Alvin Hansen on Monetary Policy

The more you read in the history of macroeconomics and monetary theory, the more you find that current debates are reprises of arguments from 50, 100 or 200 years ago.

I’ve just been reading Perry Mehrling’s The Money Interest and the Public Interest, which  is one of the two best books I know of on this subject. (The other is Arie Arnon’s Monetary Theory and Policy Since David Hume and Adam Smith.) About a third of the book is devoted to Alvin Hansen, and it inspired me to look up some of Hansen’s writings from the 1940s and 50s. I was especially struck by this 1955 article on monetary policy. It not only anticipates much of current discussions of monetary policy — quantitative easing, the maturity structure of public debt, the need for coordination between the fiscal and monetary policy, and more broadly, the limits of a single interest rate instrument as a tool of macroeconomic management — but mostly takes them for granted as starting points for its analysis. It’s hard not to feel that macro policy debates have regressed over the past 60 years.

The context of the argument is the Treasury-Federal Reserve Accord of 1951, following which the Fed was no longer committed to maintaining fixed rates on treasury bonds of various maturities. [1] The freeing of the Fed from the overriding responsibility of stabilizing the market for government debt, led to scholarly and political debates about the new role for monetary policy. In this article, Hansen is responding to several years of legislative debate on this question, most recently the 1954 Senate hearings which included testimony from the Treasury department, the Fed Board’s Open Market Committee, and the New York Fed.

Hansen begins by expressing relief that none of the testimony raised

the phony question whether or not the government securities market is "free." A central bank cannot perform its functions without powerfully affecting the prices of government securities.

He then expresses what he sees as the consensus view that it is the quantity of credit that is the main object of monetary policy, as opposed to either the quantity of money (a non-issue) or the price of credit (a real but secondary issue), that is, the interest rate.

Perhaps we could all agree that (however important other issues may be) control of the credit base is the gist of monetary management. Wise management, as I see it, should ensure adequate liquidity in the usual case, and moderate monetary restraint (employed in conjunction with other more powerful measures) when needed to check inflation. No doubt others, who see no danger in rather violent fluctuations in interest rates (entailing also violent fluctuations in capital values), would put it differently. But at any rate there is agreement, I take it, that the central bank should create a generous dose of liquidity when resources are not fully employed. From this standpoint the volume of reserves is of primary importance.

Given that the interest rate is alsoan object of policy, the question becomes, which interest rate?

The question has to be raised: where should the central bank enter the market -short-term only, or all along the gamut of maturities?

I don’t believe this is a question that economists asked much in the decades before the Great Recession. In most macro models I’m familiar with, there is simply “the interest rate,” with the implicit assumption that the whole rate structure moves together so it doesn’t matter which specific rate the monetary authority targets. For Hansen, by contrast, the structure of interest rates — the term and "risk” premiums — is just as natural an object for policy as the overall level of rates. And since there is no assumption that the whole structure moves together, it makes a difference which particular rate(s) the central bank targets. What’s even more striking is that Hansen not only believes that it matters which rate the central bank targets, he is taking part in a conversation where this belief is shared on all sides.

Obviously it would make little difference what maturities were purchased or sold if any change in the volume of reserve money influenced merely the level of interest rates, leaving the internal structure of rates unaffected. … In the controversy here under discussion, the Board leans toward the view that … new impulses in the short market transmit themselves rapidly to the longer maturities. The New York Reserve Bank officials, on the contrary, lean toward the view that the lags are important. If there were no lags whatever, it would make no difference what maturities were dealt in. But of course the Board does not hold that there are no lags.

Not even the most conservative pole of the 1950s debate goes as far as today's New Keynesian orthodoxy that monetary policy can be safely reduced to the setting of a single overnight interest rate.

The direct targeting of long rates is the essential innovation of so-called quantitative easing. [2] But to Hansen, the idea that interest rate policy should directly target long as well as short rates was obvious. More than that: As Hansen points out, the same point was made by Keynes 20 years earlier.

If the central bank limits itself to the short market, and if the lags are serious, the mere creation of large reserves may not lower the long-term rate. Keynes had this in mind when he wrote: "Perhaps a complex offer by the central bank to buy and sell at stated prices gilt-edged bonds of all maturities, in place of the single bank rate for short-term bills, is the most important practical improvement that can be made in the technique of monetary management. . . . The monetary authority often tends in practice to concentrate upon short-term debts and to leave the price of long-term debts to be influenced by belated and imperfect re- actions from the price of short-term debts." ' Keynes, it should be added, wanted the central bank to deal not only in debts of all maturities, but also "to deal in debts of varying degrees of risk," i.e., high grade private securities and perhaps state and local issues.

That's a quote from The General Theory, with Hansen's gloss.

Fast-forward to 2014. Today we find Benjamin Friedman — one of the smartest and most interesting orthodox economists on these issues — arguing that the one great change in central bank practices in the wake of the Great Recession is intervention in a range of securities beyond the shortest-term government debt. As far as I can tell, he has no idea that this “profound” innovation in the practice of monetary policy was already proposed by Keynes in 1936. But then, as Friedman rightly notes, “Macroeconomics is a field in which theory lags behind experience and practice, not the other way around.”

Even more interesting, the importance of the rate structure as a tool of macroeconomic policy was recognized not only by the Federal Reserve, but by the Treasury in its management of debt issues. Hansen continues:

Monetary policy can operate on two planes: (1) controlling the credit base - the volume of reserve balances- and (2) changing the interest rate structure. The Federal Reserve has now backed away from the second. The Treasury emphasized in these hearings that this is its special bailiwick. It supports, so it asserts, the System's lead, by issuing short- terms or long-terms, as the case may be, according to whether the Federal Reserve is trying to expand or contract credit … it appears that we now have (whether by accident or design) a division of monetary management between the two agencies- a sort of informal cartel arrangement. The Federal Reserve limits itself to control of the volume of credit by operating exclusively in the short end of the market. The Treasury shifts from short-term to long-term issues when monetary restraint is called for, and back to short-term issues when expansion is desired.

This is amazing. It’s not that Keynesians like Hansen  propose that Treasury should issue longer or shorter debt based on macroeconomic conditions. Rather, it is taken for granted that it does choose maturities this way. And this is the conservative side in the debate, opposed to the side that says the central bank should manage the term structure directly.

Many Slackwire readers will have recently encountered the idea that the maturities of new debt should be evaluated as a kind of monetary policy. It's on offer as the latest evidence for the genius of Larry Summers. Proposing that Treasury should issue short or long term debt based on goals for the overall term structure of interest rates, and not just on minimizing federal borrowing costs, is the main point of Summers’ new Brookings paper, which has attracted its fair share of attention in the business press. No reader of that paper would guess that its big new idea was a commonplace of policy debates in the 1950s. [3]

Hansen goes on to raise some highly prescient concerns about the exaggerated claims being made for narrow monetary policy.

The Reserve authorities are far too eager to claim undue credit for the stability of prices which we have enjoyed since 1951. The position taken by the Board is not without danger, since Congress might well draw the conclusion that if monetary policy is indeed as powerful as indicated, nonmonetary measures [i.e. fiscal policy and price controls] are either unnecessary or may be drawn upon lightly.

This is indeed the conclusion that was drawn, more comprehensively than Hansen feared. The idea that setting an overnight interest rate is always sufficient to hold demand at the desired level has conquered the economics profession “as completely as the Holy Inquisition conquered Spain,” to coin a phrase. If you talk to a smart young macroeconomist today, you’ll find that the terms “aggregate demand was too low” and “the central bank set the interest rate too high” are used interchangeably. And if you ask, which interest rate?, they react the way a physicist might if you asked, the mass of which electron?

Faced with the argument that the inflation of the late 1940s, and price stability of the early 1950s, was due to bad and good interest rate policy respectively, Hansen offers an alternative view:

I am especially unhappy about the impli- cation that the price stability which we have enjoyed since February-March 1951 (and which everyone is justifiably happy about) could quite easily have been purchased for the entire postwar period (1945 to the present) had we only adopted the famous accord earlier …  The postwar cut in individual taxes and the removal of price, wage, and other controls in 1946 … did away once and for all with any really effective restraint on consumers. Under these circumstances the prevention of price inflation … [meant] restraint on investment. … Is it really credible that a drastic curtailment of investment would have been tolerated any more than the continuation of wartime taxation and controls? … In the final analysis, of course,  the then prevailing excess of demand was confronted with a limited supply of productive resources.

Inflation always comes down to this mismatch between “demand,” i.e. desired expenditure, and productive capacity.

Now we might say in response to such mismatches: Well, attempts to purchase more than we can produce will encourage increased capacity, and inflation is just a temporary transitional cost. Alternatively, we might seek to limit spending in various ways. In this second case, there is no difference of principle between an engineered rise in the interest rate, and direct controls on prices or spending. It is just a question of which particular categories of spending you want to hold down.

The point: Eighty years ago, Keynes suggested that what today is called quantitative easing should be a routine tool of monetary policy. Sixty years ago, Alvin Hansen believed that this insight had been accepted by all sides in macroeconomic debates, and that the importance of the term structure for macroeconomic activity guided the debt-issuance policies of Treasury as well as the market interventions of the Federal Reserve. Today, these seem like new discoveries. As the man says, the history of macroeconomics is mostly a great forgetting.


[1] I was surprised by how minimal the Wikipedia entry is. One of these days, I am going to start having students improve economics Wikipedia pages as a class assignment.

[2] What is “quantitative about this policy is that the Fed buys a a quantity of bonds, evidently in the hopes of forcing their price up, but does not announce an explicit target for the price. On the face of it, this is a strangely inefficient way to go about things. If the Fed announced a target for, say, 10-year Treasury bonds, it would have to buy far fewer of them — maybe none — since market expectations would do more of the work of moving the price. Why the Fed has hobbled itself in this way is a topic for another post.

[3] I am not the world’s biggest Larry Summers fan, to say the least. But I worry I’m giving him too hard a time in this case. Even if the argument of the paper is less original than its made out to be, it’s still correct, it’s still important, and it’s still missing from today’s policy debates. He and his coauthors have made a real contribution here. I also appreciate the Hansenian spirit in which Summers derides his opponents as "central bank independence freaks."

Liquidity Preference on the F Line

Sitting on the subway today, I was struck by the fact that the three ads immediately opposite me were all for what you might call liquidity services. On the left was an ad for "personal asset loans" from something called Borro: "With this necklace ... I funded my first business," says a satisfied customer. Next to it was an MTA ad trumpeting the fact that you can pay your fare with a credit card. And then one from AptDeco.com, which I guess is a clearinghouse for used furniture sales, with the tagline "NYC is now your furniture store."

the Borro ad was the next one to the left

This was interesting to me because I've just been thinking about the neutrality of money, and what an incoherent and contradictory idea it is.

The orthodox view is that the level of "real" economic activity is determined by "real" factors -- endowments, tastes, technology -- and people simply hold money balances proportionate to this level of activity. In this view, a change in the money supply can't make anyone better or worse off, at least in the long run, or change anything about the economy except the price level.

Just looking at these ads shows us why that can't be true. First of all, the question of what constitutes money. All three of these ads are, in effect, inviting you to use something as money that you couldn't previously. Without the specialized intermediary services being hawked here, you couldn't pay the startup costs of a business with a necklace (what's this thing made of, plutonium?), or pay for a subway ride with a promise to pay later, or pay for much of anything with a used couch. And this new liquidity has real benefits -- otherwise, no one would be buying it, and it wouldn't be worth the cost of producing (or advertising) it. The idea -- stated explicitly in the Borro ad -- is that the liquidity they provide allows transactions to take place that otherwise wouldn't. The ability to turn a piece of jewelry or a car into cash allows people to use productive capacities that otherwise would go to waste.

And of course this makes sense. The orthodox view is that money is useful -- there must be a reason that we don't live in a barter world, and more than that, that all this huge industry of liquidity provision exists. But money, for some reason, is not subject to the same kind of smoothly diminishing returns that other useful things are. There is a fixed amount you need, you can't get by with less, and there's no benefit at all in having more. The problem is worse than that, since the standard view is that money demand is strictly proportionate to the volume of transactions. But, which transactions? Presumably, the amount of economic activity depends on the availability of money -- that's what it means to say that money is useful. And furthermore, as these ads implicitly make clear, some transactions are more liquidity-intensive than others. No one is offering specialized intermediary services to help you buy a hamburger. So both the level and composition of economic activity must depend on money holdings. But in that case, you can't say that money holdings depend only on the volume of activity -- that would be circular. In a world where money is used at all, it can't be neutral. An increase in the money supply (or better, in liquidity) may raise prices, but it won't do so proportionately, since it also enables people to benefit from increasing their money holdings (or: shifting toward more liquid balance sheet positions) and to carry out liquidity-intensive transactions that were formerly unable to.

This is a very old issue in economics. The idea that money should be neutral is as old as the discipline, and so is this line of criticism of it. You can find both already in Hume. In "Of Money," he lays out the argument that money must be neutral in the long run, since it is just an intrinsically meaningless unit of measure; real wealth depends on real resources, not on the units we count them in. Unlike most later writers, he follows this argument to its logical conclusion, that any resources devoted to liquidity provision are wasted:

This has made me entertain a doubt concerning the benefit of banks and paper-credit, which are so generally esteemed advantageous to every nation. That provisions and labour should become dear by the encrease of trade and money, is, in many respects, an inconvenience; but an inconvenience that is unavoidable, and the effect of that public wealth and prosperity which are the end of all our wishes. ... But there appears no reason for encreasing that inconvenience by a counterfeit money, which foreigners will not accept of in any payment, and which any great disorder in the state will reduce to nothing. There are, it is true, many people in every rich state, who having large sums of money, would prefer paper with good security; as being of more easy transport and more safe custody. ... And therefore it is better, it may be thought, that a public company should enjoy the benefit of that paper-credit, which always will have place in every opulent kingdom. But to endeavour artificially to encrease such a credit, can never be the interest of any trading nation; but must lay them under disadvantages, by encreasing money beyond its natural proportion to labour and commodities, and thereby heightening their price to the merchant and manufacturer. And in this view, it must be allowed, that no bank could be more advantageous, than such a one as locked up all the money it received, and never augmented the circulating coin, as is usual, by returning part of its treasure into commerce.

You can find similar language in "On the Balance of Trade":

I scarcely know any method of sinking money below its level [i.e. producing inflation], but those institutions of banks, funds, and paper-credit, which are so much practised in this kingdom. These render paper equivalent to money, circulate it throughout the whole state, make it supply the place of gold and silver, raise proportionably the price of labour and commodities, and by that means either banish a great part of those precious metals, or prevent their farther encrease. What can be more shortsighted than our reasonings on this head? We fancy, because an individual would be much richer, were his stock of money doubled, that the same good effect would follow were the money of every one encreased; not considering, that this would raise as much the price of every commodity, and reduce every man, in time, to the same condition as before. ...

It is indeed evident, that money is nothing but the representation of labour and commodities, and serves only as a method of rating or estimating them. Where coin is in greater plenty; as a greater quantity of it is required to represent the same quantity of goods; it can have no effect, either good or bad, taking a nation within itself; any more than it would make an alteration on a merchant’s books, if, instead of the Arabian method of notation, which requires few characters, he should make use of the Roman, which requires a great many. 

From this view -- which is, again, just taking the neutrality of money to its logical conclusion -- services like the ones being advertised on the F train are the exact opposite of what we want. By making more goods usable as money, they are only contributing to inflation. Rather than making it easier for people to use necklaces, furniture, etc. as means of payment, we should rather be discouraging people form using even currency as means of payment, by reducing banks to safe-deposit boxes.

That was where Hume left the matter when he first wrote the essays around 1750. But when he republished "On the Balance of Trade" in 1764, he was no longer so confident. [1] The new edition added a discussion of the development of banking in Scotland with a strikingly different tone:

It must, however, be confessed, that, as all these questions of trade and money are extremely complicated, there are certain lights, in which this subject may be placed, so as to represent the advantages of paper-credit and banks to be superior to their disadvantages. ... The encrease of industry and of credit ... may be promoted by the right use of paper-money. It is well known of what advantage it is to a merchant to be able to discount his bills upon occasion; and every thing that facilitates this species of traffic is favourable to the general commerce of a state. But private bankers are enabled to give such credit by the credit they receive from the depositing of money in their shops; and the bank of England in the same manner, from the liberty it has to issue its notes in all payments. There was an invention of this kind, which was fallen upon some years ago by the banks of Edinburgh; and which, as it is one of the most ingenious ideas that has been executed in commerce, has also been thought advantageous to Scotland. It is there called a Bank-Credit; and is of this nature. A man goes to the bank and finds surety to the amount, we shall suppose, of a 1000 pounds. This money, or any part of it, he has the liberty of drawing out whenever he pleases, and he pays only the ordinary interest for it, while it is in his hands. ... The advantages, resulting from this contrivance, are manifold. As a man may find surety nearly to the amount of his substance, and his bank-credit is equivalent to ready money, a merchant does hereby in a manner coin his houses, his household furniture, the goods in his warehouse, the foreign debts due to him, his ships at sea; and can, upon occasion, employ them in all payments, as if they were the current money of the country.

Hume is describing something like a secured line of credit, not so different from the services being advertised on the F line, which also offer ways to coin your houses and household furniture. The puzzle is why he thinks this is a good thing. The trade credit provided by banks, which is now "favourable to the general commerce of the state," is precisely what he was trying to prevent when he wrote that the best bank was one that "locked up all the money it received."Why does he now think that increasing liquidity will stimulate industry, instead of just producing a rise in prices that will "reduce every man, in time, to the same condition as before"?

You can't really hold it against Hume that he never resolved this contradiction. But what's striking is how little the debate has advanced in the 250 years since. Indeed, in some ways it's regressed. Hume at least drew the logical conclusion that in a world of neutral money, liquidity services like the ones advertised on the F train would not exist.


[1] I hadn't realized this section was a later addition until reading Arie Arnon's discussion of the essay in Monetary Theory and Policy from Hume and Smith to Wicksell. I hope to be posting more about this superb book in the near future.

Innovation in Higher Ed, 1680 Edition

Does anybody read Bagehot's Lombard Street any more? You totally should, it's full of good stuff. It's baffling to me, as a sometime teacher of History of Economic Thought, that most of the textbooks and anthologies don't mention him at all. Anyway, here he's quoting Macaulay:

During the interval between the Restoration and the  Revolution the riches of the nation had been rapidly increasing. Thousands of busy men found every Christmas that, after the expenses of  the year's housekeeping had been defrayed out of the year's income, a surplus remained ; and how that surplus was to be employed was a question of some difficulty. In … the seventeenth century, a lawyer, a physician, a retired merchant, who had saved some thousands, and who wished to place them safely and profitably, was often greatly embarrassed. … Many, too, wished to put their money where they could find it at an hour's notice, and looked about for some species of property which could be more readily transferred than a house or a field. A capitalist might lend … on personal security : but, if he did so, he ran a great risk of losing interest and principal. There were a few joint-stock companies, among which the East India Company held the foremost place : but the demand for the stock of such companies was far greater than the supply. … So great was that difficulty that the practice of hoarding was common. We are told that the father  of Pope, the poet, who retired from business in the City about the time of the Revolution, carried to a retreat in the country a strong-box containing near twenty thousand pounds, and took out from time to time what was required for household expenses... 

The natural effect of this state of things was that a crowd of projectors, ingenious and absurd, honest and knavish, employed themselves in devising new schemes for the employment of redundant capital. It was about the year 1688 that the word stock-jobber was first heard London. In the short space of four years a crowd of companies, every one of which confidently held out to subscribers the hope of immense gains, sprang into existence… There was a Tapestry Company, which would soon furnish pretty hangings for all the parlors of the middle class and for all the bedchambers of the higher. There was a Copper Company, which proposed to explore the mines of England, and held out a hope that they would prove not less valuable than those of Potosi. There was a Diving Company, which undertook to bring up precious effects from shipwrecked vessels, and which announced that it had laid in a stock of wonderful machines resembling complete suits of armor. In front of the helmet was a huge glass eye like that of Polyphemus ; and out of the crest went a pipe through which the air was to be admitted. … There was a society which undertook the office of giving gentlemen a liberal education on low terms, and which assumed the sounding name of the Royal Academies Company. In a pompous advertisement it was announced that the directors of the Royal Academies Company had engaged the best masters in every branch of knowledge, and were about to issue twenty thousand tickets at twenty shillings each. There was to be a lottery : two thousand prizes were to be drawn; and the fortunate holders of the prizes were to be taught, at the charge of the Company, Latin, Greek, Hebrew, French, Spanish, conic sections, trigonometry, heraldry, japanning, fortification, book-keeping, and the art of playing the theorbo.

Many of Macaulay's examples, which I've left out here, are familiar, thanks to Charles Mackay and more recent historians of financial folly. (Including everyone's favorite, the company that raised funds "for an Undertaking which in due time shall be revealed.") The line about Pope is also familiar, at least to reader of The General Theory: Keynes cites it as an illustration of the position of the wealth-holder in a world where the rentier had been successfully euthanized. But I, at least, had never realized that the diving suit was a product of the South Sea bubble. And I'd never heard of this spiritual ancestor of Chris Whittle and Michelle Rhee.

It would be interesting to learn more about the claims that were made for this company, and what happened to it. Alas, Google is no help. Although, "Royal Academies Company" turns out to be a weirdly popular phrase among the Markov-chain text generators that populate fake spam blogs. (Seriously, guys, this is poetry.) We can only hope that today's enterprises that promise to give gentlemen a liberal education on low terms  (or at least an education in japanning and/or ski area management) will vanish as ignominiously.

Strange Defeat

Following up on the previous post, below the fold is an article Arjun and I wrote last year for the Indian publication Economic and Political Weekly, on how liberal New Keynesian economists planted the seeds of their own defeat in the policy arena. 

I should add that Krugman is very far from the worst in this respect. If I criticize my soon-to-be colleague so much, it's only because of his visibility, and because the clarity of his writing and his genuinely admirable political commitments make it easier to see the constraints imposed by his theoretical commitments. You might say that his distinct virtues bring the common vices into sharper focus.

Ancient Economists: Two Views

John Cochrane, reporting from the NBER Summer Institute:

The use of ancient quotations came up several times. I  complained a bit about Eggertsson and Mehrotra's long efforts to tie their work to quotes from verbal speculations of Keynes, Alvin Hansen, Paul Krugman and Larry Summers. Their rhetorical device is, "aha, these equations finally explain what some sage of 80 years ago or Important Person today really meant."  Ivan Werning really complained about this in Paul Beaudry's presentation. What does this complex piece of well worked out "21st century economics" have to do with long ago muddy debates between Keynes and Hayek? It stands on its own, or it doesn't. (In his view, it did, so why belittle it?) 

Physics does not write papers about "the Newton-Aristotle debate." Our papers should stand on their own too. They are right or wrong if they are logically coherent and describe the data, not if they fulfill the vague speculations of some sage, dead or alive. It's especially unhelpful to try to make this connection, I think, because the models differ quite sharply from the speculations of the sage. Alvin Hansen certainly did not think that a Taylor interest rate rule with a phi parameter greater than one was a central culprit in "secular stagnation." I haven't checked against the speech, but I doubt he thought that inflation would completely cure the problem in the first place. 

Sure, history of thought is important; tying ideas to their historical predecessors is important; recognizing the centuries of thinking on money and business cycles is important. But let's stand up for our own generation; we do not exist simply to finally put equations in the mouths of ancient economists. 

But, tying it all up, perhaps I'm just being an old fogey. Adam Smith wrote mostly words. Marx like Keynes wrote big complicated books that people spent a century writing about "this is what they really meant." Maybe models are at best quantitative parables. Maybe economics is destined to return to this kind of literary philosophy, not quantified science.

(via Suresh, who was also there.)

For the case in favor of ancient economists, here is Axel Leijonhufvud:

According to Sir Peter Medawar

A scientist's present thoughts and actions are of necessity shaped by what others have done and thought before him: they are the wave-front of a continuous secular process in which The Past does not have a dignified independent existence of its own. Scientific understanding is the integral of a curve of learning; science therefore in some sense comprehends its history within itself.

... Not every field of learning can claim to "comprehend its history within itself." For the current state of the art to be the "integral of past learning" in Medawar's sense, the collective learning process must be one that remembers everything of value and forgets only the errors and the false leads. But this requires the recognized capability to decide what is correct or true and what is in error or false. These decisions, moreover, must compel general assent. Once an answer is arrived at, it must be generally agreed to be the answer. The field must be one in which answers kill questions so definitively that the sense of alternative possibilities disappears. ... 

A science, or a subfield within it, may come to approximate these conditions because of its positive successes. But two other mechanisms that are not so nice will also be at work. First, the people in the field agree that certain questions, which they would have a hard time deciding, are somebody else's responsibility. So economics among the social sciences, like physics among the natural sciences, had first pick of problems and left the really hard ones, on which their methods did not give them a firm grip, for the younger sister disciplines to deal with as best they might. Second, the insiders to the field will agree to exclude some people who refuse to assent to the manner in which certain important questions have been settled. Both the exclusion of undecidable questions from the field of inquiry and the exclusion of undecided people from the professional group help to achieve collective concentration and intensive interaction within the group. … 

These reflections … offer some suggestions about when scientists might find the history of their field relevant and useful to current inquiry. One suggestion is to look for situations when a research program has bogged down, when anomalies have cropped up that cannot be reduced to or converted into ordinary puzzles within the paradigm. Another is to look for cases in which three conditions seem to be met:
a) certain central questions cannot be decided in a way that commands assent,
b) the (for the time being) undecidable questions cannot very well be left for somebody else to worry about, and
c) the people who withhold their assent from some popular suggested answer cannot be ignored or excommunicated.

... Economists are wont to reduce everything to choices. Economics itself develops through the choices that economists make. To use the past for present purposes, we should see the history of the field as sequences of decisions, of choices, leading up to the present. Imagine a huge decision tree, with its roots back in the time of Aristotle, and with the present generation of economists -- not all of them birds of a feather! -- twittering away at each other from the topmost twigs and branches. 

The branching occurs at points where economists have parted company, where problematic decisions had to be made but could not be made so as to command universal assent. The two branches need not be of equal strength at all; in many cases, universal agreement is eventually reached ex post so that one branch eventually dies and falls away. The oldest part of the tree is, perhaps, just the naked trunk; but the sap still runs in some surprising places. 

If you want to translate Medawar's image of science into my decision tree metaphor, you will have to imagine his sciences as fir trees -- with physics, surely, as the redwood – majestic things with tall, straight trunks and with live branches only at the very top. Economics, in contrast, would come out as a rather tangled, ill-pruned shrub … 

As long as "normal" progress continues to be made in these established directions, there is no need to reexamine the past … Things begin to look different if and when the workable vein runs out or, to change the metaphor, when the road that took you to the "frontier of the field" ends in a swamp or in a blind alley. A lot of them do. Our fads run out and we do get stuck occasionally. Reactions to finding yourself in a cul-de-sac differ. Tenured professors might often be content to accommodate themselves to it, spend their time tidying up the place, putting in a few modern conveniences, and generally improving the neighborhood. Braver souls will want out and see a tremendous leap of the creative imagination as the only way out -- a prescription, however, that will leave ordinary mortals just climbing the walls. Another way to go is to backtrack. Back there, in the past, there were forks in the road and it is possible, even plausible, that some roads were more passable than the one that looked most promising at the time. At this point, a mental map of the road network behind the frontier becomes essential.

Boulding on Interest

Kenneth Boulding, reviewing Maurice Allais's  Économie et intérêt in 1951:

Much work on the theory of interest is hampered at the start by its unquestioned assumption that "the" rate of interest, or even some complex of rates, is a suitable parameter for use in the construction of systems of economic relationships, whether static or dynamic. This is an assumption which is almost universally accepted and yet which seems to me to be very much open to question. My reason for questioning it is that the rate of interest is not an objective magnitude... The rate of interest is not a "price"; its dimensions are those of a rate of growth, not of a ratio of exchange, even though it is sometimes carelessly spoken of as a "price of loanable funds." What is determined in the market is not strictly the rate of interest but the price of certain "property rights." These may be securities, either stocks or bonds, or they may be items or collections of physical property. Each of these property rights represents to an individual an expected series of future values, which may be both positive and negative. If this expected series of values can be given some "certainty equivalent" ... then the market price of the property determines a rate of interest on the investment. This rate of interest, however, is essentially subjective and depends on the expectations of the individual; the objective phenomenon is the present market price... 

It is only the fact that the fulfilment of some expectations seems practically certain that gives us the illusion that there is an objective rate of interest determined in the market. But in strict theory there is no such certainty, even for gilt-edged bonds; and when the uncertainties of life, inflation, and government are taken into consideration, it is evident that this theoretical uncertainty is also a matter of practice. What is more, we cannot assume either that there are any "certain equivalents" of uncertain series for it is the very uncertainty of the future which constitutes its special quality. What this means is that it is quite illegitimate even to begin an interest theory by abstracting from uncertainty or by assuming that this can be taken care of by some "risk premium"; still less is it legitimate to construct a whole theory on these assumptions … without any discussion of the problems which uncertainty creates. What principally governs the desired structure of assets on the part of the individual is the perpetual necessity to hedge -- against inflation, against deflation, against the uncertainty in the future of all assets, money included. It is these uncertainties, therefore, which are the principal governors of the demand and supply of all assets without exception, and no theory which abstracts from these uncertainties can claim much significance for economics. Hence, Allais is attempting to do something which simply cannot be done, because it is meaningless to construct a theory of "pure" interest devoid of premiums for risk, liquidity, convenience, amortization, prestige, etc. There is simply no such animal. 

In other words: There are contexts when it is reasonable to abstract from uncertainty, and proceed on the basis that people know what will happen in the future, or at least its probability distribution. But interest rates are not such a context, you can't abstract away from uncertainty there. Because compensation for uncertainty is precisely why interest is paid.

The point that what is set in the market, and what we observe, is never an interest rate as such, but the price of some asset today in terms of money today, is also important.

Boulding continues:

The observed facts are the prices of assets of all kinds. From these prices we may deduce the existence of purely private rates of return. The concept of a historical "yield" also has some validity. But none of these things is a "rate of interest" in the sense of something determined in a market mechanism.  

This search for a black cat that isn't there leads Allais into several extended discussions of almost meaningless and self-constructed questions… Thus he is much worried about the "fact" that a zero rate of interest means an infinite value for land, land representing a perpetual income, which capitalized at a zero rate of interest yields an infinite value… This is a delightful example of the way in which mathematics can lead to an almost total blindness to economic reality. In fact, the income from land is no more perpetual than that from anything else and no more certain. … We might draw a conclusion from this that a really effective zero rate of interest in a world of perfect foresight would lead to an infinite inflation; but, then, perfect foresight would reduce the period of money turnover to zero anyway and would give us an infinite price level willy-nilly! This conclusion is interesting for the light it throws on the complete uselessness of the "perfect foresight" model but for little else. In fact, of course, the element which prevents both prices from rising to infinity and (private) money rates of interest from falling to zero is uncertainty - precisely the factor which Allais has abstracted from. Another of these quite unreal problems which worries him a great deal is why there is always a positive real rate of interest, the answer being of course that there isn't! … 

Allais reflects also another weakness of "pure"interest theory, which is a failure to appreciate the true significance and function of financial institutions and of "interest" as opposed to "profit" - interest in this sense being the rate of growth of value in "securities," especially bonds, and "profit" being the rate of growth of value of items or combinations of real capital. Even if there were no financial institutions or financial instruments ... there would be subjective expected rates of profit and historical yields on past, completed investments. In such a society, however, given the institution of private property, everyone would have to administer his own property. The main purpose of the financial system is to separate "ownership" (i.e., equity) from "control," or administration, that is, to enable some people to own assets which they do not control, and others to control assets which they do not own. This arrangement is necessitated because there is very little, in the processes by which ownership was historically determined through inheritance and saving, to insure that those who own the resources of society are … capable of administering them. Interest, in the sense of an income received by the owners of securities, is the price which society pays for correcting a defect in the otherwise fruitful institution of private property. It is, of course, desirable that the price should be as small as possible - that is, that there should be as little economic surplus as possible paid to nonadministering owners. It is quite possible, however, that this "service" has a positive supply price in the long run, and thus that, even in the stationary state, interest, as distinct from profit, is necessary to persuade the nonadministering owners to yield up the administration of their capital.

This last point is important, too. Property, we must always remember, is not a relationship between people and things. it is a relationship between people and people. Ownership of an asset means the authority to forbid other people from engaging in a certain set of productive activities. The “product” of the asset is how much other people will pay you not to exercise that right. Historically, of course, the sets of activities associated with a given asset have often been defined in relation to some particular means of production. But this need not be the case. In a sense, the patent or copyright isn’t an extension of the idea of property, but property in its pure form. And even where the rights of an asset owner are defined as those connected with some tangible object, the nature of the connection still has to be specified by convention and law.

According to Wikipedia, Économie et intérêt,  published in 1947, introduced a number of major ideas in macroeconomics a decade or more before the American economists they're usually associated with, including the overlapping generations model and the golden rule for growth. Boulding apparently did not find these contributions worth mentioning. He does, though, have something to say about Allais's “economic philosophy" which "is a curious combination of Geseel, Henry George and Hayek,” involving “free markets, with plenty of trust- and union-busting, depreciating currency, and 100 per cent reserves in the banking system, plus the appropriation of all scarcity rents and the nationalization of land.” Boulding describes this as “weird enough to hit the jackpot.” It doesn’t seem that weird to me. It sounds like a typical example of a political vision you can trace back to Proudhon and forward through the “Chicago plan” of the 1930s and its contemporary admirers to the various market socialisms and more or less crankish monetary reform plans. (Even Hyman Minsky was drawn to this strain of politics, according to Perry Mehrling's superb biographical essay.)What all these have in common is that they see the obvious inconsistency between capitalism as we observe it around us and the fairy tales of ideal market exchange, but they don’t reject the ideal. Instead, they propose a program of intrusive regulations to compel people to behave as they are supposed to in an unregulated market. They want to make the fairy tales true by legislation. Allais’ proposal for currency depreciation is not normally part of this package; it's presumably a response to late-1940s conditions in France. But other than that these market utopias are fairly consistent. In particular, it's always essential to reestablish the objectivity of money.

Finally, in a review full of good lines, I particularly like this one:

Allais's work is another demonstration that mathematics and economics, though good complements, are very imperfect substitutes. Mathematics can manipulate parameters once formulated and draw conclusions out which were already implicit in the assumptions. But skills of the mathematician are no substitute for the proper skill of the economist, which is that of selecting the most significant parameters to go into the system.

Varieties of Keynesianism

Here’s something interesting from Axel Leijonhufvud. It’s a response to Luigi Pasinetti’s book on Keynes, but really it’s an assessment of the Keynesian revolution in general.

There really was a revolution, according to Pasinetti, and it can be dated precisely, to 1932. Leijonhufvud:

By the Spring of that year, Keynes had concluded that the Treatise could not be salvaged by a revised edition. He still gave his “Pure Theory of Money” lecture series which was largely based on it but members of his ‘Circus’ attended and gave him trouble. The summer of that year appears to have been a critical period. In the Fall, Keynes announced a new series of lectures with the title “The Monetary Theory of Production”. The new title signaled a break with his previous work and a break with tradition. From this point onward, Keynes felt himself to be doing work that was revolutionary in nature. 

What was revolutionary about these lectures was that they weren’t about extending or modifying the established framework of economics, but about adopting a new starting point. A paradigm in economics can be thought of as defined by the minimal model — the model that (in Pasinetti’s words) “contains those analytical features, and only those features, which the theory cannot do without.” Or as I’ve suggested here, the minimal model is the benchmark of simplicity in terms of which Occam’s razor is applied.

For the orthodox economics of Keynes’s day (and ours), the minimal model was one of “real exchange” in which a given endowment of goods and a given set of preferences yielded a vector of relative prices. Money, production, time, etc. can then be introduced as extensions of this minimal model. In Keynes’ “monetary production” model, on the other hand, the “analytical features which the theory cannot do without” are a set of income flows generated in production, and a set of expenditure flows out of income. The minimal model does not include any prices or quantities. Nor does it necessarily include exchange — it’s natural to think of the income flows as consisting of profits and wages and the expenditure flows as consumption and investment, but they can just as naturally include taxes, interest payments, asset sales, and so on.

I don’t want to suggest that the monetary production paradigm has ever been as well-defined as the real exchange paradigm. One of Leijonhufvud’s main points is that there has never been a consensus on the content of the Keynesian revolution. There are many smart people who will tell you what “Keynes really meant.” With due respect (and I mean it) I’m not convinced by any of them. I don’t think anyone knows what Keynes really meant —including Keynes himself. The truth is, the Hicks-Patinkin-Samuelson version of Keynes is no bastard; its legitimate paternity is amply documented in the General Theory. Pasinetti quotes Joan Robinson: “There were moments when we had some trouble in getting Maynard to see what the point of his revolution really was.” Which doesn’t, of course, means that Hicks-Patinkin-Samuelson is the only legitimate Keynes — here even more than  in most questions of theory, we have to tolerate ambiguity and cultivate the ability to hold more than one reading in mind at once.

One basic ambiguity is in that term, “monetary production.” Which of those words is the important one?

For Pasinetti, the critical divide is between Keynes’ theory of production and the orthodox theory of exchange. Pasinetti’s production-based Keynesianism

starts from the technological imperatives stemming from the division and specialization of labor. In this context, exchange is derivative, stemming from specialization in production. How it is institutionalized and organized is a matter that the minimal production paradigm leaves open (whereas the exchange paradigm necessarily starts by assuming at least private property and often also organized markets). Prices in the production paradigm are indices of technologically determined resource costs and, as such, leave open the question whether the system does or does not have a tendency towards the full utilization of scarce resources and, in particular, of labor. …

The exchange paradigm relies on individual self-interest, on consumer’s sovereignty, and on markets and private property as the principal institutions needed to bring about a socially desirable and harmonious outcome. In putting the division of labor and specialization at center stage, the pure production model, in contrast, highlights the “necessarily cooperative aspects of any organized society…

To an unsympathetic audience, I admit, this could come across as a bunch of commencement-speech pieties. For a rigorous statement of the pure production paradigm we need to turn to Sraffa. In Production of Commodities by Means of Commodities he starts from the pure engineering facts — the input-output matrices governing production at current levels using current technology. There’s nothing about prices, demand, distribution. His system “does not explain anything about the allocation of resources. Instead, the focus is altogether on finding a logical basis for objective measurement. It is a system for coherent, internally coherent macroeconomic accounting.”

In other words: We cannot reduce the heterogeneous material of productive activity to a single objective quantity of need-satisfaction. There is no such thing. Mengers, Jevons, Walras and their successors set off after the will-o-the-wisp of utility and, to coin a phrase, vanished into a swamp, never to be heard from by positive social science again.

The question then is, how can we consistently describe economic activity using only objective, observable data? (This was also the classical question.) Sraffa answers in terms of a “snapshot” of production at a given moment. Or as Sen puts it, in a perceptive essay, he is showing how one can do economics without the use of counterfactuals.

For Pasinetti, Keynes’ revolution and Sraffa’s anti-subjectivist revival of classical economics — his effort to ground economics in engineering data — were part of the same project, of throwing out subjectivism in favor of engineering. Leijonhufvud is not convinced. “Keynes was above all a monetary economist," he notes, "and there are good reasons to believe” that it was monetary and not production that was the key term in the “theory of monetary production.” Keynes made no use of the theory of imperfect competition, despite its development by members of his inner circle (Richard Kahn and Joan Robinson). Or consider his famous reversal on wages — in the General Theory, he assumed they were equal to the marginal product of labor, which declined with the level of output. But after this claim was challenged Dunlop, Tarshis and others, he admitted there was no real evidence for it and good reason to think it was not true. [1] The fact that JMK didn’t think anything important in his theory hinged on how wages were set, at least suggests that production side of economy was not central to his project.

The important point for us is that there is one strand of Cambridge that rejects orthodoxy on the grounds that it misrepresents a system of production based on objective relationships between inputs and outputs, as a system of exchange based on subjective preferences. But this is not the only vantage point from which one can criticize the Walrasian system and it’s not clear it’s the one occupied by Keynes or by Keynesianism — whatever that may be.

The alternative standpoint is still monetary production, but with the stress on the first word rather than the second. Leijonhufvud doesn’t talk much about this here, since this is an essay about Pasinetti. But it’s evidently something along the lines of Mehrling’s “money view” or “finance view.” [2] It seems to me this view has three overlapping elements: 1. The atomic units of the economy are money flows (and commitments to future money flows), as opposed to prices and quantities. 2. Quantities are quantities of money; productive activity is not measurable except insofar as it involves money payments. 3. The active agents of the economy are seeking to maximize money income or wealth, not to end up with some preferred consumption basket. Beside Mehrling, I would include Minsky, Paul Davidson and Wynne Godley here, among others.

I’m not going to try to summarize this work here. Let me just say how I’m coming at this.

As I wrote in comments to an earlier post, what I want is to think more systematically about the relationship between the network of financial assets and liabilities recorded on balance sheets, on the one hand, and the concrete social activities of production and consumption, on the other. What we have now, it seems to me, is either a “real” view that collapses these two domains into one, with changes in ownership and debt commitments treated as if they were decisions about production and consumption; or else a “finance” view that treats balance-sheet transactions as a closed system. I think the finance view is more correct, in the sense that at least it sees half of the problem clearly. The "real" view is a hopeless muddle because it tries to treat the concrete social activity of production and consumption as if it were a set of fungible quantities like money, and to treat money commitments as if they were decisions about production and consumption. The strength of the finance view is that it recognizes the system of contingent money payments recorded on balance sheets as a distinct social activity, and not simply a reflection of the allocation of goods and services. To be clear: The purpose of recognizing finance as a distinct thing isn’t to study it in isolation, but rather to explore the specific ways in which it interacts with other kinds of social activity. This is the agenda that Fisher dynamics, disgorge the cash, functional finance and the other projects I’m working on are intended to contribute to.


[1] It’s a bit embarrassing that this “First Classical Postulate,” which Keynes himself said "is the portion of my book which most needs to be revised," is the first positive claim in the book.

[2] Mehrling prefers to trace his intellectual lineage to the independent tradition of American monetary economics of Young, Hansen and Shaw.  But I think the essential content is similar.

Where Do Interest Rates Come From?

What determines the level of interest rates? It seems like a simple question, but I don't think economics -- orthodox or heterodox -- has an adequate answer.

One problem is that there are many different interest rates. So we have two questions: What determines the overall level of interest rates, and what determines the spreads between different interest rates? The latter in turn we can divide into the question of differences in rates between otherwise similar loans of different lengths (term spreads), differences in rates between otherwise similar loans denominated in different currencies, and all the remaining differences, grouped together under the possibly misleading name risk spreads.

In any case, economic theory offers various answers:

1. The orthodox answer, going back to the 18th century, is that the interest rate is a price that equates the desire to save with the desire to borrow. As reformulated in the later 19th century by Bohm-Bawerk, Cassel, etc., that means: The interest rate is the price of goods today relative to goods tomorrow. The interest rate is the price that balances the gains from deferring consumption with our willingness to do so. People generally prefer consumption today to consumption in the future, and because it will be possible to produce more in the future than today, so the interest rate is (normally) positive. This is a theory of all transactions that exchange spending in one period for spending (or income) in another, not specifically a theory of the interest rate on loans.

The Wicksell variant of this, which is today's central-bank orthodoxy, is that there is a well-defined natural interest rate in this sense but that for some reason markets get this one price wrong.

2. An equally old idea is that the interest rate is the price of money. In Hume's writings on money and interest, for instance, he vacillates between this and the previous story. It's not a popular view in the economics profession but it's well-represented in the business world and among populists and monetary reformers,. In this view, money is just another input to the production process, and the interest rate is its price. A creditor, in this view, isn't someone deferring consumption to the future, but someone who -- like a landlord -- receives an income thanks to control of a necessary component of the production process. A business, let's say, that needs to maintain a certain amount of working capital in the form of money or similarly liquid assets, may need to finance it with a loan on which it pays interest. Interest payments are in effect the rental price of money, set by supply and demand like anything else. As I say, this has never been a respectable view in economic theory, but you can find it in more empirical work, like this paper by Gabriel Chodorow-Reich, where credit is described in exactly these terms as an input to current production.

3. Keynes' liquidity-preference story in The General Theory. Here again the interest rate is the price of money. But now instead of asking how much the marginal business borrower will pay for the use of money, we ask how much the marginal wealth owner needs to be compensated to give up the liquidity of money for a less-liquid bond. The other side of the market is given by a fixed stock of bonds; evidently we are dealing with a short enough period that the flow of new borrowing can be ignored, and the bond stock treated as exogenously fixed. With no new borrowing, the link from the interest rate is liked to the real economy because it is used to discount the expected flow of profits from new investment -- not by business owners themselves, but by the stock market. It's an oddly convoluted story.

4. A more general liquidity-preference story. Jorg Bibow, in a couple of his essential articles on the Keynesian theory of liquidity preference, suggests that many of the odd features of the theory are due to Keynes' decision to drop the sophisticated analysis of the financial system from The Treatise on Money and replace it with an assumption of an exogenously fixed money stock. (It's striking that banks play no role in in the General Theory.) But I'm not sure how much simpler this "simplification" actually makes the story, or whether it is even logically coherent; and in any case it's clearly inapplicable to our modern world of bank-created credit money. In principle, it should be possible to tell a more general version of the liquidity preference story, where, instead of wealth holders balancing the income from holding a bond against the liquidity from holding "money," you have banks balancing net income against incremental illiquidity from simultaneously extending a loan and creating a deposit. I'm afraid to say I haven't read the Treatise, so I don't know how much you can find that story there. In any case it doesn't seem to have been developed systematically in later theories of endogenous money, which typically assume that the supply of credit is infinitely elastic except insofar as it's limited by regulation.

5. The interest rate is set by the central bank. This is the orthodox story when we turn to the macro textbook. It's also the story in most heterodox writers. From Wicksell onward, the whole discussion about interest rates in a macroeconomic context is about how the central bank can keep the interest rate at the level that keeps current expenditure at the appropriate level, and what happens if it fails to do so. It is sometimes suggested that the optimal or "natural" interest rate chosen by the central bank should be the the Walrasian intertemporal exchange rate -- explicitly by Hayek, Friedman and sometimes by New Keynesians like Michael Woodford, and more cautiously by Wicksell. But the question of how the central bank sets the interest rate tends to drop out of view. Formally, Woodford has the central bank set the interest rate by giving it a monopoly on lending and borrowing. This hardly describes real economies, of course, but Woodford insists that it doesn't matter since central banks could control the interest rate by standing ready to lend or borrow unlimited amounts at thresholds just above and below their target. The quite different procedures followed by real central banks are irrelevant. [1]

A variation of this (call it 5a) is where reserve requirements bind and the central bank sets the total quantity of bank credit or money. (In a world of bind reserve requirements, these will be equivalent.) In this case, the long rate is set by the demand for credit, given the policy-determined quantity. The interbank rate is then presumably bid up to the minimum spread banks are willing to lend at. In this setting causality runs from long rates to short rates, and short rates don't really matter.

6. The interest rate is set by convention. This is Keynes' other theory of the interest rate, also introduced in the General Theory but more fully developed in his 1937 article "Alternative Theories of the Rate of Interest." The idea here is that changes in interest rates imply inverse changes in the price of outstanding bonds. So from the lenders' point of view, the expected return on a loan includes not only the yield (as adjusted for default risk), but also the capital gain or loss that will result if interest rates change while the loan is still on their books. The longer the term of the loan, the larger these capital gains or losses will be. I've discussed this on the blog before and may come back to it in the future, but the essential point is that if people are very confident about the future value of long rates (or at least that they will not fall below some floor) then the current rate cannot get very far from that future expected rate, no matter what short rates are doing, because as the current long rate moves away from the expected long rate expected capital gains come to dominate the current yield. Take the extreme case of a perpetuity where market participants are sure that the rate will be 5% a year from now. Suppose the short rate is initially 5% also, and falls to 0. Then the rate on the perpetuity will fall to just under 4.8% and no lower, because at that rate the nearly 5% spread over the short rate just compensates market participants for the capital loss they expect when long rates return to their normal level. (Obviously, this is not consistent with rational expectations.) These kinds of self-stabilizing conventional expectations are the reason why, as Bibow puts it, "a liquidity trap ... may arise at any level of interest." A liquidity trap is an anti-bubble, if you like.

What do we think about these different stories?

I'm confident that the first story is wrong. There is no useful sense in which the interest rate on debt contracts -- either as set by markets or as target by the central bank -- is the price of goods today in terms of goods tomorrow. The attempt to understand interest rates in terms of the allocation across time of scarce means to alternative ends is a dead end. Some other intellectual baggage that should overboard with the "natural" rate of interest are the "real"rate of interest, the idea of consumption loans, and the intertemporal budget constraint.

But negative criticism of orthodoxy is too easy. The real work is to make a positive case for an alternative. I don't see a satisfactory one here.

The second and third stories depend on the existence of "money" as a distinct asset with a measurable, exogenously fixed quantity. This might be a usable assumption in some historical contexts -- or it might not -- but it clearly does not describe modern financial systems. Woodford is right about that.

The fifth story is clearly right with respect short rates, or at least it was until recently. But it's incomplete. As an empirical matter, it is true that interbank rates and similar short market rates closely follow the policy rate. The question is, why? The usual answer is that the central bank is the monopoly supplier of base money, and base money is used for settlement between banks. This may be so, but it doesn't have to be. Plenty of financial systems have existed without central banks, and banks still managed to make payments to each other somehow. And where central banks exist, they don't always have a monopoly on interbank settlement. During the 19th century, the primary tool of monetary policy at the Bank of England was the discount rate -- the discount off of face value that the bank would pay for eligible securities (usually trade credit). But if the discount rate was too high -- if the bank offered too little cash for securities -- private banks would stop discounting securities at the central bank, and instead find some other bank that was willing to give them cash on more favorable terms. This was the problem of "making bank rate effective," and it was a serious concern for 19th century central banks. If they tried to raise interest rates too high, they would "lose contact with the market" as banks simply went elsewhere for liquidity.

Obviously, this isn't a problem today -- when the Fed last raised policy rates in the mid-2000s, short market rates rose right along with it. Or more dramatically, Brazil's central bank held nominal interest rates around 20 percent for nearly a decade, while inflation averaged around 8 percent. [2] In cases like these, the central bank evidently is able to keep short rates high by limiting the supply of reserves. But why in that case doesn't the financial system develop private substitutes for reserves? Mervyn King blandly dismisses this question by saying that "it does not matter in principle whether the disequilibrium in the money market is an aggregate net shortage or a net surplus of funds—control of prices or quantities carries across irrespective of whether the central bank is the monopoly supplier or demander of its own liabilities." [3] Clearly, the central bank cannot be both the monopoly supplier and the monopoly demander of reserves, at least not if it wants to have any effect on the rest of the world. The relevant question -- to which King offers no answer -- is why there are no private substitutes for central bank reserves. Is it simply a matter of legal restrictions on interbank settlements using any other asset? But then why has this one regulatory barrier remained impassable while banks have tunneled through so many others? Anyway, going forward the question may be moot if reserves remain abundant, as they will if the Fed does not shrink its balance sheet back to pre-crisis levels. In that case, new tools will be required to make the policy rate effective.

The sixth story is the one I'm most certain of. First, because it can be stated precisely in terms of asset market equilibrium. Second, because it is consistent with what we see historically. Long term interest rates are quite stable over very long periods. Third, it's consistent with what market participants say: It's easy to find bond market participants saying that some rate is "too low" and won't continue, regardless of what the Fed might think. Last, but not least from my point of view, this view is clearly articulated by Keynes and by Post Keynesians like Bibow. But while I feel sure this is part of the story, it can't be the whole story. First, because even if a conventional level of interest rates is self-stabilizing in the long run, there are clearly forces of supply and demand in credit markets that push long rates away from this level in the short run. This is even more true if what convention sets is less a level of interest rates, than a floor. And second, because Keynes also says clearly that conventions can change, and in particular that a central bank that holds short rates outside the range bond markets consider reasonable for long enough, will be able to change the definition of reasonable. So that brings us back to the question of how it is that central banks are able to set short rates.

I think the fundamental answer lies behind door number 4. I think there should be a way of describing interest rates as the price of liquidity, where liquidity refers to the capacity to honor one's promises, and not just to some particular asset. In this sense, the scarce resource that interest is pricing is trust. And monetary policy then is at root indistinguishable from the lender of last resort function -- both are aspects of the central bank's role of standing in as guarantor for commitments within the financial system.  You can find elements of this view in the Keynesian literature, and in earlier writers going back to Thornton 200-plus years ago. But I haven't seen it stated systematically in way that I find satisfactory.


UPDATE: For some reason I brought up the idea of the interest rate as the price of money without mentioning the classic statement of this view by Walter Bagehot. Bagehot uses the term "price of money" or "value of money" interchangeably with "discount rate" as synonyms for the interest rate. The discussion in chapter 5 of Lombard Street is worth quoting at length:

Many persons believe that the Bank of England has some peculiar power of fixing the value of money. They see that the Bank of England varies its minimum rate of discount from time to time, and that, more or less, all other banks follow its lead, and charge much as it charges; and they are puzzled why this should be. 'Money,' as economists teach, 'is a commodity, and only a commodity;' why then, it is asked, is its value fixed in so odd a way, and not the way in which the value of all other commodities is fixed? 

There is at bottom, however, no difficulty in the matter. The value of money is settled, like that of all other commodities, by supply and demand... A very considerable holder of an article may, for a time, vitally affect its value if he lay down the minimum price which he will take, and obstinately adhere to it. This is the way in which the value of money in Lombard Street is settled. The Bank of England used to be a predominant, and is still a most important, dealer in money. It lays down the least price at which alone it will dispose of its stock, and this, for the most part, enables other dealers to obtain that price, or something near it. ... 

There is, therefore, no ground for believing, as is so common, that the value of money is settled by different causes than those which affect the value of other commodities, or that the Bank of England has any despotism in that matter. It has the power of a large holder of money, and no more. Even formerly, when its monetary powers were greater and its rivals weaker, it had no absolute control. It was simply a large corporate dealer, making bids and much influencing—though in no sense compelling—other dealers thereby. 

But though the value of money is not settled in an exceptional way, there is nevertheless a peculiarity about it, as there is about many articles. It is a commodity subject to great fluctuations of value, and those fluctuations are easily produced by a slight excess or a slight deficiency of quantity. Up to a certain point money is a necessity. If a merchant has acceptances to meet to-morrow, money he must and will find today at some price or other. And it is this urgent need of the whole body of merchants which runs up the value of money so wildly and to such a height in a great panic.... 

If money were all held by the owners of it, or by banks which did not pay an interest for it, the value of money might not fall so fast. ... The possessors would be under no necessity to employ it all; they might employ part at a high rate rather than all at a low rate. But in Lombard Street money is very largely held by those who do pay an interest for it, and such persons must employ it all, or almost all, for they have much to pay out with one hand, and unless they receive much with the other they will be ruined. Such persons do not so much care what is the rate of interest at which they employ their money: they can reduce the interest they pay in proportion to that which they can make. The vital point to them is to employ it at some rate... 

The fluctuations in the value of money are therefore greater than those on the value of most other commodities. At times there is an excessive pressure to borrow it, and at times an excessive pressure to lend it, and so the price is forced up and down.

The relevant point in this context is the explicit statement that the interest, or discount, rate is set by the supply and demand for money. But there are a couple other noteworthy things. First, the concept of supply and demand is one of monopolistic competition, in which lenders are not price takers, but actively trade off markup against market share. And second, that the demand for money (i.e. credit) is highly inelastic because money is needed not only or mainly to purchase goods and services, but first and foremost to meet contractual money commitments.


[1] See Perry Mehrling's useful review. Most of the text of Woodford's textbook can be downloaded for free here. The introduction is nontechnical and is fascinating reading if you're interested in this stuff.

[2] Which is sort of a problem for Noah Smith's neo-Fisherite view.

[3] in the same speech, King observes that "During the 19th century, the Bank of England devoted considerable attention to making bank rate ‘effective’." His implication is that central banks have always been able to control interest rates. But this is somewhat misleading, from my point of view: the Bank devoted so much attention to making its rate "effective" precisely because of the occasions when it failed to do so.

Mehrling on Black on Capital

In a post last week, I suggested that an alternative to thinking of capital as quantity of means of production accumulated through past investment, is to think of it as the capitalized value of expected future profit flows. Instead of writing

α = r k

where α is the profit share of national income, r is the profit rate, and k is the capital-income ratio, we should write 

k = α / r

where r is now understood as the discount rate applied to future capital income. 

Are the two rs the same? Piketty says no: the discount rate is presumably (some) risk-free interest rate, while the return on capital is typically higher. But I’m not sure this position is logically sustainable. If there are no barriers to entry, why isn’t investment carried to the point where the return on capital falls to the interest rate? On the other hand, if there are barriers to entry, so that capital can continue to earn a return above the interest rate without being flooded by new investment with borrowed funds, then profits cannot all be attributed to measured capital; some is due to whatever privilege creates the barriers. Furthermore, in that case there will not be, even tendentially, a uniform economywide rate of profit. 

In any case, whether or not we have a coherent story of how there can be a profit rate distinct from the discount rate, it’s clearly the latter that matters for corporate equity, which is the main form of capital Piketty observes in modern economies. Verizon, to take an example at random, has current annual earnings of around $20 billion and is valued by the stock market at around $200 billion. Nobody, I hope, would interpret these numbers as meaning that Verizon has $200 billion of capital and, since the economy-wide profit rate is 10%, that capital generates $20 billion in profits. Rather, Verizon — the enterprise as a whole, its physical capital, its organization and corporate culture, its brand, its relationships with regulators, the skills and compliance (or not) of its workers — currently generates $20 billion a year of profits. And the markets — applying the economy-wide discount factor embodied in the interest rate, plus a judgement about the likely change in share of the social surplus Verizon will be able to claim in the future — assess the present value of that stream of profits from now til doomsday at $200 billion.  

Now it might so happen that the stock market capitalization of a corporation is close to the reported value of assets less liabilities — this corresponds to a Tobin’s q of 1. Verizon, with total assets of $225 billion and total liabilities of $50 billion, happens to fit this case fairly well. It might also be the case that a firm’s reported net assets, deflated by some appropriate price index, correspond to its accumulated investment; it might even also be the case that there is a stable relationship between reported net capital and earnings. But as far as market capitalization goes, it makes no difference if any of those things is true. All that matters is market expectations of future earnings, and the interest rate used to discount them.

I was thinking about this in relation to Piketty’s Capital in the 21st Century. But of course the point is hardly original. Fischer Black (of the Black-Scholes option-pricing formula) made a similar argument decades ago for thinking of capital as a claim on a discounted stream of future earnings, rather than as an accumulation of past investments. 

Here’s Perry Mehrling on Black’s view of capital:

As in Fisher, Black’s emphasis is on the market value of wealth calculated as the expected present value of future income flows, rather than on the quantity of wealth calculated as the historical accumulation of savings minus depreciation. This allows Black to treat knowledge and technology as forms of capital, since their expected effects are included when we measure capital at market value. As he says: “more effective capital is more capital” (1995a, 35). Also as in Fisher, capital grows over time without any restriction from fixed factors. 

… 

For Black, the standard aggregative neoclassical production function is inadequate because it obscures sectoral and temporal detail by attributing current output to current inputs of capital and labor, but he tries anyway to express his views in that framework in order to reach his intended audience. Most important, he accommodates the central idea of mismatch to the production function framework by introducing the idea that the “utilization” of physical capital and the “effort” of human capital can vary over time. This accommodation makes it possible to express his theory in the familiar Cobb-Douglas production function form: y = A(eh)^α(fk)^(1-α), where y is output, h and k are human and physical capital, e and f are effort and utilization, and A is a temporary shock (1995, eq. 5.3). 

It’s familiar math, but the meaning it expresses remains very far from familiar to the trained economist. For one, the labor input has been replaced by human capital so there is no fixed factor. For another, both physical and human capital are measured at market values, and so are supposed to include technological change. This means that the A coefficient is not the usual technology shift factor (the familiar “Solow residual”) but only a multiplier, indeed a kind of inverse price earnings ratio, that converts the stock of effective composite capital into a flow of composite output. In effect, and as he recognizes, Black’s production function is a reduced form, not a production function at all in the usual sense of a technical relation between inputs and outputs. What Black is after comes clearer when he groups terms and summarizes as Y=AEK (eq. 5.7), where Y is output, E is composite utilization, and K is composite capital. Here the effective capital stock is just a constant multiple of output, and vice versa. It’s just an aggregate version of Black’s conception of ideal accounting practice (1993c) wherein accountants at the level of the firm seek to report a measure of earnings that can be multiplied by a constant price- earnings ratio to get the value of the firm. 

… 

In retrospect, the most fundamental source of misunderstanding came (and comes still) from the difference between an economics and a finance vision of the nature of the economy. The classical economists habitually thought of the present as determined by the past. In Adam Smith, capital is an accumulation from the careful saving of past generations, and much of modern economics still retains this old idea of the essential scarcity of capital, and of the consequent virtue attached to parsimony. The financial point of view, by contrast, sees the present as determined by the future, or rather by our ideas about the future. Capital is less a thing than an idea about future income flows discounted back to the present, and the quantity of capital can therefore change without prior saving.

In comments, A H mentioned that Post Keynesian or structuralist economics seem much closer to the kind of analysis used by finance professionals than orthodox economics does. I think one reason is that we share what Mehrling calls the “money view” or, here, the “finance vision” of the economy. Orthodoxy sees the economy as a set of exchanges of goods; the finance vision sees  a set of contractual money payments. 

Mehrling continues:

In The Nature of Capital and Income, Irving Fisher (1906) straddled the older world view of economics and the emerging world view of finance by distinguishing physical capital goods (for which the past-determines-present view makes sense) from the value of those goods (for which the future-determines-present view makes sense). By following Fisher, Black wound up employing the same straddle. 

Piketty may be in a similarly awkward position. 

The Interest Rate and the Interest Rate

We will return to secular stagnation. But we need to clear some ground first. What is an interest rate?

Imagine you are in a position to acquire a claim on a series of payments  in the future. Since an asset is just anything that promises a stream of payments in the future, we will say you are thinking of buying of an asset. What will you look at to make your decision?

First is the size of the payments you will receive, as a fraction of what you pay today. We will call that the yield of the asset, or y. Against that we have to set the risk that the payments may be different from expected or not occur at all; we will call the amount you reduce your expected yield to account for this risk r. If you have to make regular payments beyond the purchase of the asset to receive income from it (perhaps taxes, or the costs of operating the asset if it is a capital good) then we also must subtract these carrying costs c. In addition, the asset may lose value over time, in which case we have to subtract the depreciation rate d. (In the case of an asset that only lasts one period -- a loan to be paid back in full the next period, say -- d will be equal to one.) On the other hand, owning an asset can have benefits beyond the yield. In particular, an asset can be sold or used as collateral. If this is easy to do, ownership of the asset allows you to make payments now, without having to waiting for its yield in the future. We call the value of the asset for making unexpected payments its liquidity premium, l. The market value of long-lasting assets may also change over time; assuming resale is possible, these market value changes will produce a capital gain g (positive or negative), which must be added to the return. Finally, you may place a lower value on the payments from the asset simply because they take place in the future; this might be because your needs now are more urgent than you expect them to be then, or simply because you prefer income in the present to income in the future. Either way, we have to subtract this pure time-substitution rate i.

So the value of an asset costing one unit (of whatever numeraire) will be 1 + y - r - c - d + l + g - i. In equilibrium, you should be just indifferent between purchasing and not purchasing this asset, so we can write:

1 + y - r - c - d + l + g - i = 1, or

(1) y = r + c + d - l - g + i

So far, there is nothing controversial.

In formal economics, from Bohm-Bawerk through Cassel, Fisher and Samuelson to today's standard models, the practice is to simplify this relationship by assuming that we can safely ignore most of these terms. Risk, carrying costs and depreciation can be netted out of yields, capital gains must be zero on average, and liquidity is assumed not to matter or just ignored. So then we have:

(2) y = i

In these models, it doesn't matter if we use the term "interest rate" to mean y or to mean i, since they are always the same.

This assumption is appropriate for a world where there is only one kind of asset -- a risk-free contract that exchanges one good in the present for 1 + i goods in the future. There's nothing wrong with exploring what the value of i would be in such a world under various assumptions.

The problem arises when we carry equation (2) over to the real world and apply it to the yield of some particular asset. On the one hand, the yield of every existing asset reflects some or all of the other terms. And on the other hand, every contract that involves payments in more than one period -- which is to say, every asset -- equally incorporates i. If we are looking for the "interest rate" of economic theory in the economic world we observe around us, we could just as well pick the rent-home price ratio, or the profit rate, or the deflation rate, or the ratio of the college wage premium to tuition costs. These are just the yields of a house, of a share of the capital stock, of cash and of a college degree respectively. All of these are a ratio of expected future payments to present cost, and should reflect i to exactly the same extent as the yield of a bond does. Yet in everyday language, it is the yield of the bond that we call "interest", even though it has no closer connection to the interest rate of theory than any of these other yields do.

This point was first made, as far as I know, by Sraffa in his review of Hayek's Prices and Production. It was developed by Keynes, and stated clearly in chapters 13 and 17 of the General Theory.

For Keynes, there is an additional problem. The price we observe as an "interest rate" in credit markets is not even the y of the bond, which would be i modified by risk, expected capital gains and liquidity. That is because bonds do not trade against baskets of goods. They trade against money. When we see a bond being sold with a particular yield, we are not observing the exchange rate between a basket of goods equivalent to the bond's value today and baskets of goods equivalent to its yield in the future. We are observing the exchange rate between the bond today and a quantity of money today. That's what actually gets exchanged. So in equilibrium the price of the bond is what equates the expected returns on the two assets:

(3) y_B - r_B + l_B + g_B - i = l_M - i

(Neither bonds nor money depreciate or have carrying costs, and money has no risk. If our numeraire is money then money also cannot experience capital gains. If our numeraire was a basket of goods instead, then we would subtract expected inflation from both sides.)

What we see is that i appears on both sides, so it cancels out. The yield of the bond is given by:

(4) y_B  = r_B - g_B + (l_M - l_B)

The yield of the bond -- the thing that in conventional usage we call the "interest rate" -- depends on the risk of the bond, the expected price change of the bond, and the liquidity premium of money compared with the bond. Holding money today, and holding a bond today, are both means to enable you to make purchases in the future. So the intertemporal substitution rate i does not affect the bond yield.

(We might ask whether the arbitrage exists that would allow us to speak of a general rate of time-substitution i in real economies at all. But for present purposes we can ignore that question and focus on the fact that even if there is such a rate, it does not show up in the yields we normally call "interest rates".)

This is the argument as Keynes makes it. It might seem decisive. But monetarists would reject it on the grounds that nobody in fact holds money as a store of value, so equation (3) does not apply. The bond-money market is not in equilibrium, because there is zero demand for money beyond that needed for current transactions at any price. (The corollary of this is the familiar monetarist claim that any change in the stock of  money must result in a proportionate change in the value of transactions, which at full employment means a proportionate rise in the price level.) From the other side, endogenous money theorists might assert that the money supply is infinitely elastic for any credit-market interest rate, so l_M is endogenous and equation (4) is underdetermined.

As criticisms of the specific form of Keynes' argument, these are valid objections. But if we take a more realistic view of credit markets, we come to the same conclusion: the yield on a credit instrument (call this the "credit interest rate") has no relationship to the intertemporal substitution rate of theory (call this the "intertemporal interest rate.")

Suppose you are buying a house, which you will pay for by taking out a mortgage equal to the value of the house. For simplicity we will assume an amortizing mortgage, so you make the same payment each period. We can also assume the value of housing services you receive from the house will also be the same each period. (In reality it might rise or fall, but an expectation that the house will get better over time is obviously not required for the transaction to take place.) So if the purchase is worth making at all, then it will result in a positive income to you in every period. There is no intertemporal substitution on your side. From the bank's point of view, extending the mortgage means simultaneously creating an asset -- their loan to you -- and a liability -- the newly created deposit you use to pay for the house. If the loan is worth making at all, then the expected payments from the mortgage exceed the expected default losses and other costs in every period. And the deposits are newly created, so no one associated with the bank has to forego any other expenditure in the present. There is no intertemporal substation on the bank's side either.

(It is worth noting that there are no net lenders or net borrowers in this scenario. Both sides have added an asset and a liability of equal value. The language of net lenders and net borrowers is carried over from models with consumption loans at the intertemporal interest rate. It is not relevant to the credit interest rate.)

If these transactions are income-positive for all periods for both sides, why aren't they carried to infinity? One reason is that the yields for the home purchaser fall as more homes are purchased. In general, you will not value the housing services from a second home, or the additional housing services of a home that costs twice as much, as much as you value the housing services of the home you are buying now. But this only tells us that for any given interest rate there is a volume of mortgages at which the market will clear. It doesn't tell us which of those mortgage volume-interest rate pairs we will actually see.

The answer is on the liquidity side. Buying a house makes you less liquid -- it means you have less flexibility if you decide you'd like to move elsewhere, or if you need to reduce your housing costs because of unexpected fall in income or rise in other expenses. You also have a higher debt-income ratio, which may make it harder for you to borrow in the future. The loan also makes the bank less liquid -- since its asset-capital ratio is now higher, there are more states of the world in which a fall in income would require it to sell assets or issue new liabilities to meet its scheduled commitments, which might be costly or, in a crisis, impossible. So the volume of mortgages rises until the excess of housing service value over debt service costs make taking out a mortgage just worth the incremental illiquidity for the marginal household, and where the excess of mortgage yield over funding costs makes issuing a new mortgage just worth the incremental illiquidity for the marginal bank.

Monetary policy affects the volume of these kinds of transactions by operating on the l terms. Normally, it does so by changing the quantity of liquid assets available to the financial system (and perhaps directly to the nonfinancial private sector as well). In this way the central bank makes banks (and perhaps households and businesses) more or less willing to accept the incremental illiquidity of a new loan contract. Monetary policy has nothing to do with substitution between expenditure in the present period and expenditure in some future period. Rather, it affects the terms of substitution between more and less liquid claims on income in the same future period.

Note that changing the quantity of liquid assets is not the only way the central bank can affect the liquidity premium. Banking regulation, lender of last resort operations and bailouts also change the liquidity premium, by chaining the subjective costs of bank balance sheet expansion. An expansion of the reserves available to the banking system makes it cheaper for banks to acquire a cushion to protect themselves against the possibility of an unexpected fall in income. This will make them more willing to hold relatively illiquid assets like mortgages. But a belief that the Fed will take emergency action prevent a bank from failing in the event of an unexpected fall in income also increases its willingness to hold assets like mortgages. And it does so by the same channel -- reducing the liquidity premium. In this sense, there is no difference in principle between monetary policy and the central bank's role as bank supervisor and lender of last resort. This is easy to understand once you think of "the interest rate" as the price of liquidity, but impossible to see when you think of "the interest rate" as the price of time substitution.

It is not only the central bank that changes the liquidity premium. If mortgages become more liquid -- for instance through the development of a regular market in securitized mortgages -- that reduces the liquidity cost of mortgage lending, exactly as looser monetary policy would.

The irrelevance of the time-substitution rate i to the credit-market interest rate y_B becomes clear when you compare observed interest rates with other prices that also should incorporate i. Courtesy of commenter rsj at Worthwhile Canadian Initiative, here's one example: the Baa bond rate vs. the land price-rent ratio for residential property.

Both of these series are the ratio of one year's payment from an asset, to the present value of all future payments. So they have an equal claim to be the "interest rate" of theory. But as we can see, none of the variation in credit-market interest rates (y_B, in my terms) show up in the price-rent ratio. Since variation in the time-substituion rate i should affect both ratios equally, this implies that none of the variation in credit-market interest rates is driven by changes in the time-substitution interest rate. The two "interest rates" have nothing to do with each other.


(Continued here.)


EDIT: Doesn't it seem strange that I first assert that mortgages do not incorporate the intertemporal interest rate, then use the house price-rent ratio as an example of a price that should incorporate that rate? One reason to do this is to test the counterfactual claim that interest rates do, after all, incorporate Samuelson's interest rate i. If i were important in both series, they should move together; if they don't, it might be important in one, or in neither.

But beyond that, I think housing purchases do have an important intertemporal component, in a way that loan contracts do not. That's because (with certain important exceptions we are all aware of) houses are not normally purchased entirely on credit. A substantial fraction of the price is paid is upfront. In effect, most house purchases are two separate transactions bundled together: A credit transaction (for, say, 80 percent of the house value) in which both parties expect positive income in all periods, at the cost of less liquid balance sheets; and a conceptually separate cash transaction (for, say, 20 percent) in which the buyer foregoes present expenditure in return for a stream of housing services in the future. Because house purchases must clear both of these markets, they incorporate i in way that loans do not. But note, i enters into house prices only to the extent that the credit-market interest rate does not. The more important the credit-market interest rate is in a given housing purchase, the less important the intertemporal interest rate is.

This is true in general, I think. Credit markets are not a means of trading off the present against the future. They are a means of avoiding tradeoffs between the present and the future.