Duncan’s Economic Blog

Cheap Money Revisited

Posted in Uncategorized by duncanseconomicblog on July 19, 2010

As regular readers might remember, last year I did series of posts on financial capital and the control of long term interest rates. In particular I argued that a truly “Keynesian” policy would be the cheaper money policy pursued by Dalton as Chancellor from 1945-1947. This would involve using debt management techniques to hold down long term interest rates.

This culminated in a very, very, very long post. Essentially my point was that many economists misunderstand the savings/investment relationship and have forgotten the crucial insights of Keynes’ liquidity preference theory. There’ll be more blogging on this soon I’m afraid.

There was a lot of scepticism at the time about how possible this all was.

Well, just quickly, take a look at this new paper from the Fed. In particular this bit on the effects of the Fed’s purchases of US treasury bonds:

Contrary to long and widely held conventional wisdom, large asset purchases can affect long rates, both domestically and abroad. Monetary policy’s effect at the zero bound includes international channels. The reduction in foreign bond yields and the value of the USD might have stimulated the U.S. economy through export channels, for example. From an international perspective, study of the LSAP [Large Scale Asset Purchases] effects implies that central banks should coordinate their asset purchase policies to avoid contradictory or overly stimulative effects. (my emphasis)

Or try this piece from last week’s FT on the world’s shortage of safe assets.

What this means for investors is the premium on safety and liquidity should remain high. Yields on Treasuries, Bunds and gilts can remain at historically low levels. This view contrasts with mainstream orthodoxy that government yields must rise along with soaring debt-to-GDP ratios.

Next to benefit will be highly rated corporate debt with low historical default rates. The longer government yields remain low, the more likely spreads will compress on investment-grade corporate bonds. Liquidity and safety in emerging markets are improving yet yields remain attractive and the upside potential for currency appreciation is strong. This must continue if the global safe asset shortage is to be properly resolved. (my emphasis).

Or examine how Greece (Greece!) successfully manged to sell E1.6bn of bills last week, with a bid to cover ratio of over 3.5x, after deciding to issue six month bills rather than one year ones.

Maybe liquidity preference matters, maybe central banks and debt management authorities can set, or at least hold low, long term interest rates. If so, this requires a fundmental rethink of how we conduct both monetary policy and debt management policy.


7 Responses

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  1. paulinlancs said, on July 19, 2010 at 3:25 pm

    That makes intuitive sense.

    Isn’t this another bit of the inflation-fear debunking jigsaw?

    ‘In our monetary system, the Federal Reserve controls short-term interest rates through open market operations. Bank reserves normally serve this purpose. If the Fed wants a higher Fed Funds rate, it drains reserves by selling financial assets and buying up reserves. If the Fed wants a lower rate, it adds reserves by buying up financial assets – usually Treasury bonds, but more recently it has taken to buying other assets. The quantity of reserves, of course, is irrelevant; the interest rate is what counts for the economy.

    Not sure I understand all this just yet, but it’s fun grappling.

    Now, if the Federal Reserve has absolute control over short-term rates, why isn’t it reasonable to assume it also has absolute control over long-term rates too?’

  2. duncanseconomicblog said, on July 19, 2010 at 3:45 pm


    This is all quite contentious – even the notion that Central Banks can absolutely control short term rates, they can control their own official rates (Fed Funds, Bank Base, etc) but not other ones as perfectly – such as LIBOR zooming up in 2007-09.

    I take the (Post) Keynesian position that CBs can effect a lot more control on interest rates and so can government debt management authorities – like the DMO in Britain. Basically I’m with Geoff Tily (his book on this is excellent).

    Conventional theory sees savers as supplying credit to borrowers and receiving interest as the price of this. Much of the current analysis of the deficit is premised on this notion – i.e. if we don’t cut the deficit fast enough, markets (savers) will demand a higher interest rate. As the demand for savings will have gone up (govt wants to borrow more) and so the price will have to rise.

    (Post) Keynesian theory, or at least one strand of it, inverts this relationship. It says that savers have already decided to save and they demand liquid assets to meet their savings plans. As long as a supply of safe liquid assets are made available, interest rates should be very low. The problem is that governments ignore the liquidity preference of borrowers and try to borrow on longer (illiquid) terms, causing rates to be higher. I’ll post on this again later.

    As Tily put it:
    “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.”

  3. chris said, on July 19, 2010 at 4:36 pm

    Welcome back Duncan!.
    You might add this from the Bank of England: “QE may have depressed gilt yields by about 100 basis points.”

  4. crossland said, on July 21, 2010 at 3:06 pm

    Duncan, I bought Ben pimlotts bio of dalton (very good !)on the strength of your interest inn cheap money.
    Pimlott argues that Cheap money ran into problems that were Political rather than economic.
    That resistance from the city/media became too big and that while initially there was little opposition to it it may have gone on too long and Dalton’s bluff was called.

    I think there is some resonance with the Heath govt bringing in credit + competion in 1970 , both were very radical but understood by hardly anybody at the time.

    Whats your take on this issue , was Dalton ahead of his time or missing an important piece of knowledge like your point about ‘liquidity preference ‘ ?

    • duncanseconomicblog said, on July 21, 2010 at 3:24 pm

      That Pimlott book on Dalton is excellent (so is his Wilson and his Labour and the Left in the 1930s).

      I broadly agree that it was media and city pressure that did for cheap money in the end.

      He, or at least his advisors’, were fully aware of liquidity preference, much of the basis for the policy was the National Debt Exercise conducted by Keynes in the war. I think partially the problem was that neither the Treasury not eh bank of England were ever really convinced on the merits.

      If you’re really interested, I highly recommend tracking down (via a library!) a copy of this:


  5. vimothy said, on July 29, 2010 at 9:56 pm


    But surely we would not expect the same behaviour from LT rates if private sector credit demand was less weak…?

    • duncanseconomicblog said, on July 30, 2010 at 10:41 am


      I’ve got another post coming this weekend whihc may deal with some of this stuff in more detail.

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