Henry George on the Value of Transparent Theory
“When I was a boy I went down to the wharf with another boy to see the first iron steamship that had ever crossed the ocean to Philadelphia. Now, hearing of an iron steamship seemed to us then a good deal like hearing of a leaden kite or a wooden cooking-stove. But we had not been long aboard of her, before my comrade said in a tone of contemptuous disgust: “Pooh! I see how it is. She’s all lined with wood; that’s the reason she floats.” I could not controvert him for the moment, but I was not satisfied, and sitting down on the wharf when he left me, I set to work trying mental experiments. If it was the wood inside of her that made her float, then the more wood the higher she would float; and, mentally, I loaded her up with wood. But, as I was familiar with the process of making boats out of blocks of wood, I at once saw that, instead of floating higher, she would sink deeper. Then, I mentally took all the wood out of her, as we dug out our wooden boats, and saw that thus lightened she would float higher still. Then, in imagination, I jammed a hole in her, and saw that the water would run in and she would sink, as did our wooden boats when ballasted with leaden keels. And, thus I saw, as clearly as though I could have actually made these experiments with the steamer, that it was not the wooden lining that made her float, but her hollowness, or, as I would now phrase it, her displacement of water. In such ways as this, with which we are all familiar, we can isolate, analyse or combine economic principles, and, by extending or diminishing the scale of propositions, either subject them to inspection through a mental magnifying glass or bring a larger field into view. And this each one can do for himself. In the inquiry upon which we are about to enter, all I ask of the reader is that he shall in nothing trust to me.”
Ana Swanson Interviews Ken Rogoff about “The Curse of Cash”
I highly recommend Ken Rogoff’s new book, The Curse of Cash. It has several chapters that touch on my proposal to engineer a nonzero rate of return on paper currency by taking paper currency off par. The other main part of the book is about the crime-control benefits of eliminating high-denomination bills–and perhaps having physically large, but low-value coins as the only form of hand-to-hand currency.
I was an official reviewer of the book, and in that capacity strongly urged the publisher to get the book in print as soon as possible. Here is my blurb that is included in the book:
The Curse of Cash is brilliant and insightful. In addition to giving a vivid picture of the cash-crime nexus, The Curse of Cash is the book everyone should read about negative interest rates. –Miles Kimball
Ana Swanson of Wonkblog interviewed Ken Rogoff about The Curse of Cash. Here are some interesting quotations from Ken Rogoff in that interview that focus on monetary policy:
1. … the fact that monetary policy has been paralyzed because of the zero lower bound has hurt, and it will hurt in the next recession. The European Central Bank, the Nordic central banks, the Bank of Japan, they have tiptoed into negative rate territory, but they haven’t been able to do much, because they’re worried about the run into cash.
If you look at what’s happened in Europe and Japan, Japan has done quantitative easing on a scale that’s already triple what the U.S. has done. Europe is on track to buy up 20 percent of all corporate bonds within the time frame of their new quantitative-easing policy, and it’s not working very effectively. I think negative interest rates would be vastly more effective. Central bankers can’t come out and say that, but I think they all wish they had that tool. Not so they could use it today, but if something really bad happens.
2. There are other ways to do it. You can basically tax currency, by charging people when they turn currency in at the bank, which is an idea that I trace back to Kublai Khan.
3. … if you can go to a negative interest-rate policy, it’s going to depreciate the exchange rate. That said, if you wait a year or two after the policy, the negative interest rate will be gone, the U.S. economy will have strengthened, and the dollar might be higher than where it started. It’s certainly going to be controversial, but it might not be as bad as what we have now. Now no one really knows what central banks are going to do, because they’re flailing away at the zero bound trying to find something that works, and it creates an enormous amount of uncertainty.
So negative interest rates are going to come. Central bankers need them in the current environment. In 10 to 15 years, certainly in 20 years, if it’s needed, they’ll have figured out how to do it. And when they finally find a way, I think it will be regarded as leading to a better and healthier financial system.
The second quotation is referring elliptically to my proposal, which Ken discusses in detail, quite approvingly, in the book.
Henry George Eloquently Makes the Case that Correlation Is Not Causation
“That a thing exists with or follows another thing is no proof that it is because of that other thing. This assumption is the fallacy post hoc, ergo propter hoc, which leads, if admitted, to the most preposterous conclusions. Wages in the United States are higher than in England, and we differ from England in having a protective tariff. But the assumption that the one fact is because of the other, is no more valid than would be the assumption that these higher wages are due to our decimal coinage or to our republican form of government. That England has grown in wealth since the abolition of protection proves no more for free trade than the growth of the United States under a protective tariff does for protection. It does not follow that an institution is good because a country has prospered under it, nor bad because a country in which it exists in not prosperous. It does not even follow that institutions to be found in all prosperous countries and not to be found in backward countries are therefore beneficial. For this, at various times, might have been confidently asserted of slavery, of polygamy, of aristocracy, of established churches, and it may still be asserted of public debts, of private property in land, of pauperism, or of the existence of distinctively vicious or criminal classes. Nor even when it can be shown that certain changes in the prosperity of a country, of an industry, or of a class, have followed certain other changes in laws or institutions can it be inferred that the two are related to each other as effect and cause, unless it can also be shown that the assigned cause tends to produce the assigned effect, or unless, what is clearly impossible in most cases, it can be shown that there is no other cause to which the effect can be attributed. The almost endless multiplicity of causes constantly operating in human societies, and the almost endless interference of effect with effect, make that popular mode of reasoning which logicians call the method of simple enumeration worse than useless in social investigations.”
Randy Barnett's Bad List of Supreme Court Decisions
“Growing up, I was like most Americans in my reverence for the Constitution. … Until I took Constitutional Law at Harvard Law School. The experience was completely disillusioning, but not because of the professor, Laurence Tribe, who was an engaging and open-minded teacher. No, what disillusioned me was reading the opinions of the U.S. Supreme Court. Throughout the semester, as we covered one constitutional clause after another, passages that sounded great to me were drained by the Court of their obviously power-constraining meanings. First was the Necessary and Proper Clause in McCulloch v. Maryland (1819), then the Commerce Clause (a bit) in Gibbons v. Ogden (1824), then the Privileges or Immunities Clause of the Fourteenth Amendment in The Slaughter-House Cases (1873), then the Commerce Clause (this time in earnest) in Wickard v. Filburn (1942), and the Ninth Amendment in United Public Workers v. Mitchell (1947).”
Randy Barnett, in Restoring the Lost Constitution: The Presumption of Liberty
Addendum: Brad Delong replied to this quotation post with “No, State Governments Have Not Been the Sacred Hearths of Human Liberty in America. Why Do You Ask?” making the excellent point that states rights in the US have historically been used for ignoble ends and should not be accorded the same respect as individual rights. Asserting the supremacy of the federal government over state governments can easily enhance, rather than diminish, individual rights. The reason I posted this quotation is because I lament the decisions gutting the “Privileges and Immunities Clause” and the Ninth Amendment–both of which are about individual rights, not states’ rights.
How the Original Sin of Borrowing in a Foreign Currency Can Reduce the Effectiveness of Monetary Policy for Both the Borrowing and Lending Country
Link to Wikipedia article for “Original sin (economics)”
When a central bank cuts interest rates, each type of borrower-lender relationship generates more aggregate demand because (a) the shift in of the budget constraint of the lender is matched by an equal and opposite shift out in the budget constraints of the borrower, (b) borrowers generally have higher marginal propensities to consume out of changes in effective wealth and © beyond the sum of wealth effects from (a) and (b), there is also a substitution effect leading to more spending now simply because lower interest rates make spending now cheaper relative to spending later than it was before the interest rate cut. (a) is the “principle of countervailing wealth effects” I discuss in these three posts:
- Even Central Bankers Need Lessons on the Transmission Mechanism for Negative Interest Rates
- Responding to Joseph Stiglitz on Negative Interest Rates.
- Negative Rates and the Fiscal Theory of the Price Level
The Open Economy
I laid out the principle of countervailing wealth effects in “Even Central Bankers Need Lessons on the Transmission Mechanism for Negative Interest Rates” in order to dispute the idea that causing one’s currency to depreciate was almost the sole transmission mechanism for interest rate cuts into the negative range, so I concentrated on the case where every central bank in the world simultaneously cut its target rate by 100 basis points. But it is interesting considering the open economy case with only one central bank cutting its target rate.
First, it is important to realize that thinking about wealth and substitution effects in the way I describe above is only telling about consumption and investment. The extra net exports from the outward capital flow as funds flee the low domestic interests by going abroad is an addition to aggregate demand that goes beyond the wealth and substitution effect logic above.
See “International Finance: A Primer” for why funds going outward drive net exports up. That post also explains how the outward capital flow puts more of the domestic currency in the hands of foreigners and thereby drives down the foreign-exchange value of the domestic currency.
Small Open Economy, Net Creditor in Foreign-Denominated Assets. To see if there is any chance that the wealth and substitution effect logic can overturn the effect of increased capital outflow on aggregate demand, let’s begin by considering a small open economy that is a net creditor. To the extent that anyone in the country is investing domestically both before an interest rate cut, the usual principle of countervailing wealth effects holds since both borrower and lender are domestic. Because it is a small open economy, the rate of return on foreign assets should be affected by this monetary policy move only to the extent it induces expected exchange rate movements. If people expect any mean reversion of the exchange rate, the usual depreciation of the local currency accompanying a domestic interest rate cut might make people expect a bit of mean reversion and therefore a bit lower returns on foreign assets than before the interest rate cut. But overwhelming this effect, depreciation of the domestic currency makes any foreign assets already owned look bigger in value when totaled up in the depreciate domestic currency. Overall, there is very little room for any ambiguity about the stimulative effect of interest rates cuts for a small open economy that is a net creditor: there is the stimulus to net exports from increased capital outflow, plus a higher return on foreign assets when viewed in the domestic currency, plus the higher value of foreign assets when viewed from the perspective of the domestic currency.
Large Open Economy, Net Creditor in Foreign Denominated Assets. Now, consider a large open economy that is a net creditor. As with any monopolist that drives down prices by producing more and selling it, a net creditor country that increases its lending abroad could theoretically reduce the rates of return it gets abroad and so make itself effectively poorer. If this were the case, one would expect to have at least some people in that country suggest that it have policies to reduce its foreign lending in order to jack up its returns on foreign assets. In the absence of any such suggestion, it seems unlikely that a country in fact would make itself significantly poorer by increasing its foreign lending from its current level.
Net Creditor in Own Currency. If a country does significant lending in its own currency, such lending is still driven by interest rates abroad relative to interest rates at home, and like the purchase of foreign-denominated assets, puts the domestic currency in the hands of foreigners, who are likely to turn around and spend those funds in increasing net exports from the domestic economy. However, with the lending in the domestic currency, exchange rate changes no longer change wealth as viewed in the domestic currency. It now becomes logically possible for a cut in interest rates to reduce spending simply because of the reduced interest income from foreigners when rates are cut.
Germany. There are three ways of thinking of the situation for Germany. One is that seeing Germany as a set of creditors within the eurozone, where the entire eurozone is seen as domestic. When taking the eurozone as the main unit of analysis, and Germany as only a part, German lending to others in the eurozone is all internal and the principle of countervailing wealth effects still applies in its main form to the eurozone as a whole.
Second, Germany can be seen as a net creditor in its own currency.
Third, one can view the situation as the other countries in the eurozone automatically loosening their monetary policy when Germany does. The other countries loosening their monetary policy cancels out the exchange rate effects that would otherwise make the foreign assets Germans hold in other eurozone countries look like more wealth when Germany loosens its monetary policy.
Net Debtor in Own Currency. If a country owes money on net, primarily in its own currency, then in this borrower-lender relationship, a cut in interest rates will have a positive wealth on consumption by this debtor country, enhancing the positive effects on aggregate demand from borrower-lender relationships within the country, and from the capital outflow and consequent increase in net exports induced by a rate cut.
Small Open Economy, Net Debtor in Foreign-Denominated Obligations. This case is sometimes called “original sin.” Depreciation now makes debts look larger, which should overwhelm the effect of expected mean reversion in the exchange rate in lower the rate of return on those debts. If foreign-denominated obligations are large enough, it might even become impossible to stimulate the economy with an interest rate cut. Thus, getting into this situation is quite dangerous. Countries should put policies into place to avoid owing large amounts of money in foreign-denominated obligations. And the IMF should proactively discourage countries from committing the original sin of borrowing with foreign-denominated obligations.
Large Open Economy, Net Debtor in Foreign-Denominated Obligations. This does not literally mean a large economy, but only one that must pay higher interest rates when it owes more and can pay lower rates when it owes less. Assuming a depreciation of the currency from a monetary loosening that reduces the rate on own-currency debt raises net exports enough that a bit of the debt begins to be paid off and the rate paid on all of the foreign-denominated debt goes down when it is rolled over, that provides a bit of an extra wealth effect in the positive direction.
Summary
Overall, the main potential loopholes to the argument that interest rate cuts should stimulate the economy come from a country’s being a large net creditor in its own currency, or a country’s being a large net debtor in foreign-denominated obligations. In both cases, someone is borrowing in a foreign currency. Overall, having countries borrow primarily in their own currency if they do borrow is an important measure for maintaining the effectiveness of monetary policy.
Note: I am worried about the chance that I might have missed some important element of the analysis I pursue in this post. Send me a tweet (@mileskimball) if you think I got something wrong or missed something.
Update: Olivier Wang’s reply to this post generated the follow-up post “More on Original Sin and the Aggregate Demand Effects of Interest Rate Cuts: Olivier Wang and Miles Kimball.”
Henry George: That Those Who Advocate Any Extension of Freedom Choose to Go No Further than Suits Their Own Special Purpose is No Reason Why Freedom Itself Should Be Distrusted.
“When we consider that [labor] is the producer of all wealth, is it not evident that the impoverishment and dependence of [labor] are abnormal conditions resulting from restrictions and usurpations, and that instead of accepting protection, what [labor] should demand is freedom? That those who advocate any extension of freedom choose to go no further than suits their own special purpose is no reason why freedom itself should be distrusted. For years it was held that the assertion of our Declaration of Independence that all men are created equal and endowed by their Creator with unalienable rights, applied only to white men. But this in nowise vitiated the principle. Nor does it vitiate the principle that it is still held to apply only to political rights. And so, that freedom of trade has been advocated by those who have no sympathy with [labor] should not prejudice us against it. Can the road to the industrial emancipation of the masses be any other than that of freedom?”
Henry George, Protection or Free Trade.
Note: Henry George idiosyncratically substituted “endeavored” wherever “labor” would normally appear, going so far as to use “eendeavoredate” in place of “elaborate,” for example. I have reversed this for clarity.
John Locke Looks for a Better Way than Believing in the Divine Right of Kings or Power to the Strong
Wikipedia article on John Locke
Having finished blogging my way through John Stuart Mill’s “On Liberty” (see John Stuart Mill’s Defense of Freedom), I wanted to turn to John Locke’s 2d Treatise on Government: “On Civil Government.” One of the many reasons John Locke’s 2d Treatise on Government is important is that the Framers of the Constitution of the United States and those who ratified it were so well versed in John Locke’s 2d Treatise of Government. Thus, anyone attempting to determine the original public meaning of the Constitution of the United States, should be as well versed in this work as folks back in the 18th century were.
In Chapter I (“The Introduction”) of the 2d Treatise of Government “On Civil Government,” John Locke summarizes his argument of his 1st Treatise of Government demolishing an argument for the divine right of Kings, and sets the stage for what follows, writing:
It having been shewn in the foregoing discourse,
- That Adam had not, either by natural right of fatherhood, or by positive donation from God, any such authority over his children, or dominion over the world, as is pretended:
- That if he had, his heirs, yet, had no right to it:
- That if his heirs had, there being no law of nature nor positive law of God that determines which is the right heir in all cases that may arise, the right of succession, and consequently of bearing rule, could not have been certainly determined:
- That if even that had been determined, yet the knowledge of which is the eldest line of Adam’s posterity, being so long since utterly lost, that in the races of mankind and families of the world, there remains not to one above another, the least pretence to be the eldest house, and to have the right of inheritance:
All these premises having, as I think, been clearly made out, it is impossible that the rulers now on earth should make any benefit, or derive any the least shadow of authority from that, which is held to be the fountain of all power, Adam’s private dominion and paternal jurisdiction; so that he that will not give just occasion to think that all government in the world is the product only of force and violence, and that men live together by no other rules but that of beasts, where the strongest carries it, and so lay a foundation for perpetual disorder and mischief, tumult, sedition and rebellion, (things that the followers of that hypothesis so loudly cry out against) must of necessity find out another rise of government, another original of political power, and another way of designing and knowing the persons that have it, than what Sir Robert Filmer hath taught us.
After taking down the divine right of kings, John Locke sets out his goal of finding some basis for government other than power to the strong. In disagreeing with both the divine right of kings and power to the strong, John Lock is unwilling to say that because things are a certain way, that they should be that way.
In my view, asking how things should be, without too much deference to how they are now, is the secret of progress. Of course, one should pay some respect to the principle well taught in economics that there might be a good reason for the way things are. But it is the height of folly to think that things are never the way they are for a bad reason.
Let me try to make this point sharply. Speaking without mercy, any time there is any technological progress it means that in retrospect something was being done stupidly before. Any time one learns anything, it reveals one’s ignorance before. And any time a society is made more just, it reveals in high relief the injustice of what went before.
But in each case, what many only see in retrospect, someone had to see in advance, when it wasn’t so easy to see: a better way to make widgets, a new insight, or an injustice to be righted.
When I took the Landmark Education “Curriculum for Living,” they had a special definition of an insight for personal growth: “Something that occurs to you as bad news about yourself.” The bad news that something is amiss has to be allowed in before there is much hope of making things better.
What is painful in personal growth is less painful when doing research, since there an insight might be bad news about someone else’s research that one can hope to right with one’s own research. Still, there is usually some pain in seeing things askew, even if the chance to right them can advance one’s own career. It is much better to have everyone do things well than to have people do things badly so that one can shine by doing them better.
Economists are trained to tear apart a presentation intellectually to find what is wrong and can be criticized. This is very useful training. But I wish they spent at least an equal amount of effort tearing apart social reality intellectually to find what is wrong and can be criticized. That is the beginning of the path toward making things better.
The tools of economic analysis are powerful, and can often be used productively to find ways to move the world in a good direction. Of course, those tools can also be used for to help find ways to help some people at the expense of many others. (For an example, see “Us and Them.”) Or the tools of economic analysis can be used as part of a game that has no immediate effect for good or ill on the wider world, but sharpens the wits of economists for a later time when some of the participants in that game do turn toward trying to make the world a better place or trying to help some people at the expense of many others.
“Two Treatises of Government” was published anonymously by John Locke in 1689. It was only a hundred years later, in 1789, that it fully bore fruit in the Constitution of the United States. This a good example of the principle I set out in “That Baby Born in Bethlehem Should Inspire Society to Keep Redeeming Itself”:
… the fact that the young will soon replace us gives rise to an important strategic principle: however hard it may seem to change misguided institutions and policies, all it takes to succeed in such an effort is to durably convince the young that there is a better way.
Many, many things stay the same until suddenly, one day, they are different. Ideas of how to make things better and patience in putting those ideas forward are two keys to bringing change in the right direction. In my view, John Locke made the world a better place. May we also do so.
Jingoism in Cahoots with Protectionism
“Protection, moreover, has always found an effective ally in those national prejudices and hatreds which are in part the cause and in part the result of the wars that have made the annals of mankind a record of bloodshed and devastation—prejudices and hatreds which have everywhere been the means by which the masses have been induced to use their own power for their own enslavement.”
The Bank of Japan Renews Its Commitment to Do Whatever It Takes
Link to Wikipedia article on Haruhiko Kuroda
I am not impressed by a target of zero for 10-year Japanese government bonds as stimulative measure, when they have been trading at negative rates. Fortunately, I think this is simply a sign that the Bank of Japan is continuing to search for new tools. And, as you can see from “How and Why to Eliminate the Zero Lower Bound: A Reader’s Guide,” there are tools available that are much more powerful than anything the Bank of Japan has used so far.
In particular, one of the most powerful tools the Bank of Japan has not yet tried is a negative paper currency interest rate through a gradually increasing discount on paper currency obtained from the cash window of the Bank of Japan (and a corresponding gradually increasing discount in what is credited to a bank’s reserve account when paper currency is deposited). A negative paper currency interest rate in turn makes it possible to cut other short-term interest rates much further.
Watching the Bank of Japan’s actions over the last few years and talking to its chief, Governor Haruhiko Kuroda, at Jackson Hole, left me confident about the Bank of Japan’s willingness to try new tools. What I wondered is whether the Bank of Japan would declare that it was already close to the natural rate of unemployment, and so didn’t need to do much more. My view is that after 20 years of slump, the Bank of Japan needed to risk overshooting its inflation target in order to find out both what its natural level of output really is, and to find out what it takes to permanently raise inflation to 2%, as it has decided it wants to do. In its September 21, 2016 statement, the Bank of Japan declares that it has come around to that point of view–better to risk overshooting than to undershoot:
The Bank will continue expanding the monetary base until the year-on-year rate of increase in the observed CPI (all items less fresh food) exceeds the price stability target of 2 percent and stays above the target in a stable manner. Meanwhile, the pace of increase in the monetary base may fluctuate in the short run under market operations which aim at controlling the yield curve. With the Bank maintaining this stance, the ratio of the monetary base to nominal GDP in Japan is expected to exceed 100 percent (about 500 trillion yen) in slightly over one year (at present, about 80 percent in Japan compared with about 20 percent in the United States and the euro area).
The Bank will make policy adjustments as appropriate, taking account of developments in economic activity and prices as well as financial conditions, with a view to maintaining the momentum toward achieving the price stability target of 2 percent.
I think it is this stated willingness to overshoot, not the introduction of an explicit yield-curve targeting, is what caused the yen to depreciate on the Bank of Japan’s September 21 announcement.
The other key section of the the September 21, 2016 statement is the section labelled “Possible options for additional easing”:
With regard to possible options for additional easing, the Bank can cut the short-term policy interest rate and the target level of a long-term interest rate, which are two key benchmark rates for yield curve control. It is also possible for the Bank to expand asset 5 purchases as has been the case since the introduction of QQE. Moreover, if the situation warrants it, an acceleration of expansion of the monetary base may also be an option.
Note the specific mention of lower short-term rates as an option.
Beyond the policy of a gradually increasing discount on paper currency obtained from the cash window of the Bank of Japan to make it possible to lower short-term rates without inducing massive paper currency storage, the most important complementary policy is one to make negative rates more acceptable politically: a shift in the details of the interest on reserves formula to explicitly link the amount of funds on which banks can earn an above-market interest rate to their provision of zero rates to small household accounts. The government retail bank represented by Postal Savings should also be part of this program, just as if it were a private bank (although its subsidy could come from another arm of the government rather than from the interest-on-reserves formula). Here is how it works, as I detailed in my post “Ben Bernanke: Negative Interest Rates are Better than a Higher Inflation Target”:
I have advocated arranging part of the multi-tier interest on reserves formula to kill two birds with one stone: not only support bank profits but also subsidize zero interest rates in small household accounts at the same time–the provision of which is an important part of the drag on bank profits as it is now. I think being able to tell the public that no one with a modest household account would face negative rates in their checking or saving account would help nip in the bud some of the political cost to central banks.
To avoid misunderstanding, it is worth spelling out a little more this idea of using a tiered interest on reserves formula to subsidize provision of zero interest in small household checking and savings accounts. To make it manageable, I would make the reporting by banks entirely voluntary. The banks need to get their customers to sign a form (maybe online) designating that bank as their primary bank and giving an ID number (like a social security number) to avoid double-dipping. In addition to shielding most people from negative rates in their checking and savings accounts, this policy also has the advantage of setting down a marker so that it is easier for banks to explain, say, that amounts above $1500 average monthly balance in an individual checking+saving accounts or a $3000 average monthly balance in joint couple checking+saving accounts would be subject to negative interest rates. That is, the policy is designed to avoid pass-through of negative rates to small household accounts but encourage pass-through to large household accounts, in a way that reduces the strain on bank profits.
Finally, in Japan, I would tie the ability of banks to get an above-market rate on a portion of their reserves to their passing along the discount on paper currency to their customers when their customers withdraw paper currency, so that regular people would get the benefit of that discount, too.
With the combination of a negative paper currency interest rate induced by a gradually increasing discount on paper currency obtained from the cash window of the central bank, and effective subsidies to support zero rates on small household accounts to make negative rates in general more acceptable, the Bank of Japan would have as much firepower it needs to achieve its goals.
Given how little we understand about economies that have been in a 20-year slump, I applaud the objective the Bank of Japan has now announced of continuing to stimulate the Japanese economy until the signs of the Japanese economy being above the natural level of output become absolutely unmistakable by inflation going above 2%. In the case of Japan, the economic risk from doing too little is much greater than the risk from doing too much.
Note: I will be going to the Bank of Japan to deliver this message personally in a few days. I have seminars scheduled at the Bank of Japan on September 27 and October 7. You can see the regularly updated itinerary for all of my travels to promote the inclusion of full-bore negative interest rate policies in the monetary policy toolkit in my post Electronic Money: The Powerpoint File.
Ben Bernanke: Maybe the Fed Should Keep Its Balance Sheet Large →
This is a good summary of some of the most important papers at Jackson Hole this year. The description at the top of Ben’s blog post is accurate: “Ben Bernanke sees merit in the case for keeping the Fed’s balance sheet large instead of shrinking it, as is the current plan.” Having listened to the same talks, I see the same merit.
You can see Ylan Q. Mui’s reaction to this blog post of Ben’s in her Wonkblog post “The Federal Reserve confronts a possibility it never expected: No exit.”
Negative Rates and the Fiscal Theory of the Price Level
I was very pleased to be invited to the Jackson Hole monetary policy conference this past August. One of the highlights of the conference was Chris Sims’s lunchtime talk on the first main day of the conference, “Fiscal Policy, Monetary Policy and Central Bank Independence.” The fiscal theory of the price level is something I have been confused about for a long time. Chris Sims interpreted it from a remarkable simple point of view–a point of view very close in its logic to the way I analyze the transmission mechanism for interest rates cuts–including going to a negative interest rate or a deeper negative rate–in my posts
- Even Central Bankers Need Lessons on the Transmission Mechanism for Negative Interest Rates
- Responding to Joseph Stiglitz on Negative Interest Rates.
I confirmed my interpretation of what Chris was saying in a question I posed in the Q&A right after his talk. I still may have it wrong, but here is what I understood.
Why Lower Rates Increase Aggregate Demand and Higher Rates Reduce Aggregate Demand
Suppose real interest rates go down. Adding up spending from both sides of almost every borrower-lender relationship in which rates go down, aggregate demand should increase because:
- The negative shock to effective wealth of the lender is matched by an equal and opposite shock to the effective wealth of the borrower. This is the “Principle of Countervailing Wealth Effects” I discuss in the posts listed above. Long-term fixed rates can mute the shock to the effective wealth of both sides, but absent a big change in the inflation rate will still typically lead the borrower to feel better off with the change in rates and the lender to feel worse off in terms of annuity equivalents (whatever the asset values on paper).
- In almost all cases, the marginal propensity to consume is higher for the borrower than for the lender, so that adding up the effects on borrower and lender, the wealth effects add up to an increase in spending. The particular marginal propensity to consume (MPC) that matters is the marginal propensity to consume of the borrower out of reductions in interest expenses and the marginal propensity to consume of the lender out of interest earnings.
- In addition to the wealth effects on the non-interest spending of the borrower and lender, there is a substitution effect on both borrower and lender toward spending more now simply because spending now is relatively cheaper compared to spending later when the interest rate is lower. (For the lender alone, the wealth effect may easily overwhelm the substitution effect, so that the lender may spend less when interest rates go down, but for the borrower and lender combined the wealth effect and substitution effect both go in the same direction given 1 and 2: toward more non-interest spending when the rate goes down.)
What if interest rates go up? Then, adding up spending from both sides of almost every borrower-lender relationship in which rates go up, aggregate demand should decrease because:
- The positive shock to the effective wealth of the lender is matched by an equal and opposite shock to the effective wealth of the borrower–the “Principle of Countervailing Wealth Effects.” Long-term fixed rates can mute the shock to the effective wealth of both sides, but absent a big change in the inflation rate will still typically lead the lender to feel better off with the change in rates and the borrower to feel worse off in terms of annuity equivalents (whatever the asset values on paper).
- In almost all cases, the marginal propensity to consume is higher for the borrower than for the lender, so that adding up the effects on borrower and lender, the wealth effects add up to a reduction in spending. The particular MPC that matters is the marginal propensity to consume of the borrower out of reductions in interest expenses and the MPC of the lender out of interest earnings.
- In addition to the wealth effects on the non-interest spending of the borrower and lender, there is a substitution effect on both borrower and lender toward spending less now simply because spending now is relatively more expensive compared to spending later when the interest rate is higher. (For the lender alone, the wealth effect may easily overwhelm the substitution effect, so that the lender may spend more when interest rates go up, but for the borrower and lender combined the wealth effect and substitution effect both go in the same direction given 1 and 2: toward less non-interest spending when the rate goes up.)
The Fiscal Theory of the Price Level Points to the Exception
The Fiscal Theory of the Price Level comes into play when there is an exception to the rule that the borrower has a higher marginal propensity to consume than the lender. This has happened historically along the path to hyperinflations. The key borrower-lender relationship for understanding hyperinflations is the one in which the government is the borrower and bond-holders are the lenders. If inflation and interest rates are changing rapidly the wealth effects on both sides of the borrower-lender relationship in which the government is the borrower can have extra complexities, but the Principle of Countervailing Wealth Effects still applies: any effective gain in wealth to the government is an effective loss in wealth to the bond-holders and any effective loss in wealth to the government is an effective gain in wealth to the bond-holders.
One possible issue is if there is an unexpected increase in inflation that reduces even the annuity equivalent of long-term government bonds, so that the higher inflation increases aggregate demand through a higher government propensity to consume out of that inflation windfall than the reduction in spending to those who have had the annuity equivalent of their bonds eroded by inflation.
Another possible issue is related to the one envisioned in Thomas Sargent and Neil Wallace’s “Some Unpleasant Monetarist Arithmetic.” Suppose government borrowing is short-term and that the markets demand inflation compensation according to the Fisher equation, and that the central bank pushes up the real interest rate as inflation goes up. If the government reduces non-interest spending more than the bond-holders raise their spending as its real interest costs go up, then the situation is stable. But if the government keeps its non-interest spending roughly the same (financing the rising deficit out of additional borrowing), then any increase in bond-holder spending will result in an increase in aggregate demand. Unless aggregate demand goes down as a result of the effect of rising real rates on other borrower-lender relationships, the situation will be unstable. That instability can easily lead to hyperinflation.
Failure of Stabilization with a Lower Bound on Rates
Now consider the opposite situation from a hyperinflation. Suppose the economy starts with aggregate demand below what would keep the economy at the natural level of output. Interest rate cuts should raise aggregate demand according to the logic his post begins with. But if interest rate cuts are stopped short by a lower bound on rates, there may still be a deficiency in aggregate demand. And the markets, knowing that balance may not be reachable given the lower bound on rates, will not have future expectations that are as stabilizing as one would hope.
How Eliminating the Zero Lower Bound Leads to Stability
As long as rates can go as far down as needed, the logic of countervailing wealth effects–with borrowers having a higher MPC than lenders–ensures that aggregate demand will eventually rise to equal the natural level of output. Expectations of this will exert a stabilizing influence. The only potential problem is if important borrowers have lower marginal propensities to consume than the lenders on the other side of that borrower-lender relationship. The most plausible case of such a failure would be the government as borrower. But even a government in the grip of austerity because of a concern about budget deficits and national debt, is likely to have a relatively high marginal propensity to consume out of interest savings because those interest savings are manifested as a lower budget deficit–as conventionally measured–than the government would otherwise face. That is, is it really plausible that even a government in the grip of an austerity policy would spend less on non-interest items than it otherwise would because its interest expenses went down? That doesn’t seem plausible to me. Whatever reduction in non-interest spending the austerity approach lead to in itself, a low enough interest rate should reduce interest expenses enough that the government should begin spending more on non-interest items. I would be surprised if it isn’t close to 1 for 1 (MPC = 100%) in an environment where many people will be pushing the government to spend more, and for austerity proponents, pointing to a high budget deficit is one of the few effective ways of pushing back on that pressure to spend more.
How, in the Event, the Stabilization Mechanisms Need Not Be So Fiscal After All
The confidence that a low enough interest rate would bring forth enough additional aggregate demand to equal the natural level of output, plus the confidence that the central bank can and will lower the interest rate as much as necessary (having eliminated the zero lower bound) will make the economy stable. And part of that confidence may be knowing that in extremis the interest rate mechanisms described above would lead to more government spending on non-interest items as the central bank cut rates. But that does not mean that (given the initial recessionary situation) equilibrium would, in fact, be restored by a large increase in government spending on non-interest items. Knowing that the economy would return to the natural level of output, investment would be more robust. And even if there is still a big deficiency of aggregate demand, interest rate cuts raise aggregate demand through all the other borrower-lender relationships as well–many of them relationships in which the government is not involved. So it is quite possible for aggregate demand to be restored to equilibrium with the natural level of output with a relatively modest response of government spending on non-interest items as interest rates drop. Indeed, it is quite possible for the direct effect of an austerity policy to exceed the effect of interest rate cuts on government spending on non-interest items, so that government spending on non-interest items remains below normal during the recovery. Aggregate demand doesn’t have to come from the government. Interest rate cuts will guarantee that it comes from somewhere–unless the whole thing is destabilized by implausible expectations of an implausibly low government marginal propensity to consume out of interest rate savings.
Why There Is an Asymmetry Between Hyperinflation and Stabilization in the Absence of a Lower Bound on Interest Rates
Because cutting non-interest spending can be very difficult, it can and does happen that a government sometimes does have a low marginal propensity to cut non-interest spending as interest expense increases. But in a serious recession when there will be clamoring for more spending from all sides, there is nothing likely to stand in the way of even a quite austere government increasing government spending on non-interest items somewhat relative to what spending on non-interest items would have been had interest expenses been higher. On the other side of the transaction, the typical MPC of government bond-holders is quite low. And there are many, many other borrower-lender relationships in which borrowers unquestionably have a higher MPC than the lenders on the other side of the transaction. Finally, all of that leaves out the substitution effect, which can be quite powerful in raising aggregate demand in response to interest rate cuts, once one is comparing it to the sum of wealth effects for the borrowers and lenders on both sides of a transaction rather than to the wealth effect for only the lenders.
Conclusion
Anyone who forgets to think about borrowers will never understand the transmission mechanism through which interest rates affect the economy. Thinking about borrowers as well as lenders shows just how powerful cutting rates can be in stabilizing the economy once the lower bound on interest rates has been eliminated.