Financial Markets in Keynesian Macroeconomic Theory 101

class insession

Yesterday when I published my post on Krugman and the vulgar Keynesians not understanding the meaning to the term ‘liquidity trap’ I came to realise that many readers — both sympathetic and hostile — do not really understand the Keynesian theory of financial markets. I then realised that this was actually quite understandable given that it is not much discussed today (with some notable exceptions such as Jan Kregel and Minskyians like Randall Wray).

Some years ago the financial markets were very much so discussed and understood. Key references in this regard are the works of Keynes himself (particularly the Treatise on Money), GLS Shackle, Roy Harrod’s book Money and Joan Robinson’s essay ‘The Rate of Interest’. There are also some more minor works but I will not here provide a bibliography. (From a purely theoretical point-of-view I have found Shackle’s work the best while from an institutional point-of-view I have found Harrod’s work best).

Okay, let’s first start by what we mean by ‘cash’ and ‘bonds’ in Keynesian financial theory. Most people are being led down a wayward path by the likes of vulgar monetary economists like Krugman in this regard (or was he a trade economist? someone remind me…). They seem to think that ‘cash’ is money — deposits, notes, coins, that sort of thing — and ‘bonds’ are government securities. Actually, in financial marketspeak cash includes short-term government securities. It also includes money market funds and other highly liquid investments. There is a nice guide to this at the money manager Charles Schwab’s website here. In this guide the author writes:

What is cash?

Many people think of cash as physical currency—actual bills and coins in circulation. For practical purposes, however, the term “cash” also includes traditional bank deposits, such as checking and savings accounts, where you generally have access to your funds on demand and without risk of losing any principal (up to FDIC limits).

In an investment context, however, the definition of cash expands to other types of cash investments, including short-term, relatively safe investment vehicles such as money market funds, US Treasury bills (T-bills), corporate commercial paper and other short-term securities.

For the purposes of financial macroeconomics I think that we would be best to exclude corporate commercial paper. This is very short-term debt issued by corporations. Although highly liquid, it nevertheless displays many dynamics associated with what should properly be called ‘bonds’. I would also say that, following the Modern Monetary Theorists (MMTers), we should probably be clear that government securities should only be treated as cash proper if they are denominated in the currency of issuance. (For practical purposes we can modify this when needed).

What about stocks? Stocks are unusual in that they do not yield a rate of interest. Yes, they throw off dividends but this is not the same thing. The rate of interest on bonds is inversely related to the price of the same bonds. When the price rises, the rate of interest falls. When the price falls, the rate of interest rises. On stocks, however, this relationship is by no means clear. Dividends are a completely different beast. Nevertheless, we can count stocks as ‘bonds’ to a large extent if we remember that they do not have the same interest rate dynamics. Stocks are generally expected to rally when the price of actual bonds is high and their interest rates low.

Now this might seem rather odd because we all know how central banks control the interest rate, right? When the central banks want to lower the interest rate they buy up government securities, while when they want to raise the rate of interest they sell government securities and drain reserves. But if government securities are counted as ‘cash’ this really makes no difference. What the central bank is trying to do is to use cash and cash substitutes (government securities) to affect the interest rates in other markets.

The primary goal of, say, lowering the interest rate is to allow companies to borrow more cheaply. Here is a nice graph showing some interest rates to get a feel for what is going on in the financial markets. We will examine this in more granular detail later.


As we can see, the three-month Treasury bill rate tracks the overnight rate set by the Fed. This is because these are basically cash substitutes. The Corporate Baa Bond Yield, on the other hand — and this is only one of many interest rates I could have chosen — does track the other two to some extent but not completely. Although it generally gravitates toward the overnight rate it does display some independent dynamics of its own.

The gap between the yield on bonds and the ‘cash’ interest rate — to deploy our terminology — is a measure of what Keynes called ‘liquidity preference’. It reflects the market’s taste for low yield ‘cash’ over higher yield ‘bonds’. Let us be clear: in a functioning market there will always be a spread here to reflect relative risk. But, as we shall see, this spread is not fully under the control of the monetary authorities at all times and the amount by which it fluctuates day-to-day and month-to-month is reflective of liquidity preference. Schwab provides us with a nice table telling their customers how to hold this ‘cash’ liquidity.


Very broadly speaking we can say, in Keynesian terms, that checking, saving (and deposit) accounts are used for what Keynes called the ‘transactions motive’. While all the others are used for what he called the ‘precautionary motive’ and the ‘speculative motive’.

Let us zoom here on a recent period to get a better idea of what is going on.


Here I have marked two recent periods where we see financial markets clearly responding to increased perceived risk. Looking at the time series we see that the Baa Corporate Bond Yield follows the overnight rate quite smoothly. But just prior to the 2001 recession while there was turmoil in the stock markets we see a clear, small spike that is not in keeping with the general smooth movement. This spike accounts for a jump in interest rates on Baa bonds of nearly 0.5%. This may not seem all that significant but in the land of the financial markets it is a very significant event and is indicative of heightened liquidity preference.

The second period I have marked is much more extreme. Here the Fed was rapidly lowering interest rates. Markets were anticipating this lowering too. Yet the Baa bond yield spiked by two full percentage points. This is a liquidity trap proper. The market were roiled by the turmoil that was taking place after 2008 and they all rushed for cash even though the interest rate on this cash was falling. By 2010 the liquidity trap had subsided. This was mainly in response to the markets coming to believe that the bailouts were convincingly going to fix the financial system. TARP did more to ease the liquidity trap, I would argue, than QE did.

Well, that’s all for today class. Use this knowledge to go out and attack the vulgar Keynesians that are clogging up the general discourse with poorly defined terms and nonsense. Today we do not face a liquidity trap. Rather we face a situation in which investment is not responding to low interest rates. That is what vulgar ISLMist Keynesians call an ‘investment trap’ and it takes place when the IS-curve on the ISLM diagram is vertical. While I do not buy into this notion it is far closer to where we are today than being in a liquidity trap. If one must worship at the temple of ISLM at least get it right, for God’s sake!

Posted in Economic Theory, Market Analysis | 19 Comments

Paul Krugman Does Not Understand the Liquidity Trap


I came across a very amusing piece from Krugman in 2010. The piece is entitled ‘Nobody Understands the Liquidity Trap‘. Actually, Krugman might have a point — if we include him in the ‘everybody’ that does not understand the liquidity trap and thus conclude that he, and all those that listen to him, do not understand the liquidity trap.

You see Krugman confuses the zero-lower bound for the liquidity trap. But in doing so he completely scrambles the meaning of the term ‘liquidity trap’. Let us first get a feel for meaning of the term ‘liquidity trap’. Here is Keynes in the original. In the General Theory he writes:

There is the possibility… that, after the rate of interest has fallen to a certain level, liquidity-preference may become virtually absolute in the sense that almost everyone prefers cash to holding a debt which yields so low a rate of interest. In this event the monetary authority would have lost effective control over the rate of interest.

So, a liquidity trap is a situation when the central bank pumps in money and the rate of interest doesn’t respond. People say: “Meh, I don’t like the look of those bonds, I’ll just hold this cash”, and so bond prices remain low.

Krugman, on the other hand, has completely confused two concepts — that of a zero-lower bound scenario and a liquidity trap. You can see this clearly in his 1998 paper where he writes:

A liquidity trap may be defined as a situation in which conventional monetary policies have become impotent, because nominal interest rates are at or near zero: injecting monetary base into the economy has no effect, because base and bonds are viewed by the private sector as perfect substitutes. (p141)

Um, no. A liquidity trap is when people say “nah, I don’t want bonds, I want money”. It is a situation in which the rate of interest on bonds do not respond to an increase in base money. Let us be clear: in a liquidity trap people do not want to hold bonds. In a liquidity trap cautious investors spit bonds back onto the market, their prices fall and their yields rise.

It is thus obvious that a liquidity trap occurs when the rate of interest gets ‘stuck’ and does not respond to an increase in base money. As I have argued before, we saw this in 2009-2010 when interest rates on risky assets failed to respond to Fed intervention. But we do not see this today. The central bank have not today, as Keynes puts it, “lost control over the rate of interest”. After 2009 interest rates came down across the board in response to actions by the central bank. Today it is well-known to even the most myopic mainstream economist that we live in a low yield environment.

What we do see is a zero interest rate. But that is just a zero interest rate. It is not a liquidity trap. We know this because bonds are still very much so in demand. Whereas in a liquidity trap people want to hold money instead of bonds. That is not the case today. Today people are desperate to get their hands on bonds because holding money is eroding their portfolios due to the substantial negative yield being incurred. But in a liquidity trap, as Keynes says, “almost everyone prefers cash to holding a debt”.

Let’s just get that straight: the key symptom that indicates that there is a liquidity trap is that people want to hold cash instead of bonds. Let me state that one more time in a different way: a liquidity trap is when there is a panic across financial markets, people rush to cash and no matter how much cash the central bank issues the demand for financial assets remains depressed.

Last week Janet Yellen said that she was concerned that people were too eager to hold junk bonds. And here are Krugman and the New Keynesian brigade telling us we’re in a liquidity trap. It is completely absurd. What has occurred is that monetary policy has failed to revive the economy. That’s a sad day for mainstream economists who have believed for over three decades that monetary policy is a panacea. But it is still not a ‘liquidity trap’. That term has a specific meaning. It is useful. Equating it with the central bank setting the interest rate near zero is equivalent to destroying the term and sucking it of its meaning.

It gets worse when you think this through in more detail. Recall that for Keynes a liquidity trap is when “the monetary authority would have lost effective control over the rate of interest”. But have the monetary authorities lost control over the rate of interest at the zero bound level? Nope. Anyone who has actually read Keynes’ great work knows that in it he discusses Silvio Gesell’s ‘stamped money’ which would be an obvious way for the monetary authorities to impose negative interest rates of their choosing. Keynes writes:

According to this proposal currency notes (though it would clearly need to apply as well to some forms at least of bank-money) would only retain their value by being stamped each month, like an insurance card, with stamps purchased at a post office. The cost of the stamps could, of course, be fixed at any appropriate figure.

(There are quite a few variations on this idea some of which I’ve noted before — although I’m not very enamored with the idea).

So even by the simple criteria of whether the monetary authorities have lost control over the interest rate it is obvious to any reader of the General Theory that they have not. No liquidity trap here folks!

Now, I know the response to this. “Ugh! You read too many books Phil! Reading books is for humanities students! I’m an economist, I do maths and stuff and I’m a really super serious sort of person that only cares about economic theorising, I don’t care what Keynes said or what other books say, I only care about Science,” says our typical mainstream economist.

Well, this is the thing: the actual concept of a liquidity trap is a very useful tool when applied to understanding financial markets; especially when they go into meltdown. Minsky, for example, uses it at critical points in his work. Meanwhile the Krugmanians deploy it as a fancy sounding word for what is a simple and banal concept: zero interest rates. They use it to give authority to the fact that their economic theory today ultimately says “the Fed can’t lower interest rates past zero therefore we cannot rely on them to revive the economy” which is so flagrantly obvious a monkey could have come up with it — indeed, those who have read Chapter 23 of the General Theory  on stamped money know that this statement is not even true and that our simian pal would be wrong.

“Hey, I want to hide the fact that I’m saying something banal so I’m going to use this fancy-sounding word that is in Keynes and is related to the ISLM,” say the Krugmanians. I’m saying rather that we should define the concept of liquidity trap properly because it is a useful and interesting analytical tool, especially when trying to understand what happens in a crisis scenario when the demand for cash really rockets and the monetary authorities really do find that they have lost control over the price of financial assets (and, hence, interest rates).

Which usage is closer to a ‘scientific’ usage. Well, only you, dear reader, can decide that. But that decision will likely be informed by how good an understanding you have of actual financial markets and how they affect the macroeconomy. Let’s just say that economists like Minsky are a better guide than people hocking the ISLM, easily the crudest tool ever invented by a Keynesian monetary economist (Hicks himself, who became quite a good monetary economist after that particular car crash, later basically said this lest we need be reminded).

If you want to understand nothing about financial markets read Krugman and play with the ISLM, if you actually want to understand how financial markets work read Keynes, read Minsky, read Harrod, read Robinson — hell, read Hicks’ more advanced work on money and financial markets. Oh, but then you might have to open a book and actually read it rather than twisting clearly defined concepts to cover up the fact that you’re basically saying nothing beyond the fact that central banks have near zero interest rates. Terrifying prospect.

Posted in Economic Theory | 39 Comments

Can Lachmann’s Arbitrage Save the Austrian Theory of the Interest Rate?


This is the second part of my criticism of Glasner and Zimmerman’s paper. The first part can be found here and should be read and understood before proceeding with the second part. Glasner and Zimmerman note that Ludwig Lachmann tried to rescue Hayek’s theory by introducing market arbitrage. They quote Lachmann as such:

If there is a multiple of commodity rates, it is evidently possible for the money rate of interest to be lower than some but higher than others. What, then, becomes of monetary equilibrium? . . . It is not difficult, however, to close this particular breach in the Austrian rampart. In a barter economy with free competition commodity arbitrage would tend to establish an overall equilibrium rate of interest. Otherwise, if the wheat rate were the highest and the barley rate the lowest of interest rates, it would become profitable to borrow in barely and lend in wheat. Inter-market arbitrage will tend to establish an overall equilibrium in the loan market such that, in terms of a third commodity serving as numéraire, say, steel, it is no more profitable to lend in wheat than in barley. (p15)

This seems to not be a criticism of Sraffa at all. The own rates of interest still differ it is just that the differences are perfectly reflective of the knowledge that prices will fall in the future as the market equilibrates. Lachmann says this explicitly when he writes:

This does not mean that actual own-rates must all be equal, but that the disparities are exactly offset by disparities between forward prices. The case is exactly parallel to the way in which international arbitrage produces equilibrium in the international money market, where differences in local interest rates are offset by disparities in forward rates. In overall equilibrium, it must be impossible to make gains by “switching” commodities as in currencies. (p15 — My Emphasis)

It is interesting to note that Lachmann is invoking the empirically untrue theory of Purchasing Power Parity (a critique can be found here), but let us ignore this for the moment. Anyway, the above quote is not a critique of Sraffa. This is exactly what Sraffa was arguing. What is so surprising is that Glasner and Zimmerman actually quoted Sraffa saying this four pages beforehand. Here is that quote again:

Suppose there is a change in the distribution of demand between various commodities; immediately some will rise in price, and others will fall; the market will expect that, after a certain time, the supply of the former will increase, and the supply of the latter fall, and accordingly the forward price, for the date on which equilibrium is expected to be restored, will be below the spot price in the case of the former and above it in the case of the latter; in other words, the rate of interest on the former will be higher than on the latter. (p11 — My Emphasis)

Remember that this is a quote from Sraffa that the authors themselves provide! Yet Glasner and Zimmerman nevertheless write:

In contrast, Sraffa’s critique of the (unique) natural rate can apply only under intertemporal disequilibrium, but not under an intertemporal equilibrium in which future prices are correctly foreseen. (p16)

I do not know what to make of this at all. Even if the future prices are correctly foreseen — that is, in the case of a so-called ‘intertemporal equilibrium’ — the interest rates on various commodities will change in relation to one another when changes in the distribution of demand (or changes in supply) cause price changes that will, in the future, call forth changes in the structure of production. Thus Lachmann’s defence appears to have arisen from a simple misreading of Sraffa! Sraffa had already put forward Lachmann’s defence as a criticism!

All that Sraffa is saying is that as The Market directs resources through time the interest rates on various commodities will change in order to shift resources in various directions (if corn is undersupplied the interest rate on corn will rise etc.). In such a case there is no unique ‘natural rate of interest’.

In his paper Sraffa makes this point directly when he points out that there will be no unique ‘natural’ rate on producers goods and consumers goods. They will each have their own ‘natural’ rate:

But in times of expansion of production, due to additions to savings, there is no such thing as an equilibrium (or unique natural) rate of interest, so that the money rate can neither be equal to, nor lower than it: the “natural” rate of interest on producers’ goods, the demand for which has relatively increased, is higher than the ” natural ” rate on consumers’ goods, the demand for which has relatively fallen. (p51)

This is what does the damage to Hayek’s theory. Thus, Sraffa says, we are on far safer grounds with Wicksell. Wicksell used a price index to understand what he meant by the natural rate. Sraffa notes this clearly and contrasts it with Hayek’s approach:

This, however, though it meets, I think, Dr. Hayek’s criticism, is not in itself a criticism of Wicksell. For there is a ” natural ” rate of interest which, if adopted as bank-rate, will stabilise a price-level (i.e. the price of a composite commodity): it is an average of the “natural ” rates of the commodities entering into the price-level, weighted in the same way as they are in the price-level itself. (p51)

This is what Lachmann also wanted to do. Which gives a further sense that he had not read the debate properly. Recall that he wrote:

Inter-market arbitrage will tend to establish an overall equilibrium in the loan market such that, in terms of a third commodity serving as numéraire, say, steel, it is no more profitable to lend in wheat than in barley.

But this approach, while obviously more coherent, is not without its own problems. As Sraffa points out there will still be no unique rate because there will be a different structure of interest rates for each numeraire chosen as the basis of our price index (note that Sraffa refers to the numeraire as the ‘composite commodity’).

What can be objected to Wicksell is that such a price-level is not unique, and for any composite commodity arbitrarily selected there is a corresponding rate that will equalise the purchasing power, in terms of that composite commodity, of the money saved and of the additional money borrowed for investment. Each of these monetary policies will give the same results in regard to saving and borrowing as a particular non-monetary economy-that is to say, an economy in which the selected composite commodity is used as the standard of deferred payments. (p51)

Sraffa then points out that, since the selection of the numeraire is arbitrary, we may as well have just introduced a monetary standard. He writes:

It appears, therefore, that these non-monetary economies retain the essential feature of money, the singleness of the standard; and we are not much the wiser when we have been shown that a monetary policy is “neutral” in the sense of being equivalent to a non-monetary economy which differs from it almost only by name. (p51)

And so we are back to a monetary economy. The problem then becomes: what is the interest rate on money? Introducing money at different interest rates will have different effects on the interest rates on various commodities. If I open a bank in a barter economy and set the rate of interest equal to 2% the structure of interest rates that pertain across the economy will be very different to the structure of interest rates that pertain across the economy if I set the rate of interest equal to 5% or 0%. In Wicksellian terms: we are now talking not about the ‘natural’ rate of interest but rather the money rate of interest.

Well, now we are at the point where we must ask what sets the interest rate on money. Keynes, who is arguing against Hayek, says that the rate of interest on money is determined by ‘liquidity preference’; that is, the desire on the part of people to hold liquidity as opposed to interest-bearing investments. Some economists complained that Keynes was therefore allowing the interest rate to ‘hang by its own bootstraps’. But after the above discussion we see clearly that it could not have been otherwise. The money rate of interest must necessarily be autonomous of the various commodity rates of interest and so it will be set arbitrarily vis-a-vis the market system. In the real world it might be set by the markets in line with their confidence-levels, by central banks in line with either their confidence-levels or in line with an internally incoherent ‘policy rule’ that they use to absolve themselves from the responsibility of making a judgement or possibly in line with some rather arbitrary law like the usury laws of the Middle Ages.

Before signing off on this issue I should note a point of historical interest: Karl Marx actually realised this point when he investigated the money markets in Das Kapital: Volume III. In Chapter 23, aptly title ‘Division of Profit. Rate of Interest. Natural Rate of Interest.‘, Marx wrote:

The average rate of interest prevailing in a certain country — as distinct from the continually fluctuating market rates — cannot be determined by any law. In this sphere there is no such thing as a natural rate of interest in the sense in which economists speak of a natural rate of profit and a natural rate of wages.

I’m not the biggest fan of Marx but he was way ahead of the curve here. Echoing Keynes’ theory of liquidity preference he quotes Joseph Massie who wrote:

The only thing which any man can be in doubt about on this occasion, is, what proportion of these profits do of right belong to the borrower, and what to the lender; and this there is no other method of determining than by the opinions of borrowers and lenders in general; for right and wrong, in this respect, are only what common consent makes so.

The rate of interest hangs by its own bootstraps or it does not hang at all. There is no alternative.



Posted in Economic Theory | 7 Comments

Glasner and Zimmerman on the Sraffa-Hayek Bust-Up and the Natural Rate of Interest


David Glasner from over at the blog Uneasy Money has co-written an interesting paper on Sraffa and his critique of the natural rate of interest as it was put forward in Hayek’s business cycle theory. There is a lot that might be written about this paper as I believe that the debate has much contemporary relevance. Here, however, I will focus purely on the topic of the paper at hand. Namely, whether Sraffa’s critique of the natural rate of interest was coherent. I will also assume familiarity with the debate as, frankly, I’m too lazy to summarise it and interested people can read the paper which provides a fantastic overview.

Glasner and his co-author, Paul Zimmerman, quote Sraffa’s criticisms as such:

The “arbitrary” action of the banks is by no means a necessary condition for the divergence; if loans were made in wheat and farmers (or for that matter the weather) “arbitrarily changed” the quantity of wheat produced, the actual rate of interest on loans in terms of wheat would diverge from the rate on other commodities and there would be no single equilibrium rate. (p10)

Glasner and Zimmerman say that this disturbance would not persist. They write:

Deviations from equilibrium owing to fluctuations in the supply of real commodities would not persist; market forces would operate immediately to restore an equilibrium with all own rates again equalized, a tendency not mentioned by Sraffa. (p10-11)

They again quote Sraffa. In this quote Sraffa is saying that a market in which there is an increase in demand will go into backwardation. That is, a circumstance in which the forward price for a commodity is lower than the spot price.

Suppose there is a change in the distribution of demand between various commodities; immediately some will rise in price, and others will fall; the market will expect that, after a certain time, the supply of the former will increase, and the supply of the latter fall, and accordingly the forward price, for the date on which equilibrium is expected to be restored, will be below the spot price in the case of the former and above it in the case of the latter; in other words, the rate of interest on the former will be higher than on the latter. (p11)

Glasner and Zimmerman claim that Sraffa dropped the ball here. They say that he has confused nominal and real interest rates. The authors write:

What Sraffa called a multiplicity of own rates, was in fact a multiplicity of nominal rates reflecting the expected appreciation or depreciation of those commodities for which demand was increasing or decreasing. The natural rate, expressed as a real rate, (i.e., abstracting from expected price changes) remains unique in Sraffa’s exercise. (p11)

But this is not at all clear. The authors appear to be confusing expected price changes with actual price changes. This can clearly be seen if we lay out the process that Sraffa imagines to occur sequentially.

1. Demand switches from Commodity A to Commodity B.

2. Commodity B rises in price and Commodity A falls in price.

3. The financial market anticipates that this price discrepancy is only temporary. Thus the interest rate on Commodity B will increase and the interest rate on Commodity A will fall.

Note that the overall price level has not changed. The price increase in Commodity B has been offset by the price decline in Commodity A. In the future an increase in the supply of Commodity B will cause its price to fall and its interest rate to fall as it tends back toward equilibrium but this does not occur in the present. In the present we have a different structure of real interest rates. The overall price level has remained constant while the real interest rate on Commodity B has risen vis-a-vis the interest rate on Commodity A which has fallen.

In the period when the economy adjusts the quantity produced of Commodity A will fall and the quantity produced of Commodity B will rise. The price will fall back to equilibrium levels and so too will the interest rates. Again though, there is no actual change in the general price level. And the change in real interest rates that occurred in the previous period is still a fact that we cannot ignore.

Even in the case of a supply-shock this same mechanism will occur. If the amount of wheat produced falls below equilibrium level due to a change in the weather its relative price will rise. We then do have an increase in the overall price-level. The financial market in wheat will then go into backwardation and the wheat-interest-rate will rise. But unlike in the last example the other interest rates will not fall because demand for other goods remains constant. Thus we have a fall in real interest rates in these markets. Again the structure of real interest rates changes. The real interest rate on wheat has risen vis-a-vis the real interest rates on all other commodities by dint of the fact that the price level has risen while these interest rates remain the same in nominal terms while the nominal interest rate on wheat has risen.

As Sraffa showed in his paper this has policy implications as it completely befuddles Hayek who was trying to argue that the monetary authority should set the money rate of interest equal to the natural rate. The authors quote Sraffa on this point when he replied to Hayek’s reply:

Dr. Hayek now acknowledges the multiplicity of the “natural” rates, but he has nothing more to say on this specific point than that they “all would be equilibrium rates.” The only meaning (if it be a meaning) I can attach to this is that his maxim of policy now requires that the money rate should be equal to all these divergent natural rates. (p13)

This brings up the next criticism that the authors throw at Sraffa. I will deal with this in another post.

Posted in Economic Theory | 12 Comments

Uncertainty and Freedom


I am beginning to increasingly think that Keynes’ economics, with its every present emphasis on uncertainty, is actually an economics that takes the idea that humans are free seriously. That is, it is an anti-deterministic economics. I think that the only economist who recognised this was GLS Shackle.

At many points in Shackle’s work you find rather contemptuous references to philosophers. Shackle seems to be contemptuous of what he thinks to be philosophy because he seems to think that all philosophers argue in terms of a deterministic universe. I have no idea where Shackle got this idea but it is completely untrue. In fact, I think that certain strains of phenomenology — I think of the work of Jean-Paul Sartre and Maurice Merleau-Ponty — might well be the best point of departure when considering how human beings make decisions when faced with uncertainty or, what amounts to the same thing, when faced with the fact that they are free to choose.

I have a brief appendix on this issue in my forthcoming book and I am considering writing a paper on Keynes, Shackle and Sartre in the next few weeks so I will not go into this too much here. Suffice to say that it is rather amusing that marginalist economists are always talking about how in a market economy people are ‘Free to Choose’ (thanks, Dr. Friedman) but then they model human agents as pre-determined entities and study the economy as if there is no freedom of choice and everything is determined. It’s a rather silly self-contradiction but I believe it is one of the most damaging in economics.

Anyway, I would encourage people to listen to the following lecture on the philosophy of Sartre if they want to get a better feel for what I am talking about here. Pay particular attention to the discussion of temporality around the 31.30 mark.

Posted in Philosophy | 10 Comments

Mainstream Economists Completely Incoherent on the Effects of Monetary Policy

Confused Thoughts1

Bill Mitchell has a post up on his blog today criticising Mankiw’s textbook which apparently has a new edition coming out. Basically Mankiw is stuck in monetarist-land telling students that “banks control the money supply” and all that other nonsense that should have been done away with  years ago.

Mitchell’s critique is perfectly salient. But on one point I think that he drops the ball. Indeed, moving into the future I don’t think that criticisms will aim at New Monetarists like Mankiw because the profession is gradually giving up the old fashioned Friedman-esque doctrines. The point at which Mitchell makes a mistake is when he discusses the work of Wendy Carlin who is in charge of INET’s CORE curriculum reform committee. He suggests that she will likely be flogging the New Monetarist stuff when he writes:

Even so-called progressives who think they are on top of the situation like the iNET sponsored Wendy Carlin have embedded in their so-called – The 3-Equation New Keynesian Model — a Graphical Exposition – the view that savers provide the funds that the banks lend out for profit.

Well, the paper that Mitchell has linked to does not contain New Monetarist doctrines. Rather it substitutes for the LM-curve a central bank reaction curve that suggests central banks set an interest-rate target — a Taylor Rule. Thus the model recognises that central banks set the interest rate and do not seek to control the money supply.

Other mainstream textbooks have already integrated this insight. Although Paul Krugman has shown time and again that he does not remotely understand how the modern banking system works, his textbook Macroeconomics actually does contain an interest rate target rather than a money supply target (p351). This is not to say that this chapter of the textbook is not confused — it is, Krugman and his co-author flip-flop this way and that on the issue by providing a money multiplier at another point in the chapter (p331) — but they do provide the student with the idea that the central bank sets the interest rate.

The mainstream are a bit of a mess on this one. They still teach the money multiplier but they also teach interest rate targeting. Of course, the Bank of England has, as Mitchell points out, stated clearly that these two theoretical conceptions are mutually exclusive. But this is just more evidence that the mainstream don’t really understand their own theories: they just learn them by rote.

Nevertheless, if interest rate-targeting is the way of the future we must be clear that the criticisms of this approach lie elsewhere. Mitchell gives us some hints on this when he alludes to the fact that such theories are fallacious insofar as they assume instantaneous adjustment (logical time) rather than a realistic portrayal of the investment process (i.e. one embedded in historical time). He writes:

Essentially they claimed that if consumption spending fell as saving rose, more funds would be made available to the loanable funds market. The higher saving would drive down interest rates because there would be an oversupply of funds to the market relative to the current investment level.

The lower interest rates would stimulate higher investment and eventually the saving and investment changes would become equal at some lower rate than before and the spending lost to consumption would be made up by the higher investment spending. Therefore there could never be any deficiency in demand.

You will read that with a certain amount of incredulity I am sure as I did when I studied the rubbish. Basic first question – How does a firm that produces consumption goods suddenly become an investment (capital) goods producer? What about sectoral imbalances? What happens when the dynamic is the opposite?

These are important points. But the key criticism lies elsewhere: there is no natural rate of interest because, as Keynes showed us well, investment decisions are undertaken based on subjective expectations. Keynes assumed that interest rates did have an effect on investment but that these could be ‘drowned out’ by the lowered expectations of the investment community. Ultimately Keynes thought, quite rightly, that it was the expectations that were more important than the interest rate.

In fact, empirical work done since then has shown that interest rates seem to play little or no role in how businessmen and businesswomen decide on how much to invest. This is generally recognised today as Frederic Mishkin shows in his paper The Channels of Monetary Transmission: Lessons for Monetary Policy. He says that the general consensus is that the manner in which changes in policy interest rates have their effects are through the following channels:

1. Exchange rate effects — a fall in interest rates will (sometimes) lead to a weakening of the currency. This will boost exports and curtail imports.

2. Equity prices — a fall in interest rates might lead to rising stock prices which might stimulate investment and may also lead to a ‘wealth effect’ that raises consumption.

3. House prices — a fall in interest rates might lead to a pick up in house prices and thus to new investment in this sector.

4. Balance sheets — a fall in interest rates will cause financial instruments to become more valuable and this will strengthen balance sheets which may encourage borrowing/lending.

Note carefully that these affects might occur. It is by no means assured that they will occur. But even leaving this aside this is no longer a very straightforward question. In the textbook fairytale a fall in the rate of interest leads to higher investment. Thus there is some sort of nice equilibrium balancing going on. But if Mishkin is correct that the channels through which it actually works (when it works) are the above ones this does not fit nicely into the abstract fairytale model.

The above effects also do not suggest that the economy will move toward equilibrium. In the fairytale story the economy re-equilibrates through the assumed adjustment mechanism. But the above channels more so suggest that the economy will, at best, get a simple one-off boost. This is what Post-Keynesians like Joan Robinson, Nicholas Kaldor and Michal Kalecki said years ago. They never bought into the equilibration story because they were fundamentally dynamic economists (even though their theories occasionally didn’t reflect this) and they saw lowering interest rates as the equivalent of eating a sugary snack on an empty stomach: it might work once, for a few hours, but soon you’ll need another sugary snack or you’ll crash.

The history of the era of interest rate targeting bears this interpretation out too. We can basically date interest rate targeting in the US to around 1984 when monetarism and money supply controls were thoroughly abandoned. After this the interest rate was on a slippery slope downward until it hit the zero-lower bound. The following chart shows the real overnight interest rate in the US from that period (i.e. the nominal overnight rate minus the rate of inflation).

REALinterest rates

After 2008 the central bank basically ran out of sugary snacks and the economy slipped into a diabetic coma. (A similar story can be told for the UK although the monetarist era ended slightly later).

The empirical work done by the mainstream today suggests that there is no such thing as a natural rate of interest. Yet the modellers still assume that this does exist. This is yet more evidence of the incoherence in the mainstream that I have noted on this blog before. In this case it is because the modellers want to keep their equilibrium tools intact even though they do not fit the material that they are trying to use them on. This should also provide a serious warning for Post-Keynesian economists who have slipped into using comparative static tools to undertake what needs to be dynamic analysis.

Update: On the Krugman front Dirk Ehnts did a nice job last year showing how the good doctor flip-flops on this issue. When I read Krugman and Wells’ macroeconomic textbook I got the distinct impression that Krugman probably didn’t write the section on money creation and interest rates. If I’m wrong and he did then that is even worse because it means that he was cutting and pasting rather than understanding the material that he was putting together for students.

One point on which I would correct Ehnts is that the demand for loans can actually affect interest rates, just not in the way that Krugman thinks (i.e. not in the ‘loanable funds’ way). Interest rates in the economy gravitate toward the overnight central bank rate but the spread between this rate and other interest rates is determined by risk perceptions of the market (Keynes’ ‘liquidity preference’). So, if lots of people demand loans in theory the market could price in the fact that since more people are borrowing these peoples’ risk levels are higher because they are borrowing more.

But this is only one of many possibilities because risk perceptions are not what economists call ‘rational’. Rather they are set in line with subjective expectations. In a period of very buoyant borrowing risk perceptions will probably — ala Minsky — become far more accommodating. This is certainly what we saw in the run-up to 2008 and we have also seen it after the Fed’s easy money policies did their magic and dragged the economy out of a liquidity trap in 2009-2010 (yes, stop listening to Krugman about almost everything monetary; we are out of the liquidity trap for now). So, in contrast to what Krugman thinks at a time of very high borrowing it is quite likely that interest rates will actually fall as the good feelings and gnarly vibes work their way through that rather ridiculous hall of mirrors known as the financial market.

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A Storm is Coming: On the Rethinking Economics Conference in London


I’ve published a piece on Al Jazeera that gives an account of the extremely impressive London conference that the students fighting to change economics put on at the end of last month. There are some nice anecdotes and I think it gives a good overview of the movement. Al Jazeera also allowed me to make two theoretical criticisms and a methodological criticism. How often does that happen!?

The fight to reform Econ 101

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