Archive for June, 2018

The Monumental Dishonesty and Appalling Bad Faith of Chief Justice Roberts’s Decision

Noah Feldman brilliantly exposes the moral rot underlying the horrific Supreme Court decision handed down today approving the Muslim ban, truly, as Feldman describes it, a decision that will live in infamy in the company of Dred Scott and Korematsu. Here are the key passages from Feldman’s masterful unmasking of the faulty reasoning of the Roberts opinion

When Chief Justice Roberts comes to the topic of bias, he recounts Trump’s anti-Muslim statements and the history of the travel ban (this is the administration’s third version). Then he balks. “The issue before us is not whether to denounce the statements,” Roberts writes. Rather, Roberts insists, the court’s focus must be on “the significance of those statements in reviewing a presidential directive, neutral on its face, addressing the matter within the core of executive responsibility.”

That is lawyer-speak for saying that, despite its obviousness, the court would ignore Trump’s anti-Muslim bias. Roberts is trying to argue that, when a president is acting within his executive authority, the court should defer to what the president says his intention is, no matter the underlying reality.

That’s more or less what the Supreme Court did in the Korematsu case. There, Justice Hugo Black, a Franklin D. Roosevelt loyalist, denied that the orders requiring the internment of Japanese-Americans were based on racial prejudice. The dissenters, especially Justice Frank Murphy, pointed out that this was preposterous.

Justice Sonia Sotomayor, the court’s most liberal member, played the truth-telling role today. Her dissent, joined by Justice Ruth Bader Ginsburg, states bluntly that a reasonable observer looking at the record would conclude that the ban was “motivated by anti-Muslim animus.”

She properly invokes the Korematsu case — in which, she points out, the government also claimed a national security rationale when it was really relying on stereotypes. And she concludes that “our Constitution demands, and our country deserves, a Judiciary willing to hold the coordinate branches to account when they defy our most sacred legal commitments.”

Roberts tried to dodge the Korematsu comparison by focusing on the narrow text of the order, which, according to Roberts, on its own terms – absent the statements made by the author of the ban himself — is not facially discriminatory. Feldman skewers that attempt.

Roberts certainly knows the consequences of this decision. He tries to deflect the Korematsu comparison by saying that the order as written could have been enacted by any other president — a point that is irrelevant to the reality of the ban. Roberts also takes the opportunity to announce that Korematsu “was gravely wrong the day it was decided [and] has been overruled in the court of history.”

In another context, we might well be celebrating the fact that the Supreme Court had finally and expressly repudiated Korematsu, which it had never fully done before. Instead, Roberts’s declaration reads like a desperate attempt to change the subject. The truth is that this decision and Korematsu are a pair: Prominent instances where the Supreme Court abdicated its claim to moral leadership.

Following up Feldman, I just want to make it absolutely clear how closely, despite Roberts’s bad faith protestations to the contrary, the reasoning of his opinion follows the reasoning of the Korematsu court (opinion by Justice Black).

From the opinion of Chief Justice Roberts, attempting to counter the charge by Justice Sotomayor in her dissent that the majority was repeating the error of Korematsu.

Finally, the dissent invokes Korematsu v. United States, 323 U. S. 214 (1944). Whatever rhetorical advantage the dissent may see in doing so, Korematsu has nothing to do with this case. The forcible relocation of U. S. citizens to concentration camps, solely and explicitly on the basis of race, is objectively unlawful and outside the scope of Presidential authority. But it is wholly inapt to liken that morally repugnant order to a facially neutral policy denying certain foreign nationals the privilege of admission. See post, at 26–28. The entry suspension is an act that is well within executive authority and could have been taken by any other President—the only question is evaluating the actions of this particular President in promulgating an otherwise valid Proclamation.

This statement by the Chief Justice is monumentally false and misleading and utterly betrays either consciousness of wrongdoing or a culpable ignorance of the case he is presuming to distinguish from the one that he is deciding. Here is the concluding paragraph of Justice Black’s opinion in Korematsu.

It is said that we are dealing here with the case of imprisonment of a citizen in a concentration camp solely because of his ancestry, without evidence or inquiry concerning his loyalty and good disposition towards the United States. Our task would be simple, our duty clear, were this a case involving the imprisonment of a loyal citizen in a concentration camp because of racial prejudice.

Justice Black is explicitly denying that the Japanese American citizens being imprisoned were imprisoned because of racial prejudice.

Regardless of the true nature of the assembly and relocation centers — and we deem it unjustifiable to call them concentration camps, with all the ugly connotations that term implies — we are dealing specifically with nothing but an exclusion order.

And Justice Black denies that the Japanese Americans were sent to concentration camps.

To cast this case into outlines of racial prejudice, without reference to the real military dangers which were presented, merely confuses the issue.

Contrary to the assertion of Chief Justice Roberts, the Korematsu court did not “solely and explicitly” relocate U.S. citizens to concentration camps solely on the basis of race. Justice Black explicitly rejected that contention. So his attempt to distinguish his opinion from Justice Black’s majority opinion fails. Indeed Mr. Justice Black bases his decision on statutory authority given to the President by Congress, his inherent powers as Commander-in-Chief, and his assessment of the military danger of an invasion of the West Coast by the Japanese.

Korematsu was not excluded from the Military Area because of hostility to him or his race. He was excluded because we are at war with the Japanese Empire, because the properly constituted military authorities feared an invasion of our West Coast and felt constrained to take proper security measures, because they decided that the military urgency of the situation demanded that all citizens of Japanese ancestry be segregated from the West Coast temporarily, and, finally, because Congress, reposing its confidence in this time of war in our military leaders — as inevitably it must — determined that they should have the power to do just this. There was evidence of disloyalty on the part of some, the military authorities considered that the need for action was great, and time was short. We cannot — by availing ourselves of the calm perspective of hindsight — now say that, at that time, these actions were unjustified.

In almost every particular, Justice Black’s decision employed the exact same reasoning that the Chief Justice now employs to uphold the travel ban. Justice Black argued that the relocation could have been motivated by reasons of national security, just as Chief Justice now argues that the travel ban was motivated by reasons of national security. Justice Black argued that the military must be trusted to make decisions about which citizens might be disloyal and could pose a national security threat in time of war just as Chief Justice Roberts now argues that the President must be allowed to make national security decisions about who may enter the United States from abroad. Neither Justice Black nor Chief Justice Roberts is prepared to say that singling out a group based on race or religion is unjustified.

The only distinction between the cases is that Korematsu concerned the rights of American citizens not to be imprisoned without due process, and the travel ban primarily affects the rights of non-resident aliens. Clearly an important distinction, but the rights of American citizens and resident aliens are also implicated. Their rights to be free from religious discrimination are also at issue, and those rights may not be lightly disregarded.

Chief Justice Roberts concludes by attempting to distract attention from the glaring similarities between his own decision and Justice Black’s in Korematsu.

The dissent’s reference to Korematsu, however, affords this Court the opportunity to make express what is already obvious: Korematsu was gravely wrong the day it was decided, has been overruled in the court of history, and—to be clear—“has no place in law under the Constitution.” (Jackson, J., dissenting).

But in doing so, Chief Justice Roberts only provides further evidence of his own consciousness of wrongdoing and his stunning display of bad faith.


Who’s Afraid of a Flattening Yield Curve?

Last week the Fed again raised its benchmark Federal Funds rate target, now at 2%, up from the 0.25% rate that had been maintained steadily from late 2008 until late 2015, when the Fed, after a few false starts, finally worked up the courage — or caved to the pressure of the banks and the financial community — to start raising rates. The Fed also signaled its intention last week to continue raising rates – presumably at 0.25% increments – at least twice more this calendar year.

Some commentators have worried that rising short-term interest rates are outpacing increases at the longer end, so that the normally positively-sloped yield curve is flattening. They point out that historically flat or inverted yield curves have often presaged an economic downturn or recession within a year.

What accounts for the normally positive slope of the yield curve? It’s usually attributed to the increased risk associated with a lengthening of the duration of a financial instrument, even if default risk is zero. The longer the duration of a financial instrument, the more sensitive the (resale) value of the instrument to changes in the rate of interest. Because risk falls as the duration of the of the instrument is shortened, risk-averse asset-holders are willing to accept a lower return on short-dated claims than on riskier long-dated claims.

If the Fed continues on its current course, it’s likely that the yield curve will flatten or become inverted – sloping downward instead of upward – a phenomenon that has frequently presaged recessions within about a year. So the question I want to think through in this post is whether there is anything inherently recessionary about a flat or inverted yield curve, or is the correlation between recessions and inverted yield curves merely coincidental?

The beginning of wisdom in this discussion is the advice of Scott Sumner: never reason from a price change. A change in the slope of the yield curve reflects a change in price relationships. Any given change in price relationships can reflect a variety of possible causes, and the ultimate effects, e.g., an inverted yield curve, of those various underlying causes, need not be the same. So, we can’t take it for granted that all yield-curve inversions are created equal; just because yield-curve inversions have sometimes, or usually, or always, preceded recessions doesn’t mean that recessions must necessarily follow once the yield curve becomes inverted.

Let’s try to sort out some of the possible causes of an inverted yield curve, and see whether those causes are likely to result in a recession if the yield curve remains flat or inverted for a substantial period of time. But it’s also important to realize that the shape of the yield curve reflects a myriad of possible causes in a complex economic system. The yield curve summarizes expectations about the future that are deeply intertwined in the intertemporal structure of an economic system. Interest rates aren’t simply prices determined in specific markets for debt instruments of various durations; interest rates reflect the opportunities to exchange current goods for future goods or to transform current output into future output. Interest rates are actually distillations of relationships between current prices and expected future prices that govern the prices and implied yields at which debt instruments are bought and sold. If the interest rates on debt instruments are out of line with the intricate web of intertemporal price relationships that exist in any complex economy, those discrepancies imply profitable opportunities for exchange and production that tend to eliminate those discrepancies. Interest rates are not set in a vacuum, they are a reflection of innumerable asset valuations and investment opportunities. So there are potentially innumerable possible causes that could lead to the flattening or inversion of the yield curve.

For purposes of this discussion, however, I will focus on just two factors that, in an ultra-simplified partial-equilibrium setting, seem most likely to cause a normally upward-sloping yield curve to become relatively flat or even inverted. These two factors affecting the slope of the yield curve are the demand for liquidity and the supply of liquidity.

An increase in the demand for liquidity manifests itself in reduced current spending to conserve liquidity and by an increase in the demands of the public on the banking system for credit. But even as reduced spending improves the liquidity position of those trying to conserve liquidity, it correspondingly worsens the liquidity position of those whose revenues are reduced, the reduced spending of some necessarily reducing the revenues of others. So, ultimately, an increase in the demand for liquidity can be met only by (a) the banking system, which is uniquely positioned to create liquidity by accepting the illiquid IOUs of the private sector in exchange for the highly liquid IOUs (cash or deposits) that the banking system can create, or (b) by the discretionary action of a monetary authority that can issue additional units of fiat currency.

Let’s consider first what would happen in case of an increased demand for liquidity by the public. Such an increased demand could have two possible causes. (There might be others, of course, but these two seem fairly commonplace.)

First, the price expectations on which one or more significant sectors of the economy have made investments have turned out to overly optimistic (or alternatively made investments on overly optimistic expectations of low input prices). Given the commitments made on the basis of optimistic expectations, it then turns out that realized sales or revenues fall short of what was required by those firms to service their debt obligations. Thus, to service their debt obligations, firms may seek short-term loans to cover the shortfall in earnings relative to expectations. Potential lenders, including the banking system, who may already be holding the debt of such firms, must then decide whether to continue extending credit to these firms in hopes that prices will rebound back to what they had been expected to be (or that borrowers will be able to cut costs sufficiently to survive if prices don’t recover), or to cut their losses by ceasing to lend further.

The short-run demand for credit will tend to raise short-term rates relative to long-term rates, causing the yield curve to flatten. And the more serious the short-term need for liquidity, the flatter or more inverted the yield curve becomes. In such a period of financial stress, the potential for significant failures of firms that can’t service their financial obligations is an indication that an economic downturn or a recession is likely, so that the extent to which the yield curve flattens or becomes inverted is a measure of the likelihood that a downturn is in the offing.

Aside from sectoral problems affecting particular industries or groups of industries, the demand for liquidity might increase owing to a generalized increase in uncertainty that causes entrepreneurs to hold back from making investments (dampens animal spirits). This is often a response during and immediately following a recession, when the current state of economic activity and uncertainty about its future state discourages entrepreneurs from making investments whose profitability depends on the magnitude and scope of the future recovery. In that case, an increasing demand for liquidity causes firms to hoard their profits as cash rather than undertake new investments, because expected demand is not sufficient to justify commitments that would be remunerative only if future demand exceeds some threshold. Such a flattening of the yield curve can be mitigated if the monetary authority makes liquidity cheaply available by cutting short-term rates to very low levels or even to zero, as the Fed did when it adopted its quantitative easing policies after the 2008-09 downturn, thereby supporting a recovery, a modest one to be sure, but still a stronger recovery than occurred in Europe after the European Central Bank prematurely raised interest short-term rates.

Such an episode occurred in 2002-03, after the 9-11 attack on the US. The American economy had entered a recession in early 2001, partly as a result of the bursting of the dotcom bubble of the late 1990s. The recession was short and mild, and the large tax cut enacted by Congress at the behest of the Bush administration in June 2001 was expected to provide significant economic stimulus to promote recovery. However, it soon became clear that, besides the limited US attack on Afghanistan to unseat the Taliban regime and to kill or capture the Al Qaeda leadership in Afghanistan, the Bush Administration was planning for a much more ambitious military operation to effect regime change in Iraq and perhaps even in other neighboring countries in hopes of radically transforming the political landscape of the Middle East. The grandiose ambitions of the Bush administration and the likelihood that a major war of unknown scope and duration with unpredictable consequences might well begin sometime in early 2003 created a general feeling of apprehension and uncertainty that discouraged businesses from making significant new commitments until the war plans of the Administration were clarified and executed and their consequences assessed.

Gauging the unusual increase in the demand for liquidity in 2002 and 2003, the Fed reduced short-term rates to accommodate increasing demands for liquidity, even as the economy entered into a weak expansion and recovery. Given the unusual increase in the demand for liquidity, the accommodative stance of the Fed and the reduction in the Fed Funds target to an unusually low level of 1% had no inflationary effect, but merely cushioned the economy against a relapse into recession. The weakness of the recovery is reflected in the modest rate of increase in nominal spending, averaging about 3.9%, and not exceeding 5.1% in any of the seven quarters from 2001-IV when the recession ended until 2003-II when the Saddam Hussein regime was toppled.

Quarter              % change in NGDP

2001-IV               2.34%

2002-I                 5.07%

2002-II                3.76%

2002-III               3.80%

2002-IV               2.44%

2003-I                 4.63%

2003-II                5.10%

2003-III               9.26%

2003-IV               6.76%

2004-I                 5.94%

2004-II                6.60%

2004-III               6.26%

2004-IV               6.44%

2005-I                 8.25%

2005-II                5.10%

2005-III               7.33%

2005-IV               5.44%

2006-I                 8.23%

2006-II                4.50%

2006-III               3.19%

2006-IV               4.62%

2007-I                 4.83%

2007-II                5.42%

2007-III               4.15%

2007-IV               3.21%

The apparent success of the American invasion in the second quarter of 2003 was matched by a quickening expansion from 2003-III through 2006-I, nominal GDP increasing at a 6.8% annual rate over those 11 quarters. As the economy recovered, and spending began increasing rapidly, the Fed gradually raised its Fed Funds target by 25 basis points about every six weeks starting at the end of June 2004, so that in early 2006, the Fed Funds target rate reached 4.25%, peaking at 5.25% in July 2006, where it remained till September 2007. By February 2006, the yield on 3-month Treasury bills reached the yield on 10-year Treasuries, so that the yield curve had become essentially flat, remaining so until October 2008, soon after the start of the financial crisis. Indeed, for most of 2006 and 2007, the Fed Funds target was above the yield on three-month Treasury bills, implying a slight inversion at the short-end of the yield curve, suggesting that the Fed was exacting a slight liquidity surcharge on overnight reserves and that there was a market expectation that the Fed Funds target would be reduced from its 5.25% peak.

The Fed was probably tardy in increasing its Fed Funds target till June 2004, nominal spending having increased in 2003-III at an annual rate above 9%, and increasing in the next three quarters at an average annual rate of about 6.5%. In 2005 while the Fed was in auto-pilot mode, automatically raising its Fed Funds target 25 basis points every six weeks, nominal spending continued to increase at a roughly 6% annual rate, increases becoming slightly more erratic, fluctuating between 5.1% and 8.3%. But by the second quarter of 2006 when the Fed Funds target rose to 5%, the rate of increase in spending slowed to an average of just over 4% and just under 5% in the first three quarters of 2007.

While the rate of increase in spending slowed to less than 5% in the second quarter of 2006, as the yield curve flattened, and the Fed Funds target peaked at 5.25%, housing prices also peaked, and the concerns about financial stability started to be voiced. The chart below shows the yields on 10-year constant maturity Treasuries and the yield on 3-month Treasury bills, the two key market rates at opposite ends of the yield curve.

The yields on the two instruments became nearly equal in early 2006, and, with slight variations, remained so till the onset of the financial crisis in September 2008. In retrospect, at least, the continued increases in the Fed Funds rate target seem too have been extremely ill-advised, perhaps triggering the downturn that started at the end of 2007, and leading nine months later to the financial crisis of 2008.

The Fed having put itself on autopilot, the yield curve became flat or even slightly inverted in early 2006, implying that a substantial liquidity premium had to be absorbed in order to keep cash on hand to meet debt obligations. By the second quarter of 2006, insufficient liquidity caused the growth in total spending to slow, just when housing prices were peaking, a development that intensified the stresses on the financial system, further increasing the demand for liquidity. Despite the high liquidity premium and flat yield curve, total spending continued to increase modestly through 2006 and most of 2007. But after stock prices dropped in August 2007 and home prices continued to slide, growth in total spending slowed further at the end of 2007, and the downturn began.

Responding to signs of economic weakness and falling long-term rates, the Fed did lower its Fed Funds target late in 2007, cutting the Fed Funds target several more times in early 2008. In May 2008, the Fed reduced the target to 2%, but the yield curve remained flat, because the Fed, consistently underestimating the severity of the downturn, kept signaling its concern with inflation, thereby suggesting that an increase in the target might be in the offing. So, even as it reduced its Fed Funds target, the Fed kept the yield curve nearly flat until, and even after, the start of the financial crisis in September 2008, thereby maintaining an excessive liquidity premium while the demand for liquidity was intensifying as total spending contracted rapidly in the third quarter of 2008.

To summarize this discussion of the liquidity premium and the yield curve during the 2001-08 period, the Fed appropriately steepened the yield curve right after the 2001 recession and the 9/11 attacks, but was slow to normalize the slope of the yield curve after the US invasion of Iraq in the second quarter of 2003. When it did begin to normalize the yield curve in a series of automatic 25 basis point increases in its Fed Fund target rate, the Fed was again slow to reassess the effects of the policy as yield curve flattened in 2006. Thus by 2006, the Fed had effectively implemented a tight monetary policy in the face of rising demands for liquidity just as the bursting of the housing bubble in mid-2006 began to subject the financial system to steadily increasing stress. The implications of a flat or slightly inverted yield curve were ignored or dismissed by the Fed for at least two years until after the financial panic and crisis in September 2008.

At the beginning of the 2001-08 period, the Fed seemed to be aware that an unusual demand for liquidity justified a policy response to increase the supply of liquidity by reducing the Fed Funds target and steepening the yield curve. But, at the end of the period, the Fed was unwilling to respond to increasing demands for liquidity and instead allowed a flat yield curve to remain in place even when the increasing demand for liquidity was causing a slowdown in aggregate spending growth. One possible reason for the asymmetric response of the Fed to increasing liquidity demands in 2002 and 2006 is that the Fed was sensitive to criticism that, by holding short-term rates too low for too long, it had promoted and prolonged the housing bubble. Even if the criticism contained some element of truth, the Fed’s refusal to respond to increasing demands for liquidity in 2006 was tragically misguided.

The current Fed’s tentative plan to keep increasing the Fed Funds target seems less unreflective as the nearly mindless schedule followed by the Fed from mid-2004 to mid-2006. However, the Fed is playing a weaker hand now than it did in 2004. Nominal GDP has been increasing at a very lackluster annual rate of about 4-4.5% for the past two years. Certainly, further increases in the Fed Funds target would not be warranted if the rate of growth in nominal GDP is any less than 4% or if the yield curve should flatten for some other reason like a decline in interest rates at the longer end of the yield curve. Caution, possible inversion ahead.

Keynes and the Fisher Equation

The history of economics society is holding its annual meeting in Chicago from Friday June 15 to Sunday June 17. Bringing together material from a number of posts over the past five years or so about Keynes and the Fisher equation and Fisher effect, I will be presenting a new paper called “Keynes and the Fisher Equation.” Here is the abstract of my paper.

One of the most puzzling passages in the General Theory is the attack (GT p. 142) on Fisher’s distinction between the money rate of interest and the real rate of interest “where the latter is equal to the former after correction for changes in the value of money.” Keynes’s attack on the real/nominal distinction is puzzling on its own terms, inasmuch as the distinction is a straightforward and widely accepted distinction that was hardly unique to Fisher, and was advanced as a fairly obvious proposition by many earlier economists including Marshall. What makes Keynes’s criticism even more problematic is that Keynes’s own celebrated theorem in the Tract on Monetary Reform about covered interest arbitrage is merely an application of Fisher’s reasoning in Appreciation and Interest. Moreover, Keynes endorsed Fisher’s distinction in the Treatise on Money. But even more puzzling is that Keynes’s analysis in Chapter 17 demonstrates that in equilibrium the return on alternative assets must reflect their differences in their expected rates of appreciation. Thus Keynes, himself, in the General Theory endorsed the essential reasoning underlying the distinction between real and the money rates of interest. The solution to the puzzle lies in understanding the distinction between the relationships between the real and nominal rates of interest at a moment in time and the effects of a change in expected rates of appreciation that displaces an existing equilibrium and leads to a new equilibrium. Keynes’s criticism of the Fisher effect must be understood in the context of his criticism of the idea of a unique natural rate of interest implicitly identifying the Fisherian real rate with a unique natural rate.

And here is the concluding section of my paper.

Keynes’s criticisms of the Fisher effect, especially the facile assumption that changes in inflation expectations are reflected mostly, if not entirely, in nominal interest rates – an assumption for which neither Fisher himself nor subsequent researchers have found much empirical support – were grounded in well-founded skepticism that changes in expected inflation do not affect the real interest rate. A Fisherian analysis of an increase in expected deflation at the zero lower bound shows that the burden of the adjustment must be borne by an increase in the real interest rate. Of course, such a scenario might be dismissed as a special case, which it certainly is, but I very much doubt that it is the only assumptions leading to the conclusion that a change in expected inflation or deflation affects the real as well as the nominal interest rate.

Although Keynes’s criticism of the Fisher equation (or more precisely against the conventional simplistic interpretation) was not well argued, his intuition was sound. And in his contribution to the Fisher festschrift, Keynes (1937b) correctly identified the two key assumptions leading to the conclusion that changes in inflation expectations are reflected entirely in nominal interest rates: (1) a unique real equilibrium and (2) the neutrality (actually superneutrality) of money. Keynes’s intuition was confirmed by Hirshleifer (1970, 135-38) who derived the Fisher equation as a theorem by performing a comparative-statics exercise in a two-period general-equilibrium model with money balances, when the money stock in the second period was increased by an exogenous shift factor k. The price level in the second period increases by a factor of k and the nominal interest rate increases as well by a factor of k, with no change in the real interest rate.

But typical Keynesian and New Keynesian macromodels based on the assumption of no capital or a single capital good drastically oversimplify the analysis, because those highly aggregated models assume that the determination of the real interest rate takes place in a single market. The market-clearing assumption invites the conclusion that the rate of interest, like any other price, is determined by the equality of supply and demand – both of which are functions of that price — in  that market.

The equilibrium rate of interest, as C. J. Bliss (1975) explains in the context of an intertemporal general-equilibrium analysis, is not a price; it is an intertemporal rate of exchange characterizing the relationships between all equilibrium prices and expected equilibrium prices in the current and future time periods. To say that the interest rate is determined in any single market, e.g., a market for loanable funds or a market for cash balances, is, at best, a gross oversimplification, verging on fallaciousness. The interest rate or term structure of interest rates is a reflection of the entire intertemporal structure of prices, so a market for something like loanable funds cannot set the rate of interest at a level inconsistent with that intertemporal structure of prices without disrupting and misaligning that structure of intertemporal price relationships. The interest rates quoted in the market for loanable funds are determined and constrained by those intertemporal price relationships, not the other way around.

In the real world, in which current prices, future prices and expected future prices are not and almost certainly never are in an equilibrium relationship with each other, there is always some scope for second-order variations in the interest rates transacted in markets for loanable funds, but those variations are still tightly constrained by the existing intertemporal relationships between current, future and expected future prices. Because the conditions under which Hirshleifer derived his theorem demonstrating that changes in expected inflation are fully reflected in nominal interest rates are not satisfied, there is no basis for assuming that a change in expected inflation affect only nominal interest rates with no effect on real rates.

There are probably a huge range of possible scenarios of how changes in expected inflation could affect nominal and real interest rates. One should not disregard the Fisher equation as one possibility, it seems completely unwarranted to assume that it is the most plausible scenario in any actual situation. If we read Keynes at the end of his marvelous Chapter 17 in the General Theory in which he remarks that he has abandoned the belief he had once held in the existence of a unique natural rate of interest, and has come to believe that there are really different natural rates corresponding to different levels of unemployment, we see that he was indeed, notwithstanding his detour toward a pure liquidity preference theory of interest, groping his way toward a proper understanding of the Fisher equation.

In my Treatise on Money I defined what purported to be a unique rate of interest, which I called the natural rate of interest – namely, the rate of interest which, in the terminology of my Treatise, preserved equality between the rate of saving (as there defined) and the rate of investment. I believed this to be a development and clarification of of Wicksell’s “natural rate of interest,” which was, according to him, the rate which would preserve the stability of some, not quite clearly specified, price-level.

I had, however, overlooked the fact that in any given society there is, on this definition, a different natural rate for each hypothetical level of employment. And, similarly, for every rate of interest there is a level of employment for which that rate is the “natural” rate, in the sense that the system will be in equilibrium with that rate of interest and that level of employment. Thus, it was a mistake to speak of the natural rate of interest or to suggest that the above definition would yield a unique value for the rate of interest irrespective of the level of employment. . . .

If there is any such rate of interest, which is unique and significant, it must be the rate which we might term the neutral rate of interest, namely, the natural rate in the above sense which is consistent with full employment, given the other parameters of the system; though this rate might be better described, perhaps, as the optimum rate. (pp. 242-43)

Because Keynes believed that an increased in the expected future price level implies an increase in the marginal efficiency of capital, it follows that an increase in expected inflation under conditions of less than full employment would increase investment spending and employment, thereby raising the real rate of interest as well the nominal rate. Cottrell (1994) has attempted to make an argument along such lines within a traditional IS-LM framework. I believe that, in a Fisherian framework, my argument points in a similar direction.


About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

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