Friday, March 28, 2014

Liquidity Preference and Solidity Preference in the 19th Century

So I've been reading Homer and Sylla's History of Interest Rates. One of the many fascinating things I've learned, is that in the market for federal debt, what we today call an inverted yield curve was at one time the norm.

From the book:
Three small loans floated in 1820–1821, principally to permit the continued redemption of high rate war loans, provide an interesting clue to investor preference... These were: 
$4.7 million “5s of 1820,” redeemable in 1832; sold at 100 = 5%.
“6s of 1820,” redeemable at pleasure of United States; sold at 102 = 5.88%.
“5s of 1821,” redeemable in 1835; sold at 1051⁄8 =4.50%, and at 108 = 4.25%. 
The yield was highest for the issue with early redemption risk and much lower for those with later redemption risks.
Nineteenth century government bonds were a bit different from modern bonds, in that the principal was repaid at the option of the borrower; repayment is usually not permitted until a certain date. [1] They were also sold with a fixed yield in terms of face value -- that's what the "5" and "6" refer to -- but the actual yield depended on the discount or premium they were sold at. The important thing for our purposes is that the further away the earliest possible date of repayment is, the lower the interest rate -- the opposite of the modern term premium. That's what the passage above is saying.

The pattern isn't limited to the 1820-21 bonds, either; it seems to exist through most of the 19th century, at least for the US. It's the same with the massive borrowing during the Civil War:
In 1864, although the war was approaching its end, it had only been half financed. The Treasury was able to sell a large volume of bonds, but not at such favorable terms as the market price of its seasoned issues might suggest. Early in the year another $100 million of the 5–20s [bonds with a minimum maturity of 5 years and a maximum of 20] were sold and then a new longer issue was sold as follows: 
1864—$75 million “6s”  redeemable in 1881, tax-exempt; sold at 104.45 = 5.60%. 
The Treasury soon made an attempt to sell 5s, which met with a lukewarm reception. In order to attract investors to the lower rate the Treasury extended the term to redemption from five to ten years and the maturity from twenty to forty years
1864—$73 million “5%, 10–40s of 1864,” redeemable 1874, due in 1904, tax-exempt; sold at 100 = 5%.
Isn't that striking? The Treasury couldn't get investors to buy its shorter bonds at an acceptable rate, so they had to issue longer bonds instead. You wouldn't see that story today.

The same pattern continues through the 1870s, with the new loans issue to refinance the Civil War debt. The first issue of bonds, redeemable in five to ten years sold at an interest rate of 5%; the next issue, redeemable in 13-15 years sold at 4.5%; and the last issue, redeemable in 27-29 years, sold at 4%. And it doesn’t seem like this is about expectations of a change in rates, like with a modern inverted yield curve. Investors simply were more worried about being stuck with uninvestable cash than about being stuck with unsaleable securities. This is a case where “solidity preference” dominates liquidity preference.

One possible way of explaining this in terms of Axel Leijonhufvud's explanation of the yield curve.

The conventional story for why long loans normally have higher interest rates than short ones is that longer loans impose greater risks on lenders. They may not be able to convert the loan to cash if they need to make some payment before it matures, and they may suffer a capital loss if interest rates change during the life of the loan. But this can't be the whole story, because short loans create the symmetric risk of not knowing what alternative asset will be available when the loan matures. In the one case, the lender risks a capital loss, but in the other case they risk getting a lower income. Why is "capital uncertainty" a greater concern than "income uncertainty"?

The answer, Leijonhufvud suggests, lies in
Keynes' ... "Vision" of a world in which currently active households must, directly or indirectly, hold their net worth in the form of titles to streams that run beyond their consumption horizon. The duration of the relevant consumption plan is limited by the sad fact that "in the Long Run, we are all dead." But the great bulk of the "Fixed Capital of the modem world" is very long- term in nature and is thus destined to survive the generation which now owns it. This is the basis for the wealth effect of changes in asset values. 
The interesting point about this interpretation of the wealth effect is that it also provides a price-theoretical basis for Keynes' Liquidity Preference theory. ... Keynes' (as well as Hicks') statement of this hypothesis has been repeatedly criticized for not providing any rationale for the presumption that the system as a whole wants to shed "capital uncertainty" rather than "income uncertainty." But Keynes' mortal consumers cannot hold land, buildings, corporate equities, British consols, or other permanent income sources "to maturity." When the representative, risk-averting transactor is nonetheless induced by the productivity of roundabout processes to invest his savings in such income sources, he must be resigned to suffer capital uncertainty. Forward markets will therefore generally show what Hicks called a "constitutional weakness" on the demand side.
I would prefer not to express this in terms of households' consumption plans. And I would emphasize that the problem with wealth in the form of long-lived production processes is not just that it produces income far into the future, but that wealth in this form is always in danger of losing its character as money. Once capital is embodied in a particular production process and the organization that carries it out, it tends to evolve into the means of carrying out that organization's intrinsic purposes, instead of the capital's own self-expansion. But for this purpose, the difference doesn't matter; either way, the problem only arises once you have, as Leijonhufvud puts it, "a system 'tempted' by the profitability of long processes to carry an asset stock which turns over more slowly than [wealth owners] would otherwise want."

The temptation of long-lived production processes is inescapable in modern economies, and explains the constant search for liquidity. But in the pre-industrial United States? I don't think so. Long-lived means of production were much less important, and to the extent they did exist, they weren't an outlet for money-capital. Capital's role in production was to finance stocks of raw materials, goods in process and inventories. There was no such thing, I don't think, as investment by capitalists in long-lived capital goods. And even land -- the long-lived asset in most settings -- was not really an option, since it was abundant. The early United States is something like Samuelson's consumption-loan world, where there is no good way to convert command over current goods into future production. [2] So there is excess demand rather than excess supply for long-lasting sources of income.

The switch over to positive term premiums comes early in the 20th century. By the 1920s, short-term loans in the New York market consistently have lower rates than corporate bonds, and 3-month Treasury bills have rates below longer bonds. Of course the organization of financial markets changed quite a lot in this period too, so one wouldn't want to read too much into this timing. But it is at least consistent with the Leijonhufvud story. Liquidity preference becomes dominant in financial markets only once there has been a decisive shift toward industrial production by long-lived firm using capital-intensive techniques, and once claims on those firms has become a viable outlet for money-capital.

* * *

A few other interesting points about 19th century US interest rates. First, they were remarkably stable, at least before the 1870s. (This fits with the historical material on interest rates that Merijn Knibbe has been presenting in his excellent posts at Real World Economics Review.)

Second, there's no sign of a Fisher equation. Nominal interest rates do not respond to changes in the price level, at all. Homer and Sylla mention that in earlier editions of the book, which dealt less with the 20th century, the concept of a "real" interest rate was not even mentioned.

As you can see from this graph, none of the major inflations or deflations between 1850 and 1960 had any effect on nominal interest rates. The idea that there is a fundamentals-determined "real" interest rate while the nominal rate adjusts in response to changes in the price level, clearly has no relevance outside the past 50 years. (Whether it describes the experience of the past 50 years either is a question for another time.)

Finally, there is no sign of "crowding out" of private by public borrowing. It is true that the federal government did have to pay somewhat higher rates during the periods of heavy borrowing (and of course also political uncertainty) in the War of 1812 and the Civil War. But rates for other borrowers didn't budge. And on the other hand, the surpluses that resulted in the redemption of the entire debt in the 1830s didn't deliver lower rates for other borrowers. Homer and Sylla:
Boston yields were about the same in 1835, when the federal debt was wiped out, as they were in 1830; this reinforces the view that there was little change in going rates of long-term interest during this five- year period of debt redemption.
If government borrowing really raises rates for private borrowers, you ought to see it here, given the absence of a central bank for most of this period and the enormous scale of federal borrowing during the Civil War. But you don't.

[1] It seems that most, though not all, bonds were repaid at the earliest possible redemption date, so it is reasonably similar to the maturity of a modern bond.

[2] Slaves are the big exception. So the obvious test for the argument I am making here would be to find the modern pattern of term premiums in the South. Unfortunately, Homer and Sylla aren't any help on this -- it seems the only local bond markets in this period were in New England.

Tuesday, March 11, 2014

Long Run Growth and Functional Finance

Tom Michl has some comments -- insightful as always -- on the previous post on functional finance. The key point he raises is that we can't treat the long-run growth rate as given exogenously. Policy that targets current output will also have effects on the long run trajectory that have to be taken into account. He writes:
I've become convinced that the real interest rate belongs in the investment equation, g(r), which means that g-r is not something we can just set greater than zero to solve the problem of fiscal deficits. Also that fiscal policy, e.g. the debt ratio, affects the long run position of the IS curve (assuming interest payments go to rentiers who spend them on consumption), so it affects the r that stabilizes inflation.  
The question of exo/endogenous growth is important because a given growth target puts constraints on the feasible fiscal policy, or given fiscal policy, on the ability of a monetary authority to set the inflation-neutral interest rate. 
This is something I've heard from other smart people in response to these arguments. [1] I certainly agree with Tom and everyone else that a complete story cannot just take g as given. And I agree that there should be some systematic relationship between the liquidity conditions that we summarize as the interest rate and demand conditions, and the long term growth of income. But it doesn't seem so straightforward to show that this relationship will be a constraint on the fiscal position.

There are two (sets of) channels: The one Tom mentions here, from financial conditions to investment to growth, and the other, on the supply side from the output gap via the labor supply (hysteresis) or technological change (Verdoorn's law) to growth. I think the second kind of channel is very important, but it doesn't create any issues for a functional finance position. It just means that we should define a higher level of output as "full employment" or "price stability." So let's focus on the first channel.

We think of investment as additions to the capital stock. Then we have g = s/c - dk, where g is the growth rate, s is the average savings rate, c is the incremental capital-output ratio, d is the depreciation rate and k is the average capital-output ratio. This is just accounting. As we know, this accounting relationship is often used to develop the idea of knife-edge instability. But that's never seemed right to me (and I don't think it's what Harrod intended with it.) s is the average savings rate, so in a Keynesian framework it will be a negative function of output. So what this equation is telling us is that if we need to achieve a given growth rate, and the capital-output ratio is fixed, then the output gap will have to adjust so as to get s to satisfy this equation. This is the adjustment that policy is allowing us to avoid. Fiscal policy raises or lowers average s at a given level of income. Monetary policy perhaps raises or lowers s also; more conventionally it is supposed to change the desired capital-output ratio c

So from my point of view, it is not quite correct to say that growth is a function of the interest rate. Rather, variation in the interest rate allows us to reconcile full employment with our chosen growth rate, whatever it may be. 

Now, if we think that interest rates act through the capital-output ratio, then we need that as an additional degree of freedom if we want to combine full employment, our chosen growth rate, and a stable debt-income ratio. As it happens, Peter Skott and Soon Ryoo presented a paper at the Easterns where the requirement to achieve a target capital-output ratio meant that monetary policy was not available to close the output gap, requiring the use of fiscal policy. The additional degree of freedom is supplied by allowing the debt-GDP ratio to evolve freely.  This isn't a problem in this case. In their model, fiscal policy works through its additions to the stock of assets available to private wealth-owners, not through the flow of demand for currently produced goods and services. So the public-debt GDP ratio will automatically converge to whatever level satisfies the private sector's demand for net wealth above the capital stock.

So Peter's paper, I think, addresses Tom's point. Yes, fiscal policy affects the IS curve. Namely, it moves the IS curve to wherever it needs to be to get full employment at a given growth rate, as long as we are willing to let either the ratio of either capital or debt to output vary endogenously.

The bottom line is that when you move from the short run to the long run you do have to think about growth but that does not necessarily impose any additional constraint. First, if monetary policy operates through the savings rate, then the price stability target already implicitly means price stability at a given growth rate. So the model works the same regardless of what you think the growth rate is or should be. If monetary policy works through the capital-output ratio, then we can no longer say that, but in that case the capital-output ratio itself provides an additional degree of freedom. Only if we impose both a given growth rate and a given capital-output ratio do we possibly foreclose the option of setting r at whatever value is consistent with price stability and a constant debt ratio. And even then, I emphasize "possibly," because it depends on what you think happens to maintain the constraint. It seems to me the most natural answer is that at some point the desired capital-output ratio becomes insensitive to the interest rate, so, assuming that savings are also insensitive, then full employment cannot be reached at our target growth rate through monetary policy alone. In that case, fiscal policy becomes mandatory. This is where Keynes ended up, more or less, and also the implication of Peter's paper. But this doesn't give any argument for why interest rates cannot stay arbitrarily low, it just says that even very low interest rates won't be sufficiently expansionary to get us to full employment at low growth rates and that fiscal policy or some equivalent will be required as well. Which, as they say, is where we came in.

(I realize that this post probably will not make sense unless you're already having this conversation.)

[1] Last year's functional finance post is, thanks to my coauthor Arjun Jayadev, evolving into an academic article; I presented a version at the Eastern Economic Association a few days ago. This was one of the main comments there.