Money and Things – Page 2

The Natural Rate of Interest?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

“Has Finance Capitalism Destroyed Industrial Capitalism?”

(At the big economics conference earlier in January, I spoke on a virtual panel in response to Michael Hudon’s talk on the this topic. HIs paper isn’t yet available, but he has made similar arguments here and here. My comments were in part addressed to his specific paper, but were also a response to the broader discussion around financialization. A version of this post will appear in a forthcoming issue of the Review of Radical Political Economics.)

Michael Hudson argues that the industrial capitalism of a previous era has given way to a new form of financial capitalism. Unlike capitalists in Marx’s day, he argues, today’s financial capitalists claim their share of the surplus by passively extracting interest or economic rents broadly. They resemble landlords and other non-capitalist elites, whose pursuit of private wealth does not do anything to develop the forces of production, broaden the social division of labor, or prepare the ground for socialism.

Historically, the progressive character of capitalism comes from three dimensions on which capitalists differ from most elites. First, they do not merely claim the surplus from production, but control the production process itself; second, they do not use the surplus directly but must realize it by selling it on a market; and third, unlike most elites who acquire their status by inheritance or some similar political process, a capitalist’s continued existence as a capitalist depends on their ability to generate a large enough money income to acquire new means of production. This means that capitalists are under constant pressure to reduce the costs through technical improvements to the production process. In some cases the pressure to reduce costs may also lead to support for measures to socialize the reproduction costs of labor power via programs like public education, or for public provision of infrastructure and other public services.

In Hudson’s telling, financial claims on the surplus are essentially extractive; the pursuit of profit by finance generates pressure neither for technical improvements in the production process, nor for cost-reducing public investment. The transition from one to the other as the dominant form of surplus appropriation is associated with a great many negative social and political developments — lower wages, privatization of public goods, anti-democratic political reforms, tax favoritism and so on. (The timing of this transition is not entirely clear.)

Other writers have told versions of this story, but Hudson’s is one of the more compelling I have seen. I am impressed by the breadth of his analysis, and agree with him on almost everything he finds objectionable in contemporary capitalism.

I am not, however, convinced. I do not think that “financial” and “industrial” capital can be separated in the way he proposes. I think it is better to consider them two moments of a single process. Connected with this, I am skeptical of the simple before and after periodization he proposes. Looking at the relationship between finance and production historically, we can see movements in both directions, with different rhythms in different places and sectors. Often, the growth of industrial capitalism in one industry or area has gone hand in hand with a move toward more financial or extractive capitalism somewhere else. I also think the paper gives a somewhat one-sided account of developments in the contemporary United States. Finally, I have concerns about the political program the analysis points to.

Let’s start with idea that industrial capitalists support public investments in areas like education, health care or transportation because they lower the reproduction costs of labor. This is less important for owners of land, natural resources or money, whose claim on the social surplus doesn’t mainly come through employing labor.

I wouldn’t say this argument is wrong, exactly, but I was struck by the absence of any discussion of the other ways in which industrial capitalists can reduce the costs of labor — by lowering the subsistence level of workers, or reducing their bargaining power, or extracting more work effort, or shifting employment to lower-wage regions or populations. The idea that the normal or usual result of industrial capitalists’ pursuit of lower labor costs is public investment seems rather optimistic.

Conversely, public spending on social reproduction only reduces costs for capitalist class insofar as the subsistence level is fixed. As soon as we allow for some degree of conflict or bargaining over workers share of the social product, we introduce possibility that socializing reproduction costs does not lower the price of labor, but instead raises the living standards of the human beings who embody that labor. Indeed, that’s why many people support such public spending in the first place!

On the flip side, the case against landlords as a force for capitalist progress is not as straightforward as the paper suggests.

Ellen Meiksins Wood argues, convincingly, that the origins of what Hudson calls industrial capitalism should really be placed in the British countryside, where competition among tenants spurred productivity-boosting improvements in agricultural land. It may be true that these gains were mostly captured by landlords in the form of higher rents, but that does not mean they did not take place. Similarly, Gavin Wright argues that one of the key reasons for greater public investment in the ante-bellum North compared with the South was precisely the fact that the main form of wealth in the North was urban land. Land speculators had a strong interest in promoting canals, roads and other forms of public investment, because they could expect to capture gains from them in the form of land value appreciation.

In New York City, the first subways were built by a company controlled by August Belmont, who was also a major land speculator. In a number of cases, Belmont — and later the builders of the competing BMT system — would extend transit service into areas where they or their partners had assembled large landholdings, to be able to develop or sell off the land at a premium after transit made it more valuable. The possibility of these gains was probably a big factor in spurring private investment in transit service early in the 20th century.

Belmont can stand as synecdoche for the relationship of industrial and financial capital in general. As the organizer of the labor engaged in subway construction, as the one who used the authority acquired through control of money to direct social resources to the creation of new means of transportation, he appears as an industrial capitalist, contributing to the development of the forces of production as well as reducing reproduction costs by giving workers access to better, lower-cost housing in outlying areas. As the real estate speculator profiting by selling off land in those areas at inflated prices, he appears as a parasitic financial capitalist. But it’s the same person sitting in both chairs. And he only engaged in the first activity in the expectation of the second one.

None of this is to defend landlords. But it is to make the point that the private capture of the gains from the development of the forces of production is, under capitalism, a condition of that development occurring in the first place, as is the coercive control over labor in the production process. If we can acknowledge the contributions of a representative industrial capitalist like Henry Frick, author of the Homestead massacre, to the development of society’s productive forces, I think we can do the same for a swindler like August Belmont.

More broadly, it seems to me that the two modes of profit-seeking that Hudson calls industrial and financial are not the distinct activities they appear as at first glance.

It might seem obvious that profiting from a new, more efficient production process is very different from profiting by using the power of the state to get some legal monopoly or just compel people to pay you. It is true that the first involves real gains for society while the second does not. But how do those social gains come to be claimed as profit by the capitalist? First, by the exclusive access they have to the means of production that allows them to claim the product, to the exclusion of everyone else who helped produce it. And second, by their ability to sell it at a price above its cost of production that allows them to profit, rather than everyone who consumes the product. In that sense, the features that Hudson points to as defining financial capitalism are just as fundamental to industrial capitalism. Under capitalism, making a product is not a distinct goal from extracting a rent. Capturing rents is the whole point.

The development of industry may be socially progressive in a way that the development of finance is not. But that doesn’t mean that the income and authority of the industrial capitalist is different from that of the financial capitalist, or even that they are distinct people.

Hudson is aware of this, of course, and mentions that from a Marxist standpoint the capitalist is also a rentier. If he followed this thought further I think he would find it creates problems for the dichotomy he is arguing for.

Let’s take a step back.

Capital is a process, a circuit: M – C – P – C’ – M’. Money is laid out to gain control of commodities and labor power, which are the combined in a production process. The results of this process are then converted back into money through sale on the market.

At some points in this circuit, capital is embodied in money, at other points in labor power and means of production. We often think of this circuit as happening at the level of an individual commodity, but it applies just as much at larger scales. We can think of the growth of an industrial firm as the earlier part of the circuit where value comes to be embodied in a concrete production process, and payouts to shareholders as the last part where value returns to the money form.

This return to money form just as essential to the circuit of capital as production is. It’s true that payouts to shareholders absorb large fraction of profits, much larger than what they put in. We might see this as a sign that finance is a kind of parasite. But we could also see shareholder payouts as where the M movement is happening. Industrial production doesn’t require that its results be eventually realized as money. But industrial capitalism does. From that point of view, the financial engineers who optimize the movement of profits out of the firm are as integral a part of industrial capital as the engineer-engineers who optimize the production process.

My second concern is with the historical dimension of the story. The sense one gets from the paper is that there used to be industrial capitalism, and now there is financial capitalism. But I don’t think history works like that.

It is certainly true that the forms in which a surplus is realized as money have changed over time. And it is also true that while capital is a single process, there are often different human beings and institutions embodying it at different points in the circuit.

In a small business, the same person may have legal ownership of the enterprise, directly manage the production process, and receive the profits it generates. Hudson is certainly right that this form of enterprise was more common in the 19th century, which among other things allowed Marx to write in Volume One about “the capitalist” without having to worry too much about exactly where this person was located within the circuit. In a modern corporation, by contrast, production is normally in the hands of professional managers, while the surplus flows out to owners of stock or other financial claims. This creates the possibility for the contradiction between the conditions of generating a surplus and of realizing it, which always exists under capitalism, to now appear as a conflict between distinct social actors.

The conversion of most large enterprises to publicly traded corporations took place in the US in a relatively short period starting in the 1890s. The exact timing is of course different elsewhere, but this separation of ownership and control is a fairly universal phenomenon. Even at the time this was perceived as a momentous change, and if we are looking for a historical break that I think this is where to locate it. Already by the early 20th century, the majority of great fortunes took the form of financial assets, rather than direct ownership of businesses. And we can find contemporary observers like Veblen describing “sabotage” of productive enterprises by finance (in The Price System and the Engineers) in terms very similar to the ones that someone like Michael Hudson uses today.

It’s not unreasonable to describe this change as financialization. But important to realize it’s not a one-way or uniform transition.

In 1930s, Keynes famously described American capital development as byproduct of a casino, again in terms similar to Hudson’s. In The General Theory, an important part of the argument is that stock markets have a decisive influence on real investment decisions. But the funny thing is that at that moment the trend was clearly in the opposite direction. The influence of financial markets on corporate managers diminished after the 1920s, and reached its low point a generation or so after Keynes wrote.

If we think of financialization as the influence of financial markets over the organization of production, what we see historically is an oscillation, a back and forth or push and pull, rather than a well-defined before and after. Again, the timing differs, but the general phenomenon of a back and forth movement between more and less financialized capitalism seems to be a general phenomenon. Postwar Japan is often pointed to, with reason, as an example of a capitalist economy with a greatly reduced role for financial markets. But this was not a survival from some earlier era of industrial capitalism, but rather the result of wartime economic management, which displaced financial markets from their earlier central role.

Historically, we also find that moves in one direction in one place can coexist with or even reinforce moves the other way elsewhere. For example, the paper talks about the 19th-century alliance of English bankers and proto-industrialists against landlords in the fight to overturn the corn laws. Marx of course agreed that this was an example of the progressive side of capitalist development. But we should add that the flip side of Britain specializing in industry within the global division of labor was that other places came to specialize more in primary production, with a concomitant increase in the power of landlords and reliance on bound labor. Something we should all have learned from the new historians of capitalism like Sven Beckert is how intimately linked were the development of wage labor and industry in Britain and the US North with he development of slavery and cotton production in the US South; indeed they were two sides of the same process. Similar arguments have been made linking the development of English industry to slave-produced sugar (Williams), and to the second serfdom and de-urbanization in Eastern Europe (Braudel).

Meanwhile, as theorists of underdevelopment like Raul Prebisch have pointed out, it’s precisely the greater market power enjoyed by industry relative to primary products that allows productivity gains in industry to be captured by the producers, while productivity gains in primary production are largely captured by the consumers. We could point to the same thing within the US, where tremendous productivity advances in agriculture have led to cheap food, not rich farmers. Here again, the relationship between the land-industry binary and the monopoly-competition binary is the opposite as Hudson’s story. This doesn’t mean that they always line up that way, either, but it does suggest that the relationship is at least historically contingent.

Let’s turn now to the present. As we all know, since 1980 the holders of financial assets have reasserted their claims against productive enterprises, in the US and in much of the rest of the world. But I do not think this implies, as Hudson suggests, that today’s leading capitalists are the equivalent of feudal landowners. While pure rentiers do exist, the greatest accumulations of capital remain tied to control over the production process.

Even within the financial sector, extraction is only part of the story. A major development in finance over the past generation has been the growth of specialized venture capital and private equity funds. Though quite different in some ways — private equity specializing in acquisition of existing firms, venture capital in financing new ones — both can be seen as a kind of de-financialization, in the sense that both function to re-unite management and ownership. It is true of course, that private equity ownership is often quite destructive to the concrete production activities and social existence of a firm. But private equity looting happens not through the sort of arm’s length tribute collection of al landlord, but through direct control over the firm’s activity. The need for specialized venture capital funds to invest in money-losing startups, on the other hand, is certainly consistent with the view that strict imposition of financial criteria is inconsistent with development of production. But it runs against a simple story in which industry has been replaced by finance. (Instead, the growth of these sectors looks like an example of the way the capital looks different at different moments in its circuit. Venture capitalists willing to throw money at even far-fetched money-losing enterprises, are specialists in the M-C moment, while the vampires of private equity are specialists in C-M.)

It is true, of course, that finance as an industry has grown relative to the economy over the past 50 years, as have the payments made by corporations to shareholders. Hudson describes these trends as a “relapse back toward feudalism and debt peonage”, but I don’t think that’s right. The creditor and the landlord stand outside the production process. A debt peon has direct access to means of production, but is forced to hand over part of the product to the creditor or landlord. Capitalists by contrast get their authority and claim on surplus from control over the production process. This is as true today as when Marx wrote.

There is a widespread view that gains from ownership of financial assets have displaced profits from production even more many nonfinancial corporations, and that household debt service is a form of exploitation that now rivals the work place as a source of surplus, as households are forced to take on more debt to meet their subsistence needs. But these claims are mistaken — they confuse the temporary rise in interest rates after 1980 for a deeper structural shift.

As Joel Rabinovich convincingly shows, the increased financial holdings of nonfinancial corporations mostly represent goodwill from mergers and stakes in subsidiaries, not financial assets in the usual sense, while the apparent rise in their financial income of in the 1980s is explained by the higher interest on their cash holdings. With respect to household debt, it continues to overwhelmingly finance home ownership, not consumption; is concentrated in the upper part of the income distribution; and rose as a result of the high interest rates after 1980, not any increase in household borrowing. (See my discussion here.) With the more recent decline in interest rates, much of this supposed finacialization has reversed. Contrary to Hudson’s picture of an ever-rising share of income going to debt service, interest payments in the US now total about 17 percent of GDP, the same as in 1975.

On the other side, the transformation of the production process remains the source of the biggest concentrations of wealth. Looking at the Forbes 400 list of richest Americans, it is striking how rare generalized financial wealth is, as opposed to claims on particular firms. Jeff Bezos (#1), Bill Gates (#2) and Mark Zuckerberg (#3) all gained their wealth through control over newly created production processes, not via financial claims on existing ones. Indeed, of the top 20 names on the list, all but one are founders and active managers of companies or their immediate families. (The lone exception is Warren Buffet.) Finance and real estate are the source of a somewhat greater share of the fortunes found further down the list, but nowhere near a majority.

Companies like Wal Mart and Google and Amazon are clearly examples of industrial capitalism. They sell products, they lower prices, they put strong downward pressure on costs. Cheap consumer goods at Wal Mart lower the costs of subsistence for workers today just as cheap imported food did for British workers in the 19th century.

Does this mean Amazon and Wal Mart are good? No, of course not. (Tho we shouldn’t deny that their logistical systems are genuine technological accomplishments that a socialist society could build on.) My point is that the greatest concentrations of wealth today still arise from the competition to sell more desirable goods at lower prices. This runs against the idea of dominance by rentiers or passive rent-extractors.

Finally, I have some concerns about the political implications of this analysis. If we take Hudson’s story seriously, we may see a political divide between industrial capital and finance capital, and the possibility of a popular movement seeking alliance with the former. I am doubtful about this. While finance is a distinct social actor, I do not think it is useful to think of it as a distinct type of capital, one that is antagonistic to productive capital. As I’ve written elsewhere, it’s better to see finance as weapon by which the claims of wealth holders are asserted against the rest of society.

Certainly I don’t think the human embodiments of industrial capital would agree that they are victims of finance. Many of the features of contemporary capitalism he objects would appear to them as positive developments. Low wages, weak labor and light taxes are desired by capitalists in general, not just landlords and bankers. The examples Hudson points to of industrial capitalists and their political representatives supporting measures to socialize the costs of reproduction are real and worth learning from, but as products of specific historical circumstances rather than as generic features of industrial capitalism. We would need a better account of the specific conditions under which capital turns to programs for reducing labor costs in this way — rather than, for example, simply forcing down wages — to assess to what extent, and in which areas, they exist today.

Even if it were feasible, I am not sure this kind of program does much to support a more transformative political project. Hudson quotes Simon Patten’s turn-of-the-last-century description of public services like education as a “fourth factor of production” that is necessary to boost industrial competitiveness, with the implication that similar arguments might be successful today. Frankly, this kind of language strikes me as more characteristic of our neoliberal era than a basis for an alternative to it. As a public university teacher, I reject the idea that my job is to raise the productive capacity of workers, or reduce the overhead costs of American capital. Nor do I think we will be successful in defending education and other public goods from defunding and austerity using this language. And of course, it is not the only language available to us. As Mike Konczal notes in his new book Freedom from the Market, historically the case for public provision has often been made in terms of removing certain areas of life from the market, as well as the kinds of arguments Hudson describes.

More fundamentally, the framing here suggests that the objectionable features of capitalism stem from it not being capitalist enough. The focus on monopolies and rents suggests that what is wanted is more vigorous market competition. It is a strikingly Proudhonian position to say that the injustice and waste of existing capitalism stem from the failure of prices to track costs of production. Surely from a Marxist perspective it is precisely the pressure to compete on the basis of lower costs that is the source of that injustice and waste.

There is a great deal that is interesting and insightful in this paper, as there always is in Michael Hudson’s work. But I remain unconvinced that financial and industrial capitalism can be usefully thought of as two opposed systems, or that we can tell a meaningful historical story about a transition between them. Industry and finance are better thought of, in my view, as two different sides of the same system, or two moments in the same circuit of capital. Capitalism is a system in which human creative activity is subordinated to the endless accumulation of money. In this sense, finance is as integral to it as production. A focus on on the industrial-financial divide risks attributing the objectionable effects of accumulation to someone else — a rentier or landlord — leaving a one-sided and idealized picture of productive capital as the residual.

This being URPE, many people here will have at one time or another sung “is there aught we have in common with the greedy parasites?” Do we think those words refer to the banker only, or to the boss?

UPDATE: My colleague Julio Huato made similar arguments in response to an earlier version of Hudson’s paper a few years ago, here.

On Negative Rates

Negative interest rates – weird, right?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Let’s take the first set of motivations first.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Announcement: Money and Things

Arjun Jayadev and I are writing a book. The working title is Money and Things: How Finance Shapes the World. Here’s what it’s about:

Money is one of our most ubiquitous social technologies. It is also one of the most misunderstood. Economics students in college are taught that money is just a convenience to avoid the clumsiness of barter – that prices and incomes depend on underlying “real” values, and money is just a veil. Academic economists insist that money is “neutral” – that the long-run development of the economy depends on “real” factors like population growth and technological progress, which have nothing to do with money or credit. Many people still have some vague notion that money is backed by something “real”, perhaps vaults of gold under Fort Knox, while those who do understand that money is nothing but an entry on bank ledger, often feel this is dangerous and unnatural, and demand that a sharp line be drawn between credit and money. For the vast majority of people money is simply the background hum of the world they live in, something that they pay attention to only occasionally, if perhaps with a sense of unease.

This book seeks to open up the world of money as it really is and its relationship to the world. Dawing on the work of Karl Marx, John Maynard Keynes, Hyman Minsky, and other “heterodox” economic thinkers, the book argues that there is no real economy behind the monetary one. In economic questions, money itself is what is real.

This claim is developed through two related arguments. First, that money and finance are autonomous — that changes in money flows, assets and debt do not just reflect underlying activities of production and consumption but have their own independent dynamics. And second, that money does not merely facilitate economic activity, but reshapes it in far-reaching ways. This is a challenge to the conventional wisdom that money payments and quantities offer a transparent window onto the concrete, material world – that a certain amount of money must correspond to an equivalent amount of stuff. And it is a challenge to the economics orthodoxy that money is “neutral” in relation to the larger economy. On the contrary, monetary phenomena like debt and exchange rates have profound and lasting effects on the development of economies and the broader society.

The book is organized in three sections, moving from the abstract to the concrete. The first section explores the rules and logic of money as a distinct social activity, starting with the most basic building blocks of economic units and payments and building up to balance sheets, interest, exchange rates, and other more complex features of money-world. It then explores how these money terms do — and don’t — match up to the material and social world around us, critically examining concepts like “real” GDP. While numbers like this are often thought of as measuring some physical quantity, this is logically incohenerent and practically misleading.

In the second section, the book turns to the institutions that operate at the interface between money-world and society. This section explores the links between money and society, the tensions and conflicts between them, and the ways that they are actively managed. It includes chapters on the politically contested questions of reforms to the monetary system, and the sustainibility of private and public debt. The section’s main focus is on central banks and corporations as two key actors that manage the tension between an economic world imagined purely in terms of money claims and payments, and the concrete human activities of production and reproduction.

In the final section, the book explores how the tension between society and the world of money plays out politically. With chapters on Europe in the wake of the euro crisis, the US, the developing world, and the problem of climate change, it shows how many political developments can be understood in terms of a fundamental conflict between enforcing the logic of money, on the one hand, and meeting the concrete needs of human societies on the other. Much of what is called neoliberalism can be seen as an effort to compel politics and society to conform to the logic of money. At the same time, these constraints provoke counter responses, and the institutions constructed to maintain the dominance of money can themselves become vehicles for collective action toward other ends.

The book is an attempt to build a more sustained argument out of various things Arjun and I have written, especially this and this. It will also incorporate material from a great many posts on this blog over the past decade, including these and these and these.

If all goes according to plan, the book will be out from University from Chicago Press in early 2022.