Wednesday, 3 January 2018

Artificial interest rate adjustments are daft.

Summary.    The optimum or GDP maximizing price for anything, including the price of borrowed money, is the free market price. Therefor artificial adjustments to interest rates are not a GDP maximizing way of regulating demand: i.e. the best way of imparting stimulus is to simply have government and central bank create new money and spend it, and/or cut taxes.

A possible criticism of that idea is that having the state create money is equally artificial. (The word “state” is used here to refer to government and central bank as a combined or single unit.)

The answer to that criticism is that having the state create new money and spend it and/or cut taxes actually imitates the free market’s main weapon against recessions which would operate in a genuinely free market: the Pigou effect – the fact that in a genuine free market and given a recession, wages and prices would fall, which equals a rise in the real value of money, which in turn encourages spending.


It is widely accepted in economics that the optimum or GDP maximizing price for anything, including the price of borrowed money, is the free market price. Thus unless there is good evidence that the free market isn't working when it comes to interest rates, there is no good reason to interfere with interest rates – i.e. fiscal stimulus is better than interest rate adjustments. That’s “fiscal stimulus” in the form of printing new money and spending it and/or cutting taxes. Or to put that another way, “print and spend” is better than artificial interest rate adjustments. (The phrase “fiscal stimulus” will be used here to refer to the latter “print and spend and/or cut taxes” policy)

And indeed, it’s hard to see why the free market does not work in the case of interest rate determination: for example, those seeking mortgages shop around for the best deal, and those looking for a home for their savings do likewise. Seems very much like a free market to me.

It might seem there’s a reason to criticize the latter claim that the free market is working: it’s that interest rates do not fall far enough to cure recessions. The flaw in that criticism is the assumption that interest rate falls are the only or the main free market cure for recessions. They are not.

Another cure is the so called “Pigou effect”: that’s the fact that in a totally free market and given a recession, wages and prices would fall (in terms of money), which equals a rise in the real value of dollars, pounds, etc. It also equals a rise in the real value of government debt, which is a private sector asset. All in all, in a genuine free market, there’d be a rise in the real value of what MMTers call “private sector net financial assets” (base money and government debt).

Moreover, as distinct from interest rate adjustments which do not seem to be obstructed in the real world, there is a very obvious obstruction in the real world to the Pigou effect: it’s Keynes’s “wages are sticky downwards” phenomenon. That is, given a recession, wages just don’t fall all that much. Indeed in some heavily unionised sectors, any attempt by employers to cut nominal wages would be met with immediate strikes: exactly what happened when Churchill tried to cut miners’ wages in the UK in the 1920s.

Incidentally, given a gold based currency, the latter fall in wages and prices would mean a rise in the real value of gold, which would encourage the production of more gold, which in turn would enhance the rise in the real value of the stock of money. But clearly that mechanism works far too slowly.

However, the “sticky downwards” inadequacy in the Pigou effect can be easily circumvented (as I think Keynes pointed out in his General Theory) by expanding the real value of the money supply by increasing the NUMBER of dollars, pounds, etc rather than increase the value of EACH dollar, pound etc. I.e. a recession can be cured by having the state create and spend more money and/or cut taxes. The fact of spending that money increases demand, plus the private sector’s increased stock of money will ITSELF raise demand. To summarise, the latter fiscal stimulus makes more sense than interest rate cuts in a recession. Reason is that that fiscal stimulus (which actually incorporates a monetary effect – increasing the money supply) rectifies the free market mechanism that goes wrong in a recession in the real world. In contrast and to repeat, it is not at all obvious that there is any deficiency in the market for savings and loans to be rectified in a real world recession. (Incidentally, as anyone who knows anything about money will know, it’s only base money which is relevance here: that is, private bank created money is irrelevant because for each £ of such money, there is a corresponding debt.)

Another point in favor of fiscal stimulus is this. The basic purpose of the economy is to produce what people want, both in terms of what they choose to purchase out of disposable income and what they vote to have the state provide for them in the form of public spending, and given that the economy in a recession is by definition not producing enough of what “people want”, the logical solution to a recession would seem to be to increase household spending (which can be done via tax cuts) and public spending. I.e. fiscal stimulus makes more sense than interest rate cuts.

Central bank and political coordination.

If tax and/or public spending are to be adjusted quickly, come a recession, there might seem to be a problem in that decisions on tax and public spending are normally taken by politicians, and they can take far too long to make decisions for the purposes of dealing quickly with recessions. In fact that shouldn’t be too much of a problem: in the UK during the recent crisis, the technocrats at the treasury twice adjusted the sales tax, VAT, without specific permission from politicians (apart from the UK finance minister, of course).

Plus, if politicians think that for example a decision by technocrats to raise taxes results in too much of GDP being allocated to public spending, then politicians are free at their leisure to reverse that and at a later date, i.e. cut both taxes and public spending. Moreover, and with a view to making technocrat’s decisions as non-political as possible, they could be instructed, when implementing fiscal stimulus, to effect it in part via increased public spending and in part via tax cuts: that way, the proportion of GDP allocated to public spending does not change when technocrats decide to implement stimulus.

That might sound complicated to those new to the idea. Actually it’s quite simple and involves no big economic or technical problems, though POLITICAL problems are possible in the form of politicians objecting to having some of their powers removed. Bernanke (1) gave his blessing to the idea in the paragraph starting “A possible arrangement..” here. And Positive Money (2) and co –authors set out the idea here.

Public borrowing.

Having argued that interest rates should be left to their own devices, i.e. left at the free market level, there is the slight problem that government borrowing, because of the sheer scale of such borrowing, has a significant effect on interest rates. Thus it is necessary to answer the question as to what the optimum amount of such borrowing is. My preferred answer to that question is the one given by Milton Friedman and Warren Mosler, i.e. that governments should borrow nothing, except perhaps in emergencies. . (At least that was the answer given by Friedman here – he later changed his mind on the “zero interest” point). Reasons for that “borrow nothing” argument are briefly as follows

1. No one with their head screwed on borrows (and thus pays interest) unless they absolutely have to, i.e. unless they’re short of cash. And given that governments can grab any amount of cash off taxpayers, plus given that governments can print money, the idea that any government is short of cash is obvious nonsense.

2. The popular “golden rule” idea that governments should borrow to fund infrastructure investments is nonsense, first because as explained above, no one pays for an investment via borrowing if they happen to have enough cash. Second, education is one huge investment, but no one ever suggests funding the entire education budget via borrowing. So there’s some muddled thinking there!

3. Fiscal stimulus in the form of “borrow and spend” is daft because borrowing has a DEFLATIONARY effect: the opposite of the intended effect. I.e. borrow and spend with a view to stimulus makes as much sense as throwing dirt over your car before washing it.

Zero borrowing and interest rate cuts.

As explained above, the undesirability of artificial interest rate adjustments is not to rule out such adjustments in an emergency (a point made by Friedman). As to how to effect those adjustments, that might seem to be a problem in a “zero government borrowing” scenario. That is, the normal way of for example cutting interest rates is to have the central bank print money and buy up government debt. But absent any government debt, the central bank can simply offer to lend to large banks at below the going inter-bank rate.

As for interest rate hikes, the central bank can just wade into the market and offer to borrow at above the going rate.

However, there is a glaring self-contradiction in the whole idea of interest rate adjustments (other than emergencies) regardless of what is regarded as the optimum or GDP maximizing amount of government debt. The self-contradiction is this.

If it is decided that the optimum amount of public debt is X% of GDP, and to deal with a recession, the central bank prints money and buys up government debt so as to reduce interest rates, then the total amount of state debt is then below the optimum or GDP maximising level! 



1. Bernanke. “Here's How Ben Bernanke's "Helicopter Money" Plan Might Work.” Fortune.
2. Positive Money. “Towards a Twenty-First  Century Banking and Monetary System. Submission to the Independent Commission on Banking”.
3. Friedman. “A Monetary and Fiscal Framework for Economic Stability”. American Economic Review. 1948.

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