There's an idea floating around out there that I fear may be influential. And that idea is horribly wrong. Which makes it dangerous. And I want to try to kill it. But macro is hard. And it's not easy to explain clearly and simply.
I can only try. And I can only hope that others who are more influential than me, or can explain things better than me, will do the same.
"Sure, there's a risk that inflation is falling below target, and a risk that recovery will be delayed, and it would be nice if the Bank of Canada (or Sweden or wherever) could loosen monetary policy to prevent this happening. But monetary policy works by lowering interest rates and encouraging people to borrow more and spend more. And that creates a problem for financial stability, because some people are already borrowing too much. So there's a trade-off between monetary stimulus and financial stability, and monetary policy needs to take both objectives into account."
I made up that quote. But I don't think I made up the influential idea it expresses. And it's horribly wrong. It's almost the reverse of the truth.
One way to attack that idea would be to say that reducing unemployment is a much more important goal than financial stability. That might well be true, but that's not my argument here.
A second way to attack that idea would be to say that there are other and much better ways to address the concerns of financial stability and prevent some people borrowing too much. That too might well be true, but that's not my argument here.
Instead I'm going to argue that the idea is fundamentally flawed.
It rests on a fallacy of composition.
It confuses a consequence with a cause.
It misunderstands the relation between monetary policy and interest rates.
It's just horribly wrong.
1. It rests on a fallacy of composition.
Suppose the Bank of Canada wanted me, Nick Rowe, to spend more, to do my bit to promote recovery and prevent inflation falling below target. So it offers a special rate of interest just for me. Or gets the Bank of Montreal to offer a special rate of interest just for me. If it lowered the Nick Rowe rate of interest I would save less if I were a saver, and borrow more if I were a borrower. Either way I would spend more. (Unless maybe if I were a lender and the income effect of the cut in interest rates making me poorer were bigger than the substitution effect.) The magnitude of the effect on my spending would depend on my interest-elasticity of demand for consumption and investment.
It is awfully tempting, but horribly wrong, to think that if we multiply that individual experiment by 35 million (assuming I'm the average Canadian) we get the macroeconomic effect of a cut in interest rates.
It's horribly wrong because, just for starters, it ignores the Old Keynesian multiplier. If I spend more that means I am buying more from other people, so their incomes will rise, and they will spend more too, which means still other people's incomes will rise…and so on. The macroeconomic magnitude will depend not just on the interest-elasticity but on the marginal propensity to spend (equals marginal propensity to consume plus marginal propensity to invest). And, depending on how long people expect the increased spending and income to last, there is nothing to prevent that marginal propensity to spend being greater than one, which would mean an infinitely big multiplier (until the Bank of Canada sees it needs to reverse course to keep it finite).
It's even more horribly wrong when we think about another accounting identity that holds in aggregate: for every $1 borrowed there's $1 lent. To keep it very simple, imagine an economy where everyone is identical. If I wanted to borrow then so would everyone else want to borrow, which means nobody would want to lend to me, so I wouldn't be able to borrow from anyone else. And to keep it even simpler, imagine that people pay for everything with central bank cash, and that the velocity of circulation is almost infinite and so the amount of cash in circulation is vanishingly small. (Yep, like Woodford's New Keynesian model). If the central bank lowers the rate of interest, people borrow a tiny amount of extra cash from the central bank (they all want to borrow from each other but nobody wants to lend), and spend that cash, and their incomes increase as others spend, which increases their spending even more, and incomes and spending keep on rising until it reaches a level where nobody wants to borrow from other people or from the central bank (or the central bank decides it has increased enough and raises interest rates again).
This is a world in which a cut in interest rates makes people want to borrow, and monetary policy works by making people want to borrow, but there is never any actual borrowing (except for a tiny amount of borrowing cash from the central bank).
Monetary policy does not work by increasing actual borrowing. That is not the causal channel of the monetary policy transmission mechanism. Monetary policy works by increasing spending, not borrowing. And one person's spending is another person's income, so people in aggregate do not need to borrow more in order to spend more. Their increased spending finances itself.
Yep. Macro is hard. You can't just sit back and think "how would I react if my rate of interest fell?". You have to think about how my reactions would affect others, and how their reactions to my reactions would affect me, and so on.
2. It confuses a consequence for a cause.
"Dangerous roads cause drivers to slow down. If drivers slowed down there would be fewer accidents. Therefore, if we made roads more dangerous, there would be fewer accidents."
That argument is clearly invalid. The premises do not entail the conclusion. (OK, the conclusion might conceivably still be true, if safe boring roads and auto trannies lead to distracted drivers texting…). What causes accidents is roads that seem safe, so drivers speed up, but that suddenly and unexpectedly become dangerous.
People are not all identical. At any given rate of interest, some will want to borrow and others will want to lend. So some people will actually borrow from other people. Maybe via financial intermediaries. And some of those financial intermediaries issue liabilities that are used as media of exchange and so are called "banks".
And sometimes some people will borrow too much. Which means, of course, that sometimes some other people will lend them too much. Accidents happen, even on safe roads, because some people drive too fast or aren't paying enough attention. But the biggest accidents happen when an apparently safe road suddenly and unexpectedly becomes unsafe. Because the drivers can't slow down quickly enough. Or even if one driver can slow down quickly enough, another driver who can't simply ploughs into the rear of the slowing car.
OK, that's just an argument by analogy. But I think you can see the link. If central banks keep nominal income growing smoothly, most people will adjust their borrowing and lending (speed) to the prevailing conditions. And some won't, of course. But if the central bank lets nominal income fall, without giving people lots of advance warning, that means that even some otherwise safe borrowers and lenders suddenly become risky, and they crash too. And the best palliative is to get nominal income back onto as close to its previous path as possible as soon as possible. Even if that does cause drivers to speed up, now that the roads are safe again.
3. It misunderstands the relation between monetary policy and interest rates.
As Scott Sumner echoes Milton Friedman: low interest rates does not mean loose monetary policy; low interest rates are a consequence of past and expected future tight monetary policy. That's true both for nominal and real interest rates. If tight monetary policy means actual and expected inflation is low, then nominal interest rates would be low for any given equilibrium real interest rate. And if tight monetary policy means that current and expected future demand and real income are low, then people will want to save rather than counsume, and firms won't want to invest, and so the real interest rate that would equilibrate desired saving and investment will be low too.
So if you want higher nominal and real interest rates, and you want them higher not just today but for the longer term future as part of a sustainable equilibrium, then you need to loosen monetary policy. If inflation and real growth, and hence nominal income growth, are in danger of falling, then you need more monetary stimulus to raise interest rates in a sustainable way.
Microeconomists are fond of saying that the best cure for high prices is high prices. Macroeconomists should be fond of saying that the best cure for low interest rates is low interest rates.
4. It's just horribly wrong.
The idea that more monetary stimulus might be desirable but would unfortunately reduce financial stability, so we shouldn't do it, is a bad idea. It's not enough to say "yes but..", and talk about the costs of unemployment and about other ways of promoting financial stability. There's no "yes" about it. Our answer should be: "No. That idea is horribly wrong".
[I had been thinking of writing something along these lines for some months, ever since I reviewed a draft paper on the idea. Then reading Simon Wren-Lewis' good but depressing post, about Lars Svensson's resignation from the Riksbank, (plus the fact I've now got my grades in), pushed me to write it now. While I generally agree with both Simon and Lars on this issue, I fear that both concede just a little too much to the other side.]
Worthwhile Canadian Initiative 
“But monetary policy works by lowering interest rates and encouraging people to borrow more and spend more. And that creates a problem for financial stability”
There is an element of truth in this statement. If the economy is healthy and unemployment is at its equilibrium level of(say) 5% but for political reasons the govt wants to reduce it to 4% then it may encourage the CB to unexpectedly start increasing the money supply. This may induce a boom accompanied by more spending (some of it financed by borrowing) and reduced unemployment. Eventually (as the unexpected increased become expected ones) the rate of inflation and interest rates may increase. The CB may panic and unexpectedly reduce the money supply and induce financial instability.
So bad monetary policy can cause financial instability. Likewise good monetary policy can help avoid financial instability. If the CB had stood up to the govt and pointed out that if lower unemployment was a desired aim then fiscal and regulatory policy was the answer but that the CB would assist by publicly guaranteeing to hold nominal spending stable during the period when the appropriate policy was implemented then the desired result could be achieved with minimal risk of financial instability.
Starting from a point where nominal spending has fallen below trend then good monetary policy (publicly guaranteeing to get nominal spending back on trend) will increase the likelihood of financial stability while bad policy (unanchored policy that fails to match expectations and delivery) will increase those risks.
Ron: “This may induce a boom accompanied by more spending (some of it financed by borrowing)…”
That bit in brackets is false. None of it, in aggregate, is “financed” by borrowing, because income = spending. What you meant to say is that an increase in borrowing and lending will (very probably) accompany the increase in incomes and spending.
But yes, the rest of your comment is right. Fair point.
Ron: if the gov’t were to announce with sufficient time what its unemployment target will be, people would adjust.
“Monetary policy does not work by increasing actual borrowing. That is not the causal channel of the monetary policy transmission mechanism. Monetary policy works by increasing spending, not borrowing.”
i don’t follow your argument here. could you elaborate please?
Well, this certainly makes no sense for the US and Canada, which have cut total debt. The increase in public sector debt has allowed a larger decrease in private sector debt.
In Europe, OTOH, cutting government spending when there is a multiplier greater than 1 has resulted in an increase in government debt. Moreover total debt has increased significantly as a percent of GDP aggravated by the decrease in the denominator.
Still, an increase in rates would worsen the already desperate circumstances of the European banks.
It’s not just a question of rates, however. The ECB is dialing back on its unconventional monetary policies and reducing its balance sheet. Given the negative effects of the Cyprus depositor bail-in on confidence, it will probably have to reverse course soon and support the banks, which are still in desperate shape.
So regardless of the theory (and I agree it’s wrong), the situation in practice doesn’t support a policy of rate increase. [edited as per Peter N’s later comment. NR]
Nick — In part one, I think that you need to distinguish between net and gross borrowing by the private sector. Your argument is fine with regard to net borrowing, aggregating the borrowing and lending by private sector actors and looking only at the degree to which the private sector as a whole hold central bank liabilities. But the intuition behind the view you are criticizing is not about what “everybody” or “nobody” does. It presumes a heterogeneous private sector in which some actors’ propensity to borrow/dissave in order to spend is more sensitive to interest rates than other actors’, so the extra spending engendered by low interest rates creates extra aggregate income which accumulates as saving by the low-sensitivity-to-rates group matched by borrowing/dissaving of the high-sensitivity-to-rates group. There is no fallacy of composition in this story.
I hasten to add that I don’t think headline monetary policy should therefore be tempered by financial stability concerns. My view is that we have too few instruments, that in order to get both financial stability and adequate expenditure we need other tools (not “macroprudential” tools or “tough regulation”, which will never be sufficient, but income support that renders more spenders dissavers rather than net borrowers). But although you are right to point out that low interest rates don’t necessarily induce borrowing concomitant with increased spending, it’s not right to day that they logically can’t. I suspect that empirically they do.
(I could be mistaken! Unfortunately, it is very difficult to tease out the effect of headline interest rates from a million other variables that affect patterns of lending and borrowing in the one time series we have available.)
“it ignores the Old Keynesian multiplier. If I spend more that means I am buying more from other people, so their incomes will rise, and they will spend more too, which means still other people’s incomes will rise…and so on. ”
Are you saying that an increase in credit doesn’t contribute to an increase in GDP. That is, are you outlining a pure loanable funds model? If so you need to account for this:
Nick:
yes, “This may induce a boom accompanied by more spending (some of it financed by borrowing)…” is a false statement now I think about it – Macro is indeed hard !
In my first comment the last line should, of course end
“the situation in practice doesn’t support a policy of rate increase.”
[I edited your first comment to fix this. NR]
From ‘dilemmas’ to ‘trilemmas’
Stable monetary environment is good for the creation of jobs and debt (both are long term contracts). Creating jobs and debt in an unstable monetary environment is like sailing in a tiny boat across the Atlantic. Higher employment today increases the risk that employment will be lower tomorrow. The same with debt – more debt today increases the riskmof a deleveraging tomorrow. The only reason we welcome jobs and oppose debt is linguistic. Jobs sound good, debt sounds bad. That’s why I am the only person making this argument:
“Sure, there’s a risk that inflation is falling below target, and a risk that the output recovery will be delayed, and it would be nice if the Bank of Canada (or Sweden or wherever) could loosen monetary policy to prevent this happening. But monetary policy works by lowering interest rates and encouraging companies to hire more and spend more on wages. And that creates a problem for labor market stability, because some people are already working too much. So there’s a trade-off between monetary stimulus and labor market stability, and monetary policy needs to take both objectives into account.”
Monetary stimulus creates both jobs and debt.
“It’s even more horribly wrong when we think about another accounting identity that holds in aggregate: for every $1 borrowed there’s $1 lent.”
There is a way to define it so that is true. If so, for every $1 of dissaving, is there a $1 of saving?
“To keep it very simple, imagine an economy where everyone is identical.”
Let’s be more realistic. Let’s say there is Apple, Warren Buffett, a bank, and 198 other people. Assume Apple and Warren Buffett have large real earnings growth by their monthly budgets and the other 198 have slightly negative real earnings growth by their monthly budgets so they have to borrow to maintain their standard of living. Now run the model. Plus, you will need to model the bank correctly.
“If the central bank lowers the rate of interest, people borrow a tiny amount of extra cash from the central bank (they all want to borrow from each other but nobody wants to lend),”
1) If there is a bank, it will want to allow people to spend by lending.
2) Are you saying only the central bank can increase the amount of medium of exchange (MOE) / medium of acciunt (MOA)?
Nick,
“Suppose the Bank of Canada wanted me, Nick Rowe, to spend more, to do my bit to promote recovery and prevent inflation falling below target.”
To keep inflation from going below target the Bank of Canada can either promote you to spend more or prevent me from producing more. Both you and I have access to credit, I use it to fund production, you use it to fund consumption. Enter a third party – the mercenary. He wants to borrow money from the Bank of Canada to buy guns from me to shoot you. Enter a fourth party – the do gooder. He wants to borrow money from the Bank of Candada to give to you with no strings attached – you don’t have to spend it if you don’t want to. How does a central bank determine who gets a loan and who doesn’t – the consumer, producer, mercenary, and do gooder – just by setting interest rates?
“As Scott Sumner echoes Milton Friedman: low interest rates does not mean loose monetary policy; low interest rates are a consequence of past and expected future tight monetary policy. That’s true both for nominal and real interest rates.”
Low interest rates are a consequence of past purchases of interest bearing securities. More buyers than sellers will cause prices to rise (market interest rates to fall) and vice versa. Apparently Scott has never seen an inverted yield curve before. Monetary policy makers can give all the forward guidance they want, unleveraged long term security holders may decide to not sell. Even if holders of long term securities expect future tight monetary policy, that does not mean that they have to change their behavior when it happens. Scott places too much faith in expectations. Just because I expect something to happen does not mean I am going to change my behavior in response to it happening.
Nick,
I think low interest rates do promote financial instability, at least because they make it harder to value assets: when most of the present value of an asset comes from hard-to-estimate distant returns, that value is going to have a wide confidence interval, and the value may change dramatically depending on ones assumptions. That sets up a situation where small changes can cause people to rush into and out of an asset market, hence financial instability.
Nonetheless, as a first approximation, I think you’re right that the tradeoff is false. Monetary policy is like Chinese finger cuffs: the more you try to resist low interest rates, the lower they will end up going. That is surely true in nominal terms in any model with Wicksellian properties: if you keep the interest rate above the natural interest rate, the inflation rate will fall more and more (by definition of “natural interest rate”), and you will end up facing a choice between ever-accelerating deflation and cutting the nominal interest rate even lower than you originally contemplated. It’s less clear whether it’s true in real terms, but I’m inclined to think it is: the further you get below the target inflation rate, the more aggressive you’ll eventually have to be in bringing down the real interest rate to get back to target.
However, the issue of downward-sticky nominal wages complicates the issue. If wages are sticky enough and you start out from a low enough inflation rate, you can go for a long time below the natural interest rate without much decline in the inflation rate. The risk of a deflationary spiral might be extremely small, and, if you think there is a major disadvantage to low interest rates, you might decide to take the risk, keep the interest rate above the natural rate, and just wait for the natural rate to rise on its own (assuming you have reason to believe it will, as I think is the case in many models, due, e.g., to depreciation). So plausibly the trade-off between financial stability and monetary stimulus really does exist.
Peter N said: “That is, are you outlining a pure loanable funds model?”
I think he is or something similar. I don’t believe in the for every borrower there is a lender in what I call the strictest sense. “Banks” violate the concept. To see that violation requires doing some accounting of the “banks”. When “banks” are added, lower interest rates are about more currency denominated debt. I might be able to come up with a scenario(s) where lower interest rates are still about more currency denominated debt without “banks”.
Borrowing from a friend is different from borrowing from a “bank”.
JCE: think about the case where everyone is identical, so there is no way that one person would want to lend if another wanted to borrow, so there could never be any borrowing, because borrowing requires both a willing borrower and a willing lender. Does that mean it is impossible for monetary policy to increase spending? Of course not. People spend the money in their pockets, and that money returns to them when other people spend theirs. So their extra spending is financed by the extra income created by that extra spending. And even if people are not identical, that is still what happens in aggregate. If one person borrows and spends more than his income, then another person must lend, and spend less than his income. For an individual, expenditure = income plus borrowing minus lending. But in aggregate, income = expenditure.
Peter N: you lost me. Sorry. And I’m definitely not outlining a pure loanable funds model. The problem with the loanable funds model (in this context) is that it takes income as exogenous with respect to saving and investment.
Steve: “It presumes a heterogeneous private sector in which some actors’ propensity to borrow/dissave in order to spend is more sensitive to interest rates than other actors’, so the extra spending engendered by low interest rates creates extra aggregate income which accumulates as saving by the low-sensitivity-to-rates group matched by borrowing/dissaving of the high-sensitivity-to-rates group.”
It would need to presume more than just heterogeneity. It would need to presume a very particular form of heterogeneity between those who are currently net debtors and those who are currently net creditors, both with respect to interest-elasticity and with respect to income elasticity of desired spending. Because if the central bank cuts the rate of interest, income will rise. (And if I could do math I could figure out what that heterogenity would have to be to get their results.) But to a first order approximation (first term in Taylor expansion stuff) I think that heterogeneity would make no difference whatsoever to the magnitude of the effect of monetary policy. It would be exactly as if everyone had the same as the population averages of interest and income elasticities. And even then, we don’t need different interest-elasticities to get gross debt to increase when monetary stimulus succeeds. Take a simple model where everything scales with income. If there is some heterogeneity, so some debt exists, if monetary policy increase income then gross debt will increase in proportion, simply to hold debt/income ratios constant. But this is simply a side-effect of the monetary stimulus, not a causal part of the monetary policy transmission mechanism.
marcus: yep! economists can’t but think in terms of trade-offs! But in this particular case, I think the argument for trade-offs is invalid. It’s either the “monetary stimulus works by encouraging borrowing” fallacy, or else it’s the “let’s make roads more dangerous so drivers slow down and have fewer accidents” fallacy.
123; lovely!
TMF: stop now please.
“let’s make roads more dangerous so drivers slow down and have fewer accidents fallacy”
I like the NGDP corridor approach (central path of NGDP +/- 0.5%). Let them change the expected NGDP inside the corridor however they like in pursuit of financial and labor market stability. Minsky argument is that a road too straight generates a bend ahead, this is another argument for a corridor.
Yes, you can’t really model the economy without including banks. Consider the arguments of LaVoie and Godley as included by reference.
123: Maybe Minsky would want us to put frequent random bends in the roads, even when we don’t need them, so drivers don’t forget that bends exist? I wonder if he would join save the manuals?
Peter N. That’s a bit like saying: “Yes, you can’t really model the economy without including oil.” Are you saying that oil doesn’t matter, in today’s world??!!
Nick, maybe he would support it. On the other hand, an argument can be made that over the long run corridor system could achieve even higher levels of debt and employment if central bank creates bends inside the corridor skillfuly according to a dual NGDP and employment mandate.
I like where this discussion is going, even in its tangents, because these are some issues that have really got me thinking ever since I read this paper-
Click to access 2005-020.pdf
– and for the first time encountered some clear & cogent arguments for a very un-British sort of arguments (aside from some I’d come across from Friedman and some hinted at by Nick Rowe).
I’m also interested in hearing some actual arguments regarding the FIH: Nick’s analogy to roads is both witty and intelligent. If there’s something wrong with the FIH, it seems to me that it’s the econophysical nature of it. Macroeconomics has more in common with road planning than astrophysical cycles.
In other words, please continue…
Nick,
“So if you want higher nominal and real interest rates, and you want them higher not just today but for the longer term future as part of a sustainable equilibrium, then you need to loosen monetary policy. If inflation and real growth, and hence nominal income growth, are in danger of falling, then you need more monetary stimulus to raise interest rates in a sustainable way.”
Or you just set nominal interest rates by decree. This can either be done by the monetary authority (the interbank lending rate shall be such and such percent) or by the issuing agent ( U. S. Treasury announced that they are selling 30 year 7% nominal non-marketable bonds. The reason a sovereign can do it while you can’t is because the interest payments are funded by a legal requirement called tax revenue. Meaning their revenue carries legal force, while your income does not.
“It’s even more horribly wrong when we think about another accounting identity that holds in aggregate: for every $1 borrowed there’s $1 lent. To keep it very simple, imagine an economy where everyone is identical. If I wanted to borrow then so would everyone else want to borrow, which means nobody would want to lend to me, so I wouldn’t be able to borrow from anyone else.”
This is wrong. Most people can handle being both borrowers and lenders, why can’t you? I have a mortgage that I am paying off making me a borrower. I have some interest bearing securities making me a lender. I can lend to you and borrow from you simultaneously. I lend to you at a 1 year interest rate of 1% and borrow the same amount for 30 years at an interest rate of 5%.
What you seem to be missing is that there are classes of borrowers who get loans on better terms than others and there is both short term and long term lending and borrowing.
W Peden: Thanks! But what does “FIH” mean?
That paper on UK monetary policy history is fascinating. It’s hard to remember just how much monetary policy was downplayed. (And you can see the UK 1960’s origins of what now calls itself “MMT”.)
Frank: you need to understand the Wicksellian indeterminacy problem if you want the central bank to set interest rates at some arbitrarily chosen level. And the government can announce any interest rate it likes on its bonds. But whether or not people would actually buy those bonds at face value is another question, as is the resulting market-determined yield. And I’m not going to spend the time explaining those points to you here and now. You need to do some reading.
“The models we deploy are all grounded in double entry systems of accounts…in which every entry describing an income or expenditure is invariably seen as a transaction between two sectors… However to complete such a system of accounts so that ‘everything comes from somewhere and everything goes somewhere’, it is essential to additionally include all those flows of funds which show how each sector’s financial balance (the gap between its total income and expenditure) is disposed of. It will be then be found that it is impossible to complete the implied matrix of all transactions in such a way that every column and every row sums to zero without calling into existence a banking sector which provides the funds which firms need in order to finance investment, thereby simultaneously creating the credit money which households need to finance transactions and to store wealth.” Godley and Lavoie monetary Economics 2nd edition page xlv
You can, however create such a model without oil.
more information is available at http://sfc-models.net
Nick Rowe,
FIH = “Financial Instability Hypothesis”
I particularly liked the idea that interest rate increases are inflationary: music to the ears of Harold Wilson!
It seems that attempts to control inflation by direct controlling bank credit did nothing to reduce inflation, but plenty to make UK broad money aggregates less than useless.
Anyway, anytime I try to defend what Tim Congdon calls “British monetarism” (which has plenty in common with Post-Keynesianism) I find myself stuck on Thomas Sowell’s “thinking beyond step one”. So a bank lends to the government and produces a new deposit? Then what? The bank looks to borrow reserves from other banks to meet its liabilities. Then what? The bank that lends now has either eliminated an excess of reserves or is now reserve-deficient. Then what? Eventually, the analysis ends up at the central bank, which is no more lacking control over base money (given that it- prior to 2008- targets interest rates, not quantities of base money) than the Post Office lacks control over stamps because it “targets” the price of stamps rather than the quantity of stamps.
As for the credit-counterparts approach, which made so much sense at first, the Batini and Nelson paper demolishes it in short order.
You are right to draw attention to the fallacy of composition. Every time I seem to have a plausible argument for a position where base money is irrelevant, the fallacy of composition walks over and slaps me in the face.
Andy and Frank: sorry, your comments had got stuck in spam, along with one of mine!
Andy: I think I would agree with your first paragraph. If the natural rate of interest is low (or maybe low relative to the growth rate?), then small change in r (or r-g) can cause big changes in asset prices. But yes, there’s nothing much monetary policy can do about that.
I’m unsure about your last paragraph. Since I think the IS curve is (probably) upward-sloping, I don’t think it’s right.
W Peden: FIH. Aha!
I can remember that old argument that tight money was inflationary, because it raised costs! I hadn’t heard that since 1979. It seemed to make so much sense to people back then. Not just to (some) economists, but to regular folk. It’s exactly where you get to with a cost of production theory of prices, plus a fallacy of composition.
Is that what Tim Congdon calls “British Monetarism?” I’ve always associated the term with the old joke that what the Brits call a “monetarist” is what the Americans call a “sensible Keynesian”.
“Is that what Tim Congdon calls “British Monetarism?””
Yep. So-
(1) A preference for broad money over narrow money as far as explaining inflation goes.
(2) A focus on interest rates over the monetary base as far as monetary policy goes.
(3) A major role for fiscal policy in controlling the money supply and not just to avoid crowding out. (A deduction from the credit counterparts identity and some apparentely god-awful endogenous money theory.)
(4) A focus on the role of the asset prices in the transmission mechanism from money to the economy and from monetary policy to money. (This is something that Tim Congdon and Gordon Pepper- otherwise very different sorts of monetarist- have in common, I think.)
(5) A belief that public debt management is a major part of monetary policy.
(6) + any monetarist views that do not conflict with the above.
That this was considered radical anti-Keynesianism in the 1970s proves that the joke has a lot of truth in it!
These are an approximation of the real rates in the US from 1990 to date. It’s hard to escape the conclusion that the Fed loosened too much or too long in trying to compensate for the dotcom bust (and perhaps tightened a bit too much in trying to regain control).
Peter N.,
The federal reserve does not set a real interest rate, it sets a nominal interest rate. You are comparing the result of prior lending (the inflation rate) with the cost of new borrowing / price of existing bonds.
The inflation rate is the result of money borrowed to fund both production and consumption.
“It’s even more horribly wrong when we think about another accounting identity … so I wouldn’t be able to borrow from anyone else.”
This seems to ignore the form of modern private and central banking. With the switch to inflation targeting via interest rates, coupled with deregulation, the banking sector was set free of most constraints. Banks are special. They create money from thin air that is used to settle transactions. They do so by lending. If you convince the bank that you have a valuable asset then they will loan you money that they can create. The value of the loan backed by your asset is the offsetting transaction. Banks are constrained by capital (not reserves) and profitable loan prospects. Typically it is enough for the central bank to lower rates so as to make the marginal loan more profitable. In a banking crisis the interest rate cut may be insufficient without capital injections into the banking system or restoration of the creditworthiness of borrowers. The fragile aspect of this system is that everything hinges on asset prices. As long as asset prices are rising bank earnings will be sufficient to fund further lending growth (or raising further capital will be cheap). Also, with rising asset prices and it is difficult for loans, especially asset backed loans, to appear risky when asset prices are rising. And we cannot assume that banks are rational actors with perfect information of the future. The future is risky and uncertain. That asset that the bank thought was valuable, may turn out to be worth far less than expected.
The central bank does not control the money supply. The private banks do. The central bank can influence the behavior of the private banks, but they need loan growth and asset price growth to accomplish monetary growth. This system seems destined to suffer from asset price and loan growth that exceeds monetary growth. Eventually the cashflow is insufficient to service the debt, asset liquidation starts, asset prices fall, bank capital falls, loan growth falls (or goes negative) and we have a monetary contraction.
If you agree that the central bank does not control, but can only influence the money supply through the banking system, then you should also agree that banks are important to the macroeconomy. Therefore the asset prices and debt levels are very important.
Andy,
Guess who has an asset that has an infinite present non-discounted value?
Andy Behrens: assume the income elasticity of the demand for money is approximately one. Which seems empirically and intuitively roughly plausible. So commercial banks’ balance sheets would expand in rough proportion to Nominal GDP. Which means the ratio of banks’ assets and liabilities to NGDP would stay roughly the same.
If it lowered the Nick Rowe rate of interest I would save less if I were a saver, and borrow more if I were a borrower.
This is an empirical question, and depends very much on
1) how much wealth the person in question already has
2) what the person’s previous plans were
3) how far away they are from retirement/whatever life goal they were saving toward.
Most people, when the rate of interest is lowered, desire to save more, not less. You would expect wealthier people desire to save less, on the margin, and those with less wealth to desire to save more.
That is because they are engaging in buffer stock saving.
As an extreme example, if you were assuming 8% appreciation per annum on your house, and woke up one morning and discovered that your house is worth 30% less, and has an expected future appreciation of zero, then you would save more, not less, if your house was your primary savings vehicle.
In any case, you cannot assume, just because it is theoretically convenient to do so, the shape of savings demands curve with the interest rate.
As another example, suppose you think that there is a non-zero chance that you will be unemployed for one year. So you need at least one year’s income saved away to prevent yourself from being forced to sell your house or live in poverty (unemployment insurance is not enough to pay your bills). Here, you will be saving a fraction of your income each period and this fraction goes up as the interest rate declines.
I think these questions depend very much on the distribution of wealth in the economy, and I believe this is why ways of thinking about the economy that seemed to work in the 1980s are ineffectual today.
“Most people, when the rate of interest is lowered, desire to save more, not less. ”
A proposition that is seemingly inconsistent with American borrowing/saving patterns pre-recession and Canadian borrowing patterns post-recession.
So commercial banks’ balance sheets would expand in rough proportion to Nominal GDP. Which means the ratio of banks’ assets and liabilities to NGDP would stay roughly the same.
http://research.stlouisfed.org/fred2/graph/?id=TFAABSHNO
I think the answer is that “income elasticity of the demand for money ” is not a meaningful economic metric. Do you mean demand for deposits by households, demand for currency by households, or demand for reserves by banks? The latter is dominated by the availability of new financial clearing mechanisms, such as money market accounts and credit cards. The CB only controls the quantity of reserves, and the demand for reserves as a function of income is dominated by technology and banking sector consolidation, at least over the short and medium term. Over the long term, we don’t really care.
sorry, wrong Fred link: http://research.stlouisfed.org/fred2/graph/?g=i2b
Here is some data on consumption and savings behavior for households:
Click to access wp9722.pdf
One way of thinking about this is that you have two motivations: buffer-stock savings demands and consumption smoothing demands.
As wealth goes to infinity or as the interest rate goes to infinity, the latter effect dominates. As wealth goes to zero and interest rates go to zero, the former effect dominates. In the case of the latter effect, consumption is independent of present income and depends only on lifetime income and the interest rate. In the case of the former effect, consumption is a fixed proportion of current period income only.
if you choose a certainty-equivalent utility function whose derivative is symmetric with respect to the form of uncertainty (e.g. in a model of multiplicative uncertainty, logarithmic utility does the trick, or in a model with additive income uncertainty, quadratic utility is necessary), then the buffer stock savings demand disappears. If you choose a generic HARA utility funciton, then the buffer stock savings does not disappear, and in fact dominates.
Again, this is an empirical question, and low interest rate environments are exactly those when buffer stock savings will be predominant for all except the very wealthy.
Nick,
“Frank: you need to understand the Wicksellian indeterminacy problem if you want the central bank to set interest rates at some arbitrarily chosen level.”
Wicksell I believe was referring to a real (or natural) interest rate realized after money is lent. A central bank sets a nominal interest rate. A nominal interest rate by definition is arbitrary. If I lend you money at a 100% nominal interest rate and you lend it back to me at the same nominal rate are either of us any worse off?
“And the government can announce any interest rate it likes on its bonds.”
A government bond auction is structured so that the market sets the interest rate and the government sets the duration. The process can just as easily be reversed so that the government sets the interest rate and the market sets the duration. Instead of you as a market participant saying I bid 7% on 30 year government bonds, you as a market participant say I bid 30 years on 7% government bonds.
“But whether or not people would actually buy those bonds at face value is another question, as is the resulting market-determined yield.”
The interest rate on the bond is market determined in an open auction process. The yield to maturity is set as the bond is traded back and forth over its duration. Both the interest rate and the yield to maturity are set in the markets.
When interest rates drop, commercial banks create new money out of thin air and lend it out. To that extent, Nick is correct to say “there is never any actual borrowing” – in the sense that no one need forgo consumption in order for the borrower to consume more.
However, there clearly IS MORE BORROWING in the sense that non-bank entities’ debts to commercial banks have risen. And they’ve risen on the basis of low interest rates. Plus some of those non-bank entities won’t be able to repay when rates rise.
Ergo, Nick’s “never any actual borrowing” point does not invalidate concerns about what he calls “financial stability”. I.e. to put it bluntly, don’t tell me NINJA mortgagors fooled by low interest rates aren’t a problem.
Marks out of ten please Nick, and don’t be too harsh.
W. Peden,
“The bank looks to borrow reserves from other banks to meet its liabilities.” So the textbooks say, but in reality? In reality reserve requirements aren’t very restrictive. Banks have other sources of funds than demand deposits. The real limits on lending are the ratio of capital to assets at risk, the cost of funds, the availability of credit-worthy borrowers. And, of course, banks sometimes would rather invest than lend.
I have papers from economists about this going back 15 or 20 years. The Fed influences bank lending by using the discount rate to increase or decrease the cost of funds. Assuming a sloping demand curve for loans, and a fairly stable bank margin, increasing the discount rate will decrease the demand for loans as long as banks don’t have cheaper sources of funding.
And, of course, as you go up the hierarchy of aggregates from M1 to M4, the Fed’s fine tuning ability gets progressively weaker.
@ Frank Restly
I think you didn’t look carefully enough at the labels on the graph. It compares two real rates. I’m comparing mortgage rates with the discount rate. I just deflated both by the GDP deflator. That shifts both curves the same amount.
“To keep it very simple, imagine an economy where everyone is identical”. Remember the words of the master “as simple as possible but no simpler”.
I think this is a simplification too far. You can’t model lending with one person lending to herself.
One way of refuting the idea that monetary expansion increases real borrowing is to point out that this is equivalent to saying that monetary expansion increases the current account deficit, which is absurd.
Nick — Mere scaling up of absolute debt would not be a problem. As you say, it would hold heterogeneous agents’ debt to income ratios constant, so monetary easing would leave financial fragility unchanged. (I’m setting aside Andy Harlass’ interesting point about asset price uncertainty.)
But I think you are mistaken to suggest that you need a very particular model of heterogenous agent to have interest rate policy affect debt (or net wealth) to GDP ratios. I think you’d have a very hard time writing a plausible model in which agents’ have heterogeneous sensitivity of expenditure wrt interest rates yet financial strength ratios remain constant as interest rates change. Anyway, the very first model I wrote to try to check this (no mining of the model space, i promise) had showed variations of financial strength with interest rates quite immediately. Maybe we have very different ideas of plausible models! Anyway, I’ll try to write this up so you can tell me why I’m wrong.
(My “model” is a butt-simple, 2-agent discrete-time simulation that converges easily to eqm wealth-to-income ratios. No fancy analytical continuous-time models with my 7 discrete neurons!)
Nick – in the banking context, how do you factor in the endogenous money aspect? Expansion of bank balance sheets through additional gross borrowing forces a balancing item on the liability/equity side – e.g. deposits at first, at least. So the decision/approval for increased gross borrowing forces a matching form of lending (using your broader meaning of “lending”) as a result. The additional ‘lending’ aspect is involuntary from a macro perspective, because those additional liabilities/equity (e.g. deposits) won’t disappear unless people subsequently start repaying their loans. (It may also result in increased spending from additional deposits as a second order or multiplier effect.) How do you interpret the initial presence of a matching stock of ‘lending’ equivalent to the initial borrowing being automatic rather than a voluntary choice under lower rates in the banking context?
Also, in terms of financial behavior that is actually or potentially or not at all a “counterbalance” to borrowing in the context of your post, how do you interpret the technical difference in meaning as between lending and saving?