Tag: finance

Interest Rates and (In)elastic Expectations

[Apologies to any non-econ readers, this is even more obscure than usual.]

Brad DeLong observed last week that one of the most surprising things about the Great Recession is how far long-term interest rates have followed short rates toward zero.

I have gotten three significant pieces of the past four years wrong. Three things surprised and still surprise me: (1.) The failure of central banks to adopt a rule like nominal GDP targeting, or it’s equivalent. (2.) The failure of wage inflation in the North Atlantic to fall even farther than it has–toward, even if not to, zero. (3.) The failure of the yield curve to sharply steepen: federal funds rates at zero I expected, but 30-Year U.S. Treasury bond nominal rates at 2.7% I did not. 

… The third… may be most interesting. 

Back in March 2009, the University of Chicago’s Robert Lucas confidently predicted that within three years the U.S. economy would be back to normal. A normal U.S. economy has a short-term nominal interest rate of 4%. Since the 10-Year U.S. Treasury bond rate tends to be one percentage point more than the average of expected future short-term interest rates over the next decade, even five expected years of a deeply depressed economy with essentially zero short-term interest rates should not push the 10-Year Treasury rate below 3%. (And, indeed, the Treasury rate fluctuated around 3 to 3.5% for the most part from late 2008 through mid 2011.) But in July of 2011 the 10-Year U.S. Treasury bond rate crashed to 2%, and at the start of June it was below 1.5%.  [

The possible conclusions are stark: either those investing in financial markets expect … [the] current global depressed economy to endure in more-or-less its current state for perhaps a decade, perhaps more; or … the ability of financial markets to do their job and sensibly price relative risks and returns at a rational level has been broken at a deep and severe level… Neither alternative is something I would have or did predict, or even imagine.

I also am surprised by this, and for similar reasons to DeLong. But I think the fact that it’s surprising has some important implications, which he does not draw out.

Here’s a picture:

The dotted black line is the Federal Funds rate, set, of course, by the central bank. The red line is the 10-year Treasury; it’s the dip at the far right in that one that surprises DeLong (and me). The green line is the 30-year Treasury, which behaves similarly but has fallen by less. Finally, the blue line is the BAA bond rate, a reasonable proxy for the interest rate faced by large business borrowers; the 2008 financial crisis is clearly visible. (All rates are nominal.) While the Treasury rates are most relevant for the expectations story, it’s the interest rates faced by private borrowers that matter for policy.

The recent fall in 10-year treasuries is striking. But it’s at least as striking how slowly and incompletely they, and corporate bonds, respond to changes in Fed policy, especially recently. It’s hard to look at this picture and not feel a twinge of doubt about the extent to which the Fed “sets” “the” interest rate in any economically meaningful sense. As I’ve mentioned here before, when Keynes referred to the “liquidity trap,” he didn’t mean the technical zero lower bound to policy rates, but its delinking from the economically-important long rates. Clearly, it makes no difference whether or not you can set a policy rate below zero if there’s reason to think that longer rates wouldn’t follow it down in any case. And I think there is reason to think that.

The snapping of the link between monetary policy and other rates was written about years ago by Benjamin Friedman, as a potential; it figured in my comrade Hasan Comert’s dissertation more recently, as an actuality. Both of them attribute the disconnect to institutional and regulatory changes in the financial system. And I agree, that’s very important. But after reading Leijonhufvud’s On Keynesian Economics and the Economics of Keynes [1], I think there may be a deeper structural explanation.

As DeLong says, in general we think that long interest rates should be equal to the average expected short rates over their term, perhaps plus a premium. [2] So what can we say about interest rate expectations? One obvious question is, are they elastic or inelastic? Elastic expectations change easily; in particular, unit-elastic expectations mean that whatever the current short rate is, it’s expected to continue indefinitely. Inelastic expectations change less easily; in the extreme case of perfectly inelastic interest rate expectations, your prediction for short-term interest rates several years from now is completely independent of what they are now.

Inelastic interest-rate expectations are central to Keynes’ vision of the economy. (Far more so than, for instance, sticky wages.) They are what limit the effectiveness of monetary policy in a depression or recession, with the liquidity trap simply the extreme case of the general phenomenon. [3] His own exposition is a little hard to follow, but the simplest way to look at it is to recall that when interest rates fall, bond prices rise, and vice versa. (In fact they are just two ways of describing the same thing.) So if you expect a rise in interest rates in the future that means you’ll expect a capital loss if you hold long-duration bonds, and if you expect a fall in interest rates you’ll expect a capital gain.  So the more likely it seems that short-term interest rates will revert to some normal level in the future, the less long rates should follow short ones.

This effect gets stronger as we consider longer maturities. In the limiting case of a perpetuity — a bond that makes a fixed dollar period every period forever — the value of the bond is just p/i, where p is the payment in each period and i is the interest rate. So when you consider buying a bond, you have to consider not just the current yield, but the possibility that interest rates will change in the future. Because if they do, the value of the bonds you own will rise or fall, and you will experience a capital gain or loss. Of course future interest rates are never really known. But Keynes argued that there is almost always a strong convention about the normal or “safe” level of interest.

Note that the logic above means that the relationship between short and long rates will be different when rates are relatively high vs. when they are relatively low. The lower are rates, the greater the capital loss from an increase in rates. As long rates approach zero, the potential capital loss from an increase approaches infinity.

Let’s make this concrete. If we write i_s for the short interest rate and i_l for the long interest rate, B for the current price of long bonds, and BE for the expected price of long bonds a year from now, then for all assets to be willing held it must be the case that i_l = i_s – (BE/B – 1), that is, interest on the long bond will need to be just enough higher (or lower) than the short rate to cancel out the capital loss (or gain) expected from holding the long bond. If bondholders expect the long run value of bond prices to be the same as the current value, then long and short rates should be the same. [*] Now for simplicity let’s assume we are talking about perpetuities (the behavior of long but finite bonds will be qualitatively similar), so B is just 1/i_l. [4] Then we can ask the question, how much do short rates have to fall to produce a one point fall in long rates.

Obviously, the answer will depend on expectations. The standard economist’s approach to expectations is to say they are true predictions of the future state of the world, an approach with some obvious disadvantages for those of us without functioning time machines. A simpler, and more empirically relevant, way of framing the question, is to ask how expectations change based on changes in the current state of the world — which unlike the future, we can observe. Perfectly inelastic expectations mean that your best guess about interest rates at some future date is not affected at all by the current level of interest rates; unit-elastic expectations mean that your best guess changes one for one with the current level. An of course there are all the possibilities in between. Let’s quantify this as the subjective annual probability that a departure of interest rates from their current or “normal” level will subsequently be reversed. Now we can calculate the exact answer to the question posed above, as shown in the next figure.

For instance, suppose short rates are initially at 6 percent, and suppose this is considered the “normal” level, in the sense that the marginal participant in the bond market regards an increase or decrease as equally likely. Then the long rate will also be 6 percent. Now we want to get the long rate down to 5 percent. Suppose interest rate expectations are a bit less than unit elastic — i.e. when market rates change, people adjust their views of normal rates by almost but not quite as much. Concretely, say that the balance of expectations is that there is net 5 percent annual chance that rates will return to their old normal level. If the long rate does rise back to 6 percent, people who bought bonds at 5 percent will suffer a capital loss of 20 percent. A 5 percent chance of a 20 percent loss equals an expected annual loss of 1 percent, so long rates will need to be one point higher than short rates for people to hold them. [5] So from a starting point of equality, for long rates to fall by one point, short rates must fall by two points. You can see that on the blue line on the graph. You can also see that if expectations are more than a little inelastic, the change in short rates required for a one-point change in long rates is impossibly large unless rates are initially very high.

It’s easy enough to do these calculations; the point is that unless expectations are perfectly elastic, we should always expect long rates to change less than one for one with short rates; the longer the rates considered, the more inelastic expectations, and the lower initial rates, the less responsive long rates will be. At the longest end of the term structure — the limiting case of a perpetuity — it is literally impossible for interest rates to reach zero, since that would imply an infinite price.

This dynamic is what Keynes was talking about when he wrote:

If . . . the rate of interest is already as low as 2 percent, the running yield will only offset a rise in it of as little as 0.04 percent per annum. This, indeed, is perhaps the chief obstacle to a fall in the rate of interest to a very low level . . . [A] long-term rate of interest of (say) 2 percent leaves more to fear than to hope, and offers, at the same time, a running yield which is only sufficient to offset a very small measure of fear.

Respectable economists like DeLong believe that there is a true future path of interest rates out there, which current rates should reflect; either the best current-information prediction is of government policy so bad that the optimal interest rate will continue to be zero for many years to come, or else financial markets have completely broken down. I’m glad the second possibility is acknowledged, but there is a third option: There is no true future course of “natural” rates out there, so markets adopt a convention for normal interest rates based on past experience. Given the need to take forward-looking actions without true knowledge of the future, this is perfectly rational in the plain-English sense, if not in the economist’s.

A final point: For Keynes — a point made more clearly in the Treatise than in the General Theory — the effectivness of monetary policy depends critically on the fact that there are normally market participants with differing expectations about future interest rates. What this means is that when interest rates rise, people who think the normal or long-run rate of interest is relatively low (“bulls”) can sell bonds to people who think the normal rate is high (“bears”), and similarly when interest rates fall the bears can sell to the bulls. Thus the marginal bond will be held held by someone who thinks the current rate of interest is the normal one, and so does not require a premium for expected capital gains or losses. This is the same as saying that the market as a whole behaves as if expectations are unit-elastic, even though this is not the case for individual participants. [6] But when interest rates move too far, there will no longer be enough people who think the new rate is normal to willingly hold the stock of bonds without an interest-rate risk premium. In other words, you run out of bulls or bears. Keynes was particularly concerned that an excess of bear speculators relative to bulls could keep long interest rates permanently above the level compatible with full employment. The long rate, he warned,

may fluctuate for decades about a level which is chronically too high for full employment; – particularly if it is the prevailing opinion that the rate of interest is self-adjusting, so that the level established by convention is thought to be rooted in objective grounds much stronger than convention, the failure of employment to attain an optimum level being in no way associated, in the minds either of the public or of authority, with the prevalence of an inappropriate range of rates of interest’.

If the belief that interest rates cannot fall below a certain level is sufficiently widespread, it becomes self-fulfilling. If people believe that long-term interest rates can never persistently fall below, say, 3 percent, then anyone who buys long bonds much below that is likely to lose money. And, as Keynes says, this kind of self-stabilizing convention is more likely to the extent that people believe that it’s not just a convention, but that there is some “natural rate of interest” fixed by non-monetary fundamentals.

So what does all this mean concretely?

1. It’s easy to see inelastic interest-rate expectations in the data. Long rates consistently lag behind short rates. During the 1960s and 1970s, when rates were secularly rising, long rates were often well below the Federal Funds rate, especially during tightening episodes; during the period of secularly falling rates since 1980, this has almost never happened, but very large term spreads have become more common, especially during loosening episodes.

2. For the central bank to move long rates, it must persuade markets that changes in policy are permanent, or at least very persistent; this is especially true when rates are low. (This is the main point of this post.) The central bank can change rates on 30-year bonds, say, only by persuading markets that average rates over the next 30 years will be different than previously believed. Over small ranges, the existence of varying beliefs in the bond market makes this not too difficult (since the central bank doesn’t actually have to change any individual’s expectations if bond sales mean the marginal bondholder is now a bull rather than a bear, or vice versa) but for larger changes it is more difficult. And it becomes extremely difficult to the extent that economic theory has taught people that there is a long run “natural” rate of interest that depends only on technology and time preferences, which monetary policy cannot affect.

Now, the obvious question is, how sure are we that long rates are what matters? I’ve been treating a perpetual bond as an approximation of the ultimate target of monetary policy, but is that reasonable? Well, one point on which Keynes and today’s mainstream agree is that the effect of interest rates on the economy comes through demand for long-lived assets — capital goods and housing. [7] According to the BEA, the average current-cost age of private fixed assets in the US is a bit over 21 years, which implies that the expected lifetime of a new fixed asset must be quite a bit more than that. For Keynes (Leijonhufvud stresses this point; it’s not so obvious in the original texts) the main effect of interest rates is not on the financing conditions for new fixed assets, as most mainstream and heterodox writers both assume, but on the discount rate used  of the assets. In that case the maturity of assets is what matters. On the more common view, it’s the maturity of the debt used to finance them, which may be a bit less; but the maturity of debt is usually matched to the maturity of assets, so the conclusion is roughly the same. The relevant time horizon for fixed assets is long enough that perpetuities are a reasonable first approximation. [8]

3. So if long rates are finally falling now, it’s only because an environment of low rates is being established as new normal. There’s a great deal of resistance to this, since if interest rates do return to their old normal levels, the capital losses to bondholders will be enormous. So to get long rates down, the Fed has to overcome intense resistance from bear speculators. Only after a great deal of money has been lost betting on a return of interest rates to old levels will market participants begin to accept that ultra-low rates are the new normal. The recent experience of Bill Gross of PIMCO (the country’s largest bond fund) is a perfect example of this story. In late 2010, he declared that interest rates could absolutely fall no further; it was the end of the 30-year bull market in bonds. A year later, he put his money where his mouth was and sold all his holdings of Treasuries. As it turned out, this was just before bond prices rose by 30 percent (the flipside of the fall in rates), a misjudgment that cost his investors billions. But Gross and the other “bears” had to suffer those kinds of losses for the recent fall in long rates to be possible. (It is also significant that they have not only resisted in the market, but politically as well.) The point is, outside a narrow range, changes in monetary policy are only effective when they cease to be perceived as just countercyclical, but as carrying information about “the new normal.” Zero only matters if it’s permanent zero.

4. An implication of this is that in a world where the lifespan of assets is much longer than the scale of business-cycle fluctuations, we cannot expect interest rates to be stationary if monetary policy is the main stabilization tool. Unless expectations are very elastic, effective monetary policy require secular drift in interest rates, since each short-term stabilization episode will result in a permanent change in interest rates. [9] You can see this historically: the fall in long rates in the 1990 and 2000 loosenings both look about equal to the permanent components of those changes. This is a problem for two reasons: First, because it means that monetary policy must be persistent enough to convince speculators that it does represent a permanent change, which means that it will act slower, and require larger changes in short rates (with the distortions those entail) than in the unit-elastic expectations case. And second, because if there is some reason to prefer one long-ru level of interest rates to another (either because you believe in a “natural” rate, or because of the effects on income distribution, asset price stability, etc.) it would seem that maintaining that rate is incompatible with the use of monetary policy for short-run stabilization. And of course the problem is worse, the lower interest rates are.

5. One way of reading this is that monetary policy works better when interest rates are relatively high, implying that if we want to stabilize the economy with the policy tools we have, we should avoid persistently low interest rates. Perhaps surprisingly, given what I’ve written elsewhere, I think there is some truth to this. If “we” are social-welfare-maximizing managers of a capitalist economy, and we are reliant on monetary policy for short-run stabilization, then we should want full employment to occur in the vicinity of nominal rates around 10 percent, versus five percent. (One intuitive way of seeing this: Higher interest rates are equivalent to attaching a low value to events in the future, while low interest rates are equivalent to a high value on those events. Given the fundamental uncertainty about the far future, choices in the present will be more stable if they don’t depend much on far-off outcomes.) In particular — I think it is a special case of the logic I’ve been outlining here, though one would have to think it through — very low interest rates are likely to be associated with asset bubbles. But the conclusion, then, is not to accept a depressed real economy as the price of stable interest rates and asset prices, but rather to “tune” aggregate demand to a higher level of nominal interest rates. One way to do this, of course, is higher inflation; the other is a higher level of autonomous demand, either for business investment (the actual difference between the pre-1980 period and today, I think), or government spending.

[1] The most invigorating economics book I’ve read in years. It’ll be the subject of many posts here in the future, probably.

[2] Why there should be a pure term premium is seldom discussed but actually not straightforward. It’s usually explained in terms of liquidity preference of lenders, but this invites the questions of (1) why liquidity preference outweighs “solidity preference”; and (2) why lenders’ preferences should outweigh borrowers’. Leijonhufvud’s answer, closely related to the argument of this post, is that the “excessively long” lifespan of physical capital creates chronic excess supply at the long end of the asset market. In any case, for the purpose of this post, we will ignore the pure premium and assume that long rates are simply the average of expected short rates.

[3] Keynes did not, as is sometimes suggested by MMTers and other left Keynesians, reject the effectiveness of monetary policy in general. But he did believe that it was much more effective at stabilizing full employment than at restoring full employment from a depressed state. 

[4] I will do up these equations properly once the post is done.

[5] I anticipate an objection to reasoning on the basis of an equilibrium condition in asset markets. I could just say, Keynes does it. But I do think it’s legitimate, despite my rejection of the equilibrium methodology more generally. I don’t think there’s any sense that human behavior can be described as maximizing some quantity called utility,” not even as a rough approximation; but I do think that capitalist enterprises can be usefully described as maximizing profit. I don’t think that expectations in financial markets are “rational” in the usual economists’ sense, but I do think that one should be able to describe asset prices in terms of some set of expectations.

[6] We were talking a little while ago with Roger Farmer, Rajiv Sethi, and others about the desirability of limiting economic analysis to equilibria, i.e. states where all expectations are fulfilled. This implies, among other things, that all expectations must be identical. Keynes’ argument for why long rates are more responsive to short rates within some “normal” range of variation is — whether you think it’s right or not — an example of something you just can’t say within Farmer’s preferred framework.

[7] Despite this consensus, this may not be entirely the case; and in fact to the extent that monetary policy is effective in the real world, other channels, like income distribution, may be important. But let’s assume for now that demand for long-lived assets is what matters.

[8] Hicks had an interesting take on this, according to Leijonhufvud. Since the production process is an integrated whole, “capital” does not consist of particular goods but of a claim on the output of the process as a whole. Since this process can be expected to continue indefinitely, capital should be generally assumed to be infinitely-lived. When you consider how much of business investment is motivated by maintaining the firm’s competitive position — market share, up to date technology, etc. — it does seem reasonable to see investment as buying not a particular capital good but more of the firm as a whole.

[9] There’s an obvious parallel with the permanent inflation-temporary employment tradeoff of mainstream theory. Except, I think mine is correct!

In Which I Dare to Correct Felix Salmon

Felix Salmon is my favorite business blogger — super smart, cosmopolitan and impressively unimpressed by the Masters of the Universe he spends his days observing. In general, I’d expect him to be much more on top of current financial data than I am. But in today’s post on the commercial paper market, he makes an uncharacteristic mistake — or rather, uncharacteristic for him but highly characteristic of the larger conversation around finance.

According to Felix:

The commercial paper market has to a first approximation become an entirely financial market, a place for banks and shadow banks to do their short-term borrowing while the interbank market remains closed.

According to David S. Scharfstein of Harvard Business School, who also testified last week, of the 50 largest issuers of debt to money market funds today, only two are nonfinancial firms; the rest are banks and other financial companies, many of them foreign.

Once upon a time, before the financial crisis, money-market funds were a mechanism whereby individual investors could make safe, short-term loans to big corporates, disintermediating the banks. But all that has changed now. For one thing, says Davidoff, “about two-thirds of money market users are sophisticated finance investors”. For another, the corporates have evaporated away, to be replaced by financials. In the corporate world, it seems, the price mechanism isn’t working any more: either you’re a big and safe corporate and don’t want to run the refinancing risk of money-market funds suddenly drying up, or else you’re small enough and risky enough that the money market funds don’t want to lend to you at any price.

I’m sorry, but I don’t think that’s right.

Reading Felix, you get the clear impression that before the crisis, or anyway not too long ago, most borrowers in the commercial paper market were nonfinancial corporations. It has only “become an entirely financial market” relatively recently, he suggests, as nonfinancial borrowers have dropped out. But, to me at least, the real picture looks rather different.

Source: Flow of Funds

The graph shows outstanding financial and nonfinancial commercial paper on the left scale, and the financial share of the total on the right scale. As you can see the story is almost the opposite of the one Felix tells. Financial borrowers have always dominated the commercial paper market, and their share has fallen, not risen, in the wake of the financial crisis and recession. Relative to the economy, nonfinancial commercial paper outstanding is close to where it was at the peak of the past cycle. But financial paper is down by almost two-thirds. As a result, the nonfinancial share of the commercial paper market has doubled, from 7 to 15 percent — the highest it’s been since the 1990s.

Why does this matter? Well, of course, it’s important to get these things right. But I think Felix’s mistake here is revealing of a larger problem.

One of the most dramatic features of the financial crisis of fall 2008, bringing the Fed as close as it got to socializing the means of intermediation, was the collapse of the commercial paper market. But as I’ve written here before, it was almost never acknowledged that the collapse was largely limited to financial commercial paper. Nonfinancial borrowers did not lose access to credit in the way that banks and shadow banks did. The gap between the financial and nonfinancial commercial paper markets wasn’t discussed, I believe, because of the way the crisis was seen entirely through the eyes of finance.

I suspect the same thing is happening with the evolution of the commercial paper market in the past few years. The Flow of Funds shows clearly that commercial borrowing by nonfinancial borrowers has held up reasonably well; the fall in commercial paper lending is limited to financial borrowers. But that banks’ problems are everyone’s problems is taken for granted, or at most justified with a pious handwave about the importance of credit to the real economy.

And that’s the second  assumption, again usually unstated, at issue here: that providing credit to households and businesses is normally the main activity of finance, with departures from that role an anomalous recent development. But what if the main action in the financial system has never been intermediating between ultimate lenders and borrowers? What if banks have always mostly been, not to put too fine a point on it, parasites?

During the crisis of 2008 one big question was if it was possible to let the big banks fail, or if the consequences for the real economy would be prohibitively awful. On the left, Dean Baker took the first position while Doug Henwood took the second, arguing that the alternative to bailouts could be a second Great Depression. I was ambivalent at the time, but I’ve been moving toward the let-them-fail view. (Especially if the counterfactual is that governments and central banks putting comparable resources into sheltering the real economy from collapsing banks, as they have into propping them up.) The evolution of the commercial paper market looks to me like one more datapoint supporting that view. The collapse of interbank lending doesn’t seem to have affected nonbank borrowers much.

(Which brings us to a larger point, of whether the continued depressed state of the real economy is due to a lack of access to credit. Obviously I think not, but that’s beyond the scope of this post.)

An insidious feature of the world we live in is an unconscious tendency to adopt finance’s point of view. This is as true of intellectuals as of everyone else. An anthropologist of my acquaintance, for instance, did his fieldwork on the New York financial industry. Nothing wrong with that — he’s got some very smart things to say about it — but you really can’t imagine someone doing a similar project on any other industry, apart from high-tech internet stuff. In our culture, finance is just interesting in a way that other businesses are not. I’m not exempting myself from this, by the way. The financial crisis and its aftermath was the most exciting time in memory to be thinking about economics; I’m not going to deny it, it was fun. And there are plenty of people on the left who would say that a tendency, which I confess to, to let the conflict between Wall Street and the real economy displace the conflict between labor and capital in our political language, is a symptom — a kind of reaction-formation — of the same intellectual capture.

But that is perhaps over-broadening the point, which is just this: That someone as smart as Felix Salmon could so badly misread the commercial paper market is a sign of how hard we have to work to distinguish the state of the banks, from the state of the economy.

Welcome Wonkupy

When I first started reading blogs a decade ago (I’m pretty sure the first blogpost I ever read was one of these Eschaton posts on Trent Lott) there was a distinctly truncated Left in the blog world, especially on economics. Just mainstream liberals, conservatives, and libertarians as far as the eye could see. Which, what else is new, right? Except that it really wasn’t true of mailing lists, the predecessor medium, where you had super active lists like PEN-L and LBO Talk. I used to wonder if there was something specific about the formats that made mailing lists more hospitable to radical politics. Like, flatteringly, maybe we prefer collective discussions rather than one-man shows? Anyway, the question is moot now, because there’s certainly no shortage of left/radical blogs now, economics-oriented and otherwise.

All of which is a long-winded introduction to introducing a new progressive economics blog, Wonkupy. It’s by “Rotwang,” a very sharp comrade who needs to remain pseudonymous for professional reasons. It bills itself as “Occupy for wonks,” but my sense is it’s going to be more the other way round; well worth reading either way.

That said, I have some disagreements with his current post, arguing that criticism of private equity is a distraction. I put them in comments there, but since it touches on some regular themes at the Slack Wire, I thought I’d post an abridged version here.

Rotwang’s argument is that it’s wrong to suggest that buyouts and takeovers of firms by private equity funds and the like have any systematic effect on the way those firms are managed: profit maximization at the expense of workers and the pubic is the order of the day whether the bosses are vulture capitalists or just the regular kind. (It’s sort of a political-economic version of the Modigliani-Miller theorem.) Rotwang:

In [private equity] discussions, it is easy to focus on outright theft, abuse of borrowing, and inefficient government subsidies. We suggest this is not unique to PE, but is generic to Capitalism. One could imagine regulatory responses to such problems, but we insist the problems are part of the system, not tumorous growths on something otherwise fundamentally healthy. A narrow focus on PE glosses over the features it shares in common with Capitalism in general, now and throughout history. The narrow view plays to limited and ineffective remedies that fail to engage the long-standing, systematic problems of capital markets.

I disagree — tentatively on the substance, but emphatically on this way of framing it.

Suppose for the moment it’s true that the problems with private equity are no different from the problems with capitalism in general. I still don’t think that’s a valid reason to not talk about private equity in particular. After all, “X in general” is just all the specific instances of X. To the extent that the way productive enterprises are treated by PE firms like Bain is a representative example of why an economy oriented around the private pursuit of profit is incompatible with a humane and decent society, I don’t see what’s wrong with starting with it as a particularly vivid and timely example. Of course you have to then move on to a more general critique — there’s nothing that stops management at companies that aren’t subject to buyouts from acting like Bain, and many do — but a ban on discussion of particular cases doesn’t smooth the way to that general critique.

The other question is, is it really true that there is no difference between what a firm like Bain does and what a “normal” capitalist firm does? Rotwang writes, “From the worker’s standpoint, it makes little difference if her life is ruined by PE or by old management,” which is inarguable. But are we sure ruination is equally likely in either case?

It seems to me that while capitalist firms always pursue profit, and this pursuit is always ultimately inimical to the interests of workers, it’s not always equally single-minded. Managers want their firms (and themselves personally) to make money, but they also want them to survive, to grow, to gain market share, to be perceived as prestigious, cutting-edge, etc., and, in a non-trivial number of cases, to make genuinely good products by whatever objective standard of the business that they’re in. To the extent that finance exercises more active control of the firm, those other motives get subordinated to pure pursuit of profits. And I think that does tend to make life worse for their workers, and communities and customers, and everyone else who depends on the business as an ongoing enterprise.

No question, there is (or was; is Occupy still a thing?) a strong anti-finance vibe around OWS. There’s nothing wrong with criticizing that — especially in its weirder Ron Paulish forms — but it seems to me this is a case where “Yes, and” is distinctly preferable to “no, but”. For some people, a criticism of private equity may be an alternative to a broader critique of capitalism, but for many more, I suspect, it’s a starting point towards it.

What is the Liquidity Trap?

In the common usage, popularized by Krugman, a liquidity trap is just a situation where the interest rate set by the central bank has reached zero. Since it can’t go below that (the Zero Lower Bound), if more expansionary policy is needed it will have to take the form of fiscal policy or unconventional monetary policy — quantitative easing and so on. But if there were some technical fix (a tax on excess reserves, say, or abolishing cash) that allowed central banks to make the policy rate negative, there would be no limit to the capacity of monetary policy to overcome any shortfall in demand. The idea — expressed by modern monetarists in the form of the negative natural rate — is that there are so few investment opportunities with positive expected returns that if investment rose enough to equal desired saving at full employment, the expected return on the marginal new unit of capital would be negative. So you’d need a negative cost of capital to get businesses to undertake it.

That makes sense, I guess. But it’s not what Keynes meant by liquidity trap. And Keynes’ version, I think, is more relevant to our current predicament.

Keynes himself doesn’t use the term, and his explanation of the phenomenon, in chapters 13 and 15 of the General Theory, is rather confusing. (Lance Taylor has a much clearer statement of it in Reconstructing Macroeconomics, which I may add a summary or excerpt of to this post when I get home tonight and have the book.) So rather than quote chapter and verse, I’m just going to lay out what I understand the argument to be.

Interest, says Keynes, is not, as the classical economists said, the price of consuming in the future relative to the consuming in the present. It is the price of holding an illiquid rather than a liquid asset today. (This is one of the main points of the book.) The cost of holding an illiquid asset (a bond, let’s say) is the inconvenience that it can’t be used for transaction purposes, but also the opportunity cost of not being able to buy a bond later, if interest rates rise. Another way of saying the same thing: The risk of holding a bond is not just that you won’t have access to means of payment when you need it; it is also the capital loss you will suffer if interest rates rise while you are holding the bond. (Remember, the price of an existing bond always moves inversely with the interest rate.)

This last factor isn’t so important in normal times, when opinions about the future rates of bonds vary; if the supply of liquidity rises, there will be somebody who finds themselves more liquid than they need to be and who doesn’t expect a rise in interest rates in the near future, who will purchase bonds, driving up their price and driving the interest rate down. The problem arises when there is a consensus about the future level of interest rates. At that point, anyone who holds a bond yielding below that level will be anxious to sell it, to avoid the capital loss when interest rates inevitably rise. (Or equivalently, to be able to purchase a higher yield bond when they do.) This effect is strongest at low interest rates, since bondholders not only are more likely to expect a capital loss in the future, but are getting very little interest in the present to compensate them for it. Or as Keynes says,

Nevertheless, circumstances can develop in which even a large increase in the quantity of money may exert a comparatively small influence on the rate of interest. For … opinion about the future of the rate of interest may be so unanimous that a small [decrease] in present rates may cause a mass movement into cash. It is interesting that the stability of the system and its sensitiveness to changes in the quantity of money should be so dependent on the existence of a variety of opinion about what is uncertain. Best of all that we should know the future. But if not, then, if we are to control the activity of the economic system by changing the quantity of money, it is important that opinions should differ.

In other words, the essence of the liquidity trap is a convention about the normal level of interest rates. It’s important to note that this convention is self-stabilizing — if everyone believes that interest rates on a particular class of bond cannot be below 3 percent, say, for any extended period of time, then anyone who finds themselves holding a bond yield less than 3 percent will be anxious to sell it. And their efforts to do so will push the price of the bonds down, which itself will increase their yield back to 3 percent, so that the people who did not share the convention are the ones who end up suffering the loss.

This probably seems confusing and tedious to most readers (and tediously familiar to most of the rest.) Maybe it will be clearer and more interesting with some pictures:

10-Year Treasury Rate and the Federal Funds Rate
BAA Bond Rates and the Federal Funds Rate

The horizontal axis of this scatterplot is the Federal Funds rate. The vertical axis shows a market interest rate — the 10-year Treasury bond rate in the first one, and the BAA corporate bond rate in the second. The heavy black diagonal corresponds to a market rate equal to the Fed Funds rate. In both cases, there’s a clear positive relationship over normal ranges of policy rates — 3 percent to 8 percent or so. But outside of this range, particularly at the bottom end, the relationship breaks down. The floor on Treasuries is a hard 3 percent or so, while the floor on BAA bonds varies from time to time but also doesn’t go below 3 percent. [1] This is Keynes’ liquidity trap. [2] And when you look at it, it becomes much less clear that the inability to extend the black line past the origin — Krugman’s liquidity trap — is the problem here. What good would it do, if market rates stop following the policy rate well before that?

UPDATE: A smart, skeptical comment by Bruce Wilder leads me to reformulate the argument in a hopefully clearer way.

The necessary and sufficient condition for a liquidity trap is a consensus among market participants that nominal interest rates are more likely to rise than to fall over the relevant time horizon. Obviously, one basis for such a consensus might be that it is literally impossible for short rates to fall any further. [3] In this sense the ZLB liquidity trap is a special case of the Keynesian liquidity trap. But the Keynesian concept is broader, because conventions about the floor of interest rates can be strongly self-stabilizing, especially where they are backed up by the political power of rentiers.

[1] “The most stable, and the least easily shifted, element in our contemporary economy has been hitherto, and may prove to be in future, the minimum rate of interest acceptable to the generality of wealth-owners. If a tolerable level of employment requires a rate of interest much below the average rates which ruled in the nineteenth century, it is most doubtful whether it can be achieved merely by manipulating the quantity of money. … Cf. the nineteenth-century saying, quoted by Bagehot, that ‘John Bull can stand many things, but he cannot stand 2 per cent.'”

[2] It also, not coincidentally, looks like the textbook LM curve. The replacement of LM with an central bank-determined interest rate curve in newer textbooks, is not progress.

[3] Note that it is not in fact the case that nominal interests cannot be negative, because in the real world cash has substantial carrying costs.

No More ZLB

Can we please stop talking about the zero lower bound?

Krugman today insists that we do, in fact, face a problem of inadequate demand. And he’s right! But he glosses this as an “excess supply of savings even at a zero interest rate,” which isn’t right at all.

Let’s be clear: There is not “an” interest rate, certainly not a zero one. There are various interest rates, and the ones that are relevant to saving and investment remain high. The BAA corporate bond rate (the red line in the figure below) is currently at 5.7 percent — pretty much exactly where it was in the first half of 2005. And given that inflation is substantially lower than it was five years ago, that particular real interest rate is not only not zero, it’s gone up.


The real question is, can reducing the federal funds rate reduce the economically important interest rates? Now, obviously the answer is No if the fed funds rate (the blue line in the graph) is as low as it can go; in this sense the ZLB is real. But the answer can also be No when the fed funds rate is well above zero, if there’s no reliable link between the overnight Treasury rate and the rates businesses borrow at; and that seems to have been the case since sometime in the ’90s. As the figure shows, the Fed’s recent rate reductions didn’t reduce bond rates at all, even before the Fed Funds rate hit zero; and all the hikes earlier in the decade didn’t raise bond rates either. You’d see a similar picture if you looked at any other economically relevant interest rate. In general, as my friend Hasan Comert shows in his just-defended dissertation, the Fed lost control of the important interest rates some time ago. So the best thing you can say for the zero lower bound, is that arriving there has dramatized a truth that should have been evident for some time already.

As usual, Keynes got it right: “The acuteness and the peculiarity of our contemporary problem arises out of the possibility that the average rate of interest which will allow a reasonable average level of employment is one so unacceptable to wealth-owners that it cannot be readily established merely by manipulating the quantity of money. … The most stable, and the least easily shifted, element in our contemporary economy has been hitherto, and may prove to be in future, the minimum rate of interest acceptable to the generality of wealth-owners.” The failure of interest rates to move to a level compatible with full employment is not a technical problem, but a structural one.

What’s the Difference Between Money and Debt?

(An idea I’ve been playing with lately, just wanted to get something on virtual paper.)

Currency, dollar bills, are liabilities of the Federal Reserve. Federal debt is a liability of the US Treasury. Leaving aside some deliberate obscurity around the precise legal status of the Fed, both are liabilities of the US government. Of course there are various formal differences, but economically, wouldn’t it be simplest to regard them the same?

In other words, while we are taught that there are no close substitutes for money but that government and private debt are substitutes for each other, wouldn’t it be better to say that money and government debt are substitutes for each other and both are complements for private debt? More concretely, given lenders’ need for liquidity, an increase in their holding of government debt may make them more willing to hold private debt, i.e. under some circumstances, an increase in government debt could put downward rather than upward pressure on interest rates further out the yield curve.

The canonical case is the recent financial crisis. As I’ve discussed before, there’s an argument (which gets at least some support from non-crazies like Perry Mehrling and Brad DeLong) that insufficient federal debt contributed to the crisis, by creating demand for equivalently liquid but higher-return substitutes, thus fueling the financial innovation of the 1990s and 2000s. Of course this dynamic would have increased the availability of credit for private borrowers whose liabilities were (a) seen as implicitly enjoying a federal guarantee and (b) easily securitizable. But for borrowers that didn’t meet those criteria, the lack of enough new federal debt may have made banks less willing to lend to them, in exactly the same way a lack of reserves would have in the old days. And even if the restriction of credit to non-securitizable borrowers was not that big in the boom, the lack of federal debt certainly exacerbated the crash.

So far this is just thinking aloud. But a bunch of smart people seem to be heading in this direction. Take for instance Roger Farmer’s call for more quantitative easing (via DeLong). Says Farmer, “Even if the Bank of England were to buy the entire UK national debt, this policy would not be inflationary.” This is just a dramatic way of making the point that as government debt and money have become closer substitutes, the economic consequences of shifts between them have become smaller. As Farmer says, money no longer occupies a discrete, unique role. Instead, there is a continuum of assets: “At the safe end of the spectrum there is cash. At the risky end there is equity and low grade bonds.” And in a rich country like the US or UK, government debt is very close to the money end. Where Farmer is less convincing is his idea that the interchangeability of money and public debt came about all at once, when central banks began paying interest on reserves. Seems to me it was a longer process of institutional evolution.

One implication of this, again, is that a smoothly functioning financial system requires more public debt, indefinitely. (Another reason to agree with Davidson, Galbraith and Skidelsky that austerity tomorrow is no more desirable than austerity today.) But there’s a second implication: If money as a discrete category is obsolete, then so is monetary policy as we know it. If Treasuries are as liquid as so-called high-powered money, then monetary policy — which comes down to injecting and removing liquidity — must work on the former and not just the latter; but of course the volume of federal debt is orders of magnitude greater than the volume of reserves. Which suggests that quantitative easing may be the only kind of easing there is, from here on out, that is, no more distinction between monetary and fiscal policy.

EDIT: What’s the affinity between cranks and money? Everyone knows that discussions of monetary theory bring all the cranks to the yard. But am I the only one who finds that writing about this stuff, makes me feel like a crank?