years. But long rates don’t seem particularly responsive to the Federal funds rate. Between Fall 2015 and Spring 2019, for example, the Fed raised its policy rate by 2.5 points. Over this same period, the 10-year Treasury rate was essentially unchanged, and corporate bond yields actually fell. Earlier episodes show a similar non-response of long rates to Fed actions.

Nor is it obvious that business investment is particularly sensitive to interest rates, even long ones. One recent survey of the literature by Fed economists finds that hurdle rates for new investment “exhibit no apparent relation to market interest rates.”

Former Fed chair Ben Bernanke puzzled over “the black box” of monetary policy transmission. If it doesn’t move interest rates on the long-term debt that businesses mostly issue, and if even longer rates have no detectable effect on investment, how exactly is monetary policy affecting demand and inflation? It was a good question, to which no one has offered a very good answer.

To be sure, no one would claim that the Fed is powerless. Raise rates enough, and borrowers unable to roll over their loans will face default; as asset values fall and balance sheets weaken, households will have no choice but to drastically curtail consumption.

But being able to sink a ship is not the same as being able to steer it. The fact that the Fed can, if it tries hard enough, trigger a recession, does not mean that it can maintain steady growth. Perhaps it’s time to admit that there are no central banking “maestros” who know the secret of maintaining full employment and price stability. Balancing these critical social objectives requires a variety of tools, not just a single interest rate. And it is, for better or worse, the responsibility of our elected governments.

The Natural Rate of Interest?

(A year ago, I mentioned that Arjun Jayadev were writing a book about money. The project was then almost immediately derailed by covid, but we’ve recently picked it up again. I’ve decided to post some of what we’re writing here. Plucked from its context, it may be a bit unclear both where this piece is coming from and where it is going.)

The problem of interest rates is one of the key fissures between the vision of the economy in terms of the exchange of real stuff and and the reality of a web of money payments. Like a flat map laid over a globe, a rigid ideological vision can be made to lie reasonably smoothly over reality in some places only at the cost of ripping or crumpling elsewhere; the interest rate is one of the places that rips in the smooth fabric of economics most often occur. As such, it’s been a central problem since the emergence of economics as a distinct body of thought. How does the “real” rate determined by saving and investment demand get translated into the terms set for the exchange of IOUs between the bank and its customer?

One straightforward resolution to the problem is simply to deny that money plays a role in the determination of the interest rate. David Hume’s central argument in his essay “On Interest” (one of the first discussions within the genealogy of modern economics) was that changes in the supply of money do not affect the interest rate.1 

High interest arises from three circumstances: A great demand for borrowing; little riches to supply that demand; and great profits arising from commerce: And these circumstances are a clear proof of the small advance of commerce and industry, not of the scarcity of gold and silver… Those who have asserted, that the plenty of money was the cause of low interest, seem to have taken a collateral effect for a cause….  though both these effects, plenty of money and low interest, naturally arise from commerce and industry, they are altogether independent of each other. 

“Riches” here means real, material wealth, so this is an early statement of what we would today call the loanable-funds view of interest rates. Similar strong claims have been taken up by some of today’s more doctrinaire classical economists, in the form of what is known as neo-Fisherism. If the “real” rate, in the sense of the interest rate adjusted for inflation, is set by the fundamentals of preferences and technology, then central bank actions must change only the nominal rate. This implies that when the central bank raises the nominal interest rate, that must cause inflation to rise — not to fall, as almost everyone (including the central bankers!) believes. Or as Minneapolis Federal Reserve president Narayana Kocherlakota put it, if we believe that money is neutral, then “over the long run, a low fed funds rate must lead to … deflation.”2 This view is, not surprisingly, also popular among libertarians.

The idea that monetary influences on the interest rate are canceled out by changes in inflation had a superficial logic to it when those influences were imagined as a literal change in the quantity of money — of the relative “scarcity of gold and silver,” as Hume put it. If we imagine expansionary monetary policy as an increase in the fixed stock of money, then it might initially make money more available via loans, but over time as that money was spent, it would lead to a general rise in prices, leaving the real stock of money back where it started. 

But in a world where the central bank, or the private banking system, is setting an interest rate rather than a stock of money, this mechanism no longer works. More money, plus higher prices, leaves the real stock of money unchanged. But low nominal rates, plus a higher rate of inflation, leaves the real interest rate even lower. In a world where there is a fixed, central bank-determined money stock, the inflation caused by over-loose policy will cancel out that policy. But when the central bank is setting an interest rate, the inflation caused by over-loose policy implies an even lower real rate, making  the error even worse. For the real rate to be ultimately unaffected by monetary policy, low interest rates must somehow lead to lower inflation. But it’s never explained how this is supposed to come about. 

Most modern economists are unwilling to outright deny that central banks or the financial system can affect the rate of interest.3 Among other things, the privileged role of the central bank as macroeconomic manager is a key prop of policy orthodoxy, essential to stave off the possibility of other more intrusive forms of intervention. Instead, the disjuncture between the monetary interest rate observable in credit markets and the intertemporal interest rate of theory is papered over by the notion of the “natural” interest rate.

This idea, first formulated around the turn of the 20th century by Swedish economist Knut Wicksell, is that while banks can set any interest rate they want, there is only one interest rate consistent with stable prices and, more broadly, appropriate use of society’s resources. It is this rate, and not necessarily the interest rate that obtains at any given moment, that is set by the nonmonetary fundamentals of the economy, and that corresponds to the intertemporal exchange rate of theory. In the classic formulation of Milton Friedman, the natural rate of interest, with its close cousin the natural rate of unemployment, correspond to the rates that would be “ground out by the Walrasian system of general equilibrium equations, provided there is imbedded in them the actual structural characteristics of the labor and commodity markets, including market imperfections, stochastic variability in demands and supplies, the cost of gathering information about job vacancies and labor availabilities, the costs of mobility, and so on.”

The natural rate of interest is exactly the rate that you would calculate from a model of a rational individual trading off present against future — provided that the model was actually a completely different one.

Despite its incoherence, Friedman’s concept of the natural rate has had a decisive influence on economic thinking about interest in the 50 years since. His 1968 Presidential Address to the American Economics Association introducing the concept (from which the quote above comes) has been called “very likely the most influential article ever published in an economics journal” (James Tobin); “the most influential article written in macroeconomics in the past two decades” (Robert Gordon); “one of the decisive intellectual achievements of postwar economics” (Paul Krugman); “easily the most influential paper on macroeconomics published in the post-war era” (Mark Blaug and Robert Skidelsky). 4 The appeal of the concept is clear: It provides a bridge between the nonmonetary world of intertemporal exchange of economic theory, and the monetary world of credit contracts in which we actually live. In so doing, it turns the intertemporal story from a descriptive one to a prescriptive one — from an account of how interest rates are determined, to a story about how central banks should conduct monetary policy.

To understand the ideological function of R*, it’s useful to look at a couple of typical examples of how it’s used in mediating between the needs of managing a monetary economy and the real-exchange vision through which that economy is  imagined.

A 2018 speech by Fed Chair Jerome Powell is a nice example of how monetary policy practitioners think of the natural rate. He  introduces the idea of R* with the statement that “In conventional models of the economy, major economic quantities such as inflation, unemployment, and the growth rate of gross domestic product (GDP) fluctuate around values that are considered ‘normal,’ or ‘natural,’ or ‘desired.’” The slippage between the three last quoted terms is a ubiquitous and essential feature of discussions of R*. Like the controlled slipping between the two disks of a clutch in a car, it allows systems moving in quite different ways to be joined up without either fracturing from the stress. The ambiguity between these meanings is itself normal, natural and desired.

In a monetary policy context, Powell continues, these values are operationalized as “views on the longer-run normal values for the growth rate of GDP, the unemployment rate, and the federal funds rate.” Powell immediately glosses this as  “fundamental structural features of the economy …  such as the ‘natural rate of unemployment’.” Here again, we see a move from something that is expected to be true on average, to something that is a “fundamental structural feature” presumably linked to things like technology and demographics, and then to the term “natural”, which implies that these fundamental structures are produced by some quite different process than the network of money payments managed by the Fed. The term “natural” of course also implies beyond human control, and indeed, Powell says that these values “are not … chosen by anyone”. In the conventions of modeling, such natural, neutral, long-run, unchosen values are denoted with stars, so along with R* there is U* and a bevy of starred Greek letters. 

Powell, to be fair, goes on to talk about how difficult it is to navigate by these stars in practice, and criticizes his predecessors who were too quick to raise interest rates based on hazy, imprecise ideas of the natural rate of unemployment. But there’s a difference between saying the stars are hard to see, and that they are not there at all. He has not (or, plausibly, assumes his audience has not) escaped the scholastic and tautological habit of interpreting any failure of interest rate changes to deliver the expected result as a sign that the natural rate was different than expected.

It is, of course true, that if there is any stable relationship between the policy rate controlled by the Fed and a target like GDP or unemployment, then at any particular moment there is presumably some interest rate which would move that target to its desired level. But the fact that an action can produce a desired result doesn’t make it “natural” in any sense, or an unchanging structural feature of the world.

Powell, a non-economist, doesn’t make any particular effort to associate his normal or natural values with any particular theoretical model. But the normal and natural next step is to identify “fundamental structural features” of the world with the parameters of a non monetary model of real exchange among rational agents. Indeed, in the world of macroeconomics theory, that is what “deep structural parameters” mean. In the usage of Robert Lucas and his followers, which has come to dominate academic macroeconomics, structural parameters are those that describe the rational choices of agents based only on their preferences and the given, objective production function describing the economy. There’s no reason to think Powell has this narrower meaning in mind, but it’s precisely the possibility of mapping these meanings onto each other that allows the “natural rate” and its cousins to perform their ideological role.

For an example of that next step, let’s turn to a recent report from the Centre for Economic Policy Research, which assembles work by leading European macroeconomists. As with Powell’s speech, the ideological understanding of the natural rate is especially striking here because much of the substantive policy argument being made is so reasonable — fiscal policy is important, raising interest rates makes public debt problems worse, the turn to austerity after great financial crisis was a mistake. 

The CEPR economists begin with the key catechism of the real-exchange view of interest: “At its most basic level, the interest rate is the ‘price of time’ — the remuneration for postponing spending into the future.” R*, in other words, is a rate of interest determined by purely non monetary factors — it should be unaffected by developments in the financial system. This non monetary rate, 

while unobservable … provides a useful guidepost for monetary policy as it captures the level of the interest rate at which monetary policy can be considered neutral … when the economy runs below potential, pushing actual real policy rates sufficiently below R* makes policy expansionary. 

The notion of an unobservable guidepost doesn’t seem to have given the CEPR authors any pause, but it perfectly distills the contradiction embodied in the idea of R*. Yes, we can write down a model in which everyone has a known income over all future time, and with no liquidity constraints can freely trade future against present income without the need for specialized intermediaries. And we can then ask, given various parameters, what the going rate would be when trading goods at some future date for the same goods today. But given that we live in a world where the future is uncertain, where liquidity constraints are ubiquitous, and where a huge specialized financial system exists to overcome them, how do we pick one such model and say that it somehow corresponds to the real world?

And even if we somehow picked one, why would the intertemporal exchange rate in that world be informative for the appropriate level of interest rates in our own, given that the model abstracts away from the features that make monetary policy necessary and possible in the first place? In the world of the natural rate, there is no possibility for the economy to ever “run below potential” (or above it). Nor would there be any way for a single institution like a central bank to simultaneously change the terms of all those myriad private exchanges of present for future goods. 

Michael Woodford, whose widely-used graduate textbook Interest and Prices is perhaps the most influential statement of this way of thinking about monetary policy is, unusually, at least conscious of this problem. He notes that most accounts of monetary policy treat it as if the central bank is simply able to fix the price of all loan transactions, but it’s not clear how it does this or where it gets the power to do so. His answers to this question are not very satisfactory. But at least he sees the problem; the vast majority of people using this framework breeze right past it.

The CEPR writers, for instance, arrive at a definition of the natural rate as 

the real rate of interest that, averaged over the business cycle, balances the supply and demand of loanable funds, while keeping aggregate demand in line with potential output to prevent undue inflationary or deflationary pressure.

This definition simply jams together the intertemporal “interest rate” of the imagined non monetary world, with the interest rate target for monetary policy, without establishing any actual link between them. (Here again we see the natural rate as the clutch between theory and policy.) “Loanable funds” are supposed to be the real goods that their owners don’t currently want, which they agree to let someone else use.  The “while” conjunction suggests that clearing the loanable-funds market and price stability are two different criteria — that there could in principle be an interest rate that keep output at potential and inflation on target, but failed to clear the market for loanable funds. But what could this mean? Are there any observable facts about the world that would lead a central bank to conclude “the policy rate we have chosen seems to be consistent with price stability, but the supply and demand for loanable funds are not balanced”? Where would this imbalance show up? The operational meaning of the natural rate is that any rate associated with the macroeconomic outcomes sought by the central bank is, by definition, the “natural” one. And as Keynes long ago pointed out — it is a key argument of The General Theory  — the market for loanable funds always clears. There is no need for a market price balancing investment and saving, because any change in investment mechanically produces an exactly equal change in saving.

In practice, the natural rate means just this: We, the central bank, have set the interest rate under our control at a level that we hope will lead to our preferred outcomes for GDP, inflation, the unemployment rate, etc. Also, we can imagine a world in which rational agents trade present goods for future goods. Since in some such world the exchange rate between present and future goods would be the same as the policy rate we have chosen, our choice must be the optimal one.

 

 

 

 

 

On Negative Rates

Negative interest rates – weird, right?

In the five thousand years that interest rates have been recorded, they’ve never hit zero before.  Today, there’s some $15 trillion in negative-yielding bonds — admittedly down from $17 trillion last year, but still a very substantial fraction of the global bond market outside the US. At first it was only shorter bonds that were negative, but today German bunds are negative all the way out to 30 years. What’s going on? Does this mean it would be profitable to bulldoze the Rockies for farmland? Will it cause the extinction of the banking system? And more fundamentally, if the interest rate reflects the cost of a good today in terms of the same good next year, why would it ever be negative? Why would people place a higher value on stuff in the future than on stuff today?

Personally, I don’t think they’re so weird. And the reason I think that is that interest rates are not, in fact, the price of goods today in terms of goods tomorrow. It is, rather, the price of a financial asset that promises a certain schedule of money payments. Negative rates are only a puzzle in the real-exchange perspective that dominates economics, where we can safely abstract from money when discussing interest rates. In the money view, where interest transactions are swap of assets, or of a stream of money payments, nothing particularly strange about them. 

(I should say up front that this post is an attempt to clarify my own thinking. I think what I’m writing here is right, but I’m open to hearing why it’s wrong, or incomplete. It’s not a finished or settled position, and it’s not backed up by any larger body of work. At best, like most of what I wrote, it is informed by reading a lot of Keynes.)

The starting point for thinking about negative rates is to remember that these are market prices. Government is not setting a negative yield by decree, someone is voluntarily holding all those negative-yielding bonds. Or more precisely, someone is buying a bond at a price high enough, relative to the payments it promises, to imply a negative yield. 

Take the simplest example — a government bond that promises a payment of $100 at some date in the future, with no other payments in between. (A zero-coupon bond, in other words.) If the bond sells today for less than $100, the interest rate on it is positive. If the bond sells today for more than $100, the interest rate is negative. Negative yields exist insofar market participants value such a bond at greater than $100. 

So now we have to ask, what are the sources of demand for government bonds?

A lot of confusion is created, I think, by asking this question the wrong way. People think about saving, and about trading off spending today against spending tomorrow. This after all is the way an economics training encourages you to think about interest rates — as a shorthand for any exchange between present and future. Any transaction that involves getting less today in return for more tomorrow incorporates the interest rate as part of the price — at a high enough level of abstraction, they’re all the same thing. The college wage premium, say, is just as much an interest rate from this perspective as the yield on the bond. 

If we insist on thinking of interest rates this way, we would have to explain negative yields in terms of a society-wide desire to defer spending, and/or the absence of any store of wealth that even maintains its value, let alone increases it. Either of those would indeed be pretty weird!

(Or, it would be the equivalent of people paying more for a college education than the total additional wages they could expect to earn from it, or people paying more for a house than the total cost of renting an identical one for the rest of their lives. Which are both things that might happen! But also, that would be generally seen as something going wrong in the economic system.)

Since economists (and economics-influenced people) are so used to thinking of interest as reflecting a tradeoff between present and future, a kind of inter-temporal exchange rate, it’s worth an example to clarify why it isn’t. Imagine a typical household credit transaction, a car loan. The household acquires means to pay for the acquisition of a car, and commits to a schedule of payments to the bank; the bank gets the opposite positions. Is the household giving up future consumption in order to consume now? No. At every period, the value the household gets from the use of the car will exceed the payments the household is making for it — otherwise, they wouldn’t be doing it. If anything, since the typical term of a car loan is six or seven years while a new car should remain in service for a decade or more, the increased consumption comes in the future, when the car is paid off and still delivering transport services. Credit, in general, finances assets, not consumption. The reason car loans are needed is not to shift consumption from the future to the present, but because use of the transportation services provided by the car are tightly bound up with ownership of the car itself.

Nor, of course, is the lender shifting present consumption to the future. The lender itself, being a bank, does not consume. And no one else needs to forego or defer consumption for the banks to make the auto loan either. No one needs to deposit savings in a bank before it makes a loan; the lent money is endogenous, created by banks in the course of lending it. Whatever factors limit the willingness of the bank to extend additional auto loans — risk; liquidity; capital; regulation; transaction costs — a preference for current consumption is not among them. 

The intertemporal-exchange way of looking at government bonds would make sense if the only way to acquire one was to forego an equal amount of consumption, so that bond purchases were equivalent to saving in an economic sense. Then understanding the demand for government bonds, would be the same as understanding the desire to save, or defer consumption. But of course government bonds are not part of some kind of economy-wide savings equilibrium like that. First of all, the purchasers of bonds are not households, but banks and other financial actors. Second, the purchase of the bond does not entail a reduction in current spending, but a swap of assets. And third, the owners of bonds do not hold them in order to finance some intended real expenditure in the future, but rather for some combination of benefits from owning them (liquidity, safety, regulation) and an expectation of monetary profit. 

From the real-exchange perspective, there is one intertemporal price — the interest rate —  just as there is one exchange rate between any given pair of countries. From the money view perspective, there are many different interest rates, corresponding to the different prices of different assets promising future payments. Many of the strong paradoxes people describe from negative rates only exist if rates are negative across the board. But in reality, rates do not move in lockstep. We will set aside for now the question of how strong the arbitrage link between different assets actually is.

We can pass over these questions because, again, government bonds are not held for income. They are not held by households or the generic private sector. They are overwhelmingly held by banks and bank-like entities for some combination of risk, liquidity and regulatory motives, or by a broader set of financial institutions for return. Note for later: Return is not the same as income!

Let’s take the first set of motivations first. 

If you are a bank, you may want to hold some fraction of your assets as government bonds in order to reduce the chance your income will be very different from what you expected; reduce the chance that you will find yourself unable to make payments that you need or want to make (since it’s easy to sell the bonds as needed); and/or to reduce the chance that you’ll fall afoul of regulation  (which presumably is there because you otherwise might neglect the previous two goals).

The key point here is that these are benefits of holding bonds that are in addition to whatever return those bonds may offer. And if the ownership of government bonds provides substantial benefits for financial institutions, it’s not surprising they would be willing to pay for those services.

This may be clearer if we think about checking accounts. Scare stories about negative rates often ask what happens when households have to pay for the privilege of lending money to the bank. Will they withdraw it all as cash and keep it under the mattress? But of course, paying the bank to lend it money is the situation most people have always been in. Even before the era of negative rates, lots of people held money in checking accounts that carried substantial fees (explicit and otherwise) and paid no interest, or less than the cost of the fees. And of course unbanked people have long paid exorbitant amounts to be able to make electronic payments. In general, banks have no problem getting people to hold negative-yield assets. And why would they? The payments services offered by banks are valuable. The negative yield just reflects people’s willingness to pay for them.

In the national accounts, the difference between the interest that bank depositors actually receive and a benchmark rate that they in some sense should receive is added to their income as “imputed interest”, which reflects the value of the services they are getting from their low- or no- or negative-interest bank accounts. In 2019, this imputed interest came to about $250 billion for households and another $300 billion for non financial corporations. These nonexistent interest payments are, to be honest, an odd and somewhat misleading thing to include in the national accounts. But their presence reflects the genuine fact that people hold negative and more broadly below-market yield assets in large quantities because of other benefits they provide. 

Turned around this way, the puzzle is why government debt ever has a positive yield. The fundamental form of a bond sale is the creating of pair of offsetting assets and liabilities. The government acquires an asset in the form of a deposit, which is the liability of the bank; and the bank acquires an asset in the form of a bond, which is the liability of the government. Holding the bond has substantial benefits for the bank, while holding the deposit has negligible benefits for the government. So why shouldn’t the bank be the one that pays to make the transaction happen?

One possible answer is the cost of financing the holding. But, it is normally assumed that the interest rate paid by banks follows the policy rate. There’s no obvious reason for the downward shift in rates to affect spread between bank deposits and government bonds.  Of course some bank liabilities will carry higher rates, but again, that was true In the past too.

Another possible answer is the opportunity cost of not holding positive-yield asset. Again, this assumes that other yields don’t move down too. More fundamentally, it assumes a fixed size of bank balance sheets, so that holding more of one asset means less of another. In a world with with a fixed or exogenous money stock, or where regulations and monetary policy create the simulacrum of one, there is a cost to the bank of holding government debt, namely the income from whatever other asset it might have held instead. Many people still have this kind of mental model in thinking about government debt. (It’s implicit in any analysis of interest rates in terms of saving.) But in a world of endogenous credit money, holding more government debt doesn’t reduce a bank’s ability to acquire other assets. Banks’ ability to expand their balance sheets isn’t unlimited, but what limits it is concerns about risk or liquidity, or regulatory constraints. All of these may be relaxed by government debt holdings, so holding more government bonds may increase the amount of other assets banks can hold, not reduce it. In this case the opportunity cost would be negative. 

So why aren’t interest rates on government debt usually negative? As a historical matter, I suppose the reasons we haven’t seen negative yields in the past are, first, that under the gold standard, government bonds were not at the top of the hierarchy of money and credit, and governments had to pay to access higher-level money; in some contexts government debt may have been lower in the hierarchy than bank money as well. Second, in the postwar era the use of the interest rate for demand control has required central banks to ensure positive rates on public  as well as private debt. And third, the safety, liquidity and regulatory benefits of government debt holdings for the financial system weren’t as large or as salient before the great financial crisis of 2007-2009. 

Even if negative yields aren’t such a puzzle when we think about the sources of bank demand for government debt, we still have the question of how low they can go. Analytically, we would have to ask, how much demand is there for the liquidity, safety and regulatory-compliance services provided by sovereign debt holdings, and to what extent are there substitute sources for them?

But wait, you may be saying, this isn’t the whole story. Bonds are held as assets, not just as reserves for banks and bank-like entities. Are there no bond funds, are there no bond traders?

These investors are the second source of demand for government bonds. For them, return does matter. The goal of making a profit from holding the bond is the second motivation mentioned earlier.

The key point to recognize here is that return and yield are two different things. Yield is one component of return. The other is capital gains. The market price of a bond changes if interest rates change during the life of the bond, which means that the overall return on a negative-yielding bond can be positive. This would be irrelevant if bonds were held to maturity for income, but of course that is not bond investment works. 

For foreign holders, return also includes gains or losses from exchange rate changes, but we can ignore that here. Most foreign holders presumably hold government bonds as foreign exchange reserves, which is a subset of the safety/liquidity/regularity benefits discussed above. 

To understand how negative yielding bonds could offer positive returns, we have to keep in mind what is actually going on with bond prices, including negative rates. The borrower promises one or more payments of specified amounts at specified dates in the future. The purchaser then offers a payment today in exchange for that stream of future payments. What we call an interest rate is a description of the relationship between the promised payments and the immediate payment. We normally think of interest as something paid over a period of time, but strictly speaking the interest rate is a price today for a contract today. So unlike in the checking account case, the normal negative-rates situation is not the lender paying the borrower. 

Here’s an example. Suppose I offer to pay you $100 30 years from now. This is, formally, a zero-coupon 30-year bond. How much will you pay for this promse today? 

If you will pay me $41 for the promise, that is the same as saying the interest rate on the loan is 3 percent. (41 * 1.03 ^ 30 = 100). So an interest rate of 3 percent is just another way of saying that the current market price of a promise of $100 30 years from now is $41. 

If you will pay me $55 for the promise, that’s the same as an interest rate of 2 percent. If you’ll pay me $74, that’s the same as an interest rate of 1 percent.

If you’ll pay me $100 for the promise, that is of course equivalent to an interest rate of 0. And if you’ll pay me $135 for the promise of $100 30 years from now, that’s the equivalent of an interest of -1 percent. 

When we look at things this way, there is nothing special about negative rates. There is just continuous range of prices for an asset. Negative rates refer to the upper part of the range but nothing in particular changes at the boundary between them. Nothing magical or even noticeable happens when the price of an asset (in this case that promise of $100) goes from $99 to $101, any different from when it went from $97 to $99. The creditor is still paying the borrower today, the borrower is still paying the creditor in the future.

Now the next step: Think about what happens when interest rates change. 

Suppose I paid $135 for a promise of $100 thirty years from now, as in the example above. Again, this equivalent to an interest rate of -1 percent. Now it’s a year later, so I have a promise of $100 29 years from now. At an interest rate of -1 percent, that is worth $133.50. (The fact that the value of the bond declines over time is another way of seeing that it’s a negative interest rate.) But now suppose that, in the meantime, market interest rates have fallen to -2 percent. That means a promise of $100 29 years from now is now worth $178. (178 * 0.98 ^ 29 = 100.) So my bond has increased in value from $135 to $178, a capital gain of one-third! So if I think it is even modestly more likely that interest rates will fall than that they’ll rise over the next year, the expected return on that negative-yield bond is actually positive.

Suppose that it comes to be accepted that the normal, usual yield on say, German 10-year bunds is -1 percent. (Maybe people come to agree that the liquidity, risk and regulatory benefits of holding them are worth the payment of 1 percent of their value a year. That seems reasonable!) Now, suppose that the yield starts to move toward positive territory – for concreteness, say the current yield reaches 0, while people still expect the normal yield to be -1 percent. This implies that the rise to 0 is probably transitory. And if the ten-year bund returns to a yield of -1 percent, that implies a capital gain on the order of 10 percent for anyone who bought them at zero. This means that as soon as the price begins to rise toward zero, demand will rise rapidly. And the bidding-up of the price of the bund that happens in response to the expected capital gains, will ensure that the yield never in fact reaches zero, but stops rising before gets much above -1 percent. 

Bond pricing is a technical field, which I have absolutely no expertise in. But this fundamental logic has to be an important factor in decisions by investors (as opposed to financial institutions) who hold negative-yielding bonds in their portfolios. The lower you expect bond yields to be in the future, the higher the expected return on a bond with a given yield today. If a given yield gets accepted as usual or normal, then expected capital gains will rise rapidly when the yield rises above that — a dynamic that will ensure that the actual yield does not in fact depart far from the normal one. Capital gains are a bigger part of the return the lower the current yield is. So while high-yielding bonds can see price moves in response to fundamentals (or at least beliefs about them), these self-confirming expectations (or conventions) are likely to dominate once yields fall to near zero. 

These dynamics disappear when you think in terms of an intertemporal equilibrium where future yields are known and assets are held to maturity. When we think of trading off consumption today for consumption tomorrow, we are implicitly imagining something equivalent to holding bond to maturity. And of course if you have a model with interest rates determined by some kind of fundamentals by a process known to the agents in the model — what is called model-consistent or rational expectations — than it makes to sense to say that people could believe the normal or “correct” level of interest rates is anything other than what it is. So speculation is excluded by assumption.

Keynes understand all this clearly, and the fact that the long-term interest rate is conventionally determined in this way is quite important to his theory. But he seems never to have considered the possibility of negative yields. As a result he saw the possibility of capital gains as disappearing as interest rates got close to zero. This meant that for him, the conventional valuation was not symmetrical, but operated mainly as a floor. But once we allow the possibility of negative rates, conventional expectations can prevent a rise in interest rates just as easily as a fall. 

In short, negative yields are a puzzle and a problem in the real exchange paradigm that dominates economic conversation, in which the “interest rate” is the terms on which goods today exchange for goods in the future. But from the money view, where the interest rate is the (inverse of) the price of an asset yielding a flow of money payments, there is nothing especially puzzling about negative rates. It just implies greater demand for the relevant assets. A corollary is that while there should be a single exchange rate between now and later, the prices of different assets may behave quite differently. So while many of the paradoxes people pose around negative rates assume that all rates go negative together, in the real world the average rate on US credit cards, for example, is still about 15 percent — the same as it was 20 years ago. 

In the future, the question people may ask is not how interest rates could be negative, but why was it that the government for so long paid the banks for the valuable services its bonds offered them? 

“Monetary Policy in a Changing World”

While looking for something else, I came across this 1956 article on monetary policy by Erwin Miller. It’s a fascinating read, especially in light of current discussions about, well, monetary policy in a changing world. Reading the article was yet another reminder that, in many ways, debates about central banking were more sophisticated and far-reaching in the 1950s than they are today.

The recent discussions have been focused mainly on what the goals or targets of monetary policy should be. While the rethinking there is welcome — higher wages are not a reliable sign of rising inflation; there are good reasons to accept above-target inflation, if it developed — the tool the Fed is supposed to be using to hit these targets is the overnight interest rate faced by banks, just as it’s been for decades. The mechanism by which this tool works is basically taken for granted — economy-wide interest rates move with the rate set by the Fed, and economic activity reliably responds to changes in these interest rates. If this tool has been ineffective recently, that’s just about the special conditions of the zero lower bound. Still largely off limits are the ideas that, when effective, monetary policy affects income distribution and the composition of output and not just its level, and that, to be effective, monetary policy must actively direct the flow of credit within the economy and not just control the overall level of liquidity.

Miller is asking a more fundamental question: What are the institutional requirements for monetary policy to be effective at all? His answer is that conventional monetary policy makes sense in a world of competitive small businesses and small government, but that different tools are called for in a world of large corporations and where the public sector accounts for a substantial part of economic activity. It’s striking that the assumptions he already thought were outmoded in the 1950s still guide most discussions of macroeconomic policy today.1

From his point of view, relying on the interest rate as the main tool of macroeconomic management is just an unthinking holdover from the past — the “normal” world of the 1920s — without regard for the changed environment that would favor other approaches. It’s just the same today — with the one difference that you’ll no longer find these arguments in the Quarterly Journal of Economics.2

Rather than resort unimaginatively to traditional devices whose heyday was one with a far different institutional environment, authorities should seek newer solutions better in harmony with the current economic ‘facts of life.’ These newer solutions include, among others, real estate credit control, consumer credit control, and security reserve requirements…, all of which … restrain the volume of credit available in the private sector of the economy.

Miller has several criticisms of conventional monetary policy, or as he calls it, “flexible interest rate policies” — the implicit alternative being the wartime policy of holding key rates fixed. One straightforward criticism is that changing interest rates is itself a form of macroeconomic instability. Indeed, insofar as both interest rates and inflation describe the terms on which present goods trade for future goods, it’s not obvious why stable inflation should be a higher priority than stable interest rates.

A second, more practical problem is that to the extent that a large part of outstanding debt is owed by the public sector, the income effects of interest rate changes will become more important than the price effects. In a world of large public debts, conventional monetary policy will affect mainly the flow of interest payments on existing debt rather than new borrowing. Or as Miller puts it,

If government is compelled to borrow on a large scale for such reasons of social policy — i.e., if the expenditure programs are regarded as of such compelling social importance that they cannot be postponed merely for monetary considerations — then it would appear illogical to raise interest rates against government, the preponderant borrower, in order to restrict credit in the private sphere.

Arguably, this consideration applied more strongly in the 1950s, when government accounted for the majority of all debt outstanding; but even today governments (federal plus state and local) accounts for over a third of total US debt. And the same argument goes for many forms of private debt as well.

As a corollary to this argument — and my MMT friends will like this — Miller notes that a large fraction of federal debt is held by commercial banks, whose liabilities in turn serve as money. This two-step process is, in some sense, equivalent to simply having the government issue the money — except that the private banks get paid interest along the way. Why would inflation call for an increase in this subsidy?

Miller:

The continued existence of a large amount of that bank-held debt may be viewed as a sop to convention, a sophisticated device to issue needed money without appearing to do so. However, it is a device which requires that a subsidy (i.e., interest) be paid the banks to issue this money. It may therefore be argued that the government should redeem these bonds by an issue of paper money (or by an issue of debt to the central bank in exchange for deposit credit). … The upshot would be the removal of the governmental subsidy to banks for performing a function (i.e., creation of money) which constitutionally is the responsibility of the federal government.

Finance franchise, anyone?

This argument, I’m sorry to say, does not really work today — only a small fraction of federal debt is now owned by commercial banks, and there’s no longer a link, if there ever was, between their holdings of federal debt and the amount of money they create by lending. There are still good arguments for a public payments system, but they have to be made on other grounds.

The biggest argument against using a single interest rate as the main tool of macroeconomic management is that it doesn’t work very well. The interesting thing about this article is that Miller doesn’t spend much time on this point. He assumes his readers will already be skeptical:

There remains the question of the effectiveness of interest rates as a deterrent to potential private borrowing. The major arguments for each side of this issue are thoroughly familiar and surely demonstrate most serious doubt concerning that effectiveness.

Among other reasons, interest is a small part of overall cost for most business activity. And in any situation where macroeconomic stabilization is needed, it’s likely that expected returns will be moving for other reasons much faster than a change in interest rates can compensate for. Keynes says the same thing in the General Theory, though Miller doesn’t mention it.3 (Maybe in 1956 there wasn’t any need to.)

Because the direct link between interest rates and activity is so weak, Miller notes, more sophisticated defenders of the central bank’s stabilization role argue that it’s not so much a direct link between interest rates and activity as the effect of changes in the policy rate on banks’ lending decisions. These arguments “skillfully shift the points of emphasis … to show how even modest changes in interest rates can bring about significant credit control effects.”

Here Miller is responding to arguments made by a line of Fed-associated economists from his contemporary Robert Roosa through Ben Bernanke. The essence of these arguments is that the main effect of interest rate changes is not on the demand for credit but on the supply. Banks famously lend long and borrow short, so a bank’s lending decisions today must take into account financing conditions in the future. 4 A key piece of this argument — which makes it an improvement on orthodoxy, even if Miller is ultimately right to reject it — is that the effect of monetary policy can’t be reduced to a regular mathematical relationship, like the interest-output semi-elasticity of around 1 found in contemporary forecasting models. Rather, the effect of policy changes today depend on their effects on beliefs about policy tomorrow.

There’s a family resemblance here to modern ideas about forward guidance — though people like Roosa understood that managing market expectations was a trickier thing than just announcing a future policy. But even if one granted the effectiveness of this approach, an instrument that depends on changing beliefs about the long-term future is obviously unsuitable for managing transitory booms and busts.

A related point is that insofar as rising rates make it harder for banks to finance their existing positions, there is a chance this will create enough distress that the Fed will have to intervene — which will, of course, have the effect of making credit more available again. Once the focus shifts from the interest rate to credit conditions, there is no sharp line between the Fed’s monetary policy and lender of last resort roles.

A further criticism of conventional monetary policy is that it disproportionately impacts more interest-sensitive or liquidity-constrained sectors and units. Defenders of conventional monetary policy claim (or more often tacitly assume) that it affects all economic activity equally. The supposedly uniform effect of monetary policy is both supposed to make it an effective tool for macroeconomic management, and helps resolve the ideological tension between the need for such management and the belief in a self-regulating market economy. But of course the effect is not uniform. This is both because debtors and creditors are different, and because interest makes up a different share of the cost of different goods and services.

In particular, investment, especially investment in housing and other structures, is mo sensitive to interest and liquidity conditions than current production. Or as Miller puts it, “Interest rate flexibility uses instability of one variety to fight instability of a presumably more serious variety: the instability of the loanable funds price-level and of capital values is employed in an attempt to check commodity price-level and employment instability.” (emphasis added)

The point that interest rate changes, and monetary conditions generally, change the relative price of capital goods and consumption goods is important. Like much of Miller’s argument, it’s an unacknowledged borrowing from Keynes; more strikingly, it’s an anticipation of Minsky’s famous “two price” model, where the relative price of capital goods and current output is given a central role in explaining macroeconomic dynamics.

If we take a step back, of course, it’s obvious that some goods are more illiquid than others, and that liquidity conditions, or the availability of financing, will matter more for production of these goods than for the more immediately saleable ones. Which is one reason that it makes no sense to think that money is ever “neutral.”5

Miller continues:

In inflation, e.g., employment of interest rate flexibility would have as a consequence the spreading of windfall capital losses on security transactions, the impairment of capital values generally, the raising of interest costs of governmental units at all levels, the reduction in the liquidity of individuals and institutions in random fashion without regard for their underlying characteristics, the jeopardizing of the orderly completion of financing plans of nonfederal governmental units, and the spreading of fear and uncertainty generally.

Some businesses have large debts; when interest rates rise, their earnings fall relative to businesses that happen to have less debt. Some businesses depend on external finance for investment; when interest rates rise, their costs rise relative to businesses that are able to finance investment internally. In some industries, like residential construction, interest is a big part of overall costs; when interest rates rise, these industries will shrink relative to ones that don’t finance their current operations.

In all these ways, monetary policy is a form of central planning, redirecting activity from some units and sectors to other units and sectors. It’s just a concealed, and in large part for that reason crude and clumsy, form of planning.

Or as Miller puts it, conventional monetary policy

discriminates between those who have equity funds for purchases and those who must borrow to make similar purchases. … In so far as general restrictive action successfully reduces the volume of credit in use, some of those businesses and individuals dependent on bank credit are excluded from purchase marts, while no direct restraint is placed on those capable of financing themselves.

In an earlier era, Miller suggests, most borrowing was for business investment; most investment was externally financed; and business cycles were driven by fluctuations in investment. So there was a certain logic to focusing on interest rates as a tool of stabilization. Honestly, I’m not sure if that was ever true.But I certainly agree that by the 1950s — let alone today — it was not.

In a footnote, Miller offers a more compelling version of this story, attributing to the British economist R. S. Sayers the idea of

sensitive points in an economy. [Sayers] suggests that in the English economy mercantile credit in the middle decades of the nineteenth century and foreign lending in the later decades of that century were very sensitive spots and that the bank rate technique was particularly effective owing to its impact upon them. He then suggests that perhaps these sensitive points have given way to newer ones, namely, stock exchange speculation and consumer credit. Hence he concludes that central bank instruments should be employed which are designed to control these newer sensitive areas.

This, to me, is a remarkably sophisticated view of how we should think about monetary policy and credit conditions. It’s not an economywide increase or decrease in activity, which can be imagined as a representative household shifting their consumption over time; it’s a response of whatever specific sectors or activities are most dependent on credit markets, which will be different in different times and places. Which suggests that a useful education on monetary policy requires less calculus and more history and sociology.

Finally, we get to Miller’s own proposals. In part, these are for selective credit controls — direct limits on the volume of specific kinds of lending are likely to be more effective at reining in inflationary pressures, with less collateral damage. Yes, these kinds of direct controls pick winners and losers — no more than conventional policy does, just more visibly. As Miller notes, credit controls imposed for macroeconomic stabilization wouldn’t be qualitatively different from the various regulations on credit that are already imposed for other purposes — tho admittedly that argument probably went further in a time when private credit was tightly regulated than in the permanent financial Purge we live in today.

His other proposal is for comprehensive security reserve requirements — in effect generalizing the limits on bank lending to financial positions of all kinds. The logic of this idea is clear, but I’m not convinced — certainly I wouldn’t propose it today. I think when you have the kind of massive, complex financial system we have today, rules that have to be applied in detail, at the transaction level, are very hard to make effective. It’s better to focus regulation on the strategic high ground — but please don’t ask me where that is!

More fundamentally, I think the best route to limiting the power of finance is for the public sector itself to take over functions private finance currently provides, as with a public payments system, a public investment banks, etc. This also has the important advantage of supporting broader steps toward an economy built around human needs rather than private profit. And it’s the direction that, grudgingly but steadily, the response to various crises is already pushing us, with the Fed and other authorities reluctantly stepping in to perform various functions that the private financial system fails to. But this is a topic for another time.

Miller himself is rather tentative in his positive proposals. And he forthrightly admits that they are “like all credit control instruments, likely to be far more effective in controlling inflationary situations than in stimulating revival from a depressed condition.” This should be obvious — even Ronald Reagan knew you can’t push on a string. This basic asymmetry is one of the many everyday insights that was lost somewhere in the development of modern macro.

The conversation around monetary policy and macroeconomics is certainly broader and more realistic today than it was 15 or 20 years ago, when I started studying this stuff. And Jerome Powell — and even more the activists and advocates who’ve been shouting at him — deserves credit for the Fed;s tentative moves away from the reflexive fear of full employment that has governed monetary policy for so long. But when you take a longer look and compare today’s debates to earlier decades, it’s hard not to feel that we’re still living in the Dark Ages of macroeconomics