Saturday, 22 September 2012

The crunch was caused by using interest rates as a regulatory tool.

Or at least that’s part of the explanation, and for the following reasons.

There WASN’T any sort of uncontrolled boom prior to the crunch, at least in the sense that inflation was not badly out of control. However, people WERE shifting the resources at their disposal towards property speculation and away from other areas. House prices rose, while the price of other stuff fell (or rose less quickly than it would otherwise have risen). Net effect: no serious inflation.

A rise in interest rates would have choked off the speculation at least to some extent, but that didn’t happen because central banks use interest rate adjustments to control aggregate demand and inflation, and CBs didn’t think inflation merited an interest rate rise.

In contrast, aggregate demand and inflation could be controlled simply by adjusting the rate at which the government / central bank machine creates new money and spends it into the economy (and does the reverse when appropriate: withdraws money and “unprints it”). As to interest rates, they’d be left to look after themselves – and in particular, given increased demand for loans for property speculation, those rates would tend to rise.

MMT is right again.

Now what do you know? The above policy was advocated by Abba Lerner and (I think) most adherents to Modern Monetary Theory. It’s also advocated by Positive Mloney, Prof Richard Werner, and the New Economics Foundation. .


  1. In Leijonhuvud´s point of view, the crisis was caused by the mix of Inflation Targeting Theories insights ( would say) within the time path of reserve currencies of such pervasiveness as the Dollar (in its turn involved, as its very well known, in the time path of Asian external finance account surplus...thereby purchasing american assets and enabling for that reason a certain overshooting in their prices): say, because of targeting prices in general instead of targeting asset prices (overshooted because of asian growing surplus), such an approach let the short-term interest rates management to be pretty out of intertemporal equilibrium...
    "The Perils of Inflation Targeting" Voxeu...

  2. Interest rates alone are certainly a very crude an imprecise instrument.

    But then, so is measuring inflation (and also money supply).

    This, to me, is the greatest weakness in the Positive Money proposals. They seem to think that "experts" will be able to work out exactly how much money is needed in the system at any one time, and then the MCC will be able to create or destroy money to keep the money supply at the "correct" value.

    I think this suffers from a number of defects:

    - As you point out somewhere, inflation can vary widely among different sectors. House price inflation can be rampant because of speculation, while household inflation can be "normal", e.g. 2%, or even less.

    So which "inflation" does the MCC look at?

    - And how do you even measure the money supply in our modern, complex economy?

    I'm not sure what the solution is, but thngs like the housing market in the UK require very special treatment and (I would argue) quite strict lending controls and maybe even prive controls.

    We probably need much more regulation of lending and borrowing in general, for all sorts of reasons, although it should be sensitive, intelligent, and not heavy-handed.

    Using only one, aggregate "inflation rate" to control the overall money supply is probably about as dumb as what happens now, which is to use one interest rate to control the inflation rate.


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