Duncan’s Economic Blog

Interest Rates

Posted in Uncategorized by duncanseconomicblog on November 4, 2009

Last night I started planning the three posts I promised yesterday. I think I may have to scale back my ambitions – but at least I didn’t make a ‘cast-iron guarantee’.

So rather than covering the issues raised in three (what would be very long posts) I shall instead cover them in a few more shorter posts.

What I’m arguing is that Government can control long term (as well as short term) interest rates and that through this they can increase investment levels in the economy. This has the short term economic effect of making the economy more stable, the long term economic effect of higher growth and the ‘political/social’ effects of reducing both inequality and the power of financial capital.

On reflection I intend to proceed as follows (probably with the odd post on other issues to break the tedium for those not at all interested): starting to today with a couple of definitional issues on interest rate policy, I will then discuss Keynes’ liquidity preference theory, the mechanics of how interest rates can be controlled, the history of monetary reform and finally some policy implications for now.

What I’m advocating is a secular cheap money policy – i.e. not just using low rates to combat depression but having them as a permanent part of our economy.

The first thing we must do is distinguish between ‘easy money’ and ‘cheap money’.

One objection that I expect to be raised to my proposal is that we already have a ‘cheap money’ policy – that interest rates have been held too low for too long causing asset price bubbles, global imbalances and excessive consumer debt . This is incorrect – a misunderstanding driven by economists’ (in many cases) poor knowledge of economic history.

In the past year much of the West has had a cheaper money policy (ultra-low rates at the short term and QE on longer term rates) but the real yield (adjusted for CPI inflation) on UK ten year bonds is still 2.6%. That sounds low. But from 1870 until 1913 it averaged 2.4% and in the 1930s 2.7% (not much higher).

Greenspan spoke of the ‘conundrum’ of low long term real rates earlier in this decade. In reality the period of the 1980s until last year was the real conundrum. As an IMF paper of 2006 noted:

We show that current levels of real interest rates on long-term bonds in advanced economies are not low by historical standards and that it is the real long bond rates of the early 1980s through much of the 1990s that look anomalous.

In short, current levels of long-term real interest rates of around 2 percent among advanced countries appear low from the vantage point of the 1980s and 1990s, but not so low when compared with earlier epochs. In addition, periods when long-term real interest rates are below the economy’s growth rate—as they have been recently in some advanced economies (notably the United States)—are not exceptional. This was clearly the case in the last two decades of the classical gold standard, the interwar period as a whole, and the early postwar period through the 1960s.

I define ‘cheap money’ as a policy of low real long-term rates. By this definition the period from the mid 1970s until very recently can be considered a period of ‘dear money’. And policymakers globally are already discussing a return to this policy.

It is noticeable that long term periods of cheap money are associated with long term booms.

If ‘dear’/’cheap’ money can be defined by price (the rate) then ‘easy’/’tight’ money can be defined by availability & supply. Since financial liberalisation in the 1970s – money has certainly been ‘easy’. Credit availability  increased and personal borrowing in particular soared.

The period from the mid 1970s until very recently then represents a time of ‘dear’ but ‘easy’ money. We are currently (with the policy response of low rates and QE but a broken banking system) in a period of ‘cheap’ but ‘tight’ money. The long term aim of policymakers appears to be a return to ‘dear’ but ‘easy’ money.  This is misguided.

17 Responses

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  1. dannyboy said, on November 4, 2009 at 10:39 am

    agree 100% with the distinction between easy and cheap money. I see this misunderstanding repeated ad infinitum in the press, on blogs, by nearly everyone from all political and economic spectrums.

    Even steve keen seems to suffer from this blind spot.

    It wasn’t low rates (cheap money) that caused the crack up boom, it was 125% loans, self-cert etc etc etc.

    Why was this allowed, and encouraged?

    Answer: to avoid a liquidity trap that would otherwise have developed post 2001.

  2. dannyboy said, on November 4, 2009 at 11:31 am

    regarding long bond rates this is interesting:

    http://www.bankofengland.co.uk/statistics/yieldcurve/index.htm

    See ‘UK instantaneous implied real forward curve’

    This is saying that in 25 years investors will be happy with a real long bond yield of 0%?

    What does that say about short term rates in 25 years?

    • duncanseconomicblog said, on November 4, 2009 at 11:38 am

      Dannyboy,

      Ah – the mysteries of the UK yield curve… I remember getting a long and complex explaination to do with liabilitiy driven investment by pension funds in long term inflation linked gilts having a major effect further out the curve.

      • dannyboy said, on November 4, 2009 at 11:45 am

        I’m sure complicated and contorted explainations abound for the shape of the yield curve!

        The simply explaination would be that in 25 years long term investors are expecting real growth to be non existent or negative, which is exactly the conclusion I’d come too looking at the demographics.

        I have seen one interesting suggestion that if short term rates are negative (either negative nominal or negative real where investors have a cast iron reason to expect inflation > growth ) that then the yield curve would be everywhere negative as investors move longer duration seeking to avoid loss.

  3. Luis Enrique said, on November 4, 2009 at 11:33 am

    Duncan,

    OK, I misunderstood you – I thought you were talking about intervention w.r.t. coomercial bank lending rates for given central bank lending rates, but you are talking about CB rate setting. In which case I fail to understand what you wrote about banks being able to create capital at will, and how we have financier capitalism based on the notion of scarce capital. I don’t see how low CB rates change any of that.

    I’m less comfortable with your distinction between cheap money and easy money. However ‘cheap’ money is, loans should always be restricted to borrowers who can be expected to repay. If you mean credit quality deteriorated – that is, default rates rose – then why not say that? And let’s see some evidence (you are talking about post 1970, not just the latest sub-prime fiasco). Because it can become “easier” to obtain credit (the hurdles can be lowered) without credit quality necessarily deteriorating – the two notions are distinct, and I’m not sure which you mean. They also have different implications – if money is “easy” without credit quality deterioration, that would seem to be a straightforwardly good thing – and also a left-wing thing, it means the people have access to credit, rather than just the rich.

    Your main claim, that low interest rates have “the short term economic effect of making the economy more stable, the long term economic effect of higher growth and the ‘political/social’ effects of reducing both inequality and the power of financial capital” is, as yet, unsubstantiated and it flies in the face of even Keynesian orthodoxy. I very much doubt you’d find support from, say, De Long or Krugman for this idea. The most obvious objection is that low rates are inflationary. It’s also not clear that the CB can sustain low rates if the market “wants” higher rates … how does the CB keep rates down? By buying bonds? Won’t the private sector run out of bonds to sell? It’s not obvious how much control the CB has over real rates in the long-run.

    Moreover, while you are no doubt correct that real interest rates from say 1995 to 2005 were not especially low from a historical perspective, nonetheless most people believe that even these not especially low from a historical perspective rates were too low, and helped fuel the housing bubble, wipe out the domestic saving rates etc.

    I’m not sure, myself, of the extent to which not especially low rates from a historical perspective contributed toward the current mess. here is one recent explanation that involves low rates, here is an alternative.

    But the question of whether a policy of trying push down interest rates is a good idea or not, is not entirely answered by knowing whether low rates contributed to the recent crisis. There may be other reasons why the policy would be misguided.

    • duncanseconomicblog said, on November 4, 2009 at 11:47 am

      Luis,

      Thanks for the detailed comment.

      Some of which I’ll deal with in latter posts on this topic.

      “In which case I fail to understand what you wrote about banks being able to create capital at will, and how we have financier capitalism based on the notion of scarce capital. I don’t see how low CB rates change any of that. ”

      A topic for another post – I’m just putting in place the building blocks right now.

      Personally I think the distinction between ‘cheap’ and ‘easy’ is useful. It goes far beyond loan quality – although that has obviously been the big issue of the last two years.

      As I will argue in latter posts ‘cheap money’ is necessary to underpin a level of investment that provides full employment. However ‘easy money’ can be associated with speculative booms/busts. Dalton was accused of trying to achieve the euthanasia of the rentier at the cost of supporting the speculator.

      This is important in policy terms. Japan’s two decades of attempting ‘cheap money’ ended up financing the yen carry trade.

      “Your main claim, that low interest rates have “the short term economic effect of making the economy more stable, the long term economic effect of higher growth and the ‘political/social’ effects of reducing both inequality and the power of financial capital” is, as yet, unsubstantiated and it flies in the face of even Keynesian orthodoxy. I very much doubt you’d find support from, say, De Long or Krugman for this idea.”

      I haven’t tried to substantiate it yet! But I will. I agree it flies in the face of ‘Keynesian orthodoxy’ but then I’m not a ‘Keynesian’ I’m a Post-Keynesian. And whilst i agree with Krugman and De Long on many issues – I aslo disgree with them at times!

      “The most obvious objection is that low rates are inflationary.”

      Again for a later post.

      “It’s also not clear that the CB can sustain low rates if the market “wants” higher rates … how does the CB keep rates down? By buying bonds? Won’t the private sector run out of bonds to sell? It’s not obvious how much control the CB has over real rates in the long-run.”

      Hopefully I get started on this topic tomorrow (work permitting). Starting from Keynes’ liquidity preference theory and building on the work Keynes’ did on monetary policy and debt management in the late 1930s/early 40s. Very quickly though – the Second World War was financed at about 3% despite the most severe financial strain possible.

      Thanks for the links. And so if it’s frustrating to only get half an answer.

      • Luis Enrique said, on November 4, 2009 at 12:50 pm

        Duncan,

        I appreciate the meat of your arguments is still to come!

        I’m still not clear if by “easy money” you mean lowering the barriers to credit (so, say, a working class entrepreneur might find it easier to get a business loan) whether you mean deterioration in credit quality. Some barriers are there to protect credit quality (income certification ref. mortgages) so making loans easier to obtain in some cases does mean deteriorating credit quality. You say it “goes far beyond credit quality”. As somebody who is concerned that banks have excessive power allocating capital and charging interest, presumably you want money to be as easy as possible, so long as credit quality is OK?

      • Luis Enrique said, on November 4, 2009 at 12:57 pm

        sorry, I should say I agree the distinction between cheap money and easy money is useful, only I’d probably prefer to talk about the distinction between cheap money and credit quality.

        If there is a way for money to get “easier” without credit quality deterioration, that’s a fundamentally different thing from “easier” meaning credit quality deterioration.

    • dannyboy said, on November 4, 2009 at 12:21 pm

      Luis,

      with regard to low rates you may find it useful to consider this graph:

      I think the trending downwards of interest rates is a complex phenomenon that appears to have been going on since the end of the war. I’m not sure why we would expect this trend to be suddently reversed now.

      By raising rates now we’d be swimming against a trend building in strength and momentum for a very very long time.It would end in tears.

  4. duncanseconomicblog said, on November 4, 2009 at 1:28 pm

    Luis,

    By ‘easy money’ I mean the whole twenty year trend of financial liberalisation and much of the ‘innovation’. In the personal space that would 125% LTV mortgages, self cert mortgages, 5x income lending. In the corporate sector it would mean developments such as PIK (payment in kind) loans.

    Yes – I undertsand that the problem with these types of lending is ultimately credit quality – but assessing purely by credit quality isn’t workable (CDOs rated AAA, etc). I simply no longer trust a free financial sector to avoid making these sort of mistakes.

    As for freeing uop access to credit. I support some kinds of free up but not others. For example your example of a working class entrepreneur – yes I’d generally support them having access to finance. But I do think that excessive personal lending has generally been associated wth excessive consumption growth. And the only solution I can see is more direct intervention in the loan market.

    This why I think it goes beyond simple credit quality – unrestricted easy money can easily led to a situation wherby consumption is far too big a share of GDP. I don’t want to see low interest rates simply used to propel consumption growth or to finance asset bubbles. I want it used, for want of a better term, ‘productively’.

    I recognise that credit is vital to the economy, but I also recognise that simply lowering the cost of credit would lead to all sorts of problems.

  5. Tim Worstall said, on November 4, 2009 at 1:32 pm

    “We show that current levels of real interest rates on long-term bonds in advanced economies are not low by historical standards and that it is the real long bond rates of the early 1980s through much of the 1990s that look anomalous.”

    Well, yes. We might take that as evidence that investors are rational and also even that the EMH is correct.

    Before the 70s (roughly speaking) no one thought we could have stagflation. We knew we could have inflation, but this was thought to be to do with specific events, like Weimar or post war Hungary. In general we (umm, they, I’m not that old) might have thought that the experience of the 150 years up to around 1950 was that inflation was usually cancelled out by later deflation and that the price level would be, over long periods of time, stable. As indeed, in many (most?) places it was.

    The experiences of the subsequent decades rather disabused investors of that rather quaint notion.

    So, in earlier times we have expectations of inflation and also expectations of deflation. Thus real interest rates over *current* inflation rates were x.

    We now have no expectations of deflation but we do have expectations that not only will inflation be permanent it will also be variable. The the real interest rate over *current* inflation is x plus to cover that higher risk.

    Investors are rational in that they are demanding a higher price for accepting higher risk. The EMH holds for pre the 70s no one did know (or even could know) that permanent and variable inflation, without periods of deflation, would become part of the standard economic landscape. When this new information was available, market prices changed to reflect it.

    (Umm, I’m sure that others have made this point more formally, this is just a reaction off the top of my head to the point made above).

    • duncanseconomicblog said, on November 4, 2009 at 1:51 pm

      Tim,

      I’m not going to allow myself to get side tracked into the efficient markets debate!

      Nice theory though.I’m not sure it quite stacks up. The UK price level has risen every year since 1930. Now yes, the 1970s saw much higher inflation than previously, but the point stands.

      Equally inflation-linked bonds display similiar behaviour.

    • dannyboy said, on November 4, 2009 at 2:36 pm

      “We now have no expectations of deflation but we do have expectations that not only will inflation be permanent it will also be variable. The the real interest rate over *current* inflation is x plus to cover that higher risk.”

      Wasn’t the real interest rate negative at points during the 70’s?

      One could make the case for having a negative real interest rate during conditions of a general economic contraction.

      It can be implemented by deliberately holding short term risk free rates some fixed percentage below inflation. Of course that says nothing about the long end of the curve. I’m curious to see how duncan thinks the long end can be controlled.

      • duncanseconomicblog said, on November 4, 2009 at 2:39 pm

        I’m now building up suspense…

        Quick review of liquidity preference first then we can move onto Keynes’ debt management techniques.

  6. cjenscook said, on November 4, 2009 at 5:42 pm

    There are several in-built assumptions here which IMHO will negatively affect, and possibly invalidate, any conclusions based upon them.

    Firstly, the assumption that Central banks are necessary. They are not, Hong Kong has never had one, preferring a monetary authority who regulate the private banks, and some observers think that the absence of a lender of last resort has kept HSBC’s mind concentrated wonderfully….

    But that is a digression – since private banks are not strictly necessary either.

    Secondly, that Money created as debt has a cost. It does not. Credit costs nothing to create at the time of creation, whether it is created by a trade seller; a private bank, a Central Bank, or even – as advocated by Social Crediters – direct credit creation by Treasuries or Treasury Branches.

    The cost of credit over time extended by a seller is the use value of whatever he has given up in exchange for the buyer’s IOU; for intermediaries creating credit ex nihilo the cost of credit is the interest cost paid on deposits; system cost; and the cost of defaults. For private banks add the cost of capital.

    Private bank credit creation became totally detached from central bank credit creation, and CBs are now -at the zero bound – pushing on a piece of string.

    The problem is that ownership of the wealth over which IOU claims are asserted – in a sort of mathematical echo – have become over-concentrated in too few hands. This is the inevitable result of the combination of compounding debt with private property in land. There can be no long term solution without what Phillip Blond calls “re-capitalising the poor”…and these days, maybe 95% of the population are poor, with their vast debts being held by the other 5% as creditors.

    Systemic fiscal reform is the only way out of the liquidity trap….and by this I mean a one-off “debt-equity swap”.

    For those interested in returns on investment, Gregory Clark’s book

    A Farewell to Alms has interesting data.

    As he points out, in Babylonian times the return on land,which was pretty much the only productive capital in those days, was 25% pa. By medieval times investment in land, buildings, etc had created enough ‘mathematical echos’ to reduce the price to yield 10% pa.

    By the dawn of the Industrial revolution (and the wave of modern finance capital which then funded it) the market price had fallen to 5%, and by the 19th century to 3% and so on. In my view the market price of the productive capital in terms of the financial claims created over it, is probably now between 0.5% pa or even less.

    This price is of course the risk free, rentier return, absent the inflation which is – in our modern economy directly caused by the combination of deficit-based money and the profit motive – ie Gunnar Tomasson’s “Final Demand Inflation” – mentioned here

    Mainstream economics and Iceland’s economic collapse

    In conclusion, money – which IMHO may best be thought of as a relationship, rather than as an object – cannot be described as either easy, or cheap.

    Credit, on the other hand, is another subject – as is the market price, and implicit yield, of productive capital such as location/land; energy in static and dynamic forms; and knowledge.

  7. Blue said, on November 5, 2009 at 11:47 pm

    Folks, I’d love your help. There is a very conservative, right-wing, borderline racist but certainly prejudice, professor at my alma mater. He runs a blog (which he encourages students to visit) and on it says some pretty ignorant things about Muslims, homosexuals, liberals… pretty much anyone not Republican. Which is odd, since he is Canadian.

    Anyways, I’ve been fairly consistent in opposing his viewpoints in logical comments to his posts. Quite a number of times he’s deleted my comments because he didn’t appreciate my opinion or when I proved that he was a hypocrite. It’s been fun, but I’d love to take it to the next level.

    I’d appreciate it if you could visit his site and begin to post in the comments section. Having a flood of opposition is surely to confuse and frustrate him, and there’s nothing I love more than a conservative who’s frustrated at being proved wrong.

    The site is sleepyoldbear.com . Oh, and tell him Blue sent you.

  8. newmania said, on November 9, 2009 at 10:38 am

    at least I didn’t make a ‘cast-iron guarantee’

    BTW- I `d stay out of that if I were you.


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