No Maestros: Further Thoughts

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

1. In fact, the problem is even worse than this. As Sraffa pointed out long ago, in a world like this each commodity will have its own interest rate. Unless relative prices are fixed, the amount of grain today that trades for one unit of grain next year will be different from the amount of wine today that trades for one unit next year, the amount of cloth today that trades for one unit next year, etc. Any of these different proportions has as good a claim as any other to be called “the” interest rate.
2. Formally of course the frictions are specified within the model, in the form of “Calvo pricing” or whatever, but it’s entirely unclear what if any features of real economies these model frictions are supposed to map onto.
3. In Keynes’ presentation, the tradeoff is presented in terms of a choice of assets, rather than the creation of an asset and liability as with a new loan, but the logic is the same.
4. This was also Keynes argument in the General Theory. There is, oddly, no banking system in the book, only a stock market. Liquidity and the interest rate influence entrepreneurs via the asset rather than liability side of their balance sheets. Low rates stimulate investment by increasing the valuation of capital goods, not the ease with which they can be financed.
5. It was Nathan Tankus who pointed this article out to me.