Friday, November 22, 2013

Secular Stagnation, Progress in Economics


It's the topic of the moment. Our starting point is this Paul Krugman post, occasioned by this talk by Lawrence Summers.

There are two ways to understand "secular stagnation." One is that the growth rate of income and output will be slower in the future. The other is that there will be a systematic tendency for aggregate demand to fall short of the economy's potential output. It's the second claim that we are interested in.

For Krugman, the decisive fact about secular stagnation is that it implies a need for persistently negative interest rates. That achieved, there is no implication that growth rates or employment need to be lower in the future than in the past. He  is imagining a situation where current levels of employment and growth rates are maintained, but with permanently lower interest rates.

We could also imagine a situation where full employment was maintained by permanently higher public spending, rather than lower interest rates. Or we could imagine a situation where nothing closed the gap and output fell consistently short of potential. What matters is that aggregate expenditure by the private sector tends to fall short of the economy's potential output, by a growing margin. For reasons I will explain down the road, I think this is a better way of stating the position than a negative "natural rate" of interest.

I think this conversation is a step forward for mainstream macroeconomic thought. There are further steps still to take. In this post I describe what, for me, are the positive elements of this new conversation. In subsequent posts, I will talk about the right way of analyzing these questions more systematically -- in terms of a Harrod-type growth model -- and  about the wrong way -- in terms of the natural rate of interest.


The positive content of "secular stagnation"

1. Output is determined by demand.

The determination of total output by total expenditure is such a familiar part of the macroeconomics curriculum that we forget how subversive it is. It denies the logic of scarcity that is the basis of economic analysis and economic morality. Since Mandeville's Fable of the Bees, it's been recognized that if aggregate expenditure determines aggregate income, then, as Krugman says, "vice is virtue and virtue is vice."

A great deal of the history of macroeconomics over the past 75 years can be thought of as various efforts to expunge, exorcize or neutralize the idea of demand-determined income, or at least to safely quarantine it form the rest of economic theory. One of the most successful quarantine strategies was to recast demand constraints on aggregate output as excess demand for money, or equivalently as the wrong interest rate. What distinguished real economies from the competitive equilibrium of Jevons or Walras was the lack of a reliable aggregate demand "thermostat". But if a central bank or other authority set that one price or that one quantity correctly, economic questions could again be reduced to allocation of scarce means to alternative ends, via markets. Both Hayek and Friedman explicitly defined the "natural rate" of interest, which monetary policy should maintain, as the rate that would exist in a Walrasian barter economy. In postwar and modern New Keynesian mainstream economics, the natural rate is defined as the market interest rate that produces full employment and stable prices, without (I think) explicit reference to the intertemporal exchange rate that is called the interest rate in models of barter economies. But he equivalence is still there implicitly, and is the source of a great deal of confusion.

I will return to the question of what connection there is, if any, between the interest rates we observe in the world around us, and what a paper like Samuelson 1958 refers to as the "interest rate." The important thing for present purposes is:

Mainstream economic theory deals with the problems raised when expenditure determines output, by assuming that the monetary authority sets an interest rate such that expenditure just equals potential output. If such a policy is followed successfully, the economy behaves as if it were productive capacity that determined output. Then, specifically Keynesian problems can be ignored by everyone except the monetary-policy technicians. One of the positive things about the secular stagnation conversation, from my point of view, is that it lets Keynes back out of this box.

That said, he is only partway out. Even if it's acknowledged that setting the right interest rate does not solve the problem of aggregate demand as easily as previously believed, the problem is still framed in terms of the interest rate.


2. Demand normally falls short of potential

Another strategy to limit the subversive impact of Keynes has been to consign him to the sublunary domain of the short run, with the eternal world of long run growth still classical. (It's a notable -- and to me irritating -- feature of macroeconomics textbooks that the sections on growth seem to get longer over time, and to move to the front of the book.) But if deviations from full employment are persistent, we can't assume they cancel out and ignore them when evaluating an economy's long-run trajectory.

One of the most interesting parts of the Summers talk came when he said, "It is a central pillar of both classical models and Keynesian models, that it is all about fluctuations, fluctuations around a given mean." (He means New Keynesian models here, not what I would consider the authentic Keynes.) "So what you need to do is have less volatility." He introduces the idea of secular stagnation explicitly as an alternative to this view that demand matters only for the short run. (And he forthrightly acknowledges that Stanley Fischer, his MIT professor who he is there to praise, taught that demand is strictly a short-run phenomenon.) The real content of secular stagnation, for Summers, is not slower growth itself, but the possibility that the same factors that can cause aggregate expenditure to fall short of the economy's potential output can matter in the long run as well as in the short run.

Now for Summers and Krugman, there still exists a fundamentals-determined potential growth rate, and historically the level of activity did fluctuate around it in the past. Only in this new era of secular stagnation, do we have to consider the dynamics of an economy where aggregate demand plays a role in long-term growth. From my point of view, it's less clear that anything has changed in the behavior of the economy. "Secular stagnation" is only acknowledging what has always been true. The notion of potential output was never well defined. Labor supply and technology, the supposed fundamentals, are strongly influenced by the level of capacity utilization. As I've discussed before, once you allow for Verdoorn's Law and hysteresis, it makes no sense to talk about the economy's "potential growth rate," even in principle. I hope the conversation may be moving in that direction. Once you've acknowledged that the classical allocation-of-scarce-means-to-alternative-ends model of growth doesn't apply in present circumstances, it's easier to take the next step and abandon it entirely.


3. Bubbles are functional

One widely-noted claim in the Summers talk is that asset bubbles have been a necessary concomitant of full employment in the US since the 1980s. Before the real estate bubble there was the tech bubble, and before that there was the commercial real estate bubble we remember as the S&L crisis. Without them, the problem of secular stagnation might have posed itself much earlier.

This claim can be understood in several different, but not mutually exclusive, senses. It may be (1) interest rates sufficiently low to produce full employment, are also low enough to provoke a bubble. It may be (2) asset bubbles are an important channel by which monetary policy affects real activity. Or it may be (3) bubbles are a substitute for the required negative interest rates. I am not sure which of these claims Summers intends. All three are plausible, but it is still important to distinguish them. In particular, the first two imply that if interest rates could fall enough to restore full employment, we would have even more bubbles -- in the first case, as an unintended side effect of the low rates, in the second, as the channel through which they would work. The third claim implies that if interest rates could fall enough to restore full employment, it would be possible to do more to restrain bubbles.

An important subcase of (1) comes when there is a minimum return that owners of money capital can accept. As Keynes said (in a passage I'm fond of quoting),
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.[2] 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.”
If this is true, then asking owners of money wealth to accept rates of 2 percent, or perhaps much less, will face political resistance. More important for our purposes, it will create an inclination to believe the sales pitch for any asset that offers an acceptable return.

Randy Wray says that Summers is carrying water here for his own reputation and his masters in Finance. The case for bubbles as necessary for full employment justifies his past support for financial deregulation, and helps make the case against any new regulation in the future. That may be true. But I still think he is onto something important. There's a long-standing criticism of market-based finance that it puts an excessive premium on liquidity and discourages investment in long-lived assets. A systematic overestimate of the returns from fixed assets might be needed to offset the systematic overestimate of the costs of illiquidity.

Another reason I like this part of Summers' talk is that it moves us toward recognizing the fundamental symmetry between between monetary policy conventionally defined, lender of last resort operations and bank regulations. These are different ways of making the balance sheets of the financial sector more or less liquid. The recent shift from talking about monetary policy setting the money stock to talking about setting interest interest rates was in a certain sense a step toward realism, since there is nothing in modern economies that corresponds to a quantity of money. But it was also a step toward greater abstraction, since it leaves it unclear what is the relationship between the central bank and the banking system that allows the central bank to set the terms of private credit transactions. Self-interested as it may be, Summers call for regulatory forbearance here is an intellectual step forward. It moves us toward thinking of what central banks do neither in terms of money, nor in terms of interest rates, but in terms of liquidity.

Finally, note that in Ben Bernanke's analysis of how monetary policy affects output, asset prices are an important channel. That is an argument for version (2) of the bubbles claim.


4. High interest rates are not coming back

For Summers and Krugman, the problem is still defined in terms of a negative "natural rate" of interest. (To my mind, this is the biggest flaw in their analysis.) So much of the practical discussion comes down to how you convince or compel wealth owners to hold assets with negative yields. One solution is to move to permanently higher inflation rates. (Krugman, to his credit, recognizes that this option will only be available when or if something else raises aggregate demand enough to push against supply constraints.) I am somewhat skeptical that capitalist enterprises in their current form can function well with significantly higher inflation. The entire complex of budget and invoicing practices assumes that over some short period -- a month, a quarter, even a year -- prices can be treated as constant. Maybe this is an easy problem to solve, but maybe not. Anyway, it would be an interesting experiment to find out!

More directly relevant is the acknowledgement that interest rates below growth rates may be a permanent feature of the economic environment for the foreseeable future. This has important implications for debt dynamics (both public and private), as we've discussed extensively on this blog. I give Krugman credit for saying that with i < g, it is impossible for debt to spiral out of control; a deficit of any level, maintained forever, will only ever cause the debt-GDP ratio to converge to some finite level. (I also give him credit for acknowledging that this is a change in his views.) This has the important practical effect of knocking another leg out from the case for austerity. It's been a source of great frustration for me to see so many liberal, "Keynesian" economists follow every argument for stimulus with a pious invocation of the need for long-term deficit reduction. If people no longer feel compelled to bow before that shrine, that is progress.

On a more abstract level, the possibility of sub-g or sub-zero interest rates helps break down the quarantining of Keynes discussed above. Mainstream economists engage in a kind of doublethink about the interest rate. In the context of short-run stabilization, it is set by the central bank. But in other contexts, it is set by time preferences and technological tradeoff between current and future goods. I don't think there was ever any coherent way to reconcile these positions. As I will explain in a following post, the term "interest rate" in these two contexts is being used to refer to two distinct and basically unrelated prices. (This was the upshot of the Sraffa-Hayek debate.) But as long as the interest rate observed in the world (call it the "finance" interest rate) behaved similarly enough to the interest rate in the models (the "time-substitution" interest rate), it was possible to ignore this contradiction without too much embarrassment.

There is no plausible way that the "time substitution" interest rate can be negative. So the secular stagnation conversation is helping reestablish the point -- made by Keynes in chapter 17 of the General Theory, but largely forgotten -- that the interest rates we observe in the world are something different. And in particular, it is no longer defensible to treat the interest rate as somehow exogenous to discussions about aggregate demand and fiscal policy. When I was debating fiscal policy with John Quiggin, he made the case for treating debt sustainability as a binding constraint by noting that there are long periods historically when interest rates were higher than growth rates. It never occurred to him that it makes no sense to talk about the level of interest rates as an objective fact, independent of the demand conditions that make expansionary fiscal policy desirable. I don't mean to pick on John -- at the time it wasn't clear to me either.

Finally, on the topic of low interest forever, I liked Krugman's scorn for the rights of interest-recipients:
How dare anyone suggest that virtuous individuals, people who are prudent and save for the future, face expropriation? How can you suggest steadily eroding their savings either through inflation or through negative interest rates? It’s tyranny!
But in a liquidity trap saving may be a personal virtue, but it’s a social vice. And in an economy facing secular stagnation, this isn’t just a temporary state of affairs, it’s the norm. Assuring people that they can get a positive rate of return on safe assets means promising them something the market doesn’t want to deliver – it’s like farm price supports, except for rentiers.
It's a nice line, only slightly spoiled by the part about "what the market wants to deliver." The idea that it is immoral to deprive the owners of money wealth of their accustomed returns is widespread and deeply rooted. I think it lies behind many seemingly positive economic claims. If this conversation develops, I expect we will see more open assertions of the moral entitlement of the rentiers.

28 comments:

  1. I interpret DeLong as indicating Summers means 3 when he says
    He wasn't calling for more bubbles. He was pointing out that an economy that can only attain anything like full employment with stable inflation in a bubble is an economy with something deeply and structurally wrong with it--something that needs to be fixed.

    It is necessary to go beyond the interest rate. Part of the problem with the zero bound is long term rates fall but so does the risk premium which makes liquidity more attractive and investment less as the risk offers less compensation. Long rates aren't low enough because of the zero lower bound, but they are too low to tolerate the illiquidity risk creating a wedge between necessary and desired investment.

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  2. JW: "One of the most successful quarantine strategies was to recast demand constraints on aggregate output as excess demand for money, or equivalently as the wrong interest rate."

    *Not* equivalently! Never mind. carry on.

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    1. Equivalently for the purposes of the argument I'm making here.

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  3. JW: "without (I think) explicit reference to the intertemporal exchange rate that is called the interest rate in models of barter economies."

    I think so too. And it's an important point. The fact of monetary exchange, vs barter, will change a lot of real things, including the equilibrium real interest rate. Without money, we would probably still be living in caves, or fuedalism, or something.

    Just another aside. carry on.

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  4. "I don't think there was ever any coherent way to reconcile these positions."

    What determines the position of the steering wheel? The driver, or the bends in the road along which the driver travels?

    "There is no plausible way that the "time substitution" interest rate can be negative."

    I was following you well up to this paragraph, then you lost me.

    It is easy to have a model where the time substitution interest rate can be negative. If there exist no long-lived assets, for example. Now money is a long-lived asset, but we can imagine a world where money pays negative interest, either explicitly (e-money or stamped money) or via inflation. And land is another long-lived asset (my Turgot post). But your earlier point about liquidity is well-taken. I have been influenced a bit by JP Koning's excellent blog, "moneyness". Different assets will yield a different interest rate i they have different degrees of moneyness. Maybe what Summers is saying (I haven't seen/read him) is that we need to increase the moneyness of real assets to bring their equilibrium interest rates down. And, in a sense, that is exactly what Finance, as an industry, is trying to do.

    Good post JW.

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  5. A little bit about these historical interest rates (and Keynes was right about this): http://rwer.wordpress.com/2013/10/31/more-on-nineteenth-century-interest-rates-a-comparison-with-return-on-investment/

    and

    http://rwer.wordpress.com/2013/10/28/interest-rates-in-the-netherlands-1590-2012-and-the-uk-1703-1912/

    Merijn Knibbe

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  6. "Only in this new era of secular stagnation, do we have to consider the dynamics of an economy where aggregate demand plays a role in long-term growth."

    While it's long been conventional wisdom that demand side considerations were short term ones and supply side considerations mattered over the long run, there's one other piece of CW that seems to me to contradict it -- it has long been accepted that it's better to run a trade surplus than a trade deficit. To run a trade surplus is to get the benefits of other nations' demand while other nations get the benefit of your supply. To run a trade deficit means to have an influx of foreign financial capital that can be used to finance investment. Yet it seems to me that everyone agrees it is better to be the net exporter and the evidence seems to support this.

    This may be the wrong place to ask, since you disagree that demand only matters in the short run, but I'm wondering is there a coherent way to reconcile these ideas, or am I correct to perceive them as in contradiction?

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    1. This is a good point. From this perspective, it is obvious that an exogenous increase in demand will lead to a long term boost in supply. China couldn't have gotten where it is so quickly without the American consumer, and so on.

      Perhaps what is desirable about having other countries create the demand for you by being a net exporter is that it promotes none of the side effects of creating the demand internally via helicopter drops (such as greater labor power leading to higher wages, shorter work hours, and other things that don't please the bosses very much).

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    2. Eric-

      The textbook view is that a trade surplus is simply a form of lending and a trade deficit is a form of borrowing. So they are desirable or undesirable in the same situations it is beneficial for any other economic unit to lend or borrow. In other words, the familiar policy story about the benefits of export surplus is not present in academic economics.

      You could go a step further, and say that academic economics begins with the rejection of a trade surplus as a goal of policy. Certainly the founding myth of the economics profession is that it all began when Adam Smith defeated the mercantilists. That it is better to run a trade surplus is not conventional wisdom among professional economists -- quite the opposite!

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  7. JW: "If such a policy is followed successfully, the economy behaves as if it were productive capacity that determined output."
    JW: "The notion of potential output was never well defined. Labor supply and technology, the supposed fundamentals, are strongly influenced by the level of capacity utilization."

    There are ways to define these that lead to a positive natural interest rate.
    http://angrybearblog.com/2013/11/a-negative-natural-interest-rate-really-omg.html

    JW: "Output is determined by demand."
    From a basic model that I use... potential GDP is determined 83% by real output from the labor and capital being utilized and 17% by effective demand.

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  8. "There is no plausible way that the "time substitution" interest rate can be negative."

    I don't see why not (unless you mean in nominal terms). There is no storable good that is "safe" in the sense that its value in terms of your consumption basket is perfectly predictable. Of course this includes money, so technically it means that there cannot be a true "time substitution" interest rate (except subjectively). But money comes fairly close, probably a lot closer than any other storable good, or even any basket of storable goods. If the inflation rate is positive, and there are no other safe investments, then the time substitution interest rate is negative. There are other time substitution rates, but they involve risk, so they are not pure interest rates, they are interest rates plus risk compensation.

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    1. Putting my point a little differently: to speak of a "time substitution" interest rate implies some premise about what one is substituting. If one is substituting a freely storable good for a future instance of itself, then of course the interest rate can't be negative. So (abstracting from storage and insurance costs and other issues that needn't concern us now) the interest rate on gold, or on money, or on land, can't be negative. However, the interest rate on strawberries, or on backrubs, or on personal tutoring, can certainly be negative. Perhaps we want to abstract from all these particulars and substitute a generic good, an amalgam of all goods and services, for a future instance of itself, but any reasonable notion of a generic good is not going to be storable, and so there is no reason that its interest rate must be nonnegative.

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  9. Andy,

    Sorry, you're right, I put that badly. It is of course perfectly possible to describe logically a situation in which the pure rate of time substitution is negative. What I mean by "not plausible" is that i don't think this can be a description of the world we live in. We certainly have not run out of actions we can take in the present that will produce a net positive flow of income in the future.

    I agree with you that as an observable price that matches the time-substituion rate of theory, the deflation rate is a better candidate than the yield on a bond, which is normally what we think of as the "interest rate." But money has a liquidity premium, so it is not the pure thing either.

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    1. I don't think it's implausible as at least a sometime description of the world we live in. Since actual time conversion technologies are inevitably risky, and since agents IRL are heterogenous, the question is whether it is a plausible description of the marginal agent's time preferences under some circumstances that we may expect to encounter. Introspection tells me there are circumstances where my my time preference would be negative (i.e., where I would prefer future consumption to current consumption on the margin) -- specifically, if I faced a retirement significantly less comfortable than my current consumption pattern, which in fact describes the circumstances of many people. Given, again, that actual time conversion technologies are risky, it doesn't seem implausible that we might face a situation where this preference for the future is a property the marginal agent when we are talking about a hypothetical non-risky time conversion.

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    2. Come to think of it, additional introspection tells me that my actual, personal time preference is negative right now. In my case it doesn't matter because my risk preference is weaker than the market, so I'm an inframarginal holder of risky assets whose risk-adjusted return (for my risk preferences) is positive. But suppose the market risk premium were to go way down so that I would no longer choose to hold risky assets. Would I then be willing to hold large quantities of safe assets with a negative return, strictly for reasons of time preference? You bet: no way will I choose to live on Social Security when I retire. The counterfactual is problematic, admittedly, but ask me why I hold risky assets now. Is it because they have an "adequate" return and safe assets don't? No, it's because I'm being (or, rather, expecting to be) over-compensated for the risk.

      The question that aries, then: is it plausible that we live in a world where the marginal agent typically has risk preferences like those reflected in today's market but time preferences like mine? It seems quite plausible to me.

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    3. Come to think of it again, my revealed time preference is positive right now, since my assets have positive risk-adjusted returns and I'm not choosing to consume less. But this is just at the margin where we happen to be right now. My intertemporal behavior isn't going to change a whole lot in response to changes in asset returns, and it's quite plausible that risk-adjusted asset returns are going to go down (i.e., the bull market is going to continue until I no longer feel comfortable with such a large fraction of equity in my portfolio and I end up shifting to lower-risk assets that I expect to have negative real returns).

      Anyhow, my underlying point stands: our technology for shifting consumption over time is a risky technology, and there is, even in this real world in which we live, no reason (either in technology or in human nature) that its risk-adjusted return should be presumed positive in equilibrium.

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  10. Here's the general idea.

    For any asset, the total return is equal to: y + l - d - c- r + g - i , where y is the the yield, l is the liquidity from holding the asset, d is the depreciation rate, c is the carrying costs, r is the risk, g is the expected capital gain or change in relative price, and i is the pure rate of time discount. In equilibrium, all these returns should equal 0. That means the marginal agent is just indifferent between purchasing any asset or consuming in the present.

    In most economic models, we abstract away from all the terms except y and i, so we treat the yield on an asset as being equal to the time-substitution rate i.

    Now when we get to real economies, we know that the other terms are important. But we still think that in equilibrium every y should reflect the same i, along with the particular values of the other terms for that asset.

    The problem arises because there is a slippage where the "pure" interest rate i of the model is equated with the yield y of a bond IN A REAL ECONOMY. This is wrong. The y of actual debt contracts always also incorporates liquidity, risk and capital gain terms. Furthermore, every other asset with an intertemporal component also incorporates i, just as much as the bond yield does. There is no reason to single out the bond yield as the "interest rate" of theory, as opposed to the home price-rent ratio, or the profit rate, or the deflation rate, or the ratio of the college wage premium to tuition costs, or any other price with an intertemporal component.

    Now this gets to be a problem when we come to discussions of monetary policy, because people's informal discussions and all the newer formal models implicitly assume that monetary policy is working with i. But monetary policy has nothing to do with i. It is changing mainly l, and also to some extent r and g.

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    1. I should add that we have the equilibrium return = 0 only for assets that actually are held. Blackberries and backrubs are not held as assets, so there expected return will not be zero, it will be negative. Nonetheless, we can still write the total return on holding blackberries as y + l - d - c- r + g - i. In the case of blackberries, y, l and r are zero (unless you plant them in which case I suppose y would be positive), d and c are very high, g will be positive or negative depending on the time of year and so on, and i will be the equilibrium i for the economy as a whole. Again, the total return will be negative in the case of blackberries, but it still incorporates the same pure time-substitution rate i as any other possible asset,.

      Bohm-Bawerk, Wicksell, Cassel, Hayek etc. were not wrong to think that a term like i exists and is worth analyzing. Their mistake was to treat the observed y in the credit market as equivalent to i. (Actually I don't think Wicksell made this mistake.)

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  11. This part:
    But in a liquidity trap saving may be a personal virtue, but it’s a social vice. And in an economy facing secular stagnation, this isn’t just a temporary state of affairs, it’s the norm.

    reminds me of this quote:

    It is worthwhile to remark that a product is no sooner created than it, from that instant, affords a market for other products to the full extent of its own value. When the producer has put the finishing hand to his product, he is most anxious to sell it immediately, lest its value should diminish in his hands. Nor is he less anxious to dispose of the money he may get for it; for the value of money is also perishable. But the only way of getting rid of money is in the purchase of some product or other. Thus the mere circumstance of creation of one product immediately opens a vent for other products. (J. B. Say, 1803: pp.138–9)[4]

    My interpretation: Say's Law demands a negative real interest rate for money as a counterpart to real, perishable output.

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  12. One weird effect though is that as interest rates fall, asset prices bubble up but also become more volatile. Also commodities get used as financial assets. Although the finance sector may not gain much return by holding any given asset long term, they can bleed the economy by making trading gains at the expense of the real economy. The 2008 crisis was at least partly precipitated by a run up in commodity prices that was at largely driven by financial speculation. Industry will have to buy raw materials irrespective of cost. That lack of maneuverability makes them sitting ducks for speculative price spikes etc.

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  13. Stone-

    The link you suggest from interest rates to the behavior of commodity prices is clearly real and probably important. But we need to think through more systematically exactly how it operates.

    My thought is: Speculative positions need to be financed. The cost of this financing depends on the availability of liquidity. Sometimes taking an illiquid position -- one that you cannot costlessly reverse -- is relatively expensive. (This includes the case of high interest rates but is broader than it.) Then you need a fairly confident expectation if a fairly large price change to make a speculative position worthwhile. On the other hand, when liquidity is cheap, it's worth taking positions even when the expected price change is small and uncertain. So there will be more speculation. But as the proportion if demand accounted for by capital gain-seeking speculators increases, the price becomes more volatile. (For a couple reasons.) This is especially likely if supply and non-speculative demand are price inelastic, as you say. But the high volatility in turn promises larger capital gains to anyone who thinks they can take a position ahead of the market. So low interest rates can trigger a shift toward speculative dynamics in an asset market that then persist even when interest rates rise again. This was a common story about the stock market in the 1920s -- you'll find it for instance in Galbraith Sr.'s book on the crash.

    On a slightly different note, Robert Triffin thought the relationship between interest rates and commodity prices was a stabilizing factor for the gold standard. His argument was that the Uk was an importer of commodities, and at any given moment there would be significant stocks being held in the country. These stocks had to financed. If the UK balance of payments moved toward deficit, interest rates would rise, making holding stocks of commodities more expensive and encouraging their liquidation. This would push down the price of Britain's commodity imports and so improve its trade balance and help eliminate the balance of payments deficit.

    There's some debate about how important this "Triffin effect" was in practice. And of course -- and this is the real point -- the fact that these dynamics were stabilizing for gold standard-era Britain is basically an institutional accident. There's no reason a similar process couldn't operate in a destabilizing direction.

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  14. I even wonder whether a liquidity glut might make persistent stagnation more likely if it induces commodity price volatility that acts as a cost drag on the real economy. If investing in infrastructure or manufacturing or whatever becomes unattractive because of the danger that a project will be derailed by wild swings in commodity prices, then such investment won't take place. Instead the money will be diverted to playing those wild price swings. We will then have more unemployment and inefficient, outdated, industry etc etc.

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  15. It seems that there is some consensus on the idea that low interest rates cause bubbles.

    But, are we sure that it is the low rate, and not the downward movement of the rates, that causes the bubbles?

    When the interest rate falls, all assets should have a rise in price:
    I understand that the price of assets is more or less inversely proportional to the rate of interest (since the "correct" price of an asset is that price where the profits from that asset exactly cover the debt incurred to buy it, if the profits are fixed but i falls, the value of the asset has to rise).
    If this rise in price overshoots whe have a bubble. But it is not the low interest that causes the bubble, but the downward movement of the interest rate that causes it.

    For what I can understand, we lived through 2-3 decades of continuous fall in the interest rate, so it seems to me that this might be an explanation for the continuous bubbles.

    In this account, I would have secularly rising asset prices (due to monetary policy) that create bubbles (and hence debt, and hence demand). [this would be your "(2) asset bubbles are an important channel by which monetary policy affects real activity" I suppose].

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    1. Yes, this seems plausible; it's what Kalecki thought also, I believe.

      In fact the same might be said about interest rates and aggregate expenditure in general -- the main expansionary effect is not of low rates in themselves, but rates that are low relative to what was previously expected. This is Ed Leamer's argument also, more or less. But I'm not sure about this...

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  16. Thanks for clarifying the difference between your and SRW's views on real rates a couple weeks back.

    I have a question on something you said in the above post: ... there is nothing in modern economies that corresponds to a quantity of money.

    Would you dumb that down to my level for me? Thanks!

    Old post. I hope you find this.

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    1. Hi Art.

      Thanks, it's an important point. Let me put it this way, tell me if it helps.

      Take a cafe or restaurant. They can serve only so many people. There are various limits on their capacity but one is the number of tables. Any customer has to have a tbale to sit at. Now, the amount of time a customer spends at a table isn't fixed -- there are all kinds of strategies businesses use t get their tables to turn over more quickly. And sometimes there are extra tables and then the number of tables isn't limiting the restaurant's business at all. But by and large, we can say that if a restaurant wants to do twice as much business, it will need twice as many tables, that doubling the number of tables often will lead to twice as much business over time, and that, in general, the number of tables is an important factor in how many people a restaurant serves, independent of everything else.

      Now consider another variable -- the number of times the restaurant door opens. Well, obviously, no one can go in or out without opening the door. And if you put some kind of sensor on the door to count the number of times it opened during the day, you'd probably see a stable relationship between the number of times the door opened and the amount of business the restaurant was doing. But you wouldn't learn anything from that exercise that you didn't alrady know jus tby looking at how many people you were serving, the way you might learn something form comparing the number of tables to the number of people actually eating. And obviously, there is no sense in which "number of times the door opens each day" is an independent factor in the business a restaurant does. Adding tables to increase your business might or might not work, but flapping the door (or greasing it so it opens more easily) is transparently silly. The door opens whenever someone walks in or out, that's all.

      So what I'm saying is, economists used to think of "money" as something like the number of tables in a restaurant. Now they think of it as something like the number of times the door opens each day.

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    2. Crap. I thought it was making sense this time when I read it. And then I got to the last part, where you say money is like the flapping door, a meaningless thing.

      FRED still identifies M1 money as "funds that are readily accessible for spending." Is that defunct too?

      I know that financial innovation has caused money to evolve. What I don't know is whether the highly evolved form is viable. I frankly doubt that our economy can survive it. Thanks, JW.

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