Rogoff on the Zero Lower Bound

I was at the ASSAs in Chicago this past weekend. [1] One of the most interesting panels I went to was this one, on Advances in Open Economy Macroeconomics. Among other big names, Ken Rogoff was there, as the discussant for a rather strange paper by Pierre-Olivier Gourinchas and Helene Rey.

The Gourinchas and Rey paper, like much of mainstream macro these days, made a big deal of how different everything is at the zero lower bound. Rogoff wasn’t having it. Here’s a rough transcript of what he said:

The obsession with the zero lower bound is encouraging all kinds of wacko ideas. People are saying that at the ZLB, productivity increases are bad (Eggertsson/Krugman/Summers), protectionism is good (Eichngreen), price flexibility is bad, and so on.

But there is an emerging literature that says economists are taking the zero lower bound too literally. In fact, getting negative rates is not that hard. So before you take seriously these, let’s say, very creative ideas, it would be simpler to think about getting rid of the zero bound.

There are lots of ways to do it. I talk about some in my book, but people already understood this back in the 1930s. There was Robert Eisler’s proposal to have banks accept cash deposits at a discount, for instance, which would have effectively created negative rates. If Keynes had read Eisler, he might have gone in a different direction. [2] It’s a very old idea — Kublai Khan did something similar. There will be pushback from the financial sector, of course, who think negative rates will be costly for them, but fundamentally it is not hard to do.

These rather striking comments crystallized something in my mind. What is the big deal about the ZLB? For mainstream macroeconomists, including Gourinchas and Rey in this paper, the reason the ZLB matters is that it prevents the central bank form setting an interest rate low enough to keep output at potential. [3] It’s precisely this that makes inapplicable the conventional analysis of a nonmonetary problem of allocating scarce resources between alternative ends, and requires thinking about other entry points. If the central bank can’t solve the problem of aggregate demand then you have to take it seriously, with all the wacko and/or creative stuff that follows.

In the dominant paradigm, this is a specific technical problem of getting interest rates below zero. Solve that, and we are back in the comfortable Walrasian world. But for those of us on the heterodox side, it is never the case that the central bank can reliably keep output at potential — maybe because market interest rates don’t respond to the policy rate, or because output doesn’t respond to interest rates, or because the central bank is pursuing other objectives, or because there is no well-defined level of “potential” to begin with. (Or, in reality, all four.) So what people like Gourinchas and Rey, or Paul Krugman, present as a special, temporary state of the economy, we see as the general case.

One way of looking at this is that the ZLB is a device to allow economists like Krugman and Gourinchas and Rey — who whatever their scholarly training, are aware of the concrete reality around them — to make Keynesian arguments without forfeiting their academic respectability. You can understand why someone like Rogoff sees that as cheating. We’ve spent decades teaching that the fundamental constraint on the economy is the real endowment of resources and technology; that saving boosts growth; that trade is always win-win; that money and finance matter only in the short run (and the short run is tolerably short). The practical problem of negative policy rates doesn’t let you forget all of that.

Which, if you turn it around, perhaps reflects well on the ZLB crowd. Maybe they want to forget all that? Maybe, you could say, they take the zero lower bound seriously because they don’t take it literally. That is, they treat it as a hard constraint precisely because they are aware that it is only a stand-in for a deeper reality.

 

[1] The big annual economics conference. It stands for Allied Social Sciences Association — the disciplinary imperialism is right there in the name.

[2] This was an odd thing for Rogoff to say, since of course while Keynes didn’t discuss Eisler as far as I know, he talks at length about the similar proposals for depreciating cash of Silvio Gesell and Major Douglas. Notoriously he says these “brave cranks and heretics” have more to offer than Marx.

[3] Gourinchas and Rey are reality-based enough to say “the policy rate,” not “the interest rate.”

 

EDIT: Added the seriously-but-not-literally phrasing as suggested by Steve Roth on Twitter.

At Jacobin: Socializing Finance

(Cross-posted from Jacobin. A shorter version appears in the Fall 2016 print issue.)

 

At its most basic level, finance is simply bookkeeping — a record of money obligations and commitments. But finance is also a form of planning – a set of institutions for allocating claims on the social product.

The fusion of these two logically distinct functions – bookkeeping and planning – is as old as capitalism, and has troubled the bourgeois conscience for almost as long. The creation of purchasing power through bank loans is hard to square with the central ideological claim about capitalism, that market prices offer a neutral measure of some preexisting material reality. The manifest failure of capitalism to conform to ideas of how this natural system should behave, is blamed on the ability of banks (abetted by the state) to drive market prices away from their true values. Somehow separating these two functions of the banking system –  bookkeeping and planning –  is the central thread running through 250 years of monetary reform proposals by bourgeois economists, populists and cranks. We can trace it from David Hume, who believed a “perfect circulation” was one where gold alone were used for payments, and who doubted whether bank loans should be permitted at all; to the 19th century advocates of a strict gold standard or the real bills doctrine, two competing rules that were supposed to restore automaticity to the creation of bank credit; to Proudhon’s proposals for giving money an objective basis in labor time; to Wicksell’s prescient fears of the instability of an unregulated system of bank money; to the oft-revived proposals for 100%-reserve banking; to Milton Friedman’s proposals for a strict money-supply growth rule; to today’s orthodoxy that dreams of a central bank following an inviolable “policy rule” that reproduces the “natural interest rate.” What these all have in common is that they seek to restore objectivity to the money system, to legislate into existence the real values that are supposed to lie behind money prices. They seek to compel money to actually be what it is imagined to be in ideology: an objective measure of value that reflects the real value of commodities, free of the human judgements of bankers and politicians.

*

Socialists reject this fantasy. We know that the development of capitalism has from the beginning been a process of “financialization” – of extension of money claims on human activity, and of representation of the social world in terms of money payments and commitments. We know that there was no precapitalist world of production and exchange on which money and then credit were later superimposed: Networks of money claims are the substrate on which commodity production has grown and been organized.  And we know that the social surplus under capitalism is not allocated by “markets,” despite the fairy tales of economists.  It is allocated by banks and other financial institutions, whose activities are not ultimately coordinated by markets either, but by planners of one sort or another.

However decentralized in theory, market production is in fact organized through a highly centralized financial system. And where something like competitive markets do exist, it is usually thanks to extensive state management, from anti-trust laws to all the elaborate machinery set up by the ACA to prop up a rickety market for private health insurance. As both Marx and Keynes recognized, the tendency of capitalism is to develop more social, collective forms of production, enlarging the domain of conscious planning and diminishing the zone of the market. (A point also understood by some smarter, more historically minded liberal economists today.) The preservation of the form of markets becomes an increasingly utopian project, requiring more and more active intervention by government. Think of the enormous public financing, investment, regulation required for our “private” provision of housing, education, transportation, etc.

In  world where production is guided by conscious planning — public or private — it makes no sense to think of  money values as reflecting the objective outcome of markets, or of financial claims as simply a record of “real’’ flows of income and expenditure. But the “illusion of the real,” as Perry Mehrling somewhere calls it, is very hard to resist. We must constantly remind ourselves that market values have never been, and can never be, an objective measure of human needs and possibilities. We must remember that values measured in money – prices and quantities, production and consumption – have no existence independent of the market transactions that give them quantitative form. We must recognize the truth that Keynes – unlike so many bourgeois economists – clearly stated: a quantitative comparison between disparate use-values is possible only when they actually come into market exchange, and only on the terms given by the concrete form of that exchange. It is meaningless to compare  economic quantities over widely separated periods of time, or in countries at very different levels of development. On such questions only qualitative, more or less subjective judgements can be made.

It follows that socialism cannot be described in terms of the quantity of commodities produced, or the distribution of them. Socialism is liberation from the commodity form. It is defined not by the disposition of things but by the condition of human beings. It is the progressive extension of the domain of human freedom, of that part of our lives governed by love and reason.

There are many critics of finance who see it as the enemy of a more humane or authentic capitalism. They may be managerial reformers (Veblen’s “Soviet of engineers”) who oppose finance as a parasite on productive enterprises; populists who hate finance as the destroyer of their own small capitals; or sincere believers in market competition who see finance as a collector of illegitimate rents. On a practical level there is much common ground between these positions and a socialist program. But we can’t accept the idea of finance as a distortion of some true market values that are natural, objective, or fair.

Finance should be seen as a moment in the capitalist process, integral to it but with two contradictory faces. On the one hand, it is finance (as a concrete institution) that generates and enforces the money claims against social persons of all kinds — human beings, firms, nations — that extend and maintain the logic of commodity production. (Student loans reinforce the discipline of wage labor, sovereign debt upholds the international division of labor.)

Yet on the other hand, the financial system is also where conscious planning takes its most fully developed form under capitalism. Banks are, in Schumpeter’s phrase, the private equivalent of Gosplan, the Soviet planning agency. Their lending decisions determine what new projects will get a share of society’s resources, and suspend — or enforce — the “judgement of the market” on money-losing enterprises. A socialist program must respond to both these faces of finance.  We oppose the power of finance if we want to progressively reduce the extent to which human life is organized around the accumulation of money. We embrace the planning already inherent in finance because we want to expand the domain of conscious choice, and reduce the domain of blind necessity. “It is a work of culture — not unlike the draining of the Zuider Zee.”

*

The development of finance reveals the progressive displacement of market coordination by planning. Capitalism means production for profit; but in concrete reality profit criteria are always subordinate to financial criteria. The judgement of the market has force only insofar as it is executed by finance. The world is full of businesses whose revenues exceed their costs, but are forced to scale back or shut down because of the financial claims against them. The world is full of businesses that operate for years, or indefinitely, with costs in excess of their revenues, thanks to their access to finance. And the institutions that make these financing decisions do so based on their own subjective judgement, constrained ultimately not by some objective criteria of value, but by the terms set by the central bank.

There is a basic contradiction between the principles of competition and finance. Competition is imagined as a form of natural selection: Firms that make profits reinvest them and thus grow, while firms that make losses can’t invest and must shrink and eventually disappear. This is supposed to be a great advantage of markets.

But the whole point of finance is to break this link between profits yesterday and investment today. The surplus paid out as dividends and interest is available for investment anywhere in the economy, not just where it was generated. Conversely, entrepreneurs can undertake new projects that have never been profitable in the past, if they can convince someone to bankroll them. Competition looks backward: The resources you have today depend on how you’ve performed in the past. Finance looks forward: The resources you have today depend on how you’re expect (by someone!) to perform in the future. So, contrary to the idea of firms rising and falling through natural selection, finance’s darlings — from Amazon to Uber and the whole unicorn herd — can invest and grow indefinitely without ever showing a profit. This is also supposed to be a great advantage of markets.

In the frictionless world imagined by economists, the supercession of markets by finance is already carried to its limit. Firms do not control or depend on their own surplus. All surplus is allocated centrally, by financial markets. All funds for investment comes from financial markets and all profits immediately return in money form to these markets. This has two contradictory implications. On the one hand, it eliminates  any awareness of the firm as a social organism, of the activity the firm carries out to reproduce itself, of its pursuit of ends other than maximum profit for its “owners”. The firm, in effect, is born new each day by the grace of those financing it.

But by the same token, the logic of profit maximization loses its objective basis. The quasi-evolutionary process of competition – in which successful firms grow and unsuccessful ones decline and die  – ceases to operate if the firm’s own profits are no longer its source of investment finance, but both instead flow into a common pool. In this world, which firms grow and which shrink depends on the decisions of the financial planners who allocate capital between them. Needless to say it makes no difference if we move competition “one level up” – money managers also borrow and issue shares.

The contradiction between market production and socialized finance becomes more acute as the pools of finance themselves combine or become more homogenous. This was a key point for turn-of-the-last-century Marxists like Hilferding (and Lenin), but it’s also behind the recent fuss in the business press over the rise of index funds. These funds hold all shares of all corporations listed on a given stock index; unlike actively managed funds they make no effort to pick winners, but hold shares in multiple competing firms. Per one recent study, “The probability that two randomly selected firms in the same industry from the S&P 1500 have a common shareholder with at least 5% stakes in both firms increased from less than 20% in 1999 to around 90% in 2014.”

The problem is obvious: If corporations work for their shareholders, then why would they compete against each other if their shares are held by the same funds? Naturally, one proposed solution is more state intervention to preserve the form of markets, by limiting or disfavoring stock ownership via broad funds. Another, and perhaps more logical, response is: If we are already trusting corporate managers to be faithful agents of the rentier class as a whole, why not take the next step and make them agents of society in general?

And in any case the terms on which the financial system directs capital are ultimately set by the central bank. Its decisions — monetary policy in the narrow sense, but also the terms on which financial institutions are regulated, and rescued in crises – determine not only the overall pace of credit expansion but the criteria of profitability itself. This is acutely evident in crises, but it’s implicit in routine monetary policy as well. Unless lower interest rates turn some previously unprofitable projects into profitable ones, how are they supposed to work?

At the same time, the legitimacy of the capitalist system — the ideological justification of its obvious injustice and waste —  comes from the idea that economic outcomes are determined by “the market,” not by anyone’s choice. So the planning has to be kept out of site. Central bankers themselves are quite aware of this aspect of their role. In the early 1980s, when the Fed was changing the main instrument it used for monetary policy, officials there were concerned that their choice preserve the fiction that interest rates were being set by the markets. As Fed Governor Wayne Angell put it, it was essential to choose a technique that would “have the camouflage of market forces at work.”

Mainstream economics textbooks explicitly describe the long-term trajectory of capitalist economies in terms of an ideal planner, who is setting output and prices for all eternity in order to maximize the general wellbeing. The contradiction between this macro vision and the ideology of market competition is papered over by the assumption that over the long run this path is the same as the “natural” one that would obtain in a perfect competitive market system without money or banks. Outside of the academy, it’s harder to sustain faith that the planners at the central bank are infallibly picking the outcomes the market should have arrived at on its own. Central banks’ critics on the right — and many on the left — understand clearly that central banks are engaged in active planning, but see it as inherently illegitimate. Their belief in “natural” market outcomes goes with fantasies of a return to some monetary standard independent of human judgement – gold or bitcoin.

Socialists, who see through central bankers’ facade of neutral expertise and recognize their close association with private finance, may be tempted by similar ideas. But the path toward socialism runs the other way. We don’t seek to organize human life on an objective grid of market values, free of the distorting influence of finance and central banks. We seek rather to bring this already-existing conscious planning into the light, to make it into a terrain of politics, and to direct it toward meeting human needs rather than reinforcing relations of domination. In short: the socialization of finance.

*

in the U.S. context, this analysis suggests a transitional program perhaps along the following lines.

Decommodify money. While there is no way to separate money and markets from finance, that does not mean that the routine functions of the monetary system must be a source of private profit. Shifting responsibility for the basic monetary plumbing of the system to public or quasi-public bodies is a non-reformist reform – it addresses some of the directly visible abuse and instability of the existing monetary system while pointing the way toward more profound transformations. In particular, this could involve:

 1. A public payments system. In the not too distant past, if I wanted to give you some money and you wanted to give me a good or service, we didn’t have to pay a third party for permission to make the trade. But as electronic payments have replaced cash, routine payments have become a source of profit. Interchanges and the rest of the routine plumbing of the payments system should be a public monopoly, just as currency is.

 2. Postal banking. Banking services should similarly be provided through post offices, as in many other countries. Routine transactions accounts (check and saving) are a service that can be straightforwardly provided by the state.

 3. Public credit ratings, both for bonds and for individuals. As information that, to perform its function, must be widely available, credit ratings are a natural object for public provision even within the overarching logic of capitalism. This is also a challenge to the coercive, disciplinary function increasingly performed by private credit ratings in the US.

 4. Public housing finance. Mortgages for owner-occupied housing are another area where a patina of market transactions is laid over a system that is already substantively public. The 30-year mortgage market is entirely a creation of regulation, it is maintained by public market-makers, and public bodies are largely and increasingly the ultimate lenders. Socialists have no interest in the cultivation of a hothouse petty bourgeoisie through home ownership; but as long as the state does so, we demand that it be openly and directly rather than disguised as private transactions.

 5. Public retirement insurance. Providing for old age is the other area, along with housing, where the state does the most to foster what Gerald Davis calls the “capital fiction” – the conception of one’s relationship to society in terms of asset ownership. But here, unlike home ownership, social provision in the guise of financial claims has failed even on its own narrow terms. Many working-class households in the US and other rich countries do own their own houses, but only a tiny fraction can meet their subsistence needs in old age out of private saving. At the same time, public retirement systems are much more fully developed than public provision of housing. This suggests a program of eliminating existing programs to encourage private retirement saving, and greatly expanding Social Security and similar social insurance systems.

Repress finance. It’s not the job of socialists to keep the big casino running smoothly. But as long as private financial institutions exist, we cannot avoid the question of how to regulate them. Historically financial regulation has sometimes taken the form of “financial repression,” in which the types of assets held by financial institutions are substantially dictated by the state. This allows credit to be directed more effectively to socially useful investment. It also allows policymakers to hold market interest rates down, which — especially in the context of higher inflation — diminishes both the burden of debt and the power of creditors. The exiting deregulated financial system already has very articulate critics; there’s no need to duplicate their work with a detailed reform proposal. But we can lay out some broad principles:

1. If it isn’t permitted, it’s forbidden. Effective regulation has always depended on enumerating specific functions for specific institutions, and prohibiting anything else. Otherwise it’s too easy to bypass with something that is formally different but substantively equivalent. And whether or not central banks are going to continue with their role as the main managers of aggregate demand —  increasingly questioned by those inside the citadel as well as by outsiders — they also need this kind of regulation to effectively control the flow of credit.

2. Protect functions, not institutions. The political power of finance comes from ability to threaten routine social bookkeeping, and the security of small property owners. (“If we don’t bail out the banks, the ATMs will shut down! What about your 401(k)?”) As long as private financial institutions perform socially necessary functions, policy should focus on preserving those functions themselves, and not the institutions that perform them. This means that interventions should be as close as possible to the nonfinancial end-user, and not on the games banks play among themselves. For example: deposit insurance.

3. Require large holdings of public debt. The threat of the “bond vigilantes” against the US federal government has  been wildly exaggerated, as was demonstrated for instance by the debt-ceiling farce and downgrade of 2012. But for smaller governments – including state and local governments in the US – bond markets are not so easily ignored. And large holdings of pubic debt also reduce the frequency and severity of the periodic financial crises which are, perversely, one of the main ways in which finance’s social power is maintained.

4. Control overall debt levels with lower interest rates and higher inflation. Household leverage in the US has risen dramatically over the past 30 years; some believe that this is because debt was needed to raise living standards of living in the face of stagnant or declining real incomes. But this isn’t the case; slower income growth has simply meant slower growth in consumption. Rather, the main cause of rising household debt over the past 30 years has been the combination of low inflation and continuing high interest rates for households. Conversely, the most effective way to reduce the burden of debt – for households, and also for governments – is to hold interest rates down while allowing inflation to rise.

As a corollary to financial repression, we can reject any moral claims on behalf of interest income as such. There is no right to exercise a claim on the labor of others  through ownership of financial assets. To the extent that the private provision of socially necessary services like insurance and pensions is undermined by low interest rates, that is an argument for moving these services to the public sector, not for increasing the claims of rentiers.

Democratize central banks. Central banks have always been central planners. Choices about interest rates, and the terms on which financial institutions will be regulated and rescued, inevitably condition the profitability and the direction as well as level of productive activity. This role has been concealed behind an ideology that imagines the central bank behaving automatically, according to a rule that somehow reproduces the “natural” behavior of markets.

Central banks’ own actions since 2008 have left this ideology in tatters. The immediate response to the crisis have forced central banks to intervene more directly in credit markets, buying a wider range of assets and even replacing private financial institutions to lend directly to nonfinancial businesses. Since then, the failure of conventional monetary policy has forced central banks to inch unwillingly toward a broader range of interventions, directly channeling credit to selected borrowers. This turn to “credit policy” represents an admission – grudging, but forced by events – that the anarchy of competition is unable to coordinate production. Central banks cannot, as the textbooks imagine, stabilize the capitalists system by turning a single knob labeled “money supply” or “interest rate.” They must substitute their own judgement for market outcomes in a broad and growing range of asset and credit markets.

The challenge now is to politicize central banks — to make them the object of public debate and popular pressure.  In Europe, the national central banks – which still perform their old functions, despite the common misperception that the ECB is now the central bank of Europe – will be a central terrain of struggle for the next left government that seeks to break with austerity and liberalism. In the US, we can dispense for good with the idea that monetary policy is a domain of technocratic expertise, and bring into the open its program of keeping unemployment high in order to restrain wage growth and workers’ power. As a positive program, we might demand that the Fed aggressively using its existing legal authority to purchase municipal debt, depriving rentiers of their power over financially constrained local governments as in Detroit and Puerto Rico, and more broadly blunting the power of “the bond markets” as a constraint on popular politics at the state and local level. More broadly, central banks should be held responsible for actively directing credit to socially useful ends.

Disempower shareholders. Really existing capitalism consists of narrow streams of market transactions flowing between vast regions of non-market coordination. A core function of finance is to act as the weapon in the hands of the capitalist class to enforce the logic of value on these non-market structures. The claims of shareholders over nonfinancial businesses, and bondholders over national governments, ensure that all these domains of human activity remain subordinate to the logic of accumulation. We want to see stronger defenses against these claims – not because we have any faith in productive capitalists or national bourgeoisies, but because they occupy the space in which politics is possible.

Specifically we should stand with corporations against shareholders. The corporation, as Marx long ago noted, is “the abolition of the capitalist mode of production within the capitalist mode of production itself.” Within the corporation, activity is coordinated through plans, not markets; and the orientation of this activity is toward the production of a particular use-value rather than money as such. “The tendency of big enterprise,” Keynes wrote, “is to socialize itself.” The fundamental political function of finance is to keep this tendency in check. Without the threat of takeovers and the pressure of shareholder activists, the corporation becomes a space where workers and other stakeholders can contest control over production and the surplus it generates – a possibility that capitalist never lose sight of.

Needless to say, this does not imply any attachment to the particular individuals at the top of the corporate hierarchy, who today are most often actual or aspiring rentiers  without any organic connection to the production process. Rather, it’s a recognition of the value of the corporation as a social organism; as a space structured by relationships of trust and loyalty, and by intrinsic motivation and “professional conscience”; and as the site of consciously planned production of use-values.

The role of finance with respect to the modern corporation is not to provide it with resources for investment, but to ensure that its conditional orientation toward production as an end in itself is ultimately subordinate to the accumulation of money. Resisting this pressure is no substitute for other struggles, over the labor process and the division of resources and authority within the corporation. (History gives many examples of production of use values as an end in itself, which is carried out under conditions as coercive and alienated as under production for profit.) But resisting the pressure of finance creates more space for those struggles, and for the evolution of socialism within the corporate form.

Close borders to money (and open them to people). Just as shareholder power enforces the logic of accumulation on corporations, capital mobility does the same to states. In the universities, we hear about the supposed efficiency  of unrestrained capital flows, but in the political realm we hear more their power to “discipline” national governments. The threat of capital flight and balance of payments crises protects the logic of accumulation against incursions by national governments.

States can be vehicles for conscious control of the economy only insofar as financial claims across borders are limited. In a world where capital flows are large and unrestricted, the concrete activity of production and reproduction must constantly adjust itself to the changing whims of foreign investors. This is incompatible with any strategy for  development of the forces of production at the national level; every successful case of late industrialization has depended on the conscious direction of credit through the national banking system. More than that, the requirement that real activity accommodate cross-border financial flows is  incompatible even with the stable reproduction of capitalism in the periphery. We have learned this lesson many times in Latin America and elsewhere in the South, and are now learning it again in Europe.

So a socialist program on finance should include support for efforts of national governments to delink from the global economy, and to maintain or regain control over their financial systems. Today, such efforts are often connected to a politics of racism, nativism and xenophobia which we must uncompromisingly reject. But it is possible to move toward a world in which national borders pose no barrier to people and ideas, but limit the movement of goods and are impassible barriers to private financial claims.

In the US and other rich countries, it’s also important to oppose any use of the authority – legal or otherwise – of our own states to enforce financial claims against weaker states. Argentina and Greece, to take two recent examples, were not forced to accept the terms of their creditors by the actions of dispersed private individuals through financial markets, but respectively by the actions of Judge Griesa of the US Second Circuit and Trichet and Draghi of the ECB. For peripheral states to foster development and serve as vehicle for popular politics, they must insulate themselves from international financial markets. But the power of those markets comes ultimately from the gunboats — figurative or literal — by which private financial claims are enforced.

With respect to the strong states themselves, the markets have no hold except over the imagination. As we’ve seen repeatedly in recent years — most dramatically in the debt-limit vaudeville of 2011-2013 — there are no “bond vigilantes”; the terms on which governments borrow are fully determined by their own monetary authority. All that’s needed to break the bond market’s power here is to recognize that it’s already powerless.

In short, we should reject the idea of finance as an intrusion on a preexisting market order. We should resist the power of finance as an enforcer of the logic of accumulation. And we should reclaim as a site of democratic politics the social planning already carried out through finance.

New-Old Paper on the Balance of Payments

Four or five years ago, I wrote a paper arguing that the US current account deficit, far from being a cause of the crisis of 2008, was a stabilizing force in the world economy. I presented it at a conference and then set it aside. I recently reread it and I think the arguments hold up well. If anything the case that the US, as the center of the world financial system, ought to run large current account deficits indefinitely looks even stronger now, given the contrasting example of Germany’s behavior in the European system.

I’ve put the paper up as a working paper at John Jay economics department site. Here’s the abstract:

Persistent current account imbalances need not contribute to macroe- conomic instability, despite widespread claims to the contrary by both mainstream and Post Keynesian economists. On the contrary, in a world of large capital inflows, a high and stable level of world output is most likely when the countries with the least capacity to generate capital inflows normally run current account surpluses, while the countries with the greatest capacity to generate capital inflows (the US in particular) normally run current account deficits. An emphasis on varying balance of payments constraints is consistent with the larger Post Keynesian vision, which emphasizes money flows and claims are not simply passive reflections of “real” economic developments, but exercise an important influence in their own right. It is also consistent with Keynes’ own views. This perspective helps explain why the crisis of 2008 did not take the form of a fall in the dollar, and why reserve accumulation in East Asia successfully protected those countries from a repeat of the crisis of 1997. Given the weakness of the “automatic” mechanisms that are supposed to balance trade, income and financial flows, a reduction of the US current account deficit is likely to exacerbate, rather than ameliorate, global macroeconomic instability.

You can read the whole thing here.

A Quick Point on Models

According to Keynes the purpose of economics is “to provide ourselves with an organised and orderly method of thinking out particular problems”; it is “a way of thinking … in terms of models joined to the art of choosing models which are relevant to the contemporary world.” (Quoted here.)

I want to amplify on that just a bit. The test of a good model is not whether it corresponds to the true underlying structure of the world, but whether it usefully captures some of the regularities in the concrete phenomena we observe. There are lots of different regularities, more or less bounded in time, space and other dimensions, so we are going to need lots of different models, depending on the questions we are asking and the setting we are asking them in. Thus the need for the “art of choosing”.

I don’t think this point is controversial in the abstract. But people often lose sight of it. Obvious case: Piketty and “capital”. A lot of the debate between Piketty and his critics on the left has focused on whether there really is, in some sense, a physical quantity of capital, or not. I don’t think we need to have this argument.

We observe “capital” as a set of money claims, whose aggregate value varies in relation to other observable monetary aggregates (like income) over time and across space. There is a component of that variation that corresponds to the behavior of a physical stock — increasing based on identifiable inflows (investment) and decreasing based on identifiable outflows (depreciation). Insofar as we are interested in that component of the observed variation, we can describe it using models of capital as a physical stock. The remaining components (the “residual” from the point of view of a model of physical K) will require a different set of models or stories. So the question is not, is there such a thing as a physical capital stock? It’s not even, is it in general useful to think about capital as a physical stock? The question is, how much of the particular variation we are interested is accounted for by the component corresponding to the evolution of a physical stock? And the answer will depend on which variation we are interested in.

For example, Piketty could say “It’s true that my model, which treats K as a physical stock, does not explain much of the historical variation in capital-output ratios at decadal frequencies, like the fall and rise over the course of the 20th century. But I believe it does explain very long-frequency variation, and in particular captures important long-run possibilities for the future.” (I think he has in fact said something like this, though I can’t find the quote at the moment.) You don’t have to agree with him — you could dispute that his model is a good fit for even the longest-frequency historical variation, or you could argue that the shorter frequency variation is more interesting (and is what his book often seems to be about). But it would be pointless to criticize him on the grounds that there isn’t “really” such a thing as a physical capital stock, or that there is no consistent way in principle to measure it. That, to me, would show a basic misunderstanding of what models are.

An example of good scientific practice along these lines is biologists’ habit of giving genes names for what happens when gross mutations are induced in them experimentally. Names like eyeless or shaggy or buttonhead: the fly lacks eyes, grows extra hair, or has a head without segments if the gene is removed. It might seem weird to describe genes in terms of what goes wrong when they are removed, as opposed to what they do normally, but I think this practice shows good judgement about what we do and don’t know. In particular, it avoids any claim about what the gene is “for.” There are many many relationships between a given locus in the genome and the phenotype, and no sense in which any of them is more or less important in an absolute sense. Calling it the “eye gene” would obscure that, make it sound like this is the relationship that exists out in the world, when for all we know the variation in eye development in wild populations is driven by variation in entirely other locuses. Calling it eyeless makes it clear that it’s referring to what you observe in a particular experimental context.

EDIT: I hate discussions of methodology. I should not have written this post. (I only did because I liked the gene-naming analogy.)  That said, if you, unlike me, enjoy this sort of thing, Tom Hickey wrote a long and thoughtful response to it. He mentions among others, Tony Lawson, who I would certainly want to read more of if I were going to write about this stuff.

Minsky on the Non-Neutrality of Money

I try not to spend too much time criticizing orthodox economics. I think that heterodox people who spend all their energy pointing out the shortcomings and contradictions of the mainstream are, in a sense, making the same mistake as the ones who spend all their energy trying to make their ideas acceptable to the mainstream. We should focus on building up our positive knowledge of social reality, and let the profession fend for itself.

That said, like almost everyone in the world of heterodoxy I do end up writing a lot, and often obstreperously, about what is wrong with the economics profession. To which you can fairly respond: OK, but where is the alternative economics you’re proposing instead?

The honest answer is, it doesn’t exist. There are many heterodox economics, including a large contingent of Post Keynesians, but Post Keynesianism is not a coherent alternative research program. [1] Still, there are lots of promising pieces, which might someday be assembled into a coherent program. One of these is labeled “Minsky”. [2] Unfortunately, while Minsky is certainly known to a broader audience than most economists associated with heterodoxy, it’s mainly only for the financial fragility hypothesis, which I would argue is not central to his contribution.

I recently read a short piece he wrote in 1993, towards the end of his career, that gives an excellent overview of his approach. It’s what I’d recommend — along with the overview of his work by Perry Mehrling that I mentioned in the earlier post, and also the overview by Pollin and Dymski — as a starting point for anyone interested in his work.

* * *

“The Non-Neutrality of Money” covers the whole field of Minsky’s interests and can be read as a kind of summing-up of his mature thought. So it’s interesting that he gave it that title. Admittedly it partly reflects the particular context it was written in, but it also, I think, reflects how critical the neutrality or otherwise of money is in defining alternative visions of what an economy is.

Minsky starts out with a description of what he takes to be the conceptual framework of orthodox economics, represented here by Ben Bernanke’s “Credit in the Macroeconomy“:

The dominant paradigm is an equilibrium construct in which initial endowments of agents, preference systems and production relations, along with maximizing behavior, determine relative prices, outputs and allocation… Money and financial interrelations are not relevant to the determination of these equilibrium values … “real” factors determine “real” variables.

Some people take this construct literally. This leads to Real Business Cycles and claims that monetary policy has never had any effects. Minsky sees no point in even criticizing that approach. The alternative, which he does criticize, is to postulate some additional “frictions” that prevent the long-run equilibrium from being realized, at least right away. Often, as in the Bernanke piece, the frictions take the form of information asymmetries that prevent some mutually beneficial transactions — loans to borrowers without collateral, say — from taking place. But, Minsky says, there is a contradiction here.

On the one hand, perfect foresight is assumed … to demonstrate the existence of equilibrium, and on the other hand, imperfect foresight is assumed … to generate the existence of an underemployment equilibrium and the possibility of policy effectiveness.

Once we have admitted that money and money contracts are necessary to economic activity, and not just an arbitrary numeraire, it no longer makes sense to make simulating a world without money as the goal of policy. If money is useful, isn’t it better to have more of it, and worse to have less, or none? [3] The information-asymmetry version of this problem is actually just the latest iteration of a very old puzzle that goes back to Adam Smith, or even earlier. Smith and the other Classical economists were unanimous that the best monetary system was one that guaranteed a “perfect” circulation, by which they meant, the quantity of money that would circulate if metallic currency were used exclusively. But this posed two obvious questions: First, how could you know how much metallic currency would circulate in that counterfactual world, and exactly which forms of “money” in the real world should you compare to that hypothetical amount? And second, if the ideal monetary system was one in which the quantity of money came closest to what it would be if only metal coins were used, why did people — in the most prosperous countries especially — go to such lengths to develop forms of payment other than metallic coins? Hume, in the 18th century, could still hew to the logic of theory and and conclude that, actually, paper money, bills of exchange, banks that functioned as anything but safety-deposit boxes [4] and all the rest of the modern financial system was a big mistake. For later writers, for obvious reasons, this wasn’t a credible position, and so the problem tended to be evaded rather than addressed head on.

Or to come back to the specific way Minsky presents the problem. Suppose I have some productive project available to me but lack sufficient claim on society’s resources to carry it out. In principle, I could get them by pledging a fraction of the results of my project. But that might not work, perhaps because the results are too far in the future, or too uncertain, or — information asymmetry — I have no way of sharing the knowledge that the project is viable or credibly committing to share its fruits. In that case “welfare” will be lower than it the hypothetical perfect-information alternative, and, given some additional assumptions, we will see something that looks like unemployment. Now, perhaps the monetary authority can in some way arrange for deferred or uncertain claims to be accepted more readily. That may result in resources becoming available for my project, potentially solving the unemployment problem. But, given the assumptions that created the need for policy in the first place, there is no reason to think that the projects funded as a result of this intervention wil be exactly the same as in the perfect-information case. And there is no reason to think there are not lots of other unrealized projects whose non-undertaking happens not to show up as unemployment. [5]

Returning to Minsky: A system of markets

is not the only way that economic interrelations can be modeled. Every capitalist economy can be described in terms of interrelated balance sheets … The entries on balance sheets can be read as payment commitments (liabilities) and expected payment receipts (assets), both denominated in a common unit.

We don’t have to see an endowments of goods, tastes for consumption, and a given technology for converting the endowments to consumption goods as the atomic units of the economy. We can instead start with a set of money flows between units, and the capitalized expectations of future money flows captured on balance sheets. In the former perspective, money payments and commitments are a secondary complication that we may want to introduce for specific problems. In the latter, Minskyan perspective, exchanges of goods are just one of the various forms of money flows between economic units.

Minsky continues:

In this structure, the real and the financial dimensions of the economy are not separated. There is no “real economy” whose behavior can be studied by abstracting from financial considerations. … In this model, money is never neutral.

The point here, again, is that real economies require people to make commitments today on the basis of expectations extending far into an uncertain future. Money and credit are tools to allow these commitments to be made. The more available are money and credit, the further into the future can be deferred the results that will justify today’s activity. If we can define a level of activity that we call full employment or price stability — and I think Keynes was much too sanguine on this point — then a good monetary authority may be able to regulate the flow of money or credit (depending on the policy instrument) to keep actual activity near that level. But there is no connection, logical or practical, between that state of the economy and a hypothetical economy without money or credit at all.

For Minsky, this fundamental point is captured in Keynes’ two-price model. The price level of current output and capital assets are determined by two independent logics and vary independently. This is another way of saying that the classical dichotomy between relative prices and the overall price level, does not apply in a modern economy with a financial system and long-lived capital goods. Changes in the “supply of money,” whatever that means in practice, always affect the prices of assets relative to current output.

The price level of assets is determined by the relative value that units place on income in the future and liquidity now. …  

The price level of current output is determined by the labor costs and the markup per unit of output. … The aggregate markup for consumption goods is determined by the ratio of the wage bill in investment goods, the government deficit… , and the international trade balance, to the wage bill in the production of consumption goods. In this construct the competition of interest is between firms for profits.

Here we see Minsky’s Kaleckian side, which doesn’t get talked about much. Minsky was convinced that investment always determined profits, never the other way round. Specifically, he followed Kalecki in treating the accounting identity that “the capitalists get what they spend” as causal. That is, total profits are determined as total investment spending plus consumption by capitalists (plus the government deficit and trade surplus.)

Coming back to the question at hand, the critical point is that liquidity (or “money”) will affect these two prices differently. Think of it this way: If money is scarce, it will be costly to hold a large stock of it. So you will want to avoid committing yourself to fixed money payments in the future, you will prefer assets that can be easily converted into money as needed, and you will place a lower value on money income that is variable or uncertain. For all these reasons, long-lived capital goods will have a lower relative price in a liquidity-scare world than in a liquidity-abundant one. Or as Minsky puts it:

The non-neutrality of money … is due to the difference in the way money enters into the determination of the price level of capital assets and of current output. … the non-neutrality theorem reflects essential aspects of capitalism in that it recognizes that … assets exist and that they not only yield income streams but can also be sold or pledged.

Finally, we get to Minsky’s famous threefold classification of financial positions as hedge, speculative or Ponzi. In context, it’s clear that this was a secondary not a central concern. Minsky was not interested in finance for its own sake, but rather in understanding modern capitalist economies through the lens of finance. And it was certainly not Minsky’s intention for these terms to imply a judgement about more and less responsible financing practices. As he writes, “speculative” financing does not necessarily involve anything we would normally call speculation:

Speculative financing covers all financing that involves refinancing at market terms … Banks are always involved in speculative financing. The floating debt of companies and governments are speculative financing.

As for Ponzi finance, he admits this memorable label was a bad choice:

I would have been better served if I had labeled the situation “the capitalization of interest.” … Note that construction finance is almost always a prearranged Ponzi financing scheme. [6]

For me, the fundamental points here are (1) That our overarching vision of capitalist economies needs to be a system of “units” (including firms, governments, etc.) linked by current money payments and commitments to future money payments, not a set of agents exchanging goods; and (2) that the critical influence of liquidity comes in the terms on which long-lived commitments to particular forms of production trade off against current income.

[1] Marxism does, arguably, offer a coherent alternative — the only one at this point, I think. Anwar Shaikh recently wrote a nice piece, which I can’t locate at the moment, contrasting the Marxist-classical and Post Keynesian  strands of heterodoxy.

[2] In fact, as Perry Mehrling demonstrates in The Money Interest and the Public Interest, Minsky represents an older and largely forgotten tradition of American monetary economics, which owes relatively little to Keynes.

[3] Walras, Wicksell and many others dismiss the idea that more money can be beneficial by focusing on its function as a unit of account. You can’t consistently arrive earlier, they point out, by adjusting your watch, even if you might trick yourself the first few times. You can’t get taller by redefining the inch. Etc. But this overlooks the fact that people do actually hold money, and pay real costs to acquire  it.

[4] “The dearness of every thing, from plenty of money, is a disadvantage … This has made me entertain a doubt concerning the benefit of banks and paper-credit, which are so generally esteemed advantageous … to endeavour artificially to encrease such a credit, can never be the interest of any trading nation; but must lay them under disadvantages, by encreasing money beyond its natural proportion to labour and commodities… And in this view, it must be allowed, that no bank could be more advantageous, than such a one as locked up all the money it received, and never augmented the circulating coin, as is usual, by returning part of its treasure into commerce.” Political Discourses, 1752.

[5] This leads into Verdoorn’s law and anti-hysteresis, a topic I hope to return to.

[6] Daniel Davies should appreciate this.

What to Read on Liquidity

In comments, someone asks for references behind “the point is liquidity, the point is liquidity, the point is liquidity.” So, here are my recommended readings on liquidity.

Mike Beggs: “Liquidity as a Social Relation.” This is the best single discussion I know of the Keynesian view of liquidity. Beside laying out the fundamental conceptual issues, and sketching the historical development of the concept, this piece also has a good discussion of how the definition of liquidity used in monetary policy has been transformed over the past couple decades. This is the first thing I’d recommend to anyone who wants to understand what exactly those of us in the left-Keynsian tradition mean by “liquidity.”

John Hicks: “Liquidity.” A lucid and intelligent summary of where the discussion of liquidity stood 20 years after Keynes’ death.

Jorg Bibow: “Liquidity preference theory revisited: to ditch or to build on it?” A rigorous analysis of the role of liquidity in the Keynesian theory of interest rates, with particular attention to the dynamics of conventional expectations. If you want to know how Keynes’ ideas about liquidity fit into contemporary debates about monetary policy, Bibow is your man. Also worth reading: “On Keynesian Theories of Liquidity Preference,” and Bibow’s book.

J. M. Keynes: chapters 12, 13, 15, 17 and 23 of the General Theory. Also: “The General Theory of Employment”; “The Ex-Ante Theory of Interest. The original source. I think  the presentation in the articles is clearer than in the book. Beggs and Hicks and Bibow are even clearer.

Jean Tirole, “Illiquidity and All Its Friends.” Within the mainstream, Tirole has by far the best discussion of liquidity that I’m aware of. I have profoundly mixed feelings about his approach but I’ve certainly learned from him — for example, the distinction between funding liquidity and market liquidity is genuinely useful. If you’re tempted to criticize “mainstream” economics’ treatment of liquidity, you need to seriously engage with Tirole first — he incorporates a surprisingly large part of the Keynesian vision of liquidity into an orthodox framework.

Jim Crotty, “The Centrality of Money, Credit and Intermediation in Marx’s Crisis Theory”. Addresses liquidity in a somewhat different context than most of the above — he asks how the specifically monetary character of capitalist production shapes the dynamics of accumulation as described by Marx and his followers. It’s a bit askew to the other pieces here, but the underlying questions are, I think, the same. And it is one of the most brilliant scholarly essays I have read.

Perry Mehrling, “The Vision of Hyman Minsky.” I think this lays out the logic of Minsky’s work better than anything by Minsky himself. Also see Mehrling’s book, The Money Interest and the Public Interest. Everything we need to know about liquidity is in there, though you may have to read between the lines to find it. His “Inherent Hierarchy of Money” is also useful, making the point that any system of payments is inherently hierarchical, with the same instrument appearing as credit at one level and as money at the level below.

EDIT: Should also include Joan Robinson, “The Rate of Interest,” which has a useful taxonomy distinguishing illiquidity in the strict sense from capital uncertainty, income uncertainty and lender’s risk.

By the way, the phrasing the post starts with is taken from Tree of Smoke, Denis Johnson’s Vietnam war novel. (I know that’s not what you were asking.) It’s the best novel I read this year, I recommend it almost unreservedly. There of course the point is Vietnam.

Alvin Hansen on Monetary Policy

The more you read in the history of macroeconomics and monetary theory, the more you find that current debates are reprises of arguments from 50, 100 or 200 years ago.

I’ve just been reading Perry Mehrling’s The Money Interest and the Public Interest, which  is one of the two best books I know of on this subject. (The other is Arie Arnon’s Monetary Theory and Policy Since David Hume and Adam Smith.) About a third of the book is devoted to Alvin Hansen, and it inspired me to look up some of Hansen’s writings from the 1940s and 50s. I was especially struck by this 1955 article on monetary policy. It not only anticipates much of current discussions of monetary policy — quantitative easing, the maturity structure of public debt, the need for coordination between the fiscal and monetary policy, and more broadly, the limits of a single interest rate instrument as a tool of macroeconomic management — but mostly takes them for granted as starting points for its analysis. It’s hard not to feel that macro policy debates have regressed over the past 60 years.

The context of the argument is the Treasury-Federal Reserve Accord of 1951, following which the Fed was no longer committed to maintaining fixed rates on treasury bonds of various maturities. [1] The freeing of the Fed from the overriding responsibility of stabilizing the market for government debt, led to scholarly and political debates about the new role for monetary policy. In this article, Hansen is responding to several years of legislative debate on this question, most recently the 1954 Senate hearings which included testimony from the Treasury department, the Fed Board’s Open Market Committee, and the New York Fed.

Hansen begins by expressing relief that none of the testimony raised

the phony question whether or not the government securities market is “free.” A central bank cannot perform its functions without powerfully affecting the prices of government securities.

He then expresses what he sees as the consensus view that it is the quantity of credit that is the main object of monetary policy, as opposed to either the quantity of money (a non-issue) or the price of credit (a real but secondary issue), that is, the interest rate.

Perhaps we could all agree that (however important other issues may be) control of the credit base is the gist of monetary management. Wise management, as I see it, should ensure adequate liquidity in the usual case, and moderate monetary restraint (employed in conjunction with other more powerful measures) when needed to check inflation. No doubt others, who see no danger in rather violent fluctuations in interest rates (entailing also violent fluctuations in capital values), would put it differently. But at any rate there is agreement, I take it, that the central bank should create a generous dose of liquidity when resources are not fully employed. From this standpoint the volume of reserves is of primary importance.

Given that the interest rate is alsoan object of policy, the question becomes, which interest rate?

The question has to be raised: where should the central bank enter the market -short-term only, or all along the gamut of maturities?

I don’t believe this is a question that economists asked much in the decades before the Great Recession. In most macro models I’m familiar with, there is simply “the interest rate,” with the implicit assumption that the whole rate structure moves together so it doesn’t matter which specific rate the monetary authority targets. For Hansen, by contrast, the structure of interest rates — the term and “risk” premiums — is just as natural an object for policy as the overall level of rates. And since there is no assumption that the whole structure moves together, it makes a difference which particular rate(s) the central bank targets. What’s even more striking is that Hansen not only believes that it matters which rate the central bank targets, he is taking part in a conversation where this belief is shared on all sides.

Obviously it would make little difference what maturities were purchased or sold if any change in the volume of reserve money influenced merely the level of interest rates, leaving the internal structure of rates unaffected. … In the controversy here under discussion, the Board leans toward the view that … new impulses in the short market transmit themselves rapidly to the longer maturities. The New York Reserve Bank officials, on the contrary, lean toward the view that the lags are important. If there were no lags whatever, it would make no difference what maturities were dealt in. But of course the Board does not hold that there are no lags.

Not even the most conservative pole of the 1950s debate goes as far as today’s New Keynesian orthodoxy that monetary policy can be safely reduced to the setting of a single overnight interest rate.

The direct targeting of long rates is the essential innovation of so-called quantitative easing. [2] But to Hansen, the idea that interest rate policy should directly target long as well as short rates was obvious. More than that: As Hansen points out, the same point was made by Keynes 20 years earlier.

If the central bank limits itself to the short market, and if the lags are serious, the mere creation of large reserves may not lower the long-term rate. Keynes had this in mind when he wrote: “Perhaps a complex offer by the central bank to buy and sell at stated prices gilt-edged bonds of all maturities, in place of the single bank rate for short-term bills, is the most important practical improvement that can be made in the technique of monetary management. . . . The monetary authority often tends in practice to concentrate upon short-term debts and to leave the price of long-term debts to be influenced by belated and imperfect re- actions from the price of short-term debts.” ‘ Keynes, it should be added, wanted the central bank to deal not only in debts of all maturities, but also “to deal in debts of varying degrees of risk,” i.e., high grade private securities and perhaps state and local issues.

That’s a quote from The General Theory, with Hansen’s gloss.

Fast-forward to 2014. Today we find Benjamin Friedman — one of the smartest and most interesting orthodox economists on these issues — arguing that the one great change in central bank practices in the wake of the Great Recession is intervention in a range of securities beyond the shortest-term government debt. As far as I can tell, he has no idea that this “profound” innovation in the practice of monetary policy was already proposed by Keynes in 1936. But then, as Friedman rightly notes, “Macroeconomics is a field in which theory lags behind experience and practice, not the other way around.”

Even more interesting, the importance of the rate structure as a tool of macroeconomic policy was recognized not only by the Federal Reserve, but by the Treasury in its management of debt issues. Hansen continues:

Monetary policy can operate on two planes: (1) controlling the credit base – the volume of reserve balances- and (2) changing the interest rate structure. The Federal Reserve has now backed away from the second. The Treasury emphasized in these hearings that this is its special bailiwick. It supports, so it asserts, the System’s lead, by issuing short- terms or long-terms, as the case may be, according to whether the Federal Reserve is trying to expand or contract credit … it appears that we now have (whether by accident or design) a division of monetary management between the two agencies- a sort of informal cartel arrangement. The Federal Reserve limits itself to control of the volume of credit by operating exclusively in the short end of the market. The Treasury shifts from short-term to long-term issues when monetary restraint is called for, and back to short-term issues when expansion is desired.

This is amazing. It’s not that Keynesians like Hansen  propose that Treasury should issue longer or shorter debt based on macroeconomic conditions. Rather, it is taken for granted that it does choose maturities this way. And this is the conservative side in the debate, opposed to the side that says the central bank should manage the term structure directly.

Many Slackwire readers will have recently encountered the idea that the maturities of new debt should be evaluated as a kind of monetary policy. It’s on offer as the latest evidence for the genius of Larry Summers. Proposing that Treasury should issue short or long term debt based on goals for the overall term structure of interest rates, and not just on minimizing federal borrowing costs, is the main point of Summers’ new Brookings paper, which has attracted its fair share of attention in the business press. No reader of that paper would guess that its big new idea was a commonplace of policy debates in the 1950s. [3]

Hansen goes on to raise some highly prescient concerns about the exaggerated claims being made for narrow monetary policy.

The Reserve authorities are far too eager to claim undue credit for the stability of prices which we have enjoyed since 1951. The position taken by the Board is not without danger, since Congress might well draw the conclusion that if monetary policy is indeed as powerful as indicated, nonmonetary measures [i.e. fiscal policy and price controls] are either unnecessary or may be drawn upon lightly.

This is indeed the conclusion that was drawn, more comprehensively than Hansen feared. The idea that setting an overnight interest rate is always sufficient to hold demand at the desired level has conquered the economics profession “as completely as the Holy Inquisition conquered Spain,” to coin a phrase. If you talk to a smart young macroeconomist today, you’ll find that the terms “aggregate demand was too low” and “the central bank set the interest rate too high” are used interchangeably. And if you ask, which interest rate?, they react the way a physicist might if you asked, the mass of which electron?

Faced with the argument that the inflation of the late 1940s, and price stability of the early 1950s, was due to bad and good interest rate policy respectively, Hansen offers an alternative view:

I am especially unhappy about the impli- cation that the price stability which we have enjoyed since February-March 1951 (and which everyone is justifiably happy about) could quite easily have been purchased for the entire postwar period (1945 to the present) had we only adopted the famous accord earlier …  The postwar cut in individual taxes and the removal of price, wage, and other controls in 1946 … did away once and for all with any really effective restraint on consumers. Under these circumstances the prevention of price inflation … [meant] restraint on investment. … Is it really credible that a drastic curtailment of investment would have been tolerated any more than the continuation of wartime taxation and controls? … In the final analysis, of course,  the then prevailing excess of demand was confronted with a limited supply of productive resources.

Inflation always comes down to this mismatch between “demand,” i.e. desired expenditure, and productive capacity.

Now we might say in response to such mismatches: Well, attempts to purchase more than we can produce will encourage increased capacity, and inflation is just a temporary transitional cost. Alternatively, we might seek to limit spending in various ways. In this second case, there is no difference of principle between an engineered rise in the interest rate, and direct controls on prices or spending. It is just a question of which particular categories of spending you want to hold down.

The point: Eighty years ago, Keynes suggested that what today is called quantitative easing should be a routine tool of monetary policy. Sixty years ago, Alvin Hansen believed that this insight had been accepted by all sides in macroeconomic debates, and that the importance of the term structure for macroeconomic activity guided the debt-issuance policies of Treasury as well as the market interventions of the Federal Reserve. Today, these seem like new discoveries. As the man says, the history of macroeconomics is mostly a great forgetting.

[1] I was surprised by how minimal the Wikipedia entry is. One of these days, I am going to start having students improve economics Wikipedia pages as a class assignment.

[2] What is “quantitative about this policy is that the Fed buys a a quantity of bonds, evidently in the hopes of forcing their price up, but does not announce an explicit target for the price. On the face of it, this is a strangely inefficient way to go about things. If the Fed announced a target for, say, 10-year Treasury bonds, it would have to buy far fewer of them — maybe none — since market expectations would do more of the work of moving the price. Why the Fed has hobbled itself in this way is a topic for another post.

[3] I am not the world’s biggest Larry Summers fan, to say the least. But I worry I’m giving him too hard a time in this case. Even if the argument of the paper is less original than its made out to be, it’s still correct, it’s still important, and it’s still missing from today’s policy debates. He and his coauthors have made a real contribution here. I also appreciate the Hansenian spirit in which Summers derides his opponents as “central bank independence freaks.”

Varieties of Keynesianism

Here’s something interesting from Axel Leijonhufvud. It’s a response to Luigi Pasinetti’s book on Keynes, but really it’s an assessment of the Keynesian revolution in general.

There really was a revolution, according to Pasinetti, and it can be dated precisely, to 1932. Leijonhufvud:

By the Spring of that year, Keynes had concluded that the Treatise could not be salvaged by a revised edition. He still gave his “Pure Theory of Money” lecture series which was largely based on it but members of his ‘Circus’ attended and gave him trouble. The summer of that year appears to have been a critical period. In the Fall, Keynes announced a new series of lectures with the title “The Monetary Theory of Production”. The new title signaled a break with his previous work and a break with tradition. From this point onward, Keynes felt himself to be doing work that was revolutionary in nature. 

What was revolutionary about these lectures was that they weren’t about extending or modifying the established framework of economics, but about adopting a new starting point. A paradigm in economics can be thought of as defined by the minimal model — the model that (in Pasinetti’s words) “contains those analytical features, and only those features, which the theory cannot do without.” Or as I’ve suggested here, the minimal model is the benchmark of simplicity in terms of which Occam’s razor is applied.

For the orthodox economics of Keynes’s day (and ours), the minimal model was one of “real exchange” in which a given endowment of goods and a given set of preferences yielded a vector of relative prices. Money, production, time, etc. can then be introduced as extensions of this minimal model. In Keynes’ “monetary production” model, on the other hand, the “analytical features which the theory cannot do without” are a set of income flows generated in production, and a set of expenditure flows out of income. The minimal model does not include any prices or quantities. Nor does it necessarily include exchange — it’s natural to think of the income flows as consisting of profits and wages and the expenditure flows as consumption and investment, but they can just as naturally include taxes, interest payments, asset sales, and so on.

I don’t want to suggest that the monetary production paradigm has ever been as well-defined as the real exchange paradigm. One of Leijonhufvud’s main points is that there has never been a consensus on the content of the Keynesian revolution. There are many smart people who will tell you what “Keynes really meant.” With due respect (and I mean it) I’m not convinced by any of them. I don’t think anyone knows what Keynes really meant —including Keynes himself. The truth is, the Hicks-Patinkin-Samuelson version of Keynes is no bastard; its legitimate paternity is amply documented in the General Theory. Pasinetti quotes Joan Robinson: “There were moments when we had some trouble in getting Maynard to see what the point of his revolution really was.” Which doesn’t, of course, means that Hicks-Patinkin-Samuelson is the only legitimate Keynes — here even more than  in most questions of theory, we have to tolerate ambiguity and cultivate the ability to hold more than one reading in mind at once.

One basic ambiguity is in that term, “monetary production.” Which of those words is the important one?

For Pasinetti, the critical divide is between Keynes’ theory of production and the orthodox theory of exchange. Pasinetti’s production-based Keynesianism

starts from the technological imperatives stemming from the division and specialization of labor. In this context, exchange is derivative, stemming from specialization in production. How it is institutionalized and organized is a matter that the minimal production paradigm leaves open (whereas the exchange paradigm necessarily starts by assuming at least private property and often also organized markets). Prices in the production paradigm are indices of technologically determined resource costs and, as such, leave open the question whether the system does or does not have a tendency towards the full utilization of scarce resources and, in particular, of labor. …

The exchange paradigm relies on individual self-interest, on consumer’s sovereignty, and on markets and private property as the principal institutions needed to bring about a socially desirable and harmonious outcome. In putting the division of labor and specialization at center stage, the pure production model, in contrast, highlights the “necessarily cooperative aspects of any organized society…

To an unsympathetic audience, I admit, this could come across as a bunch of commencement-speech pieties. For a rigorous statement of the pure production paradigm we need to turn to Sraffa. In Production of Commodities by Means of Commodities he starts from the pure engineering facts — the input-output matrices governing production at current levels using current technology. There’s nothing about prices, demand, distribution. His system “does not explain anything about the allocation of resources. Instead, the focus is altogether on finding a logical basis for objective measurement. It is a system for coherent, internally coherent macroeconomic accounting.”

In other words: We cannot reduce the heterogeneous material of productive activity to a single objective quantity of need-satisfaction. There is no such thing. Mengers, Jevons, Walras and their successors set off after the will-o-the-wisp of utility and, to coin a phrase, vanished into a swamp, never to be heard from by positive social science again.

The question then is, how can we consistently describe economic activity using only objective, observable data? (This was also the classical question.) Sraffa answers in terms of a “snapshot” of production at a given moment. Or as Sen puts it, in a perceptive essay, he is showing how one can do economics without the use of counterfactuals.

For Pasinetti, Keynes’ revolution and Sraffa’s anti-subjectivist revival of classical economics — his effort to ground economics in engineering data — were part of the same project, of throwing out subjectivism in favor of engineering. Leijonhufvud is not convinced. “Keynes was above all a monetary economist,” he notes, “and there are good reasons to believe” that it was monetary and not production that was the key term in the “theory of monetary production.” Keynes made no use of the theory of imperfect competition, despite its development by members of his inner circle (Richard Kahn and Joan Robinson). Or consider his famous reversal on wages — in the General Theory, he assumed they were equal to the marginal product of labor, which declined with the level of output. But after this claim was challenged Dunlop, Tarshis and others, he admitted there was no real evidence for it and good reason to think it was not true. [1] The fact that JMK didn’t think anything important in his theory hinged on how wages were set, at least suggests that production side of economy was not central to his project.

The important point for us is that there is one strand of Cambridge that rejects orthodoxy on the grounds that it misrepresents a system of production based on objective relationships between inputs and outputs, as a system of exchange based on subjective preferences. But this is not the only vantage point from which one can criticize the Walrasian system and it’s not clear it’s the one occupied by Keynes or by Keynesianism — whatever that may be.

The alternative standpoint is still monetary production, but with the stress on the first word rather than the second. Leijonhufvud doesn’t talk much about this here, since this is an essay about Pasinetti. But it’s evidently something along the lines of Mehrling’s “money view” or “finance view.” [2] It seems to me this view has three overlapping elements: 1. The atomic units of the economy are money flows (and commitments to future money flows), as opposed to prices and quantities. 2. Quantities are quantities of money; productive activity is not measurable except insofar as it involves money payments. 3. The active agents of the economy are seeking to maximize money income or wealth, not to end up with some preferred consumption basket. Beside Mehrling, I would include Minsky, Paul Davidson and Wynne Godley here, among others.

I’m not going to try to summarize this work here. Let me just say how I’m coming at this.

As I wrote in comments to an earlier post, what I want is to think more systematically about the relationship between the network of financial assets and liabilities recorded on balance sheets, on the one hand, and the concrete social activities of production and consumption, on the other. What we have now, it seems to me, is either a “real” view that collapses these two domains into one, with changes in ownership and debt commitments treated as if they were decisions about production and consumption; or else a “finance” view that treats balance-sheet transactions as a closed system. I think the finance view is more correct, in the sense that at least it sees half of the problem clearly. The “real” view is a hopeless muddle because it tries to treat the concrete social activity of production and consumption as if it were a set of fungible quantities like money, and to treat money commitments as if they were decisions about production and consumption. The strength of the finance view is that it recognizes the system of contingent money payments recorded on balance sheets as a distinct social activity, and not simply a reflection of the allocation of goods and services. To be clear: The purpose of recognizing finance as a distinct thing isn’t to study it in isolation, but rather to explore the specific ways in which it interacts with other kinds of social activity. This is the agenda that Fisher dynamics, disgorge the cash, functional finance and the other projects I’m working on are intended to contribute to.

[1] It’s a bit embarrassing that this “First Classical Postulate,” which Keynes himself said “is the portion of my book which most needs to be revised,” is the first positive claim in the book.

[2] Mehrling prefers to trace his intellectual lineage to the independent tradition of American monetary economics of Young, Hansen and Shaw.  But I think the essential content is similar.

The Interest Rate, the Interest Rate, and Secular Stagnation

In the previous post, I argued that the term “interest rate” is used to refer to two basically unrelated prices: The exchange rate between similar goods at different periods, and the yield on a credit-market instrument. Why does this distinction matter for secular stagnation?

Because if you think the “natural rate of interest,” in the sense of the credit-market rate that brings aggregate expenditure to a desired level in some real-world economic situation, should be the time-substitution rate that would exist in a model that somehow corresponds to that situation, when the two are in fact unrelated — well then, you are going to end up with a lot of irrelevant and misleading intuitions about what that rate should be.

In general, I do think the secular stagnation conversation is a real step forward. So it’s a bit frustrating, in this context, to see Krugman speculating about the “natural rate” in terms of a Samuelson-consumption loan model, without realizing that the “interest rate” in that model is the intertemporal substitution rate, and has nothing to do with the Wicksellian natural rate. This was the exact confusion introduced by Hayek, which Sraffa tore to pieces in his review, and which Keynes went to great efforts to avoid in General Theory. It would be one thing if Krugman said, “OK, in this case Hayek was right and Keynes was wrong.” But in fact, I am sure, he has no idea that he is just reinventing the anti-Keynesian position in the debates of 75 years ago.

The Wicksellian natural rate is the credit-market rate that, in current conditions, would bring aggregate expenditure to the level desired by whoever is setting monetary policy. Whether or not there is a level of expenditure that we can reliably associate with “full employment” or “potential output” is a question for another day. The important point for now is “in current conditions.” The level of interest-sensitive expenditure that will bring GDP to the level desired by policymakers depends on everything else that affects desired expenditure — the government fiscal position, the distribution of income, trade propensities — and, importantly, the current level of income itself. Once the positive feedback between income and expenditure has been allowed to take hold, it will take a larger change in the interest rate to return the economy to its former position than it would have taken to keep it there in the first place.

There’s no harm in the term “natural rate of interest” if you understand it to mean “the credit market interest rate that policymakers should target to get the economy to the state they think it should be in, from the state it in now.”And in fact, that is how working central bankers do understand it. But if you understand “natural rate” to refer to some fundamental parameter of the economy, you will end up hopelessly confused. It is nonsense to say that “We need more government spending because the natural rate is low,” or “we have high unemployment because the natural rate is low.” If G were bigger, or if unemployment weren’t high, there would be a different natural rate. But when you don’t distinguish between the credit-market rate and time-substitution rate, this confusion is unavoidable.

Keynes understood clearly that it makes no sense to speak of the “natural rate of interest” as a fundamental characteristic of an economy, independent of the current state of aggregate demand:

In my Treatise on Money I defined what purported to be a unique rate of interest, which I called the natural rate of interest — namely, the rate of interest which, in the terminology of my Treatise, preserved equality between the rate of saving (as there defined) and the rate of investment. I believed this to be a development and clarification of Wicksell’s “natural rate of interest”, which was, according to him, the rate which would preserve the stability if some, not quite clearly specified, price-level. 

I had, however, overlooked the fact that in any given society there is, on this definition, a different natural rate of interest for each hypothetical level of employment. And, similarly, for every rate of interest there is a level of employment for which that rate is the “natural” rate, in the sense that the system will be in equilibrium with that rate of interest and that level of employment. Thus it was a mistake to speak of the natural rate of interest or to suggest that the above definition would yield a unique value for the rate of interest irrespective of the level of employment. I had not then understood that, in certain conditions, the system could be in equilibrium with less than full employment. 

I am now no longer of the opinion that the concept of a “natural” rate of interest, which previously seemed to me a most promising idea, has anything very useful or significant to contribute to our analysis. It is merely the rate of interest which will preserve the status quo; and, in general, we have no predominant interest in the status quo as such.

EDIT: In response to Nick Edmonds in comments, I’ve tried to restate the argument of these posts in simpler and hopefully clearer terms:

Step 1 is to recognize that in a model like Samuelson’s, “interest rate” just means any contract that allows you to make a payment today and receive a flow of income in the future. It would be the exact same model, capturing the exact same features of the economy, if we wrote “profit rate” or “house price-to-rent ratio” instead of “interest rate.” Any valid intuition the model gives us, applies to ALL asset yields, not just to the the credit-instrument yields that we call “interest rates” in every day life.

Step 2 is to think about the other factors that enter into real-world asset yields, besides the intertemporal exchange rate Samuelson is interested in — risk, liquidity, carrying costs and depreciation, and expected capital gains. Since all real-world asset yields incorporate at least one of these factors, none correspond exactly to Samuelson’s intertemporal interest rate.

Step 3 is to realize that not only are credit-instrument yields not exactly the Samuelson “interest rate,” they aren’t even approximately it. The great majority of credit market transactions we see in real economies are not exchanges of present income for future income, but exchanges of two different claims on future income. So the intertemporal interest rate enters on both sides and cancels out.

At that point, we have established that the “interest rate” the monetary authority is targeting is not the “interest rate” Samuelson is writing about.

Step 4 is then to ask, what does it mean to say that some particular credit-market interest rate is the “natural” one? That is where the dependence on fiscal policy, income distribution, etc. come in. But those factors are not part of the argument for why the credit-market rate is not even approximately the intertemporal rate.

The Interest Rate and the Interest Rate

We will return to secular stagnation. But we need to clear some ground first. What is an interest rate?

Imagine you are in a position to acquire a claim on a series of payments  in the future. Since an asset is just anything that promises a stream of payments in the future, we will say you are thinking of buying of an asset. What will you look at to make your decision?

First is the size of the payments you will receive, as a fraction of what you pay today. We will call that the yield of the asset, or y. Against that we have to set the risk that the payments may be different from expected or not occur at all; we will call the amount you reduce your expected yield to account for this risk r. If you have to make regular payments beyond the purchase of the asset to receive income from it (perhaps taxes, or the costs of operating the asset if it is a capital good) then we also must subtract these carrying costs c. In addition, the asset may lose value over time, in which case we have to subtract the depreciation rate d. (In the case of an asset that only lasts one period — a loan to be paid back in full the next period, say — d will be equal to one.) On the other hand, owning an asset can have benefits beyond the yield. In particular, an asset can be sold or used as collateral. If this is easy to do, ownership of the asset allows you to make payments now, without having to waiting for its yield in the future. We call the value of the asset for making unexpected payments its liquidity premium, l. The market value of long-lasting assets may also change over time; assuming resale is possible, these market value changes will produce a capital gain g (positive or negative), which must be added to the return. Finally, you may place a lower value on the payments from the asset simply because they take place in the future; this might be because your needs now are more urgent than you expect them to be then, or simply because you prefer income in the present to income in the future. Either way, we have to subtract this pure time-substitution rate i.

So the value of an asset costing one unit (of whatever numeraire) will be 1 + y – r – c – d + l + g – i.

(EDIT: On rereading, this could use some clarification:

Of course all the terms can take on different (expected) values in different time periods, so they are vectors, not scalars. But if we assume they are constant, and that the asset lasts forever (i.e. a perpetuity), then we should write its equilibrium value as: V = Y/i, where Y is the total return in units of the numeraire, i.e. Y = V(y – r – c + l + g) and i is the discount rate. Divide through both sides by V/i and we have i = y – r – c + l + g. We can now proceed as below.)

In equilibrium, you should be just indifferent between purchasing and not purchasing this asset, so we can write:

y – r – c – d + l + g – i = 0, or

(1) y = r + c + d – l – g + i

So far, there is nothing controversial.

In formal economics, from Bohm-Bawerk through Cassel, Fisher and Samuelson to today’s standard models, the practice is to simplify this relationship by assuming that we can safely ignore most of these terms. Risk, carrying costs and depreciation can be netted out of yields, capital gains must be zero on average, and liquidity is assumed not to matter or just ignored. So then we have:

(2) y = i

In these models, it doesn’t matter if we use the term “interest rate” to mean y or to mean i, since they are always the same.

This assumption is appropriate for a world where there is only one kind of asset — a risk-free contract that exchanges one good in the present for 1 + i goods in the future. There’s nothing wrong with exploring what the value of i would be in such a world under various assumptions.

The problem arises when we carry equation (2) over to the real world and apply it to the yield of some particular asset. On the one hand, the yield of every existing asset reflects some or all of the other terms. And on the other hand, every contract that involves payments in more than one period — which is to say, every asset — equally incorporates i. If we are looking for the “interest rate” of economic theory in the economic world we observe around us, we could just as well pick the rent-price ratio for houses, or the profit rate, or the deflation rate, or the ratio of the college wage premium to tuition costs. These are just the yields of a house, of a share of the capital stock, of cash and of a college degree respectively. All of these are a ratio of expected future payments to present cost, and should reflect i to exactly the same extent as the yield of a bond does. Yet in everyday language, it is the yield of the bond that we call “interest”, even though it has no closer connection to the interest rate of theory than any of these other yields do.

This point was first made, as far as I know, by Sraffa in his review of Hayek’s Prices and Production. It was developed by Keynes, and stated clearly in chapters 13 and 17 of the General Theory.

For Keynes, there is an additional problem. The price we observe as an “interest rate” in credit markets is not even the y of the bond, which would be i modified by risk, expected capital gains and liquidity. That is because bonds do not trade against baskets of goods. They trade against money. When we see a bond being sold with a particular yield, we are not observing the exchange rate between a basket of goods equivalent to the bond’s value today and baskets of goods equivalent to its yield in the future. We are observing the exchange rate between the bond today and a quantity of money today. That’s what actually gets exchanged. So in equilibrium the price of the bond is what equates the expected returns on the two assets:

(3) y_B – r_B + l_B + g_B – i = l_M – i

(Neither bonds nor money depreciate or have carrying costs, and money has no risk. If our numeraire is money then money also cannot experience capital gains. If our numeraire was a basket of goods instead, then -g would be expected inflation, which would appear on both sides and cancel out.)

What we see is that i appears on both sides, so it cancels out. The yield of the bond is given by:

(4) y_B  = r_B – g_B + (l_M – l_B)

The yield of the bond — the thing that in conventional usage we call the “interest rate” — depends on the risk of the bond, the expected price change of the bond, and the liquidity premium of money compared with the bond. Holding money today, and holding a bond today, are both means to enable you to make purchases in the future. So the intertemporal substitution rate i does not affect the bond yield.

(We might ask whether the arbitrage exists that would allow us to speak of a general rate of time-substitution i in real economies at all. But for present purposes we can ignore that question and focus on the fact that even if there is such a rate, it does not show up in the yields we normally call “interest rates”.)

This is the argument as Keynes makes it. It might seem decisive. But monetarists would reject it on the grounds that nobody in fact holds money as a store of value, so equation (3) does not apply. The bond-money market is not in equilibrium, because there is zero demand for money beyond that needed for current transactions at any price. (The corollary of this is the familiar monetarist claim that any change in the stock of  money must result in a proportionate change in the value of transactions, which at full employment means a proportionate rise in the price level.) From the other side, endogenous money theorists might assert that the money supply is infinitely elastic for any credit-market interest rate, so l_M is endogenous and equation (4) is underdetermined.

As criticisms of the specific form of Keynes’ argument, these are valid objections. But if we take a more realistic view of credit markets, we come to the same conclusion: the yield on a credit instrument (call this the “credit interest rate”) has no relationship to the intertemporal substitution rate of theory (call this the “intertemporal interest rate.”)

Suppose you are buying a house, which you will pay for by taking out a mortgage equal to the value of the house. For simplicity we will assume an amortizing mortgage, so you make the same payment each period. We can also assume the value of housing services you receive from the house will also be the same each period. (In reality it might rise or fall, but an expectation that the house will get better over time is obviously not required for the transaction to take place.) So if the purchase is worth making at all, then it will result in a positive income to you in every period. There is no intertemporal substitution on your side. From the bank’s point of view, extending the mortgage means simultaneously creating an asset — their loan to you — and a liability — the newly created deposit you use to pay for the house. If the loan is worth making at all, then the expected payments from the mortgage exceed the expected default losses and other costs in every period. And the deposits are newly created, so no one associated with the bank has to forego any other expenditure in the present. There is no intertemporal substitution on the bank’s side either.

(It is worth noting that there are no net lenders or net borrowers in this scenario. Both sides have added an asset and a liability of equal value. The language of net lenders and net borrowers is carried over from models with consumption loans at the intertemporal interest rate. It is not relevant to the credit interest rate.)

If these transactions are income-positive for all periods for both sides, why aren’t they carried to infinity? One reason is that the yields for the home purchaser fall as more homes are purchased. In general, you will not value the housing services from a second home, or the additional housing services of a home that costs twice as much, as much as you value the housing services of the home you are buying now. But this only tells us that for any given interest rate there is a volume of mortgages at which the market will clear. It doesn’t tell us which of those mortgage volume-interest rate pairs we will actually see.

The answer is on the liquidity side. Buying a house makes you less liquid — it means you have less flexibility if you decide you’d like to move elsewhere, or if you need to reduce your housing costs because of unexpected fall in income or rise in other expenses. You also have a higher debt-income ratio, which may make it harder for you to borrow in the future. The loan also makes the bank less liquid — since its asset-capital ratio is now higher, there are more states of the world in which a fall in income would require it to sell assets or issue new liabilities to meet its scheduled commitments, which might be costly or, in a crisis, impossible. So the volume of mortgages rises until the excess of housing service value over debt service costs make taking out a mortgage just worth the incremental illiquidity for the marginal household, and where the excess of mortgage yield over funding costs makes issuing a new mortgage just worth the incremental illiquidity for the marginal bank. (Incremental illiquidity in the interbank market may — or may not — mean that funding costs rise with the volume of loans, but this is not necessary to the argument.)

Monetary policy affects the volume of these kinds of transactions by operating on the l terms. Normally, it does so by changing the quantity of liquid assets available to the financial system (and perhaps directly to the nonfinancial private sector as well). In this way the central bank makes banks (and perhaps households and businesses) more or less willing to accept the incremental illiquidity of a new loan contract. Monetary policy has nothing to do with substitution between expenditure in the present period and expenditure in some future period. Rather, it affects the terms of substitution between more and less liquid claims on income in the same future period.

Note that changing the quantity of liquid assets is not the only way the central bank can affect the liquidity premium. Banking regulation, lender of last resort operations and bailouts also change the liquidity premium, by chaining the subjective costs of bank balance sheet expansion. An expansion of the reserves available to the banking system makes it cheaper for banks to acquire a cushion to protect themselves against the possibility of an unexpected fall in income. This will make them more willing to hold relatively illiquid assets like mortgages. But a belief that the Fed will take emergency action prevent a bank from failing in the event of an unexpected fall in income also increases its willingness to hold assets like mortgages. And it does so by the same channel — reducing the liquidity premium. In this sense, there is no difference in principle between monetary policy and the central bank’s role as bank supervisor and lender of last resort. This is easy to understand once you think of “the interest rate” as the price of liquidity, but impossible to see when you think of “the interest rate” as the price of time substitution.

It is not only the central bank that changes the liquidity premium. If mortgages become more liquid — for instance through the development of a regular market in securitized mortgages — that reduces the liquidity cost of mortgage lending, exactly as looser monetary policy would.

The irrelevance of the time-substitution rate i to the credit-market interest rate y_B becomes clear when you compare observed interest rates with other prices that also should incorporate i. Courtesy of commenter rsj at Worthwhile Canadian Initiative, here’s one example: the Baa bond rate vs. the land price-rent ratio for residential property.

Both of these series are the ratio of one year’s payment from an asset, to the present value of all future payments. So they have an equal claim to be the “interest rate” of theory. But as we can see, none of the variation in credit-market interest rates (y_B, in my terms) show up in the price-rent ratio. Since variation in the time-substituion rate i should affect both ratios equally, this implies that none of the variation in credit-market interest rates is driven by changes in the time-substitution interest rate. The two “interest rates” have nothing to do with each other.

(Continued here.)

EDIT: Doesn’t it seem strange that I first assert that mortgages do not incorporate the intertemporal interest rate, then use the house price-rent ratio as an example of a price that should incorporate that rate? One reason to do this is to test the counterfactual claim that interest rates do, after all, incorporate Samuelson’s interest rate i. If i were important in both series, they should move together; if they don’t, it might be important in one, or in neither.

But beyond that, I think housing purchases do have an important intertemporal component, in a way that loan contracts do not. That’s because (with certain important exceptions we are all aware of) houses are not normally purchased entirely on credit. A substantial fraction of the price is paid is upfront. In effect, most house purchases are two separate transactions bundled together: A credit transaction (for, say, 80 percent of the house value) in which both parties expect positive income in all periods, at the cost of less liquid balance sheets; and a conceptually separate cash transaction (for, say, 20 percent) in which the buyer foregoes present expenditure in return for a stream of housing services in the future. Because house purchases must clear both of these markets, they incorporate i in way that loans do not. But note, i enters into house prices only to the extent that the credit-market interest rate does not. The more important the credit-market interest rate is in a given housing purchase, the less important the intertemporal interest rate is.

This is true in general, I think. Credit markets are not a means of trading off the present against the future. They are a means of avoiding tradeoffs between the present and the future.