“Monetary Policy in a Changing World”

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

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

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

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

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

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

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

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

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

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

Miller:

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

Finance franchise, anyone?

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

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

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

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

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

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

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

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

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

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

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

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

Miller continues:

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

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

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

Or as Miller puts it, conventional monetary policy

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

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

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

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

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

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

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

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

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

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

1. “Still” isn’t quite right — perhaps “again” would be better.
2. Then as now, one of the top-ranked journals in economics.
3. “During the downward phase, when both fixed capital and stocks of materials are for the time being redundant and working-capital is being reduced, the schedule of the marginal efficiency of capital [i.e. expected return] may fall so low that it can scarcely be corrected, so as to secure a satisfactory rate of new investment, by any practicable reduction in the rate of interest. Thus with markets organised and influenced as they are at present, the market estimation of the marginal efficiency of capital may suffer such enormously wide fluctuations that it cannot be sufficiently offset by corresponding fluctuations in the rate of interest.”

   This is from chapter 22; there’s a similar passage at the end of chapter 12.

4. This post discusses a rather garbled version of this argument from the usually sharp Neel Kashkari here, which, in an effort to make it fit contemporary textbook stories, transposes it into a nonsensical claim about borrowers.
5. I mean, think about it. Money, we’re told, is useful — it allows transactions that wouldn’t happen in a world of barter. Normally, if something is useful, it’s more useful when you have more of it. But apparently in the case of money all possible gains are realized the moment the first iota of it comes into existence.