Archive for the 'loanable-funds theory' Category

Phillips Curve Musings: Second Addendum on Keynes and the Rate of Interest

In my two previous posts (here and here), I have argued that the partial-equilibrium analysis of a single market, like the labor market, is inappropriate and not particularly relevant, in situations in which the market under analysis is large relative to other markets, and likely to have repercussions on those markets, which, in turn, will have further repercussions on the market under analysis, violating the standard ceteris paribus condition applicable to partial-equilibrium analysis. When the standard ceteris paribus condition of partial equilibrium is violated, as it surely is in analyzing the overall labor market, the analysis is, at least, suspect, or, more likely, useless and misleading.

I suggested that Keynes in chapter 19 of the General Theory was aiming at something like this sort of argument, and I think he was largely right in his argument. But, in all modesty, I think that Keynes would have done better to have couched his argument in terms of the distinction between partial-equilibrium and general-equilibrium analysis. But his Marshallian training, which he simultaneously embraced and rejected, may have made it difficult for him to adopt the Walrasian general-equilibrium approach that Marshall and the Marshallians regarded as overly abstract and unrealistic.

In my next post, I suggested that the standard argument about the tendency of public-sector budget deficits to raise interest rates by competing with private-sector borrowers for loanable funds is fundamentally misguided, because it, too, inappropriately applies the partial-equilibrium analysis of a narrow market for government securities, or even a more broadly defined market for loanable funds in general.

That is a gross mistake, because the rate of interest is determined in a general-equilibrium system along with markets for all long-lived assets, embodying expected flows of income that must be discounted to the present to determine an estimated present value. Some assets are riskier than others and that risk is reflected in those valuations. But the rate of interest is distilled from the combination of all of those valuations, not prior to, or apart from, those valuations. Interest rates of different duration and different risk are embeded in the entire structure of current and expected prices for all long-lived assets. To focus solely on a very narrow subset of markets for newly issued securities, whose combined value is only a small fraction of the total value of all existing long-lived assets, is to miss the forest for the trees.

What I want to point out in this post is that Keynes, whom I credit for having recognized that partial-equilibrium analysis is inappropriate and misleading when applied to an overall market for labor, committed exactly the same mistake that he condemned in the context of the labor market, by asserting that the rate of interest is determined in a single market: the market for money. According to Keynes, the market rate of interest is that rate which equates the stock of money in existence with the amount of money demanded by the public. The higher the rate of interest, Keynes argued, the less money the public wants to hold.

Keynes, applying the analysis of Marshall and his other Cambridge predecessors, provided a wonderful analysis of the factors influencing the amount of money that people want to hold (usually expressed in terms of a fraction of their income). However, as superb as his analysis of the demand for money was, it was a partial-equilibrium analysis, and there was no recognition on his part that other markets in the economy are influenced by, and exert influence upon, the rate of interest.

What makes Keynes’s partial-equilibrium analysis of the interest rate so difficult to understand is that in chapter 17 of the General Theory, a magnificent tour de force of verbal general-equilibrium theorizing, explained the relationships that must exist between the expected returns for alternative long-lived assets that are held in equilibrium. Yet, disregarding his own analysis of the equilibrium relationship between returns on alternative assets, Keynes insisted on explaining the rate of interest in a one-period model (a model roughly corresponding to IS-LM) with only two alternative assets: money and bonds, but no real capital asset.

A general-equilibrium analysis of the rate of interest ought to have at least two periods, and it ought to have a real capital good that may be held in the present for use or consumption in the future, a possibility entirely missing from the Keynesian model. I have discussed this major gap in the Keynesian model in a series of posts (here, here, here, here, and here) about Earl Thompson’s 1976 paper “A Reformulation of Macroeconomic Theory.”

Although Thompson’s model seems to me too simple to account for many macroeconomic phenomena, it would have been a far better starting point for the development of macroeconomics than any of the models from which modern macroeconomic theory has evolved.

Advertisements

The Trump Rally

David Beckworth has a recent post about the Trump stock-market rally. Just before the election I had a post in which I pointed out that the stock market seemed to be dreading the prospect of a Trump victory, based on the strong positive correlation between movements in the dollar value of the Mexican peso and the S&P 500, though, in response to a comment by one of my readers, I did partially walk back my argument. As the initial returns and exit polls briefly seemed to be pointing toward a Clinton victory, the correlation between the peso and the S&P 500 (futures) seemed to be very strong and getting stronger, and after the returns started to point increasingly toward a Trump victory, the strong correlation between the peso and the S&P 500 remained all too evident, showing a massive decline in both the peso and the S&P 500. But what seemed like a Trump panic was suddenly broken, when Mrs. Clinton phoned Trump to concede and Trump appeared to claim victory with a relatively restrained and conciliatory statement that calmed the worst fears about a messy transition and the potential for serious political instability. The survival of a Republican majority in the Senate was perhaps viewed as a further positive sign and strengthened hopes for business-friendly changes in the US corporate and personal taxes. The earlier losses in S&P 500 futures were reversed even without any recovery in the peso.

So what explains the turnaround in the reaction of the stock market to Trump’s victory? Here’s David Beckworth:

I have a new piece in The Hill where I argue markets are increasingly seeing the Trump shock as an inflection point for the U.S. economy:

It seems the U.S. economy is finally poised for robust economic growth, something that has been missing for the past eight years. Such strong economic growth is expected to cause the demand for credit to increase and the supply of savings to decline

Though this is not the main point, I will just register my disagreement with David’s version of how interest rates are determined, which essentially restates the “loanable-funds” theory of interest determination, which is often described as the orthodox alternative to the Keynesian liquidity preference theory of interest rates. I disagree that it is the alternative to the Keynesian theory. I think that is a very basic misconception perpetrated by macroeconomists with either a regrettable memory lapse or an insufficient understanding of, the Fisherian theory of interest rates. In the Fisherian theory interest rates are implicit in the intertemporal structure of all prices, they are therefore not determined in any single market, as asserted by the loanable-funds theory, any more than the price level is determined in any single market. The way to think about interest-rate determination is to ask the following question: at what structure of interest rates would holders of long-lived assets be content to continue holding the existing stock of assets? Current savings and current demand for credit are an epiphenomenon of interest-rate determination, not a determinant of interest rates — with the caveat that every factor that influences the intertemporal structure of prices is one of the myriad determinants of interest rates.

Together, these forces are naturally pushing interest rates higher. The Fed’s interest rate hike today is simply piggybacking on this new reality.

If “these forces” is interpreted in the way I have suggested in my above comment on David’s previous sentence, then I would agree with this sentence.

Here are some charts that document this upbeat economic outlook as seen from the treasury market. The first one shows the treasury market’s implicit inflation forecast (or “breakeven inflation”) and real interest rate at the 10-year horizon. These come from TIPs and have their flaws, but they provide a good first approximation to knowing what the bond market is thinking. In this case, both the real interest rate and expected inflation rate are rising. This implies the market expects both higher real economic growth and higher inflation. The two may be related–the higher expected inflation may be a reflection of higher expected nominal demand growth causing real growth. The higher real growth expectations are also probably being fueled by Trump’s supply-side reforms.

beckworth_interest_rates

I agree that the rise in real interest rates may reflect improved prospects for economic growth, and that the rising TIPS spread may reflect expectations of at least a small rise in inflation towards the Fed’s largely rhetorical 2-percent target. And I concur that a higher inflation rate could be one of the causes of improving implicit forecasts of economic growth. However, I am not so sure that expectations of rising inflation and supply-side reforms are the only explanations for rising real interest rates.

What “reforms” is Trump promising? I’m not sure actually, but here is a list of possibilities: 1) reducing and simplifying corporate tax rates, 2) reducing and simplifying personal tax rates, 3) deregulation, 4) tougher enforcement of immigration laws, 5) deportation of an undetermined number of illegal immigrants, 6) aggressively protectionist international trade policies.

I think that there is a broad consensus in favor of reducing corporate tax rates. Not only is the 35% marginal rate on corporate profits very high compared to the top corporate set by other countries, the interest deduction is a perverse incentive favoring debt rather than equity financing. As I pointed out in a post five years ago, Hyman Minsky, one of the favorite economists of the left, was an outspoken opponent of corporate income taxation in general, precisely because it encourages debt rather than equity financing. I think that the Obama administration would have been happy to propose reducing the corporate tax rate as part of a broader budget deal, but no broader deal with the Republican majority in Congress was possible, and a simple reduction of the corporate tax rate would have been difficult for Obama to sell to his own political base without offering them something that could be described as reducing inequality. So cutting the top corporate tax rate would almost certainly be a good thing (but subject to qualification by the arguments in the next paragraph), and expectations of a reduction in the top corporate rate would tend to raise stock prices, though the effect on stock prices would be moderated by increased issues of new corporate stock.

Reducing and simplifying corporate and personal tax rates seems like a good thing, but there’s at least one problem. Not all earnings of taxable income is socially productive. Lots of earned income is generated by completely, or partially, unproductive activities associated with private gains that exceed social gains. I have written in the past about how unproductive many types of information gathering and knowledge production is (e.g., here, here, here, and here). Much of this activity enables the person who acquires knowledge or information to gain an information advantage over people with whom he transacts, so the private return to the acquisition of such knowledge is greater than the social gain, because the gain to one party to the trade comes not from an increase in output but by way of a transfer from the other less-informed party to the transaction.

The same is true — to a somewhat lesser extent, but the basic tendency is the same – of activity aimed at the discovery of knew knowledge over which an intellectual property right can be exercised for a substantial length of time. The ability to extract monopoly rents over newly discovered knowledge is likely to confer a private gain on the discoverer greater than the social gain accruing from the discovery, because the first discoverer to acquire exclusive rights can extract the full value of the discovery even though the marginal benefit accruing to the discovery is only the value of the new knowledge over the elapsed time between the moment of the discovery and the moment when the discovery would have been made, perhaps soon afterwards, by someone else. In general, there is a whole range of income accruing to a variety of winner-takes-all activities in which the private gain to the winner greatly exceeds the social gain. A low marginal rate of income taxation increases the incentive to engage in such socially wasteful winner-takes-all activities.

Deregulation can be a good thing when it undermines monopolistic price-fixing and legally imposed entry barriers entrenching incumbent suppliers. A lot of regulation has historically been of this type. But although it is convenient for libertarian ideologues to claim that monopoly enhancement or entrenchment characterizes all government regulation, I doubt that most current regulations are for this purpose. A lot of regulation is aimed at preventing dishonest or misleading business practices or environmental pollution or damage to third-parties. So as an empirical matter, I don’t think we can say whether a reduction in regulation will have a net positive or a net negative effect on society. Nevertheless, regulation probably does reduce the overall earnings of corporations, so that a reduction in regulation will tend to raise stock prices. If it becomes easier for corporations to emit harmful pollution into the atmosphere and into our rivers, lakes and oceans, the reductions in private costs enjoyed by the corporations will be capitalized into their stock prices while the increase in social costs will be borne in a variety of ways by all individuals in the country or the world. Insofar as stock prices have risen since Trump’s election because of expectations of a roll back in regulation, it is not clear to me at least whether that reflects an increase in net social welfare or a capitalization of the value of enhanced rights to engage in socially harmful conduct.

The possible effects of changes in immigration laws, in the enforcement of immigration laws and in trade policies seem to me far too murky at this point even to speculate upon. I would just observe that insofar as the stock market has capitalized the effects of Trump’s supposed supply-side reforms, those reforms would have tended to reduce, not increase, inflation expectations. So it does not seem likely to me that whatever increase in stock prices we have seen so far reflects a pure supply-side effect.

I am more inclined to believe that the recent increases in stock prices and inflation expectations reflect expectations that Trump will fulfill his commitments to conduct irresponsible fiscal policies generating increased budget deficits, which the Republican majorities in Congress will now meekly accept and dutifully applaud, and that Trump will be able either to cajole or intimidate enough officials at the Federal Reserve to accommodate those policies or will appoint enough willing accomplices to the Fed to overcome the opposition of the current FOMC.

Thinking about Interest and Irving Fisher

In two recent posts I have discussed Keynes’s theory of interest and the natural rate of interest. My goal in both posts was not to give my own view of the correct way to think about what determines interest rates,  but to identify and highlight problems with Keynes’s liquidity-preference theory of interest, and with the concept of a natural rate of interest. The main point that I wanted to make about Keynes’s liquidity-preference theory was that although Keynes thought that he was explaining – or perhaps, explicating — the rate of interest, his theory was nothing more than an explanation of why, typically, the nominal pecuniary yield on holding cash is less than the nominal yield on holding real assets, the difference in yield being attributable to the liquidity services derived from holding a maximally liquid asset rather than holding an imperfectly liquid asset. Unfortunately, Keynes imagined that by identifying and explaining the liquidity premium on cash, he had thereby explained the real yield on holding physical capital assets; he did nothing of the kind, as the marvelous exposition of the theory of own rates of interest in chapter 17 of the General Theory unwittingly demonstrates.

For expository purposes, I followed Keynes in contrasting his liquidity-preference theory with what he called the classical theory of interest, which he identified with Alfred Marshall, in which the rate of interest is supposed to be the rate that equilibrates saving and investment. I criticized Keynes for attributing this theory to Marshall rather than to Irving Fisher, which was, I am now inclined to think, a mistake on my part, because I doubt, based on a quick examination of Fisher’s two great books The Rate of Interest and The Theory of Interest, that he ever asserted that the rate of interest is determined by equilibrating savings and investment. (I actually don’t know if Marshall did or did make such an assertion.) But I think it’s clear that Fisher did not formulate his theory in terms of equating investment and savings via adjustments in the rate of interest rate. Fisher, I think, did agree (but I can’t quote a passage to this effect) that savings and investment are equal in equilibrium, but his analysis of the determination of the rate of interest was not undertaken in terms of equalizing two flows, i.e., savings and investment. Instead the analysis was carried out in terms of individual or household decisions about how much to consume out of current and expected future income, and in terms of decisions by business firms about how much available resources to devote to producing output for current consumption versus producing for future consumption. Fisher showed (in Walrasian fashion) that there are exactly enough equations in his system to solve for all the independent variables, so that his system had a solution. (That Walrasian argument of counting equations and unknowns is mathematically flawed, but later work by my cousin Abraham Wald and subsequently by Arrow, Debreu and McKenzie showed that Fisher’s claim could, under some more or less plausible assumptions, be proved in a mathematically rigorous way.)

Maybe it was Knut Wicksell who in his discussions of the determination of the rate of interest argued that the rate of interest is responsible for equalizing savings and investment, but that was not how Fisher understood what the rate of interest is all about. The Wicksellian notion that the equilibrium rate of interest equalizes savings and investment was thus a misunderstanding of the Fisherian theory, and it would be a worthwhile endeavor to trace the genesis and subsequent development of this misunderstanding to the point that Keynes and his contemporaries could have thought that they were giving an accurate representation of what orthodox theory asserted when they claimed that according to orthodox theory the rate of interest is what ensures equality between savings and investment.

This mistaken doctrine was formalized as the loanable-funds theory of interest – I believe that Dennis Robertson is usually credited with originating this term — in which savings is represented as the supply of loanable funds and investment is represented as the demand for loanable funds, with the rate of interest serving as a sort of price that is determined in Marshallian fashion by the intersection of the two schedules. Somehow it became accepted that the loanable-funds doctrine is the orthodox theory of interest determination, but it is clear from Fisher and from standard expositions of the neoclassical theory of interest which are of course simply extensions of Fisher’s work) that the loanable-funds theory is mistaken and misguided at a very basic level. (At this point, I should credit George Blackford for his comments on my post about Keynes’s theory of the rate of interest for helping me realize that it is not possible to make any sense out of the loanable-funds theory even though I am not sure that we agree on exactly why the loanable funds theory doesn’t make sense. Not that I had espoused the loanable-funds theory, but I did not fully appreciate its incoherence.)

Why do I say that the loanable-funds theory is mistaken and incoherent? Simply because it is fundamentally inconsistent with the essential properties of general-equilibrium analysis. In general-equilibrium analysis, interest rates emerge not as a separate subset of prices determined in a corresponding subset of markets; they emerge from the intertemporal relationships between and across all asset markets and asset prices. To view the rate of interest as being determined in a separate market for loanable funds as if the rate of interest were not being simultaneously determined in all asset markets is a complete misunderstanding of the theory of intertemporal general equilibrium.

Here’s how Fisher put over a century ago in The Rate of Interest:

We thus need to distinguish between interest in terms of money and interest in terms of goods. The first thought suggested by this fact is that the rate of interest in money is “nominal” and that in goods “real.” But this distinction is not sufficient, for no two forms of goods maintain or are expected to maintain, a constant price ratio toward each other. There are therefore just as many rates of interest in goods as there are forms of goods diverging in value. (p. 84, Fisher’s emphasis).

So a quarter of a century before Sraffa supposedly introduced the idea of own rates of interest in his 1932 review of Hayek’s Prices and Production, Fisher had done so in his first classic treatise on interest, which reproduced the own-rate analysis in his 1896 monograph Appreciation and Interest. While crediting Sraffa for introducing the concept of own rates of interest, Keynes, in chapter 17, simply — and brilliantly extends the basics of Fisher’s own-rate analysis, incorporating the idea of liquidity preference and silently correcting Sraffa insofar as his analysis departed from Fisher’s.

Christopher Bliss in his own classic treatise on the theory of interest, expands upon Fisher’s point.

According to equilibrium theory – according indeed to any theory of economic action which relates firms’ decisions to prospective profit and households’ decisions to budget-constrained searches for the most preferred combination of goods – it is prices which play the fundamental role. This is because prices provide the weights to be attached to the possible amendments to their net supply plans which the actors have implicitly rejected in deciding upon their choices. In an intertemporal economy it is then, naturally, present-value prices which play the fundamental role. Although this argument is mounted here on the basis of a consideration of an economy with forward markets in intertemporal equilibrium, it in no way depends on this particular foundation. As has been remarked, if forward markets are not in operation the economic actors have no choice but to substitute their “guesses” for the firm quotations of the forward markets. This will make a big difference, since full intertemporal equilibrium is not likely to be achieved unless there is a mechanism to check and correct for inconsistency in plans and expectations. But the forces that pull economic decisions one way or another are present-value prices . . . be they guesses or firm quotations. (pp. 55-56)

Changes in time preference therefore cause immediate changes in the present value prices of assets thereby causing corresponding changes in own rates of interest. Changes in own rates of interest constrain the rates of interest charged on money loans; changes in asset valuations and interest rates induce changes in production, consumption plans and the rate at which new assets are produced and capital accumulated. The notion that there is ever a separate market for loanable funds in which the rate of interest is somehow determined, and savings and investment are somehow equilibrated is simply inconsistent with the basic Fisherian theory of the rate of interest.

Just as Nick Rowe argues that there is no single market in which the exchange value of money (medium of account) is determined, because money is exchanged for goods in all markets, there can be no single market in which the rate of interest is determined because the value of every asset depends on the rate of interest at which the expected income or service-flow derived from the asset is discounted. The determination of the rate of interest can’t be confined to a single market.


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.

Archives

Enter your email address to follow this blog and receive notifications of new posts by email.

Join 2,198 other followers

Follow Uneasy Money on WordPress.com
Advertisements