Is the natural rate of interest zero?

One of tenants of Modern Monetary Theory (MMT) is that the natural rate of interest is zero. That is, the claim (if I’ve got it right) is that the inter bank rate will always tend towards zero and that this is desirable.

For the arguments behind this claim, see paper by Warren Mosler and Mathew Forstater.

One of their arguments does not stand inspection: the claim that “lower rates support investment” (p.12). The answer to that point is that while low rates certainly do “support investment”, there is an OPTIMUM AMOUNT of investment and the optimum is not necessarily that which pertains at a zero (or low) rate of interest. That is, more investment is not an end in itself.

The optimum amount of investment is attained when the marginal disutility (or marginal “pain”) of forgone consumption used to fund investments equals the marginal utility or marginal benefit of such investments (as I point out here.)

But the above “investment” argument is not the only one put by Mosler and Forstater. Does the rest of their argument stand up? I don’t think so – or rather, I think their basic point is sort of valid, but that I can argue their case better than they can. Here goes.

If a country is to avoid paradox of thrift unemployment, it must supply the private sector with the latter’s desired level of net financial assets, i.e. money (as the advocates of MMT have rightly pointed out a thousand times). However, there is absolutely no reason for those holding these assets to earn interest on these holdings. They do the country no favours whatever by holding $X in savings or checking accounts.

If anything, it’s the country doing private sector entities a favour by creating and supplying such entities a volume of “monopoly money” which makes those entities feel comfortable enough to spend, or “play the game”.

Notice that two quite different rates of interest above. First, the rate that brings an optimum amount of real investment, and second, the rate applicable to “monopoly money”.

Given these two rates, there is obvious scope for someone to make a fast buck: that is, borrow at near zero interest from the holders of monopoly money and lend to those wanting to borrow long term. And indeed, the relevant “fast buck / profit making” wheeze has been going on for centuries. The wheeze is called maturity transformation and it is carried about by banks.

This results in a misallocation of resources, because it breaks the relationship between the above two “marginal” factors.

But suppose maturity transformation were disallowed, that would destroy or reduce the ability of central banks to influence that rates of interest involved in REAL investments. Would that matter? The answer is “NO”, because fiddling with interest rates is not a good way of regulating economies for reasons I set out here.

And finally, for a bit more on maturity transformation, see here.

Anatole Kaletsky should study economics.

The longer the recession lasts, the more the ignorance of conventional economic commentators become apparent.

Anatole Kaletsky, principal economic commentator of the The Times (London) claims today that if we get double dip or no recovery then the government has a choice between no debt reduction and a prolonged recession (see his last para in particular).

Kaletsky needs to study Keynes, and/or Abba Lerner and/or Milton Friedman. As these three individuals made clear, additional debt is wholly unnecessary for the purposes of bringing extra stimulus.

Re Friedman: see here.

Re Keynes…search for phrase “borrowed or printed money” here.

Of course, those of us with an innate understanding of economics (i.e. advocates of Modern Monetary Theory) don’t even need to read the above material by Keynes, Friedman, etc. to understand the above point about irrelevance of debt. But great minds think alike, and speaking as a great mind (self appointed), it’s always nice to see minds which conventional bores describe as “great” thinking the same way as oneself.

But we can’t expect the conventionally minded ignoramuses to bother looking at anything unconventional. If you’ve got a well paid job churning out drivel in some newspaper, why bother THINKING?

Anti stimulus idiots.

An argument put about five hundred times in the last year in the Wall Street Journal (mouth piece of anti stimulus idiots) is the argument that the stimulus to date has not worked, therefor stimulus never works.

That is as daft as claiming that because pouring some water on a fire does not extinguish the fire, therefor water does not put out fires.

The flaw in both arguments is of course that in the case of fires, recessions, and a whole string of other problems, it is necessary to apply the RIGHT AMOUNT of remedy. And in many cases, this is not easy to do.

I’ll illustrate that by reference to an ultra example. The following paragraph (in red) contains only monosyllabic words, so hopefully the anti stimulus brigade will understand it.

Put too little water on a house fire, and the fire won’t go out. Put too much on, and water can do more harm than the fire.

Most mentally retarded six year olds will understand the latter point, though whether the Heritage Foundation and the Peter Peterson Foundation can understand it is moot. (The two latter are the source of many anti-stimulus articles in the WSJ).

There are a couple of other relevant points here (way beyond the comprehension of the two latter “foundations”). One is that the size of the stimulus is puny: almost irrelevant compared to the other factors making up the deficit. For some numbers, see here.

Second, in that stimulus has consisted of the creation of monetary base, this has got the above “foundations” jumping up and down with excitement about inflation. What they evidently haven’t tumbled to is that the monetary base expansion is arguably no more than the destruction of private or commercial bank created money brought about by deleveraging. See this Credit Suisse paper.

Finally, it should be mentioned that the amount of additional stimulus needed is very definitely not the same in different countries or continents. For example inflation is well under control in the U.S. but not so well under control in the U.K. (it’s around 3%). On that basis, more stimulus, relative to GDP, is permissible in the U.S. than U.K.

A daft form of stimulus: deliberately stoking inflation.

One of the most fatuous forms of stimulus ever advocated is the idea that a central bank should announce a higher inflation target (advocated for example by Mark Thoma). The big idea is that given higher inflation, the private sector will try to dispose of cash, which in turn will raise demand and reduce unemployment. Also, at the current zero or near zero interest rates, higher inflation means an effective drop in interest rates which ought to have a stimulatory effect.

The above idea certainly ought to work, but there are serious problems with it. That is, there are better forms of stimulus.

The first problem is the question as to how big an effect a mere announcement by a central bank is. If the mere announcement that inflation will be X% in Y years’ time makes it so, then this is news to the world’s central banks. No doubt they dearly wish they had that measure of control over inflation. (Though arguably it is easier to talk up inflation than talk it down.)

As distinct from mere announcements, the really effective way of raising inflation is to do something which is well known to raise inflation, e.g. effect a big rise in demand, for example by lowering interest rates too much or printing and spending too much extra money.

But this works primarily (or only) to the extent that demand becomes excessive. And the ultimate purpose of the “high inflation target idea” is to raise demand and reduce unemployment! So what’s the point of the “high inflation”, given that the only or main way that the high inflation policy works (raising demand) is itself the solution to the problem?

The second big drawback with “inflation increasing” is that inflation is notoriously difficult to control compared to other methods of influencing demand. For example it took best part of a decade to get the excessive inflation of the 1970s and 80s under control. That is far too long a time span for dealing with recessions and inflationary booms. A vastly better method of influencing demand is the standard Modern Monetary Theory one: just alter taxes or one or more of the various forms of government spending.

The only delay involved in the two latter is the time taken by bureaucrats to get a move on, and DO IT. For example, the U.K. adjusted its sales tax (VAT) downwards on 1st December 2008 and then up again thirteen months later.

Home ownership versus renting.

Peter Peterson claims that UncleSam should not be promoting home ownership. L.Randall Wray attacks PP for making this claim.

I rarely agree with PP, but on this point he is right. That there is no inherent merit in owner occupation as opposed to renting.

Levels of home ownership vary a huge amount across Europe as between different countries. And it’s certainly not exclusively the richest countries where home ownership rates or high, or poor countries where home ownership rates are low. For example Germany is one of the richest countries, but it has the lowest rate of home ownership! See “International trends in housing….” By Kathleen Scanlon and Christine Whitehead, p. 10.

Does anyone know what the economy is for?

Forgive the statement of the bleeding obvious, but the basic purpose of the economy is to produce what the consumer wants. To be more accurate, the purpose is to produce what the consumer wants BOTH as expressed via consumers’ credit cards, cash, etc, AND as expressed via the ballot box. That is, consumer / citizens express the desire for a portion of GDP to be supplied free at the point of delivery by government: state schools, health care, etc. It shouldn’t be necessary to make those statements of the obvious. Unfortunately it IS necessary, and for reasons set out below.

It follows from the above that where GDP is less than it could be, i.e. given excess unemployment, the consumer needs more spending power, plus government spending needs to be boosted.

Unfortunately, come a recession, a variety of weirdos come out of the woodwork, each with their own pet scheme for expanding the economy. These schemes involve everything BUT the above “bleeding obvious” cures.

For example, there are those who seem to want banks to revert to their pre-crunch excessive lending activities, e.g. Tim Congdon in The Times. And the governor of the BoE claimed that “We cannot have a sustainable recovery at trend growth unless the banking system returns to more normal levels of lending to start up and small businesses.” That is total bunk.

Basic economics teaches that if the marginal (or “least profitable”) unit sold is UNPROFITABLE (i.e. makes a loss), the business should be CONTRACTED NOT EXPANDED. And what did the marginal or least profitable loans made by banks just prior to the credit crunch consist of? They consisted of ninja mortgages and loans to businesses made more or less on demand. On that basis, the banking industry should be CONTRACTED, not expanded.

And a further piece of evidence that the entire banking industry is too large is that UK bank assets as a proportion of GDP were 50% between 1880 and 1970, but then shot up to 500% in 2006.

But the London based elite is mesmerised by senior bankers: even the left of centre elite. Gordon Brown, former U.K. prime minister and head of the supposedly left of centre Labour Party, loved big banks so much that he facilitated the merger of two “too big to fail banks” thus creating one “cannot under any conceivable circumstances be allowed to fail” bank. Pure genius!

The elite adopts the same attitude to Main Street as Marie Antoinette adopted to peasants. The elite prefers the criminals and fraudsters of Wall Street to the honest folk in Main Street.

The businesses which were acting responsibly prior to the crunch were the bog standard boring ones that senior politicians and the elite just cannot stand: garages, hair dressers, you name it. Stalin made exactly the same mistake: he just loved megga investment projects – big dams and canals. Whether such projects made economic sense was, for Stalin, oh so boring.

The reality is that bank finance is just ONE method of financing businesses. One alternative is for entrepreneurs, plus their friends, family and businesses associates to have enough money to finance their own businesses. The extent to which banks finance businesses relative to other methods of finance is very variable: it varies significantly as between different European countries.

A second alternative is the stock market.

Third, at the height of the credit crunch, various German firms (Siemens in particular) greatly expanded the loans they made to suppliers and customers. And there is much to be said for this type of lending: most firms are probably as good a judge of the credit worthiness of their suppliers and customers as the latters’ banks. In short, if bank’s lending operations were closed down altogether, a range of smaller quasi banks would soon take their place: at least they would in a free market.

Problem is of course that the market is not free. That is, it’s only those big banks, favoured by the elite, that get the “too big to fail subsidies”.

But even if quasi banks do NOT make up for any reduced lending by the irresponsible / criminal banks, does that matter? Economies are flexible: most production processes involve a range of possibilities on the capital intensive versus labour intensive scale. In addition, the consumer has a choice between capital intensive produced goods and labour intensive produced products. If borrowing becomes more expensive, consumers will shift some of their spending towards labour intensive produced stuff.

But Mervyn King and the other smartly dressed well paid individuals who work in central London (like people the world over) like to retain power in their own hands. They make complementary remarks about “small businesses”, but they don’t want real power (i.e. money) shifted to plumbers or restaurant owners in Northern England. They’d rather retain power in central London and have the plumbers and restaurant owners come to them begging. And if the elite make a hash of that power by failing to get banks to lend, well the elite still have their cocktail parties to attend, where they can make economically illiterate and hypocritical noises about “banks failing to lend”.

Quite apart from the above point, there is another bank related form of stimulus which is pretty much of a nonsense: cutting interest rates. This boosts the economy only via people and institutions which rely on variable rate loans. To repeat the bleeding obvious point made at the outset (pity it needs repeating): the basic purpose of economic activity is to produce what the consumer wants. So come a recession, put more spending power into ALL consumers’ pockets (not just those who borrow heavily) and boost government spending.

Moreover, “consumer stimulus” leads AUTOMATICALLY to a certain amount bank stimulus (for the benefit of those who seem to think that banks are some sort of end in themselves!). That is, an increased demand by consumers leads to increased demand for working capital by businesses (and in some cases to an increased need for other types of capital investment).

And wouldn’t you know it: the latter is exactly what Modern Monetary Theory involves.

Note added 21st August. A further point here is that interest rates are probably artificially low because we allow maturity transformation (i.e. we let banks borrow short and lend long). See here. This artificially low interest rate means the banking industry is larger than it would be if maturity transformation were abolished.

Also there is some evidence here that it is plain straightforward extra demand that businesses need.

Interest on reserves discourages lending?

The Atlanta Fed wonders whether interest payments by the Fed on reserves discourages bank lending (the word “bank” is used here to refer to private sector or “commercial” banks.)

The obvious answer is “yes”. But longer term, and especially if that interest rate rises, the answer is no. Reasons are thus.

Where a bank lends $X, the money mostly ends up in accounts in other banks. The first bank then has to transfer $X of reserves to those other banks, and operation done in the Fed’s books. Thus the first bank loses interest on reserves. And if interest is earned on reserves, then the latter are a disincentive to lend.

But the private sector banking system AS A WHOLE does not lose interest. This means that there is potential profit for this system to act “as a whole”: that is get together and by-pass the Fed.

And members of most professions are normally quick to think up mutually beneficial arrangements (monopolies, cartels, etc), which involve members of the profession acting “as a whole” . Or as Adam Smith said , “People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.”

So how would a “Fed bypassing” system work? One option would be an agreement (formal or informal) by banks just to ignore the Fed and adjust numbers in their own books to reflect which bank owed what to which other bank. This agreement could include a clause saying that any bank asking the Fed to do the relevant book-keeping would be punished by other banks: i.e. if one bank asked the Fed to debit the accounts (in the Fed’s books) of other banks, the latter banks would effectively say to the first bank “OK, at the next suitable opportunity, we’ll ask the Fed to debit your account”. And if a “next suitable opportunity” does not arise within some specified, time, “we’ll invoice you for the interest we’ve lost”.

It is possible that an agreement along the above lines would be illegal, but that is of limited relevance: the law has never been a big obstacle for monopolies, cartels and so on. And the banking industry is not just any old cartel: it’s a super efficient cartel. In the words of Congressman Dick Durbin referring to banks and Congress respectively, “Frankly they own the place”.

Another factor which renders interest on reserves an ineffective method of discouraging bank lending is that banks are well aware that this interest is probably a temporary measure, because we are in unusual economic circumstances. If a bank sees a lending opportunity which because of interest on reserves is not profitable now, but will become profitable when this interest vanishes, the bank will go ahead with the loan: most businesses are happy with a small loss for a short period if it results in increased market share in the long run.