How Not to Think about Negative Rates

Last week’s big monetary-policy news was the ECB’s decision to target a negative interest rate, in the form of an 0.25 percent tax on bank reserves. This is the first time a major central bank has announced a negative policy rate, though some smaller ones (like the Bank of Sweden) have done so in the past few years.

Whether a tax on reserves is really equivalent to a negative interest rate, and whether this change should be expected to pass through to interest rates or credit availability for private borrowers, are not easy questions. I’m not going to try to answer them now. I just want to call attention to this rather extraordinary Neil Irwin column, as an example of how unsuited mainstream discussion is to addressing these questions.  

Here’s Irwin’s explanation of what a negative interest rate means:

When a bank pays a 1 percent interest rate, it’s clear what happens: If you deposit your money at the bank, it will pay you a penny each year for every dollar you deposited. When the interest rate is negative, the money goes the other direction. … Put bluntly: Normally the banks pay you to keep your money there. Under negative rates, you pay them for the privilege.

Not mentioned here, or anywhere else in the article, is that people pay interest to banks, as well as receiving interest from them. In Irwin’s world, “you” are always a creditor, never a borrower. 

Irwin continues:

The theory is that when it becomes more costly for European banks to keep money in the E.C.B., they will have incentive to do something else with it: Lend it out to consumers or businesses, for example.

Here’s the loanable funds theory in all its stupid glory. People put their “money” into a bank, which then either holds it or lends it out. Evidently it is not a requirement to be a finance columnist for the New York Times to know anything about how bank loans actually work. 

Irwin:

Banks will most likely pass these negative interest rates on to consumers, or at least try to. They may try to do so not by explicitly charging a negative interest rate, but by paying no interest and charging a fee for account maintenance.

Note that “consumers” here means depositors. The fact that banks also make loans has escaped Irwin’s attention entirely. 

Of course, most of us are already in this situation: We don’t receive any interest rate on our transaction balances, and pay are willing to pay various charges and fees for the liquidity benefits of holding them. 

The danger of negative rates, per Irwin, is that 

It is possible that, assuming banks pass along the negative rates through either fees or explicitly charging negative interest, people will withdraw their money as cash rather than keeping it on deposit at banks. … That is one big reason that the E.C.B. and other central banks are going to be reluctant to make rates highly negative; it could result in people pulling cash out of the banking system.

Again the quantity theory in its most naive and stupid form: there is a fixed quantity of “money” out there, which is either being kept in banks — which function, in Irwin’s world, as glorified safe deposit boxes — or under mattresses. Evidently he’s never thought about why the majority of us who already face negative rates on our checking accounts continue to hold them. More fundamentally, there’s no explanation of what makes negative rates special. Bank deposits don’t, in general, finance holdings of reserves, they finance bank loans. Any kind of expansionary policy must reduce the yield on bank loans and also — if margins are constant — on deposits and other bank liabilities. Making returns to creditors the acid test of policy, as Irwin does, would seem to be an argument against expansionary monetary policy in general — which of course it is.

What’s amazing to me in this piece is that here we have an article about monetary policy that literally makes no mention of loans or borrowers. In Irwin’s world, “you” are, by definition, an owner of financial assets; no other entities exist. It’s the 180-proof distillation of the bondholder’s view of the world.

Heterodox criticism of the loanable-funds theory of interest and insistence that loans create deposits, can sometimes come across as theological, almost ritual.  Articles like this are a reminder of why we can’t let these issues slide, if we want to make any sense of the financial universe in which we live.

That Safe Asset Shortage, Continued

Regular readers of the blog will know that we have been having a contradiction with Brad DeLong and the rest of the monetarist mainstream of modern macroeconomics.

They think that demand constraints imply, by definition, an excess demand for money or "safe assets." Unemployment implies disequilibrium, for them; if everyone can achieve their desired transactions at the prevailing prices, then society's productive capacity will always be fully utilized. Whereas I think that the interdependence of income and expenditure means that all markets can clear at a range of different levels of output and employment.

What does this mean in practice? I am pretty sure that no one thinks the desire to accumulate safe assets  directly reduces demand for current goods from households and nonfinancial businesses. If a safe asset shortage is restricting demand for real goods and services, it must be via an unwillingness of banks to hold the liabilities of nonfinancial units. Somebody has to be credit constrained.

So then: What spending is more credit constrained now, than before the crisis?

It's natural to say, business investment. But in fact, nonresidential investment is recovering nicely. And as I pointed out last week, by any obvious measure credit conditions for business are exceptionally favorable. Risky business debt is trading at historically low yields, while the volume of new issues of high-risk corporate debt is more than twice what it was on the eve of the crisis. There's some evidence that credit constraints were important for businesses in the immediate post-Lehmann period, if not more recently; but even for the acute crisis period it's hard to explain the majority of the decline in business investment that way. And today, it certainly looks like the supply of business credit is higher, not lower, than before 2008.

Similarly, if a lack of safe assets has reduced intermediaries' willingness to hold household liabilities, it's hard to see it in the data. We know that interest rates are low. We know that most household deleveraging has taken place via default, as opposed to reduced borrowing. We know the applications for mortgages and new credit cards have continued to be accepted at the same rate as before the crisis. And this week's new Household Credit and Debt Report confirms that people are coming no closer than before the crisis, to exhausting their credit-card credit. Here's a graph I just made of credit card balances and limits, from the report:

Ratio of total credit card balances to total limits (blue bars) on left scale; indexes of actual and trend consumption (orange lines) on right scale. Source: New York Fed.

The blue bars show total credit card debt outstanding, divided by total credit card limits. As you can see, borrowers did significantly draw down their credit in the immediate crisis period, with balances rising from about 23% to about 28% of total credit available. This is just as one would expect in a situation where more people were pushing up against liquidity constraints. But for the past year and a half, the ratio of credit card balances to limits has been no higher than before the crisis. Yet, as the orange lines show, consumption hasn't returned to the pre-crisis trend; if anything, it continues to fall further behind. So it looks like a large number of household were pressing against their credit limit during the recession itself (as during the previous one), but not since 2011. One more reason to think that, while the financial crisis may have helped trigger the downturn, household consumption today is not being held back a lack of available credit, or a safe asset shortage.

If it's credit constraints holding back real expenditure, who or what exactly is constrained?

Summers on Microfoundations

From The Economist's report on this weekend's Institute for New Economic Thinking conference at Bretton Woods:

The highlight of the first evening's proceedings was a conversation between Harvard's Larry Summers, till recently President Obama's chief economic advisor, and Martin Wolf of the Financial Times. Much of the conversation centred on Mr Summers's assessments of how useful economic research had been in recent years. Paul Krugman famously said that much of recent macroeconomics had been "spectacularly useless at best, and positively harmful at worst". Mr Summers was more measured... But in its own way, his assessment of recent academic research in macroeconomics was pretty scathing.

For instance, he talked about all the research papers that he got sent while he was in Washington. He had a fairly clear categorisation for which ones were likely to be useful: read virtually all the ones that used the words leverage, liquidity, and deflation, he said, and virtually none that used the words optimising, choice-theoretic or neoclassical (presumably in the titles or abstracts). His broader point—reinforced by his mentions of the knowledge contained in the writings of Bagehot, Minsky, Kindleberger, and Eichengreen—was, I think, that while it would be wrong to say economics or economists had nothing useful to say about the crisis, much of what was the most useful was not necessarily the most recent, or even the most mainstream. Economists knew a great deal, he said, but they had also forgotten a great deal and been distracted by a lot.

Even more scathing, perhaps, was his comment that as a policymaker he had found essentially no use for the vast literature devoted to providing sound micro-foundations to macroeconomics.

Pretty definitive, no?

And that's it it -- I promise! -- on microfoundations, methodology, et hoc genus omne in these parts, at least for a while. I have a couple new posts at least purporting to offer concrete analysis of the concrete situation, just about ready to go.

Microfoundations, Again

Sartre has a wonderful bit in the War Diaries about his childhood discovery of atheism:

One day at La Rochelle, while waiting for the Machado girls who used to keep me company every morning on my way to the lycee, I grew impatient with their lateness and, to while away the time, decided to think about God. "Well," I said, "he doesn't exist." It was something authentically self-evident, although I have no idea any more what it was based on. And then it was over and done with...

Similarly with microfoundations: First of all, they don't exist. But this rather important point tends to get lost sight of when we follow the conceptual questions too far out into the weeds.

Yes, your textbook announces that "Nothing appears in this book that is not based on explicit microfoundations." But then 15 pages later, you find that "We assume that all individuals in the economy are identical," and that these identical individuals have intertemporally-additive preferences. How is this representative agent aggregated up from a market composed of many individuals with differing preferences? It's not. And in general, it can't be. As Sonnenschein, Mantel and Debreu showed decades ago, there is no mathematical way to consistently aggregate a set of individual demand functions into a well-behaved aggregate demand function, let alone one consistent with temporally additive preferences. So let's say we are interested in the relationship between aggregate income and consumption. The old Keynesian (or structuralist) approach is to stipulate a relationship like C = cY, where c < 1 in the short run and approaches 1 over longer horizons; while the modern approach is to derive the relationship explicitly from a representative agent maximizing utility intertemporally. But since there's no way to get that representative agent by aggregating heterogeneous individuals -- and since even the representative agent approach doesn't produce sensible results unless we impose restrictive conditions on its preferences -- there is no sense in which the latter is any more microfounded than the former.

So if the representative agent can't actually be derived from any model of individual behavior, why is it used? The Obstfeld and Rogoff book I quoted before at least engages the question; it considers various answers before concluding that "Fundamentally," a more general approach "would yield few concrete behavioral predictions." Which is really a pretty damning admission of defeat for the microfoundations approach. Microeconomics doesn't tell us anything about what to expect at a macro level, so macroeconomics has to be based on observations of macro phenomena; the "microfoundations" are bolted on afterward.

None of this is at all original. If Cosma Shalizi and Daniel Davies didn't explicitly say this, it's because they assume anyone interested in this debate knows it already. Why the particular mathematical formalism misleadingly called microfoundations has such a hold on the imagination of economists is a good question, for which I don't have a good answer. But the unbridgeable gap between our supposed individual-level theory of economic behavior and the questions addressed by macroeconomics is worth keeping in mind before we get too carried away with discussions of principle.