I'm optimistic about US recovery. If I'm reading the signs right, the market is also optimistic about US recovery. But that's not what makes me optimistic. Again, if I'm reading the signs right, the market is more optimistic about US recovery than the Fed is. And the market believes it is more optimistic about US recovery than the Fed is. That's what makes me optimistic about US recovery.
Let's start with a bit of Wicksell. If the Fed sets a market interest rate above/below some natural rate, there will be a cumulative decline/rise in the price level. Throw in a bit of Keynes. And there will also be a decline/rise in real output too.
Now let's throw in some expectations. The actual natural rate matters. But what the market believes the natural rate is matters too, and probably matters even more than the actual natural rate. Start in equilibrium. Hold the actual natural rate constant. Hold what the Fed does constant. Now suppose the market changes its beliefs and (falsely) believes that the natural rate has increased. And suppose the market also believes that the Fed does not share the market's view, so will not change what it does. And suppose the market understands Wicksell, and Keynes. What happens?
Since the actual natural rate has not changed, and since the market rate set by the Fed has not changed, you might think that no individual will want to change his desired savings or investment. But, because each individual (falsely) thinks that the natural rate has increased, relative to the market rate, each individual thinks that every other individual will increase desired investment and reduce desired saving. So each individual expects the Wicksellian/Keynesian cumulative process will cause rising prices and output. And this is what causes each individual to increase his own desired investment and reduce his own desired saving. And so there is a Wicksellian/Keynesian cumulative process of rising prices and output.
Somewhere, deep in the metaphysical vaults of preferences and technology, there exists a true natural rate. And if everybody knew what it was, and the Fed did too, and set the market rate equal to it, the economy would be in metastable equilibrium, with no cumulative process in either direction. But the true natural rate matters much less than what the market believes the natural rate is. Because even if you are impatient, or have a good investment opportunity, you will not consume or invest as much if you expect falling prices and falling spending by everyone else.
And beliefs about the future matter too. If the market believes the Fed will set a market rate below the natural rate in future, then the market will expect a Wicksellian/Keynesian cumulative rise in prices and output in the future. And that causes a rise in desired investment and a fall in desired savings today. And so the cumulative process starts today, not in the future. And the Fed would have to raise the market rate right now, to prevent it.
It's the gap that matters. In the simplest Wicksellian story, the gap is the gap between the natural rate and the market rate. Throw in expectations about the future, and what matters is the gap between what the market believes will happen and what the market believes the Fed believes will happen. I think we have just such a gap right now. The market believes the Fed is too pessimistic. That creates an upside cumulative process. That's what makes me optimistic.
I wonder if the Fed might be deliberately making pessimistic noises (Tim Duy, via Mark Thoma) just to make the market optimistic, like me?
Worthwhile Canadian Initiative 
Nick, how do you square this story with your argument that central banks should not announce what they expect the future overnight rate to be? Do you say that the expectational Wicksell is the wrong kind of cumulative process and that the better alternatives are available?
variation on a commitment by the Fed to be imprudent, or reckless, or whatever that phrase was?
TMDB: Good question. Essentially, this post is (implicitly) based on the same model as that previous post. I think the difference is this:
The previous post was about the Canadian case, where the inflation target is reasonably credible. In the absence of additional information, the market will expect the Bank of Canada to get it right. So we don’t want to give the market additional information about what the Bank thinks. We want Et[M(t+1)] to be always zero, to minimise the variance of inflation around target.
This post is about the Fed, and the Fed’s inflation target is not so credible. The market will not give the Fed the benefit of the doubt. It doesn’t even know what the Fed’s target is. It has been scared of deflation and recession. So if we want a recovery in the US, we want the Et[M(t+1)] term to be positive.
anon: Yep. It’s just a lot more credible, if people think you are overly pessimistic, so they think that you think you will be doing the right thing.
Nick, I think I agree with this post insofar as I like multiple equilibria stories.
However, I need to quibble with your terminology. The natural rate is nothing more than whatever real rate balances saving and investment at the full employment income level.
According to that definition the story you’re telling is not one where the “true” natural rate has stayed the same but the market perception is that it increased. Your story is one of the natural rate itself increasing while the real rate that prevails in the market stays the same.
Your mistake, if I can really call it that, is here: “Somewhere, deep in the metaphysical vaults of preferences and technology, there exists a true natural rate…”
No, the natural rate always, in any model, depends on expectations as well as preferences and technology. Standard models pin down expectations by assuming them to be rational expectations but they don’t have to assume this.
The definition I gave above works just as well with any expectations.
Adam: Yep. There’s a lot to be said for your way of defining the “natural rate”. That’s actually how I normally prefer to define it myself. But when I started to write this post, using your definition, I kept tying myself up in verbal knots. It ought to be possible to re-write this post using your definition. But I just couldn’t think of any way to do it clearly.
I agree with Adam P.
The natural interest rate is the level of interest rates that coordinates saving and investment. However, I will grant that some use it to refer to the some kind of physical return on capital, of which a more accurate version is technology and tastes.
Still, I see Nick’s puzzle. More investment and consumption demand raise the natural interest rate.
Nick, you said:
“The previous post was about the Canadian case, where the inflation target is reasonably credible. In the absence of additional information, the market will expect the Bank of Canada to get it right. So we don’t want to give the market additional information about what the Bank thinks. We want Et[M(t+1)] to be always zero, to minimise the variance of inflation around target.
This post is about the Fed, and the Fed’s inflation target is not so credible. The market will not give the Fed the benefit of the doubt. It doesn’t even know what the Fed’s target is. It has been scared of deflation and recession. So if we want a recovery in the US, we want the Et[M(t+1)] term to be positive.”
But if in 15 years Canada gets into the zero interest rate trap, debates about the comprehensive framework for disclosure of future intentions will delay the recovery. The losses in the zero interest rate trap are much greater than the benefit of low transparency today. So I support the disclosure of the interest rate forecast for Canada.
If we follow your logic, we should get transparency cycles – if monetary policy is good, policymakers should gradually reduce transparency to prolong the period of good monetary performance. But policymakers should increase transparency when macro outcomes are bad. Do we get anything like this in practice?
Hi, Nick. You end your post with a speculation that the Fed may be “deliberately making pessimistic noises”. If so, does that undermine the premise of your post, that the Fed is in fact more pessimistic than the market? If the Fed is in fact not as pessimistic as its public signals suggest, would you still be optimistic about the US recovery?
Thank you for sharing your thoughts on the prospect of a US recovery. I hope you are right!
“Since the actual natural rate has not changed, and since the market rate set by the Fed has not changed..”
You are assuming that the Fed sets the cost of capital, but really it lowers the short term funding costs of banks, who do not lend against capital but against land.
By lowering rates (or keeping them low) the CB is subsidizing the acquisition of land, and assuming that this subsidy spills over into capital, rather than impoverishing capital.
It’s not clear why this should be the case.
Suppose that households in equilibrium will demand the same return for holding land as they would for holding stock. Say land prices go up 10% because of the lowered rates, as do stock prices.
Now do the higher stock prices reflect investors accepting lower dividends, or do they reflect investor expectations of higher dividend growth rates?
If it’s the former, then the CB has succeed in lowering the cost of capital, but in the latter case, the CB may have actually increased the cost of capital.
And you wont be able to tell over the short run whether the cost of capital has increased or decreased.
You only find out that it was the second case when the stock market crash occurs and firms start liquidating when the earnings growth rates are not realized.
It’s complex, and heavily dependent on the institutions involved. But even ignoring the capital/land distinction, we can put this cumulative process to a test.
There are some countries in which banks do fund capital, because the capital markets are either undeveloped or repressed.
For example, in China, or some of the other asian growth miracle countries.
There, banks primarily fund capital and the government can control the lending rates. So China is an example of the monetarists Utopia in which the central bank actually controls investment rates and you can play with reaction functions in the straight-forward way.
Here, there are clear examples of engineering investment-led booms as a result of low interest rates. But the cumulative process primarily results in asset price inflation, not consumer price inflation, or even capital goods price inflation, and ultimately deflation and/or falling MPK equalize the marginal efficiency of investment to the nominal investment rates, not marginal adjustment costs. At least, this is the case in the asian investment-led growth booms.
So you are assuming too many things here, namely that the cost of capital is some increasing function of central bank policy, and that a rising marginal adjustments costs, rather than falling MPK, are what equalize the investment rate with the nominal rate. All of those assumptions are heavily dependent on the credit market institutions and the production characteristics involved. I don’t think they are justified for the case of the U.S.
Nick:
It seems to me that you are essentially saying that confidence in the economy by actors in the economy matters. It’s interesting that the relationship between overall confidence and the central bank’s confidence might matter too.
But there’s something else that matters, and that I think you are leaving out. That is the actual spending power of the economy, related to the money supply. If you could suddenly wipe out the spending power of a whole bunch of people in such a way that “the market” did not notice and confidence was unaffected, you are still going to cause a drop in demand just because there is less total spending power in the economy.
I think that is pretty close to what has happened in the U.S. The economic crisis destroyed a lot of spending power. Many people are not able to spend because they are being forced to pay down debt. Normally, the Fed could correct this by boosting the money supply, but it is up against the zero lower bound, which essentially blocks the way it normally gets the money it creates out into the real economy to boost spending power. It can lower other interest rates by “quantitative easing”, but they have a lower bound too, probably considerably above zero because of default risk, so how much good will that do?
I am pessimistic about the U.S. economy. The way around the block would be for the government to borrow money and spend it. It would essentially be borrowing from the Fed because the Fed will create all the money needed to keep interest rates at zero. It gives the Fed a way around the block it faces and allows it to boost overall spending power. But politically, that does not seem about to happen.
I think the U.S. is just repeating all the mistakes Japan made in its “lost decade”, and that were made in the 1930’s. I expect the result will be similar. But maybe I just read too much Krugman.
TMDB: Hmmm. Maybe. You have a point.
Kien: “If so, does that undermine the premise of your post, that the Fed is in fact more pessimistic than the market? If the Fed is in fact not as pessimistic as its public signals suggest, would you still be optimistic about the US recovery?”
Hmmm. I think so, as long as the market believes the Fed will act as if it were more pessimistic about the recovery.
RSJ: it’s not the cost of capital; it’s the gap between the expected rate of return on capital and the cost. Tobin’s Q. But that’s not what this post is about.
Paul: shocks to demand happen, and must be offset. But I am persuaded by Scott Sumner’s argument that much of the debt crisis was a consequence, not simply a cause, of the expected downturn in demand. So the downturn fed upon itself.
And then a central banker sneezes during a speech and the market picks up this “belief momentum” that an epidemic of mad cow disease is infecting rational thought at the fed. The market rationally decides to think irrationally in order to predict future interest rate moves. This aggregate irrationality, however, is the integral over all persons individual irrationality.
A new pseudo science emerges in academia called “crazy” market theory. Retrospectively has an answer for all macro phenomena. More consistent, because it is not bound by the need to even try to make sense. Unfortunately only predicts future events with random accuracy.
The natural rate of interest is ZERO
Gizzard. Thanks for the link. But he’s wrong.
Really badly wrong.
In a growing economy, or one with a positive rate of time preference, the natural rate will be positive in real terms. Bilbo wants the central bank to set a zero nominal rate. Now economists like Milton Friedman understand that a zero nominal rate might be possible, if we had deflation. Bilbo doesn’t. And Bilbo doesn’t want deflation either, presumably. Bilbo wants a zero nominal rate, and so a zero or negative real rate, and fiscal policy to prevent inflation getting out of hand. That can be done, for a time, but it would normally mean running very large permanent fiscal surpluses. So the government saves by a large enough amount to offset the gap between private investment and savings. And if the government runs permanent large surpluses, eventually the debt goes to zero, then negative, and eventually the government owns the whole capital stock of the country. So we end up in communism. Now, Bilbo is certainly not a communist, but that’s where his preferred policy would lead.
Sorry.
Nick: is that really true? It seems to me that it would be about equivalent to the government earning the risk free rate on the money supply – a role that is currently played by the banks, and then recycling it into the economy as services rather than bank dividends. So they wouldn’t own the whole economy (anymore than the banks currently do).
And draining money through taxes and deleting it is not the same thing as owning the capital stock. How does control pass from the shareholders to the prime minister?
A stable zero nominal rate is the same thing as keeping deflation at the rate of growth. It seems to me that over the long run this will be achieved by keeping the money supply constant. So long as we have taxation and helicopter drops I really don’t see how this is either unstable or the road to communism.
K: Yep. It’s true. Consolidate the central bank and the government’s balance sheets. The government must be doing a lot of saving (running a surplus), in order to push the equilibrium interest rate down to zero. And the money supply has to rise in line with nominal GDP, so it can’t be buying back money with its surplus. Initially the government can buy back government bonds with its surplus. But when the national debt goes to zero, what does it start buying? Commercial bonds, and commercial stocks. Land, houses, anything there is to buy. Eventually the government owns everything. God only knows what happens after that. It starts buying people, maybe?
But the money supply doesn’t have to rise or fall if they run deflation at the same rate as GDP. And it’s perfectly stable to do that so long as they can do helicopter drops if necessary.
Nick,
While I agree that bilbo is horribly wrong isn’t there an even more fundamental misunderstanding here?
What I mean is, is there a natural nominal rate of interest? I’d think no, I’d think there can be a natural real rate, which surely would not be zero, but that there’d be no natural nominal rate.
There’s no natural nominal rate. I don’t think he means it in the same sense as the natural real rate. I assume he just means that it’s natural the keep the money supply about constant in the long run. Sometimes you have to add some money, and sometimes take some away. In that case the “natural” nominal rate is zero, with deflation equal to the real rate on average. I don’t see the problem.
Actually, I am no longer sure what he’s saying. I think I read it with a generous mind set on the first pass. On the second pass, I don’t see any evidence that he’s advocating deflation. He really does seem to be advocating government confiscation to the point where real rates decline to zero. Or something.
Nick
Do you care to address any of DR Mitchells substantive arguments or are you simply dismissing him? He presents a well argued case, understands exactly the origins of Wicksellian theory on interest rates and shows how it doesnt apply to a modern monetary system. I’d be interested in your full critique, not a simple dismissal.
Gizzard,
I’m not trying to preempt a critique from Nick. But here’s my objection. Mitchell doesn’t offer a mathematical model, so it’s really hard to criticize exactly what he is saying because it isn’t exactly clear. And I don’t find the words very clear either, especially on the issues where he most obviously disagrees with “mainstream” economists. If you want to criticize the dominant theory, you have to engage it on it’s terms. You can’t define new ones and expect everyone to engage you on your playing field. If you want a physicist to consider your perpetual motion machine, you first have to demonstrate using standard scientific methods, why the second law of thermodynamics is wrong. You can’t just send some elaborate design, and expect experts to read it.
I happen to agree that the mmters may be onto some really important ideas – in particular the lack of necessity of government debt (other than money). But I can’t understand why it’s not possible to engage the rest of the community on standard terms.
“What I mean is, is there a natural nominal rate of interest? ”
Hmm, I would ask, is there such a thing as a “real” rate of interest at all? Real interest rates are artifacts of simple models — e.g. 1 period models with no yield curve, an assumption of expectations hypothesis, and constant inflation.
I don’t think there is even agreement on the definition of what a real interest would be without these assumptions. Perhaps I am wrong.
Suppose that the CPI is 100 in period 1, 120 in period 2, and, 125 in period 3, and 130 in period 4.
I purchase a risk-free bond for $80 in period 1 that pays $5 each period, and repays $100 of principle in period 3.
What is the “real” interest rate of this bond?
Suppose that over the same time period, 1 period zero coupon bills with a face value of $100 cost $90 in period 1, $85 in period 2, and $90 in period 3.
Does that information change your definition of what the real interest rate was?
Gizzard,
The argument for a zero OIR is not “well-argued”. The argument is basically this:
1. If the government spent by creating new money, then these would end up as being excess reserves. If the government did not did not sell bonds to drain excess reserves, then the OIR would fall to zero. (all true)
2. Therefore the government has to intervene to keep the OIR above zero. The “natural” rate for OIR is zero.
3. It’s good to squeeze rentiers, which a zero rate would accomplish — why “should” anyone obtain a positive return from making a zero day risk-free capital commitment?
First, the government is “intervening” by creating new money as well. So the intervention to sell bonds is the mirror image of the deficit spending intervention. One is not more natural than the other.
Second, in a growing economy you are going to get a positive risk-free return. You can get that return by buying land, or stocks, or anything else. The profit rate is the growth rate of the economy, assuming fixed price/earnings ratios, and it will be positive regardless of what you feel it “should” be based on some poorly thought out moralistic arguments.
Most importantly, this is not an economic argument at all. It’s a philosophical argument to justify a certain economic policy position. The actual policy position should be based on economic reasoning — e.g. that output and employment will be higher with one policy stance than with another, or that overall welfare will increase. I don’t see how subsidizing capital is going to do that.
Adam: the same thought crossed my mind as I was reading it. I couldn’t see any evidence that he saw the distinction between real and nominal rates. But I also couldn’t be certain that he didn’t understand the distinction. So I left it aside. But you’re probably right.
Did you notice, by the way, that your recent post on the lack of correlation between money base and inflation applies equally well to Bill’s diagrams on the lack of correlation between the overnight rate and inflation?
K: If he were arguing for deflation, to bring the nominal rate down to zero, despite a positive real natural rate, I would understand that. That’s what Milton Friedman was arguing for. (Though I disagree with Friedman on this.) But he doesn’t mention Friedman, which is surprising, since Friedman is obviously the locus classicus for that argument. And everything else I’ve read of his says he does not advocate deflation. So the only way I can interpret him is that he wants to use fiscal policy to push the real natural rate to zero (or even below, if he wants small positive inflation). Which can, presumably, be done (though maybe not in a small open economy with capital mobility like Australia?), but would end up with the government owning everything.
Gizzard: Sometimes Bill Mitchell writes interesting stuff. If I were totally dismissive of him, I wouldn’t have bothered to read it at all. I did give my argument why I thought he was wrong. I could have said more, as I said in response to Adam above. Real vs nominal rates. And the absence of correlation in the charts he posts are exactly what we would expect to see if a central bank were successfully targeting inflation. But I didn’t go through everything he said, point by point. Didn’t seem worth it. Yes, if Krugman (say) had written it, I would have gone through it point by point. But there’s only so many hours in the day.
As RSJ says (if I re-phrase him slightly), it’s not that Bill is saying the natural rate is zero. Rather, it’s that he wants the government to make the OIR zero. And one wonders what would happen to the equilibrium price of land and houses in such an economy.
Gizzard: “Do you care to address any of DR Mitchells substantive arguments or are you simply dismissing him? He presents a well argued case, understands exactly the origins of Wicksellian theory on interest rates and shows how it doesnt apply to a modern monetary system. I’d be interested in your full critique, not a simple dismissal.”
I have read that Bilbo post in the past and the basic problem with it is he does not present a well argued case, completely misunderstands the origins of Wicksellian theory on interest rates and completely fails to show it doesn’t apply to a modern monetary system.
Bill Mitchell is somewhat like Steve Keen in that his “critiques” of what he sees as maintsream economics are pretty laughable in that they only make clear his understanding of what the mainstream models are saying is less than zero (because he thinks these models say things that they don’t). I should add, I’m not in any way claiming either of those two don’t have good ideas. I’m just saying they’d be better served just explaining their ideas without the silly attempts to critique the mainstream that pretty much make them seem stupid.
RSJ: “Real interest rates are artifacts of simple models — e.g. 1 period models with no yield curve, an assumption of expectations hypothesis, and constant inflation. ”
That statement doesn’t even have a toehold on reality. Not one of the assumptions you’ve mentioned has anything to do with coherently defining a real interest rate.
One can have a serious discussion of whether or not real interest rates are well defined concepts but not from that starting point.
Nick: Yep, absolutely. His charts are just another example of the same point, that monetary policy reactions are endogenous.
K:
He doesnt offer mathematical models? Thats your criticism? Cmon. How about showing that the standard mathematical models are based on flawed assumptions? Like “money as a neutral veil”, “loanable funds market” or the Friedman idea that Central Banks can control the stock of money. He has demonstrated that each of these assumptions, which are necessarily true if the rest of the theory is true, are FALSE. They are false because it can be shown they are untrue under many circumstances. An assumption at the base of a theory, being shown to be untrue, disproves the theory.
You obviously havent read much of Mitchells stuff the engages mainstream myths daily. On their own terms.
RSJ:
Of course the govt is “intervening” to create new money, THATS who creates money. No surprise. Friedman thought the CB “should”. Which of course they cant because they only control price not amount. Fiscal authorities can control amount.
And yes you are right that in “growing economy” there are opportunities for profit or return on investment but it requires someone to be adding more than just “credit” to the economy. CB should stop playing the interest rate game and take their regulation of banking operations seriously. THAT is how this policy will improve welfare over the current one! A CB rate of zero does not remove profit opportunities from the system but it removes a whole worthless kabuki theater game being played periodically as the world awaits the words of Ben Bernanke.
Nick:
I dont understand this; “Rather, it’s that he wants the government to make the OIR zero.”
Its the govt that makes it other than zero in the first place! Thats his point. Set it at zero and forget it! Output and returns will adjust to new rates and we never have to wait for “Greenspan to speak”. Stop playing these CB games that do NOTHING to enhance economic welfare. Let the market activites have a rate of return, which of course will emerge as some things are shown to be more profitable then others, but stop with these monetarist fiddlings. They dont work and they add uncertainty. Money supply via credit channels is endogenously generated as he has demonstrated time and again, it comes form credit worthy borrowers seeking loans regardless of the amount of reserves in the system. Friedman was wrong that central banks control money supply, people control it via their search for loans. If they have no incomes coming in (like now) they wont be seeking new loans even if the interest were zero.
Gizzard: “Its the govt that makes it other than zero in the first place! Thats his point. Set it at zero and forget it!”
Yes, I understood that that was his point. And that the government should then use fiscal policy to ensure the desired level of aggregate demand. And my point is that he doesn’t understand that this would mean much tighter fiscal policy (i.e. bigger surpluses) on average. Higher taxes and/or lower government spending on average, if monetary policy is permanently very loose, and also (a point I didn’t mention) much more variable taxes and/or government spending, if monetary policy isn’t playing its usual countercyclical role. And if you have permanently higher surpluses, you end up with the government debt going to minus infinity. So the government owns everything. At which point you might say “Hmmm, maybe we need to loosen fiscal policy; which means we need to tighten monetary policy to keep aggregate demand where we want it to be.”
Gizzard: I don’t think words are enough, especially given Mitchell’s informal and somewhat long winded style. I agree with Nick that he needs to fully account for wealth distribution and also output. If he expresses his thoughts concisely in a general equilibrium model, there are enough people who are interested in what he is saying that his model would get serious attention.
Nick,
Something like what RSJ said, and your interpretation of RSJ, and your further comments, and this:
The MMT definition of “natural rate” has nothing to do with the “mainstream” (presumably non-MMT) definition of the natural rate. You are the expert on the latter.
The MMT “natural rate” is a banking system operational construct. The central bank stops issuing bonds, and deficit spending ends up as deposit liabilities and excess reserve assets. The government treasury and central bank balance sheets are effectively fused, with a resulting net liability profile for the combined entity. The big difference is that a net bond liability (usually) now becomes an excess reserve liability. Along with currency, that liability constitutes the cumulative government deficit over time.
From that starting point, the state has a choice about what interest rate to pay on reserves. E.g. it can choose to conduct monetary policy by actively increasing or decreasing the rate paid on reserves, thereby setting a lower bound for the overnight rate, tightening or easing interest rate policy according to whatever indicators and targets it is looking at.
The MMT preference is that this rate be set permanently at zero. The reason is that MMT wants fiscal policy to usurp the function of monetary policy. E.g. MMT would tighten money by reducing spending and/or increasing taxes.
Thus, zero becomes the “natural rate” in the context of the MMT preference for fiscal policy over monetary policy. Ironically, this is an artificial construction of the idea of “natural” in the context of a preconceived ideological preference for fiscal policy. I suspect it has nothing to do with the use of the term “natural rate” in your world.
I see nothing that would preclude Nick Rowe’s natural rate from superseding the MMT natural rate under certain monetary conditions in an MMT world. It might even be inevitable. All it would take is a failure of MMT policy to tighten appropriately via its preferred fiscal channel, in which case the natural rate of your world would overtake the MMT natural rate by forcing monetary policy makers to break the zero rule – by increasing the rate paid on reserves, essentially following the leadership of Nick Rowe’s (more) natural market rate.
“That statement doesn’t even have a toehold on reality. Not one of the assumptions you’ve mentioned has anything to do with coherently defining a real interest rate.”
Wow, that’s a pretty bombastic statement, apart from being incorrect.
I’d like to see your definition of the “real” rate of interest without relying on any of the above assumptions in order to get a well-defined definition.
That would be pretty interesting, actually.
P.S.
I view the MMT zero natural rate as a peg of sorts. The scenario I described in my final paragraph above probably wouldn’t happen unless the market believed it could force the central bank to abandon the peg.
K: Yep. e.g. Here’s my very simple model:
1. Desired private savings depends positively on the real rate of interest and on real income.
2. Desired private investment depends negatively on the real rate of interest and positively on real income.
3. There exists some maximum level of real income Y* beyond which inflation eventually accelerates to undesirably high level.
4. Desired savings equal private plus government savings; desired investment equals private plus government investment.
5. Define the natural rate of interest r* as the real rate at which desired savings equals desired investment at Y*.
Given Canada’s history, r* has been positive, and debt/GDP has been roughly stationary. We would have needed bigger government savings or less government investment to have kept r* at zero (or negative, given r=i minus inflation, and Bill wants i=0). And that would have meant a non-stationary declining debt/GDP, declining to negative levels and eventually to the government owning everything.
Actually, my simple model is far too complicated.
Scrap 1, 2, and 4, and replace them with:
1. Real output demanded depends negatively on the real interest rate and on the government budget surplus.
Keep 3.
Replace 5 with:
5′. Define the natural rate of interest as the real rate of interest at which real output demanded equals Y*.
JKH: I think I understood that. And I think it also reflects my understanding of MMT. My contention is that the MMTers don’t understand that setting the nominal overnight rate to zero (unless we had steady deflation, so the real overnight rate would be above zero) would mean much tighter fiscal policy than they seem to envisage. And this would imply the debt/GDP ratio falling without limit into negative territory, and keep on falling.
And I can only think of two ways to make sense of the MMT argument:
1. Deny that aggregate demand depends on the real interest rate (vertical IS curve, in which case monetary policy is irrelevant).
2. Assert that real aggregate demand can increase without limit, without ever causing an undesirable level of inflation. Horizontal LRAS or LR Phillips Curve.
RSJ, imagine a world in which everyone consumes the same consumption basket and this basket is known to never change. The nominal price of the basket is our CPI index. There are many periods, as many as you like.
There are default free zero coupon inflation linked bonds traded, one expiry for each future period out to some maximum (say 30 or 50 years). Since we have this unchanging consumption basket that everyone consumes (in varying amounts perhaps) then we can express the prices of the index linked bonds in units of this basket.
The index linked bonds define a rate of transformation of one unit of the consumption basket today for (1+r) units at some date in the future (the maturity date of the bond). This number r is then the real rate between today and the maturity date of the bond (in principle we could have r < 0).
That seems to me to be a well defined real interest rate, in fact an entire term structure of real interest rates, without needing a 1 period model or the expectations hypothesis or constant inflation.
Now, if your complaint was simply that I have a term structure and thus not a single real rate (the real rate) then I respond I was using the same language that is typical with respect to nominal rates. We have a term structure and the interest rate is taken as the one period rate unless stated otherwise. So, I’ll mean the real rate to mean the one period real rate from the one period index linked bond.
Notice however that in no case does the expectations hypothesis or constant inflation play any role.
The point here is that the substantive issues around whether or not there exists a real interest rate have to do with things like differences in consumption baskets. If your and my consumption baskets differ from each other and are both different from the basket of goods whose price index is linked to the bond then neither of us actually views the bond as a real bond, though we may think it pretty close.
Nick,
I think they’ve considered your point. MMT sets it up this way because their starting view is that fiscal policy is systematically (not just cyclically) too tight. The zero natural rate regime liberates deficit spending from bond financing and allows more deficit spending – not less – until they see inflation in the eye, and pull back on fiscal policy in response. I seem to recall you asking them a question about the Phillips curve at one point. The zero natural rate is all about enabling them to reach full employment more quickly, dealing with inflation after that.
JKH: Australia, and Canada, have had roughly 2% inflation over the last 20 or so years. And the MMTers are saying that they wish both fiscal policy and monetary policy had been permanently looser?!!!
If that’s right, then it’s at this point the “Zimbabwean” charge really does start to stick. And I’m going to make it, even though it does piss them off.
🙂
Nick,
Question for you:
The MMT zero natural rate concept depends (effectively) on the idea of replacing $ 8 trillion of publicly held government bonds (roughly, in the case of the US) with $ 8 trillion in reserves.
That’s a withdrawal of $ 8 trillion of term structure from dollar denominated bond markets.
How would that affect the interpretation of and/or the observation of the real rate of interest?
“How would that affect the interpretation of and/or the observation of the real rate of interest?”
The interpretation would be completely unchanged. Although there is no real one period zero coupon bond traded as a theoretical construct we can just as well talk about the shadow price of such a bond. The shadow price is the price that would clear the market were such a bond traded.
Of course, the observation I guess would get even more difficult insofar as we wouldn’t have as liquid a nominal term structure.
On the other hand, before the US treasury was borrowing people used to use the railroads, at the time all AAA, as the default-free nominal term structure. Presumably there are AAA corportates around that would permit some observation of a (nearly) default-free nominal term structure.
“Presumably there are AAA corportates around that would permit some observation of a (nearly) default-free nominal term structure.”
Any thoughts on whether/how such a significantly reduced supply of term structure would affect term real rates?
JKH: What Adam said.
I would add this though:
In normal times, outside a ZLB problem, if you replace all the national debt with zero interest currency/reserves, will people want to hold all $8 trillion at a 0% nominal interest rate? No way. The price of all private assets, both real and financial, would go through the roof, as people tried, unsuccessfully in aggregate of course, to sell 0% interest government paper for anything they could hold instead. And aggregate demand would go through the roof too.
And the only way to stop AD and inflation going through the roof would be for the government to buy back sufficient of its paper so that the remaining paper were willingly held at 0% interest. How much would that be? My guess would be somewhere around $5 trillion. So you would need a one-time tax of around $5 trillion to prevent AD rising.
Basically, people will hold some currency at 0% nominal interest, because having currency at around 5% of GDP (10% in the US, because of foreigners and druggies) because it makes the shopping easier. But there is no way people will hold (say) 50% of GDP at 0% nominal interest rates, or minus 2% real interest rates. So the only way government could make it happen is through a very large tax increase. essentially, confiscate all the bonds that people are unwilling to hold at 0% nominal.
Is that what the MMTers are proposing? God help us if they ever get anywhere near power. Zimbabwe, or confiscate the national debt (excluding currency)? Take your pick.
If you are right in your interpretation of MMT policy, JKH, then I really hadn’t realised how totally out of it they are.
Nick,
This is not a boilerplate MMT proposal per se in terms of having uniform acceptance by all MMT’ers. But it may as well be – because it is definitely THE proposal that is actively favoured/promoted by Mitchell and Mosler, who along with Wray are probably the leaders of the public MMT movement.
(E.g. I suspect that Scott Fullwiler would analyze this objectively as a definite option under MMT, while acknowledging that it is not necessarily promoted by all MMT’ers.)
Nevertheless, the fact that a key group of MMT intellectual leaders strongly favours it makes it a very important idea at least. And it has caught on like wildfire on their blogs.
The nuts and bolts implication for the banking system is something I tried to draw out when I was commenting more frequently on their blogs. I think it’s pretty fascinating, because it’s so radical a change.
Because you have previously taken the lead in actively engaging them in discussion, I think it is also important that you understand this central idea about MMT – whether viewed as a specific proposal of their leadership, or as a “viable” structural option by the “rank and file” of MMT’ers. As I say, it is a very important idea in its own right, and your comments about the numbers and related orders of magnitude are very interesting. We need more of that kind of discussion about real system numbers at the macro level.
Keep in mind that this is my reporting on MMT, and is not coming from an MMT’er. But I have 99.99 per cent confidence that my reporting is fundamentally accurate.
“will people want to hold all $8 trillion at a 0% nominal interest rate?”
From an MMT operational perspective, people in aggregate have little choice.
The government deficit spends by handing you a check. You deposit in your bank account. Reserves increase.
The only way money supply changes operationally from there is by the banking system altering its own asset liability structure, which could happen if the public attempts to buy assets held by banks.
Or by the government moving from deficit to surplus, as you suggest.
But MMT suggests that there is no operational force of nature that requires either type of adjustment.