Why Thomas Piketty is Wrong About Inflation and Interest Rates

bogeyman

I have pointed out on here recently that Thomas Piketty’s views on public sector debt are wholly un-Keynesian. Well, we should also point out that his view of inflation and interest rates are also fairly un-Keynesian. Piketty basically thinks that the reason that governments have been able to run persistent government deficits is due to consistent inflation which erodes the real interest rates governments must pay on their debt. This may be true, but the conclusions he draws from it are altogether incorrect and, again I must stress, not the conclusions a Keynesian economist would draw. Piketty writes,

The inflation mechanism cannot work indefinitely. Once inflation becomes permanent, lenders will demand a higher nominal interest rate, and the higher price will not have the desired effects. Furthermore, high inflation tends to accelerate constantly, and once the process is under way, its consequences can be difficult to master: some social groups saw their incomes rise considerably, while others did not. It was in the late 1970s—a decade marked by a mix of inflation, rising unemployment, and relative economic stagnation (“stagflation”)—that a new consensus formed around the idea of low inflation. (p134)

In his book Money, the Post-Keynesian economist Roy Harrod brings to the reader’s attention a part of Keynes’ monetary theory that is not widely appreciated today. Namely, that Keynes thought — contrary to what the vast majority of working economists today assume — that the expected rate of inflation and, indeed, the actual rate of inflation have no effect on baseline interest rates. Harrod writes,

In the Keynes scheme the prospect of inflation has no tendency to raise the rate of interest. This springs from his contention that to understand the nature of the market rate, one must fix one’s spotlight firmly on the relation between cash and bonds. The point here is that cash itself is as liable to erosion by inflation as the promises to pay cash. If the choice is between holding cash and holding promises to pay cash, there is no difference whatever as between these two assets in regard to the prospect of inflation. (p179)

This leads Harrod to say, echoing Keynes, that central banks have entire control over the rate of interest. The markets really just have to take what they can get in this regard. If the choice is between cash being eroded by, say, a 7% rate of inflation every year and a bond yielding 3% being eroded by a 7% rate of inflation, the investor just has to make their choice and stand by it.

Of course, the money could flee the country. That is, there could be a run on the currency in question. But that seems very unlikely outside of a hyperinflation. And in a hyperinflation the dynamics will be self-limiting in two directions. (1) The rapidity of the increase in the money supply will greatly outpace any foreign outflow. (2) In a hyperinflation a currency generally loses its foreign exchange value almost completely, making it impossible for people to take their money out of the country and buy foreign assets.

Outside of a hyperinflationary collapse of an economy, people have to work and earn money and businesses have to turn a profit. This requires money to circulate within the country. Ultimately, this money has to go somewhere when it accrues as savings and if all of it left the country at once the economy would simply come to a halt. This has never happened in history, of course, and if you think it through it is truly an absurdity. In practice the markets just have to accept the fact that they might have negative yield on their hands. Ceteris paribus this will put them under very great pressure to invest the money in riskier assets within the country and this is part of the Keynes schema. Harrod writes,

What the prospect of inflation does affect is the comparative yield of bonds on the one hand and equities and real estate on the other. Equities and real estate are hedges against inflation, and, in periods when inflation is expected, the rate of interest on bonds should be higher than the yield on equities of comparable standing… But the fact that the prospect of inflation causes the yield of equities to fall relatively to the yield on bonds does not entail that it causes the yield on bonds to rise absolutely. According to Keynes it is impossible for it to have that effect. (pp179-180)

This is extremely important because the Keynesian view is very much so at odds with what many working economists will tell you. The Keynesian view will tell you that in an inflation risky assets will become more popular. That means that interest rates on these assets will fall, not rise. Interest rates on safe assets, like Treasury Bills, will remain wherever the central bank sets them. This is also what the historical data shows to be the case.

So, why don’t working economists generally accept this? Two reasons. First, is the loanable funds theory. This theory states that interest rates must increase when output increases. When confronted with the fact that the monetary authorities set the interest rate, loanable funds theorists have recourse to the soothing idea that too much demand will lead to inflation and this will lead to an automatic rise in interest rates. This myth salvages the model in which these economists have invested their intellectual capital. But it is inaccurate and at odds with reality.

Secondly, many working economists work in central banks or market institutions. The idea that inflation might lead to a rise in interest rates serves a nice mythic purpose for both. For the central bankers it acts as a taboo that reinforces their inflation fears because they believe that if they violate some sort of Divine Law then they will lose control over the situation. For the market economists it gives the illusion that their institutions — market institutions — have some modicum of control over interest rates. It also serves as an implicit threat to the authorities that if they dare to provoke inflation — which, of course, the financial markets hate beyond all else — market actors will jack up the interest rate.

But none of this is true. In reality, the authorities control the interest rate and no amount of inflation will move it beyond the boundaries in which they set it. High inflation may be an evil in its own right but let’s not fool ourselves with some sort of old time religion. Economists like Piketty would do well to give these issues a bit more thought before spooking the general public with the boogeyman of the supposed burdens of public sector debt and the supposed unsustainability, reminiscent of the doomsday warnings of the Austrian cranks, of eroding it through a healthy inflation.

About pilkingtonphil

Philip Pilkington is a London-based economist and member of the Political Economy Research Group (PERG) at Kingston University. You can follow him on Twitter at @pilkingtonphil.
This entry was posted in Economic History, Economic Policy, Economic Theory. Bookmark the permalink.

35 Responses to Why Thomas Piketty is Wrong About Inflation and Interest Rates

  1. philippe101 says:

    Even if the CB sets the base rate at a low level, couldn’t the yield curve steepen dramatically, so that the yield on long term government bonds rises significantly even as the overnight rate stays low?

    Also, it seems to depend on the monetary regime – see the Eurozone for example (low base rate and sky high government bond yields).

  2. Rob Rawlings says:

    “Secondly, many working economists work in central banks or market institutions. The idea that inflation might lead to a rise in interest rates serves a nice mythic purpose for both”

    Many central banks target inflation and will raise interest rates when inflation starts to move above target. They did this quite successfully .for 2 decades before 2008, when the ZLB meant that they started to underachieve the target.

    How would this apparent successful inflation targeting be explained by those Keynesian who think “the actual rate of inflation ha[s] no effect on baseline interest rates” ?

    • That is an entirely different mechanism. You’re saying that central banks will raise the interest rate in response to inflation. The mainstream theory is that the markets will. Totally different argument.

  3. philippe101 says:

    Wouldn’t the base rate rise on its own if the central bank didn’t increase the quantity of reserves? If so, then the market can raise the base rate, but the central bank can also opt to hold it down by creating more money.

    According to mainstream economists however, under ‘normal’ (i.e. non ‘liquidity trap’) conditions, more base money is inflationary. Which means that unless the CB wants ever increasing inflation, it has to allow the base rate to rise.

    • That’s not really the issue here. The issue is whether people still need liquid assets even when these are yielding a negative rate of interest.

      In an inflation will there still be a large group of investors that require T-bills even if these are yielding negative interest rates? Keynes, Harrod and I say “yes”. The Japanese and other examples indicate that we are correct.

  4. Dan Kervick says:

    “This leads Harrod to say, echoing Keynes, that central banks have entire control over the rate of interest.”

    But surely not all rates of interest, right Philip? There is no such thing as “the rate of interest.” Only those rates of interest that you call “baseline” rates – i.e. the rates on government bonds – are directly under the government’s control. Yes, if all an investor has to choose between is holding cash and holding liquid government securities, they will buy the securities even if they have a negative real yield, so long as that negative yield isn’t as bad as the negative yield from holding interest-free dollars. And even if inflation creates higher demand and lower yields on riskier assets, that doesn’t mean that it will pull those asset yields down. The government may be able to get away with offering extremely low yields during a persisting economic crisis, when the demand for safe assets is exceptionally high. But when an economy offers more opportunities for investing money profitably with relatively low risk, then government rates go higher.

    Piketty is not trying to spook the public about the burdens of public debt or about solvency issues etc. What he is primarily interested in is the way in which public debt can lead to a redistribution of the wealth share toward rentiers, and the way it has done so historically, since public debt has always been one of the leading investment vehicles for the capital class. The question is whether the yields on public debt have typically exceeded the rate of inflation. Throughout history, I believe they have, and by margins substantial enough that rentiers have been able to make tidy profits simply by investing in the day-to-day operations of government.

    Anyway, I think you are raising important issues, and Piketty should revisit this topic with an expanded understanding of the options. But here’s the main issue for me: a government like the US government has, in principle, the ability to print, or electronically create, units of the currency and spend them. It can also tax; and it can employ some combination of these two operations to run a deficit of optimal size.

    But what these government do instead is not create currency units and spend them. They create interest-bearing instruments and swap them for the non-interest bearing currency instruments already in existence. And they do this mainly with people who are already affluent, and have large sums of the non-interest bearing stuff to swap. Why do this? Even if the rates are very low – and the central bank can always guarantee a market for securities at any positive nominal rate by committing to immediately buy back whatever the government sells at some rate minimally profitable to the buyer – why do it?

    • But when an economy offers more opportunities for investing money profitably with relatively low risk, then government rates go higher.

      No. That is precisely what I am arguing against. That is precisely what Harrod and Keynes are arguing against.

      • Dan Kervick says:

        Well here are 10-yr treasuries. It seems to me that the main trend is inflation related, but that we also see an increase in yields during recoveries.

        http://research.stlouisfed.org/fred2/series/GS10

        Also, the passage you quoted from p. 134 isn’t part of an explanation of “the reason governments have been able to run persistent deficits”, as you say. He is discussing the distributional effects of deficits, and considering the ways in which government debt financing might or might not benefit rentiers. He is considering the possibility that issuing debt in the context of inflation can offset the upward re-distribution, and his claim is that it can, but not indefinitely.

        Piketty’s book is not a treatise on employment, inflation, growth, etc. It is a treatise on distributional economics, not aggregate economics. His considerations are all related to that topic. His main point in that part of the book is that public debt is always owned by a wealthy minority of the population, and that historically, this has helped make that minority richer.

      • Fed raises interest rate in response to inflation. Market in 10 years responds to Fed hiking overnight rate. Central bank decision, not market action.

      • philippe101 says:

        “Fed raises interest rate in response to inflation”

        Say for example that inflation is running high. If the Fed simply stopped adding new base money to the system, the Fed Funds rate would eventually rise on its own, up to the Fed’s discount window rate. If the Fed were to stop making discount window loans, the fed funds rate would continue to rise, on its own, above the discount rate.

        So the fed funds rate does change on its own, but the Fed also has ways to keep it close to its target.

      • I assumed an interest rate targeting regime in the piece.

    • Dan Kervick says:

      I have no doubt that’s true, but the result is that people can almost always make serious money by investing in treasury debt, except during recessions with ZIRP. And central bank policy is not unrelated to market conditions.

      • And central bank policy is not unrelated to market conditions.

        I’m not sure who was making the case that is was. Although I would also say that distributional theory is not unrelated to macroeconomic theory. Further than this I would say that the relationship between releasing new government debt and inequality is by no means as linear as Piketty assumes. Perhaps they are more important points… perhaps… you know, given Piketty’s anti-Keynesian “more government debt = more inequality” narrative.

  5. dansullivan0 says:

    I would add that banking privilege (of lending credit into circulation and seeing that credit treated as money) is far more inflationary and far less job-creating that deficit spending. That is partly because banks mostly lend to consumers, though mortgage lending, car loans, student loans and credit card debts. Deficit spending, on the other hand, tends to focus on infrastructure and other public goods that enhance the environment for production of wealth to purchase.

    One area where Modern Monetary Theory is dead on is that, to the extent that injecting additional money creates additional jobs and the production of additional goods and services, it is not inflationary at all. Deficit spending can target job creation at the outset, and only indirectly generate consumption as the money circulates, which is to say, as the producers consume.

    Bank lending, on the other hand, usually stimulates consumption, and production is only secondarily stimulated by the consumption. In some cases, the loans to not stimulate production so much as they stimulate the bidding up of land prices, stock prices and so on, creating more rent-seeking behavior than productive behavior.

    Finally, banks tend to lend most during the growth part of the business cycle and to abruptly curtail lending when the bubbles they had stimulated burst. The need to infuse money in a “counter-cyclical” fashion is more drastic the more banks had been allowed to lend money in the first place. There is altogether too much focus on deficit spending by government and too little on deficit lending by commercial banks.

  6. philippe101 says:

    Phil,

    “I assumed an interest rate targeting regime in the piece.”

    Even with an interest rate targeting regime, the Fed Funds rate changes on its own. The Fed intervenes to keep it close to its target.

    This picture shows both the target FF rate and the actual, or effective FF rate:

    (I’ve tried posting this comment a few times btw)

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  8. John Hobgood says:

    “For the central bankers it acts as a taboo that reinforces their inflation fears because they believe that if they violate some sort of Divine Law then they will lose control over the situation.”

    It’s no so big a secret, look what happens when Federal Receipts go up ~2.5% or so from a recent trough:
    http://research.stlouisfed.org/fred2/graph/fredgraph.png?g=AVg

    Now, top that with some austereberries, freely garnished with questionable loans and a nice fear sauce and you’ll have the electorate nibbling out of the palm of your hand in no time.

    From there to Payday loans is just a short jump. You rake it in while they blame themselves. Cha-ching!!

  9. “In reality, the authorities control the interest rate and no amount of inflation will move it beyond the boundaries in which they set it.”

    Depends what interest rate your talking about. If your talking about the central bank short term rate then yes. The central bank rate is largely irrelevant to most of the economy though as most entities don’t directly deal with the central bank. The more relevant rates to the economy are the market rates and I’m not sure the central bank controls these. It certainly influences and the degree of influence may vary but control is too strong a word IMO.

    • I was talking about both the short-term and long-term rates on government debt. That is what Piketty is dealing with in the book.

      • If the gov loses credibility what about gov default risk? People might not accept leaving money with gov unless they receive a specific rate of return (places like Argentina come to mind). As a result the gov may not be able to reduce the rate beyond a certain level. Do you think the Argentinian gov could engineer 2% rates on their 10 years bonds? I’m not sure its possible. I could be wrong though.

      • They borrowed in dollars and effectively had a currency crisis. Completely different situation.

        If you want to see how default risk affects rates in a floating FX system check out the bond yields on US treasuries when the fiscal cliff came up.

      • ‘They borrowed in dollars and effectively had a currency crisis. Completely different situation.”

        Argentina recently did a bond issue in Pesos (3 year bonds) at 26% interest. Do you think they could engineer 2% on those or any rate the gov wants? I really doubt it.

        “If you want to see how default risk affects rates in a floating FX system check out the bond yields on US treasuries when the fiscal cliff came up.”

        I dont think the default risk was significant though in the US example. Im not saying that default risk will limit gov control over rates but that it can. If I understand correctly your saying the gov can never lose control over rates but I think it is possible.

        Also arent all or most currency regimes non floating once credibility declines enough?

      • Argentina recently did a bond issue in Pesos (3 year bonds) at 26% interest. Do you think they could engineer 2% on those or any rate the gov wants? I really doubt it.

        Yeah, I do. But it would cause capital outflow which is not in line with their current goals: namely, to secure the value of the peso.

        I dont think the default risk was significant though in the US example.

        Please lend me your crystal ball next time the fiscal cliff comes up. I’ll make a killing…

        Also arent all or most currency regimes non floating once credibility declines enough?

        No idea what this means.

      • How would Argentina bring the rate to 2%? Ignoring the capital outflow aspect.

        “Please lend me your crystal ball next time the fiscal cliff comes up. I’ll make a killing…”

        You don’t need a crystal ball to figure out the past. I was talking about an event that already occurred.

      • The central bank would set a new target rate and engage in OMOs.

        As to saying how much default risk there was in retrospect, that kind of circumvents the notion of risk. That’s like me saying that, since the roulette table landed on red five minutes ago, there was always more of a chance of it landing on red than on black on that particular spin.

  10. “The central bank would set a new target rate and engage in OMOs.”

    So the central bank would try to bid up the price of those bonds by expanding the money supply massively. Seems likely to be very destabilizing. Zimbabwe comes to mind. I think we get hyperinflation and then it will be even harder to control rates or even sell any bonds on primary markets.

    “As to saying how much default risk there was in retrospect, that kind of circumvents the notion of risk. That’s like me saying that, since the roulette table landed on red five minutes ago, there was always more of a chance of it landing on red than on black on that particular spin.”

    Im not sure if the market really believed there was any real prospect of default ahead of time either. I don think there is any precedent of US default and things like the debt limit have come up several times. Im not saying though that the central bank absolutely cannot control rates in circumstances of default risk. Im saying that in some circumstances it can and in others it cant. Your saying it always can I think that is a bit far fetched.

    What about countries with a recent precedent of default? Im not sure they can really control rates to whatever level they want. For example sending Argie rates to 2%.

    • If there were hyperinflation it would be due to the capital outflows and the currency crashing. But we’re not talking about effects. We’re talking about if they could do it in theory. They could.

      As to your ideas about default risk, you seem rather sure of yourself. You should put some skin in the game and play the markets. Tell me how you do.

      Apart from that I can only repeat myself: they can always control rates. If you want to argue otherwise get me an example where they have tried and failed.

  11. “If there were hyperinflation it would be due to the capital outflows and the currency crashing. But we’re not talking about effects. We’re talking about if they could do it in theory. They could.”

    Hyperinflation could also come about as a result of large increase in money supply. I dont think you are saying they could do it, you are saying they always will. I’m the one saying they could do it and also sometimes they cant. You saying always and I’m saying sometimes yes and sometimes no.

    “As to your ideas about default risk, you seem rather sure of yourself. You should put some skin in the game and play the markets. Tell me how you do.”

    If feel pretty sure the US gov wont default in the next 10 years. I don’t know the future though. You seem pretty sure of yourself too. Maybe we can be counterparties?

    “Apart from that I can only repeat myself: they can always control rates. If you want to argue otherwise get me an example where they have tried and failed.”

    Do you think making absolute statements like the previous may be because you are failing to take into account the complexity of the system? In order to move rates to extremes requires more effort and/or extreme policies. Don’t you think that doing extreme things carries risks and these risk can undermine the system make it erratic, unstable and subject to collapse.

    Wouldnt most monetary systems in distress in history or which collapsed be an example of one where the CB couldn’t control rates?

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  14. Carlos says:

    Before people who think that they are the judges on who and what is Keynesian or not proclaim their judgements (not that I would personally care about being called anti-Keynesian or pseudo-Keynesian or whatever, I care about content and not labels and tribal identity) they might want to understand that deficit spending means that government debt increases temporarily and is totally unrelated to the average level of public debt.
    You can very well be for massive deficit spending and a low amount of public debt (or even advocate that governments are net savers!). And lest the halfwits are still confused, the latter has nothing to do with the overall size of the government but only with the right-hand side of the public balance sheet.

    • While we’re all very impressed that you read about the tax multiplier in your macro class some of us in the real-world have to deal with countries with very high marginal propensities to save (due to aging populations, for example) and countries with very high marginal propensities to import, Carlos.

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