Cheap Money & Interest Rates
This is a long (4,500 words) post. It has taken me quite some time to write up. There is more to come – focussed more around history & politics. I fully understand if only the most dedicated read it.
A few weeks back I wrote a post in response to Open Left’s question on the Future of Capitalism. I fleshed out similar ideas in a post for Social Europe. I considered the nature of the current financial system – broadly put: finance capitalism and drawing on the insights of Keynes and the work doen by the Labour Party in the 1930s concluded that:
A policy of undermining the scarcity of capital through low interest rates whilst harnessing the power of finance to ‘the service of the community’ would herald the shift from ‘finance capitalism’ to the next stage of development. In many ways it represents the unfinished legacy of the Attlee Government.
As Keynes wrote:
I see, therefore, the rentier aspect of capitalism as a transitional phase which will disappear when it has done its work. And with the disappearance of its rentier aspect much else in it besides will suffer a sea-change. …
Thus we might aim in practice (there being nothing in this which is unattainable) at an increase in the volume of capital until it ceases to be scarce, so that the functionless investor will no longer receive a bonus; and at a scheme of direct taxation which allows the intelligence and determination and executive skill of the financier, the entrepreneur et hoc genus omne (who are certainly so fond of their craft that their labour could be obtained much cheaper than at present), to be harnessed to the service of the community on reasonable terms of reward.
I suspect that some readers have been awaiting a rather dry, quasi-academic post, dealing with the technical economic aspects of the control of interest rates and how this is achievable. I may disappoint as whilst this post will certainly be dry and possibly a bit technical at times, it is impossible to confine myself solely to economics.
Because that is the route of the problem – economists confining themselves to economics and politicians to politics and theory. What the left has to recognise is that what matters is political economy. The conventional wisdom of the economics profession, variously called ‘neo-liberalism’, ‘neo-classical economics’, or whatever is not simply an academic theory or a observation of how the world works in practice – it is a model of political economy – a notion of how the world should operate. It embodies power relationships and assumptions about political and social organisation. The dominance of financial capital over both workers and industrial capital is embodied in our conventional thinking. Indeed the notion of, for want of a better, less loaded term, ‘class interest’ is almost entirely absent. But this does not have to be the case. To turn once again to Keynes:
Interest today rewards no genuine sacrifice, any more than does the rent of land. The owner of capital can obtain interest because capital is scarce, just as the owner of land can obtain rent because land is scarce. But whilst there may be intrinsic reasons for the scarcity of land, there are no intrinsic reasons for the scarcity of capital.
The idea that financial capital does not have to be scare and that interest rates can be controlled provoked some controversy in the comments on my previous posts. It is to this question that I’ll turn today.
Money , Savings & Investment
But before turning to the immediate question, it is worth going over some old ground first. The detail in each case is provided by previous posts, so I’ll merely summarise the issues here (those especially interested can refer back).
Readers might be advised to first refresh themselves of some of my views on ‘money’. In a post a few months ago I noted that:
Basically the growth of the shadow banking system and the use of Special Purpose Vehicles (SPVs) in securitisations has potentially ‘broken’ the monetary data. Simply put there are now lots of quasi-banks which are not technically banks and so not treated as banks in the official data. Their holdings of money are included in the monetary data and have the effect of inflating the numbers – even when it will have no effect on economic activity in the traditional sense.
The effects have been dramatic. It’s worth taking a look at the ‘sectoral’ monetary data that the BOE produces monthly. In February M4 growth has a rapid +18.7%, but the growth of households’ money was a very modest +4.2% and the growth of non financial corporations’ money was actually a negative -2.1%! This was all hidden by non-bank financial business holdings of money growing at a staggering +55.6%.
A monetarist would argue that if we double money supply then we simply double prices and have no real change on economic activity. I’d argue that if we double prices, we typically don’t double debt and so the debt burden on consumers and corporates is reduced in terms of spending power available after debt payments and economic activity will shift as a result. Similarly if prices move down, and debt stays constant in nominal terms, then spending power – and hence effective demand, is reduced. This is what worries me about the prospect of deflation – we step outside the typical bounds of the business cycle and face disaster.
I’d argue further that money supply in and of itself is not the crucial variable – the crucial variable is credit, i.e. lending. It is lending that drives economic activity not money. Economists have focused on money for a long time. For decades this was reasonable. As most credit came from banks, money growth was a decent proxy for credit growth. As deposits (money) grew, and the liability side of the banks’ balance sheets expanded, credit also grew (the asset side of the banks’ balance sheets).
This cozy relationship though may no longer hold. The growth of ‘other credit providers’ – specialist mortgage lenders, credit card companies, car finance, store cards, the shadow banking system, etc – might have caused this relationship to break down. So money supply might soar with little impact on inflation or activity. Or banks might want to reduce their loan to deposit ratio from 130% to 100% (or even 90%) – again money supply (deposits) could soar with no growth in lending and hence little impact on activity. Mechanical monetarism doesn’t work.
The point of all the above is that ‘money’ is not as simple as many people seem to assume. The relationship between ‘money’ and credit is unstable and uncertain.
Money stopped being simple as the economy shifted from a system based on ‘commodity money’ (backed, typically by gold) to a system based around ‘bank money’ – essentially created by banks through lending, to the modern system of ‘finance capital’ – where ‘money’ may be consist of various types of financial instruments – many of which can be created by certain institutions and groups almost at will. This is something which central bank statistics on ‘money’ struggle to capture, as noted above.
Is there much difference between a loan extended by a ‘bank; and a loan extended by a ‘consumer finance company’? Or extended by a retailer offering an instalment plan on a new sofa? The traditional idea of banks taking deposits and extending credit is a million miles from the current situation.
Against this background it is important to be clear on the relationship between savings and investment. ‘Savings = Investment’ is an economic accounting identify. In the traditional ‘neo-classical’ view savings cause investment, in effect savings represent deferred consumption and saver is rewarded for this by being allowed them fruits of their saving. Saving is a virtue and as saving drives investment and hence growth is a very desirable virtue. The Keynesian notion of the ‘Paradox of Thrift’ is absent from this world. Or at least only holds in the very short term.
Again I’ve written about this fairly extensively over the past few months, most notably here.
I quoted Holt & Pressman:
Thus, Post Keynesians and neoclassicists can pretty much agree on definitions of saving and investment, for example. They can also agree that in a simple economy with no government and no foreign trade, savings must equal investment. This is, in fact, a basic national income accounting identity. Where these two schools differ is not here, but in how they see the causal nexus between the two. For neoclassicists, savings cause investment; it provides the funds needed to build new capital equipment. In contrast, Post Keynesians hold that investment determines savings. Investment can be financed by borrowing from banks, which does not require savings because banks create money by lending. Investment, in turn, generates jobs and incomes. Some of this income will be spent, and the rest saved; thus, at the end of the process, savings come to equal investment.
Empirical Post Keynesian Economics, Holt & Pressman (Emphasis mine).
In the comments, John from the much missed Post Keynesian-Observations blog gave a very clear exposition on Post-Keynesian versus neo-Classical thought:
My position on Investment-Saving is this. First off, I would agree with Duncan that the equality between the two is a mere accounting identity. These two values (in a closed economy with no government–gets a bit more complex if you include them, but still same basic story) must, ex post, be the same. Planned saving and planned investment need not be equal, however, and therein lie the interesting stories.
Take, since it fits in with the discussion above, a situation in which planned investment is greater than planned saving. As you all have observed, what happens next depends on your view of the financial system. In the classical loanable-funds version, where savings is an absolute limit on the credit banks can extend, the planned investment cannot take place as it cannot be financed. Well, it goes up some, but only because savings rises, too. What happens is that the excess of investment-funding demand over savings causes a rise in the interest rate. That leads to both a decline in planned investment and a rise in saving. They will come to rest at a new, higher level of investment and saving. In this world, savers had to be goaded into saving a bit more or the investment could not take place and the rate of interest plays the role of setting S=I.
Keynes (whose work is not represented by the “Keynesians” or the IS-LM model) disagreed, and Post Keynesians have extended his view thusly. Banks have a great deal of latitude, despite the reserve requirement, in terms of their ability to create credit. Banks are almost never “loaned up,” and the entrepreneurs in the banking sector are very creative in terms of coming up with new instruments that others will accept as collateral or payment. Is this ability endless? Some Post Keynesians think so (they are called “horizontalists,” for their view that the money-supply curve is horizontal), but I don’t agree. Surely it must become more and more expensive to squeeze another ounce of credit from the system. But, apparently, it’s a very long time before it becomes prohibitively expensive, such that in general banks do not have a terribly difficult time creating new credit. And one of Keynes’ major points is that savings is not the limit, liquidity preference is. Without going into great detail, we prefer to remain liquid when we are concerned about the future. Funds held in fairly liquid accounts are more difficult for banks to loan out (take a–and I’m not sure of the British equivalents here–checking account versus a savings account). So they will have to move to more expensive options. But they are not out of options.
In terms of savings being necessary, that is absolutely true, but only in a relatively trivial sense. Banks must have some assets, to be sure, but only enough to cover the eventuality that they are forced to make good on the many promises they have made. While there are, as Tim points out, reserve requirements, there is still a lot of wiggle room–enough to make it absolutely possible for investment to rise without a prior increase in saving. In fact, that’s the typical pattern for, as Duncan points out, who wants to invest when consumers are saving more? I asked this of a Neoclassical colleague one day, incidentally, and he was flabbergasted. He’d never thought about it before! That’s something else that’s going on below the surface here, by the way. The traditional model used by my Neoclassical colleague is really set up to explain a different world, one in which full employment is either assumed to exist continuously or at least as the only equilibrium position. The salient issues in such a world are very different from Keynes’, where less-than-full employment is not only seen as possible, but likely. Why, indeed, bother about the effect on demand of rising savings if full employment is guaranteed? But, what if it is not. Now this requires consideration of some very different questions.
To summarize, the traditional argument assumes the following sequence:
rising S => falling interest rates => rising I (until S =I)
Post Keynesians argue:
rising S => falling demand => falling I => falling incomes => falling S (until S=I)
The concept that investment determines savings, rather than savings driving investment is crucial to all that follows. As is the acceptance of the notion that banks (or quasi-banks) can ‘create money’.
What neither myself not John touched on in any detail was the determinants of the rate of investment. This is crucial. And will be dealt with more fully at a later stage. But important to bear in mind at this stage is that investment is the most volatile component of GDP and often the largest component of short term recessions, as well as the driver of long run economic growth.
Interest rates & Liquidity Preference
Following the preceding discussion of money, savings & investment attention can now be turned to interest rates. The first thing to note is that a ‘pure economic’ approach risks missing factors. As Ann Pettifor wrote in ‘The Crash, A View from the Left’ :
As the Credit Crunch took hold after the events of August 2007, central bank governors succumbed to demands from the banking sector to immediately lower official interest rates. However, privately-fixed interest rates – fixed in London by the British Bankers Association and known as LIBOR (the London Inter-Bank Offered Rate) – continued to rise, in defiance of the official rates set by central banks. This was the clearest evidence yet seen of the loss of control by central banks and governments over a key lever of the economy – the power to set the rate of interest over all loans, whether short, long, safe or risky. The growing gulf between LIBOR
and the lower official rates fixed by central bankers showed the impotence of central bank governors in the midst of financial meltdown. The guardians of the nation’s finances had ceded control over one of the most important levers of the economy – one that determines the cost of debts, the gains to be made by lenders, and the ability of borrowers to repay. The rate of interest is a social construct, not a product of market forces. By ceding control over rates, central bankers had raised their hands in surrender, abandoning the helm of the ship that is the economy, and with it millions of innocent victims of the crisis. (My emphasis)
This idea that the rate of interest is not solely determined by market forces is not as unusual as it sounds. Joan Robinson, an early Keynesian, wrote that:
‘The most important influences upon interest rates – which account for, say, the difference between 30% in a Chinese village and 3% in London – are social, legal and institutional’.
Neo-classical theory generally holds some form of ‘loanable funds theory’. This can be summarised as follows:
The loanable funds theory is a theory of the determination of real interest rates – that is, rates of return expressed in terms of real purchasing power. The theory derives from the notion that savers make a decision between consumption now and consumption in the future. The more people consume now out of present income (and the less they save and hence the smaller are the funds available for investment), the lower will be future income. Thus, a trade off always exists between present consumption and future consumption. It is assumed that people would prefer to consume now, other things being equal. Hence, to persuade them to save and provide funds for investment, they must be paid interest. The real interest rate is therefore the rate needed to persuade people to forgo present consumption. It was sometimes referred to as the reward for waiting – the reward for postponing the pleasure of consumption and waiting to consume later. It follows that savings will be positively related to the rate of interest.
Real investment, on the other hand, is a negative function of the interest rate since the interest rate reflects the productivity of investment projects. The lower the rate of interest the more investment projects become profitable and the more willing investors will be to borrow in order to invest. Thus, we obtain savings and investment curves.
Thus, the real interest rate is determined by the intersection of the demand for savings (the willingness to forgo present consumption – sometimes referred to as thrift) and the demand for investment (reflecting the productivity of investment projects). This all assumes that present income and the rates of return on investment projects are known, allowing people to make a rational choice between goods now and goods in the future.
Keynes, on the other hand, argued instead for the theory of Liquidity Preference. This can be summarized as:
We have noted above, however, that the notion that people make rational decisions about the allocation of real income between the present and future periods requires them to have a great deal of knowledge about real income in the current period and about real rates of return into the future. Potential investors also must know a good deal about the profuctivity of future investment. It is easy to argue that in the real world this level of information and of certainty about the future does not exist. It is also easy to argue that in fact people bargain over and make decisions about nominal values rather than real values and about the present rather than the future.
If one accepts these propositions, it is possible to adopt the view taken in the IS-LM model at the beginning of the course – that the key element in determining the actual amount of saving that takes place in a given time period is the level of income itself. Interest rates might, of course, have an impact on savings levels but the difference between the amount of saving in one period and that in another is much more likely to be because the level of income has changed. In other words, people make saving plans on the basis of their expected level of income and the expected rate of inflation (as in the loanable funds model) but these plans are often not fulfilled because their expectations, especially about the level of income, are frequently wrong. Under these circumstances, the most pressing question does not concern current and future consumption but is about the way in which to hold the existing level of wealth. In an uncertain world, people seek a degree of liquidity and it is this demand for liquidity that is a major element in the determination of interest rates.
Crucial to the liquidity preference theory is the role of uncertainty – a central factor in (Post) Keynesian thinking. The quote above represents traditional ‘Keynesian’ thinking rather Post Keynesian thinking – hence the reference to the IS-LM model.
Geoff Tily, in his book ‘Keynes’s General Theory, The Rate of Interest and ‘Keynesian Economics’’ provides a very clear exposition of liquidity preference from a Post-Keynesian view, building on earlier work and extending the theory to other financial instruments rather than simply ‘money’. One problem that liquidity preference theory suffers from is that ‘money’ serves more than one purpose – it is both a store of value and a medium of exchange – this has to be accounted for.
Tily notes that whilst the theory of money as a medium of exchange (or active money) concerns the creation of and day to day use of bank money. The decision relates to whether to hold cash or bank deposits. By contrast:
the theory of money as a store of value (inactive money demands) concerns, matters that occur after the creation of bank money. Inactive money demands are demands for liquid assets into which holdings of wealth can be placed as an alternative to illiquid bonds. In general, the institutions carrying out the majority of such transactions are not households but financial institutions on behalf of households.
As Tily further notes, for financial institutions the key short term liquid asset is the bill. ‘The speculation that Keynes discussed takes place in practice between bonds and bills’. ‘From the perspective of wealth holders, the supply of bills is a specific component of a wider supply of assets across the whole spectrum of liquidity. From the perspective of the issuer, the supply of assets is a supply of debt’.
At this point Tily makes his, to me at least, important claim:
“In liquidity preference theory, households demand liquidity for their stock of wealth; while in the classical model, households supply a flow of saving.”
The crucial feature of liquidity preference theory – which empirically is a far better fit for the real world than the loanable funds theory – is that it totally reverses classical thought on savings.
Households (via financial intermediaries) demand financial assets, rather than supply savings.
Interest Rates & Debt Management
Armed with the insight outlined above, Tily writes:
…firms and governments need only pay a rate of interest for loans if they supply insufficient short-term assets (leaving aside risk considerations and administrative costs). The reality is that the interaction is mutually beneficial: households need to find an outlet for their savings, and businesses and governments need finance and funding.
The notion that through manipulation, or rather accommodation, of liquidity preference interest rates can be controlled is not explicit in the General Theory. It has however regularly found in his later works and was implemented during his time at the Treasury (perhaps the best statement of it comes in the National Debt Enquiry (NDE) of 1945). The most comprehensive review is to be found in Tily.
To sum up, interest is paid not as a reward for parting with savings but as a reward for the parting with the liquidity of wealth. Firms and governments do not need to encourage households to save to gain access to their idle resources. If firms and governments are willing to borrow on liquid terms then they would not need to pay any reward for access to those resources…
Debt management policy should permit a sensible and coherent framework for the balancing of firms’, government’s and households’ differing preferences towards holding and borrowing wealth with degrees of liquidity/illiquidity.
Tily shows how Keynes set out (in the NDE) practical policies aimed allowing governments to set rates of interest across the whole spectrum of liquidity. This then underpins the prices for all other types of debt.
The problem, as Keynes saw it, was that government debt issuance generally was a manifestation of the government’s own counter-liquidity preference, the desire for long term debt. As the public’s liquidity preference was not considered in any detail – the rate was higher than it needed to be.
Keynes policy had several stages.
First, the conventional method of issuing government debt should be abandoned in favour of a mthod allowing the public to stay as liquid as they liked. This was the ‘tap issuance’. Under a tap system the government announces the price and maturity of a bond being issued, but sets no limits to the amount to be raised. The ‘tap’ was held open – rather than being all issued on a given day through an auction – so that institutions and individuals can purchase as much as they want, whenever they want. In effect the public chooses the quantity of debt issued at each degree of liquidity at a price set by the government.
Second, the degrees of liquidity available were extended by issuing debt at a wider range of maturities.
Finally, the notion of diminishing returns on capital play an important part in a cheap money policy. Once the public become aware that the long term rate of interest would move in line with the yield on capital, then would come to appreciate that the long term direction of interst rates was down.
Once the real determinants of interest rates have been grasped (liquidity preference rather than loanable funds) then the management of expectations and the accommodation of liquidity preference through a radical form government borrowing, can be used to lower rates across the whole spectrum of time.
This article has mainly dealt with the theoretical aspects of Keynes’ work. A subsequent article, (hopefully not as long!) will deal both with the historical experience of the 1945-1947 and with the important work done by the Labour Party in the 1930s of integrating Keynes ideas into a left wing framework. Keynes may have been a Liberal but as Dalton noted his policies could be used ‘for socialist ends’. The implementation of these policies however is in direct conflict with the desires of financial capital.
Suffice to say at this point that not only did the implementation of these policies, by a Labour Government committed to reform, work, in the worst imaginable financial conditions but as Tily writes:
The policy eventually culminated in an attempt to hold long-term rates at 2.5% from which the Government eventually retreated. Yet this ‘failure’ should not detract from the more general preservation of cheap money under the Attlee government. Its economic and social achievements arguably stand apart from those of any other government in history. In the wake of post-war debt and currency instability, the economic growth and employment performance were outstanding.
But the Labour Government lost office in the wake of infighting caused by the Korean War. The Conservative Party took office, and in November 1951 the re-activation of the discount rate as an instrument of economic policy was symbolic of the end of the monetary polcies of the post-depression age.
The Labour Party Victory at the 1945 general election had made the financial reform agenda that had been debated for a half a century a brief reality. As with Keynes’s theory itself, this policy, its successes and failures are largely lost to history.