Posts Tagged 'Adam Smith'

Interest on Reserves and Credit Deadlock

UPDATE (2/25/2022): George Selgin informs me that in the final version (his book Floored) of the Cato working paper which I discuss below he modified the argument that I criticize that paying interest on reserves caused banks to raise their lending rates to borrowers and that he now generally agrees with my argument that paying interest on reserves did not cause banks to raise the interest rates they charged borrowers. George also points out that I did misstate his position slightly. He did not argue, as I wrote, that paying interest on reserves caused banks to raise interest rates to borrowers; his argument was that banks would accept a reduced percentage of loan applications at the prevailing rate of interest.

The economic theory of banking has a long and checkered history reflecting an ongoing dialectic between two views of banking. One view, let’s call it the reserve view, is that the circulating bank liabilities, now almost exclusively bank deposits, are created by banks after they receive deposits of currency (either metallic or fiat). Rather than hold the currency in their vaults as “safe deposits,” banks cleverly (or in the view of some, deceitfully or fraudulently) lend out claims to their reserves in exchange for the IOUs of borrowers, from which they derive a stream of interest income.

The alternative view of banking, let’s call it the anti-reserve view (in chapter 7 of my new book Studies in the History of Monetary Theory, I trace the two views David Hume and Adam Smith) bank liabilities are first issued by established money lenders, probably traders or merchants, widely known to be solvent and well-capitalized, whose debts are widely recognized as reliable and safe. Borrowers therefore prefer to exchange their own debt for that of the lenders, which is more acceptable in exchange than their own less reliable debt. Lenders denominate their IOUs in terms of an accepted currency so that borrowers can use the lender’s IOU instead of the currency. To make their IOUs circulate like currency, lenders promise to redeem their IOUs on demand, so they must either hold, or have immediate access to, currency.

These two views of banking lead to conflicting interpretations of the hugely increased reserve holdings of banks since the aftermath of the 2008 financial crisis. Under the reserve view, reserves held by banks are the raw material from which deposits are created. Because of the inflationary potential of newly created deposits, a rapid infusion of reserves into the banking system is regarded as an inflationary surge waiting to happen.

On the anti-reserve view, however, causation flows not from reserves to deposits, but from deposits to reserves. Banks do not create deposits because they hold redundant reserves; they hold reserves because they create deposits, the holding of reserves being a the cost of creating deposits. Being a safe asset enabling banks to satisfy instantly, and without advance notice, demands for deposit redemption, reserves are held only as a precaution.

All businesses choose the forms in which to hold the assets best-suited to their operations. Manufactures own structures, buildings and machines used in producing the products they sell as well as holding inventories of finished or semi-finished outputs and inputs into the production process, as well as liquid capital like bank deposits, and other interest or income-generating assets. Banks also hold a variety of real assets (e.g., buildings, vaults, computers and machines) and a variety of financial assets. An important class of those financial assets are promissory notes of borrowers to whom banks have issued loans by creating deposits. In the ordinary course of business, banks accumulate reserves when new or existing customers make deposits, and when net positive clearings with other banks cause an inflow of reserves. The direction and the magnitude of the flow of reserves into, or out of, a bank are not beyond its power to control. Nor does a bank lack other means than increasing lending to reduce its holdings of unwanted reserves.

While reserves are the safest, most liquid, and most convenient asset that banks can hold, non-interest-bearing reserves provide banks with no pecuniary yield, so holding reserves rather than interest-bearing assets, or assets expected to appreciate involve a sacrifice of income that must be offset by the safety, liquidity and convenience provided by reserves. When the Fed began paying interest on reserves in October 2008, the holding of reserves no longer required foregoing a pecuniary yield offered by alternative assets. The next safest and most liquid class of assets available to banks is short-term Treasury notes, which do provide at least a small nominal interest return. Until October 2008, there was an active overnight market for reserves — the Federal Funds market — in which banks with excess reserves could lend to banks with insufficient reserves, thereby enabling the banking system as a whole to minimize the aggregate holding of excess (i.e., not legally required) reserves.

Legally required reserves being unavailable to banks to satisfy redemption demands without incurring a penalty for non-compliance with the legal reserve requirement, required reserves provide banks with little safety or liquidity. So, to obtain the desired safety and liquidity, banks must hold excess reserves. The cost (foregone interest) of holding excess reserves banks can be minimized by holding interest-bearing Treasuries easily exchanged for reserves and by lending or borrowing as needed in the overnight Fed Funds market. In normal conditions, the banking system can operate efficiently with excess reserves equal to only about one percent of total deposits.

The Fed did not begin paying interest on reserves until October 2008, less than a month after a financial panic and crisis brought the US and the international financial system to the brink of a catastrophic meltdown. The solvency of financial institutions and banks having been impaired by a rapid loss of asset value, distinguishing between solvent and insolvent counterparties became nearly impossible, putting almost any economic activity dependent on credit at risk of being unwound.

In danger of insolvency and desperate for liquidity, banks tried to hoard reserves and increase holdings of Treasury debt. Though yielding minimal interest, Treasury notes serve as preferred collateral in the Fed Funds market, enabling borrowers to offer lenders nearly zero-risk overnight or short-term lending opportunities via repurchase agreements in which Treasury notes are sold spot and repurchased forward at a preset price reflecting an implied interest rate on the loan.

Increased demand for Treasuries raised their prices and reduced their yields, but declining yields and lending rates couldn’t end the crisis once credit markets became paralyzed by pervasive doubts about counterparty solvency. Banks stopped lending to new customers, while hesitating, or even refusing, to renew or maintain credit facilities for existing customers, and were themselves often unable to borrow reserves without posting Treasuries as collateral for repo loans.

After steadfastly refusing to reduce its Fed Fund target rate and ease credit conditions, notwithstanding rapidly worsening economic conditions, during the summer of 2008, an intransigent stance from which it refused to budge even after the financial panic erupted in mid-September. While Treasury yields were falling as the markets sought liquidity and safety, chaotic market conditions caused overnight rates in the Fed Funds market to fluctuate erratically. Finally relenting in October as credit markets verged on collapse, the Fed reduced its Fed Funds target rate by 50 basis points. In the catastrophic conditions of October 2008, the half-percent reduction in the Fed Funds target was hardly adequate.

To prevent a system-wide catastrophe, the Fed began lending to banks on the security of assets of doubtful value or to buy assets — at book, rather than (unknown) market, value – that were not normally eligible to be purchased by the Fed. The resulting rapid expansion of the Fed’s balance sheet and the creation of bank reserves (Fed liabilities) raised fears (shared by the Fed) of potential future inflation. 

Fearing that its direct lending to banks and its asset purchases were increasing bank reserves excessively, thereby driving the Fed Funds rate below its target, the Fed sought, and received, Congressional permission to begin paying interest on bank reserves so that banks would hold the newly acquired reserves, rather use the reserves to acquire assets like borrower IOUs, lest total spending and aggregate demand increase. Avoiding such a potentially inflationary increase in aggregate demand had been the chief policy objective of the Fed throughout 2008 even as the economy slid into deep recession just prior to the start of the financial crisis, and the Fed was sticking to that policy.

Struggling to contain a deepening financial crisis while adhering to a commitment to a 2-percent inflation target, the Fed experimented for almost two months with both its traditional Fed Funds target and its new policy of paying interest on bank reserves. The Fed eventually settled on a target for the Fed Funds rate between zero and .25% while paying .25% interest on reserves, thereby making it unnecessary for banks with accounts at the Fed to borrow, and making them unwilling to lend, reserves in the Fed Funds market. Thanks to the massive infusion of reserves into the banking system, the panic was quelled and the immediate financial crisis receded, but the underlying weakness of an economy was aggravated and continued to deepen; the liquidity and solvency problems that triggered the crisis were solved, but the aggregate-demand deficiency was not.

In his excellent historical and analytical account of how and why the Fed adopted its policy of paying interest on reserves, George Selgin credits the idea that had the Fed not paid interest to banks on their reserves, they would have used those reserves to increase lending, thereby providing stimulus to the economy. (Update: as noted above, the argument I criticize was made in Cato Working Paper not in the published version of George’s book, and he informs me that he modified the argument in the published version and now disavows it.) Although I agree with George that paying interest on bank reserves reduced aggregate demand, I disagree with his argument that the reduction in aggregate demand was caused by increased interest charged to borrowers owing to the payment of interest on reserves.

George believes that, by paying interest on reserves, the Fed increased the attractiveness of holding reserves relative to higher-yielding assets like the IOUs of borrowers. And, sure enough, after the Fed began paying interest on reserves, the share of bank loans in total bank assets declined by about the same percentage as the share of reserves in total bank assets.

The logic underlying this argument is that, at the margin, an optimizing bank equates the anticipated yield from holding every asset in its portfolio. If the expected return at margin from bank loans exceeds the expected return from reserves, an optimizing bank will increase its lending until the marginal return from lending no longer exceeds the marginal return from holding reserves. When the Fed began paying interest on reserves, the expected return at the margin from holding reserves increased and exceeded the expected return at the margin from bank loans, giving banks an incentive to increase their holdings of reserves relative to their holdings of bank loans. Presumably this means that banks would try to increase their holdings of bank reserves and reduce their lending.

At least two problems undercut this logic. First, as explained above, the yield from holding an asset can be pecuniary – a yield of interest, of dividends, or appreciation – or a flow of services. Clearly, the yield from holding reserves is primarily the service flow associated with the safety, liquidity and convenience provided by reserves. Before October 2008, reserves provided no pecuniary yield, either in explicit interest or expected appreciation, the optimal quantity of reserves held was such that, at the margin, the safety, liquidity and convenience generated by reserves was just sufficient to match the pecuniary return from the loan assets expected by an optimizing bank.

After the Fed began paying interest on reserves, the combined pecuniary and service return from holding reserves exceeded the return from banks’ loan assets. So, banks therefore chose to increase their holdings of reserves until the expected pecuniary and service yield from reserves no longer exceeded the expected return from loan assets. But as banks increased their reserve holdings, the marginal service flow provided by reserves diminished until the marginal pecuniary plus service yield was again equalized across the assets held in banks’ asset portfolios. But that does not imply that banks reduced their lending or the value of the loan assets in their portfolios compared to the value of loan assets held before interest was paid on reserves; it just means that optimal bank portfolios after the Fed began paying interest on bank reserves contained more reserves than previously.

Indeed, because reserves provided a higher pecuniary yield and more safety, liquidity and convenience than holding Treasuries, banks were willing to add reserves to their portfolios without limit, because holding reserves became costless. The only limit on the holding of bank reserves was the willingness of the Fed to create more reserves by buying additional assets from the private sector. The proceeds of sales would be deposited in the banking system. The yield on the acquired assets would accrue to the Fed, and that yield would be transferred to the banking system by way of interest paid on those reserves.

So, if I don’t think that paying interest on bank reserves caused banks to raise interest rates on loans, why do I think that paying interest on bank reserves reduced aggregate demand and slowed the recovery from the Little Depression (aka Great Recession)?

The conventional story, derived from the reserve view, is that if banks have more reserves than they wish to hold, they try to dispose of their excess reserves by increasing their lending to borrowers. But banks wouldn’t increase lending to borrowers unless the expected profitability of such lending increased; no increase in the quantity of non-interest-bearing reserves of the banks would have increased the profitability of bank lending unless consumer confidence or business optimism increased, neither of which depends in a straightforward way on the quantity of reserves held by banks.

In several published papers on classical monetary theory which were revised and republished in my new book Studies in the History of Monetary Theory (chapters 2-5 and 7 see front matter for original publication information), I described a mechanism of bank lending and money creation. Competitive banks create money by lending, but how much money they create is constrained by the willingness of the public to hold the liabilities (deposits) emitted in the process of lending.

The money-lending, deposit-creation process can be imperfectly described within a partial-equilibrium, marginal-revenue, marginal-cost framework. The marginal revenue from creating money corresponds to the spread between a bank’s borrowing rate (the interest rate paid on deposits) and its lending rate (the interest rate charged borrowers). At the margin, this spread equals the bank’s cost of intermediation, which includes the cost of holding reserves. The cost of intermediation increases as the difference between the yields on Treasuries and reserves increase, and as the quantity of reserves held increases.

So, in the basic model I work with, paying interest on reserves reduces the cost of creating deposits, thereby tending to increase the amount of lending by banks, contrary to Selgin’s argument that paying interest on reserves reduces bank lending by inducing banks to raise interest rates on loans.

But, in a recession — and even more so in a financial crisis or panic — the cost of intermediation increases, causing banks to reduce their lending, primarily by limiting or denying the extension of credit to new and existing customers. Of course, in a recession, businesses and households demand fewer loans to finance spending plans, and instead seek credit with which to meet current obligations coming due. As banks’ costs of intermediation rise, they inevitably curtail lending, increasing the share of reserves in banks’ total assets.

While Selgin attributes the increasing share of reserves in banks’ assets to the payment of interest on reserves, a more plausible explanation of the increase is that it results from the increased intermediation costs associated with recession and a financial crisis, which more than offset the cost reduction from paying interest on reserves.

Although paying interest on reserves was a major innovation, in a sense it was just a continuation of the policy approach adopted by the Fed in 2004 when started gradually raising its Fed Funds target rate to 5.25% in June 2006, where it stood until July 2007. Combined with the bursting of the housing bubble in 2006, the 5.25% Fed Funds target produced a gradual slowdown that led the Fed to reduce its target, but always too little and too late, as the economy slid into recession at the end of 2007. So, the payment of interest on reserves, intended to ensure that the reserves would not trigger a surge in spending, was entirely consistent with the restrictive policy orientation of the Fed before the financial panic and crisis of 2008, which continued during and after the crisis. That policy was largely responsible for the unusually weak economic recovery and expansion in the decade after the crisis, when banks willingly absorbed all the reserves created by the Fed.

The specific point on which I disagree with Selgin is his belief that paying interest on bank reserves discouraged banks from increasing their lending despite the increase in their reserves. I maintain that paying interest on reserves did not discourage banks from lending, but instead altered their incentive to hold reserves versus holding Treasuries. That decision was independent of the banks’ lending decisions. The demand for loans to finance spending plans by businesses and households was declining because of macroeconomic conditions in a recessionary economy during a financial crisis and recession and the subsequent slow recovery.

Had the Fed not paid interest on reserves while purchasing assets to provide liquidity to the banking system, I am doubtful that banks would have provided credit for increased private spending. If no interest were paid on reserves, it seems more likely that banks would have used the additional reserves created by the Fed to purchase Treasuries than to increase lending, driving up their prices and reducing their yields. Instead of receiving interest of .25% on their reserves, banks would have received slightly less interest on short-term Treasuries. So, without interest on reserves, banks would have received less interest income, and incurred slightly more risk, than they actually did. The Fed, on the other hand, would have had a net increase in revenue by not paying more interest to banks than it received from the Treasuries sold by the banks to the Fed.

The only plausible difference between paying interest on reserves and not doing so that I can see is that the Fed, by paying interest on reserves, lent credibility to its commitment to keep inflation at, or below, its 2-percent target. The Fed’s own justification for seeking permission to pay interest on reserves, as Selgin (Floored, p. 18) documented with a passage from Bernanke’s memoir , was that not doing so might result in an inflationary increase in lending by banks trying to shed their excess reserves. Because I believe that expectations of inflation have a tendency to be self-fulfilling, I don’t dismiss the idea that paying interest on reserves helped the Fed anchor inflation expectations at or near its 2-percent inflation target.

Economic conditions after the financial crisis of 2008-09 were characterized by an extreme entrepreneurial pessimism that Ralph Hawtrey called a credit deadlock, conditions akin to, but distinct from, the more familiar Keynesian phenomenon of a liquidity trap. The difference is that a credit deadlock results from pessimism so intense that entrepreneurs (and presumably households as well) are unwilling, regardless of the interest rate on loans, to undertake long-term spending plans (capital investment by businesses or consumer-durables purchases by households) requiring credit financing. In a liquidity trap, such spending plans might be undertaken at a sufficiently low interest rate, but the interest rate cannot fall, bear speculators cashing in their long-term bond holdings as soon as long-term bond prices rise to a level that speculators regard as unsustainable. To me, at least, the Hawtreyan credit deadlock seems a more plausible description of conditions in 2008-09 than the Keynesian liquidity trap.

In a Hawtreyan credit deadlock, the capacity of monetary policy to increase spending and aggregate demand is largely eliminated. Here’s Hawtrey’s description from the 1950 edition of his classic work Currency and Credit.

If the banks fail to stimulate short-term borrowing, they can create credit by themselves buying securities in the investment market. The market will seek to use the resources thus placed in it, and it will become more favourable to new flotations and sales of securities. But even so and expansion of the flow of money is not ensured. If the money created is to move and to swell the consumers’ income, the favourable market must evoke additional capital outlay. That is likely to take time and conceivably capital outlay may fail to respond. A deficiency of demand for consumable goods reacts on capital outlay, for when the existing capacity of industries is underemployed, there is little demand for capital outlay to extend capacity. . .

The deadlock then is complete, and, unless it is to continue unbroken till some fortuitous circumstance restarts activity, recourse must be had to directly inflationary expedients, such as government expenditures far in excess of revenue, or a deliberate depreciation of the foreign exchange value of the money unit.

In this passage, Hawtrey, originator of the widely reviled “Treasury View” (also see chapters 10-11 of my Studies in the History of Monetary Theory) that denied the efficacy of fiscal policy as a countercyclical tool, acknowledged the efficacy of fiscal policy in a credit deadlock, while monetary policy could be effective only through currency devaluation or depreciation, though I would add that in monetary policy could also be effective by inducing or creating expectations of inflation.

The long, but painfully slow, recovery from the 2008-09 financial crisis lent credence to Hawtrey’s description of credit deadlock, and my own empirical findings of the unusual positive correlation between changes in inflation expectations and changes in the S&P 500 supports the idea that increasing inflation expectations are a means whereby monetary policy can enable an escape from credit deadlock.

In Defense of Stigler

I recently discussed Paul Romer’s criticism of Robert Lucas for shifting from the Feynman integrity that, in Romer’s view, characterized Lucas’s early work, to the Stigler conviction that Romer believes has characterized Lucas’s later work. I wanted to make a criticism of Lucas different from Romer’s, so I only suggested in passing that that the Stigler conviction criticized by Romer didn’t seem that terrible to me, and I compared Stigler conviction to Galileo’s defense of Copernican heliocentrism. Now, having reread the essay, “The Nature and Role of Originality in Scientific Progress,” from which Romer quoted, I find, as I suspected, that Romer has inaccurately conveyed the message that Stigler meant to convey in his essay.

In accusing Lucas of forsaking the path of Feynman integrity and chosing instead the path of Stigler conviction, making it seem as if Stigler had provided justification for pursuing an ideological agenda, as Romer believes Lucas and other freshwater economists have done, Romer provides no information about the context of Stigler’s essay. Much of Stigler’s early writing in economics was about the history of economics, and Stigler’s paper on originality is one of those; in fact, it was subsequently republished as the lead essay in Stigler’s 1965 volume Essays in the History of Economics. What concerns Stigler in the essay are a few closely related questions: 1) what characteristic of originality makes it highly valued in science in general and in economics in particular? 2) Given that originality is so highly valued, how do economists earn a reputation for originality? 3) Is the quest for originality actually conducive to scientific progress?

Here is Stigler’s answer to the first question provided at the end of the introductory section under the heading “The Meaning of Originality.”

Scientific originality in its important role should be measured against the knowledge of a man’s contemporaries. If he opens their eyes to new ideas or to new perspectives on old ideas, he is an original economist in the scientifically important sense. . . . Smith, Ricardo, Jevons, Walras, Marshall, Keynes – they all changed the beliefs of economists and thus changed economics.

It is conceivable for an economist to be ignored by contemporaries and yet exert considerable influence on later generations, but this is a most improbable event. He must have been extraordinarily out of tune with (in advance of?) his times, and rarely do first-class minds throw themselves away on the visionary. Perhaps Cournot is an example of a man whose work skipped a half a century, but normally such men become famous only by reflecting the later fame of the rediscovered doctrines.

Originality then in its scientifically important role, is a matter of subtle unaccustomedness – neither excessive radicalism nor statement of the previous unformulated consensus.

The extended passage quoted by Romer appears a few paragraphs later in the second section of the paper under the heading “The Techniques of Persuasion.” Having already established that scientific originality must be both somehow surprising yet also capable of being understood by other economists, Stigler wants to know how an original economist can get the attention of his peers for his new idea. Doing so is not easy, because

New ideas are even harder to sell than new products. Inertia and the many unharmonious voices of those who would change our ways combine against the balanced and temperate statement of the merits of one’s ” original ” views. One must put on the best face possible, and much is possible. Wares must be shouted — the human mind is not a divining rod that quivers over truth.

It is this analogy between the selling of new ideas and selling of new products that leads Stigler in his drollery to suggest that with two highly unusual exceptions – Smith and Marshall – all economists have had to resort to “the techniques of the huckster.”

What are those techniques? And who used them? Although Stigler asserted that all but two famous economists used such techniques, he mentioned only two by name, and helpfully provided the specific evidence of their resort to huckster-like self-promotional techniques. Whom did Stigler single out for attention? William Stanley Jevons and Eugen von Bohm-Bawerk.

So what was the hucksterism committed by Jevons? Get ready to be shocked:

Writing a Theory of Political Economy, he devoted the first 197 pages of a book of 267 pages to his ideas on utility!

OMG! Shocking; just shocking. How could he have stooped so low as that? But Bohm-Bawerk was even worse.

Not content with writing two volumes, and dozens of articles, in presenting and defending his capital theory, he added a third volume (to the third edition of his Positive Theorie des Kapitals) devoted exclusively to refuting, at least to his own satisfaction, every criticism that had arisen during the preceding decades.

What a sordid character that loathsome Austrian aristocrat must have been! Publishing a third volume devoted entirely to responding to criticisms of the first two. The idea!

Well, actually, they weren’t as bad as you might have thought. Let’s read Stigler’s next paragraph.

Although the new economic theories are introduced by the technique of the huckster, I should add that they are not the work of mere hucksters. The sincerity of Jevons, for example, is printed on every page. Indeed I do not believe that any important economist has ever deliberately contrived ideas in which he did not believe in order to achieve prominence: men of the requisite intellectual power and morality can get bigger prizes elsewhere. Instead, the successful inventor is a one-sided man. He is utterly persuaded of the significance and correctness of his ideas and he subordinates all other truths because they seem to him less important than the general acceptance of his truth. He is more a warrior against ignorance than a scholar among ideas.

I believe that Romer misunderstood what Stigler mean to say here. Romer seems to interpret this passage to mean that if a theorist is utterly convinced that he is right, he somehow can be justified in “subordinat[ing] all other truths” in cutting corners, avoiding contrary arguments or suppressing contradictory evidence that might undercut his theory – the sorts of practices ruled out by Feynman integrity, which is precisely what Romer was accusing Lucas of having done in a paper on growth theory. But to me it is clear from the context that what Stigler meant by “subordinating all other truths” was not any lack of Feynman integrity, but the single-minded focus on a specific contribution to the exclusion of all others. That was why Stigler drew attention to the exorbitant share of Jevons’s book entitled Principles of Political Economy devoted to the theory of marginal utility or the publication by Bohm-Bawerk of an entire volume devoted to responding to criticisms of his two earlier volumes on the theory of capital and interest. He neither implied nor meant to suggest that either Jevons or Bohm-Bawerk committed any breach of scientific propriety, much less Feynman integrity.

If there were any doubt about the correctness of this interpretation of what Stigler meant, it would be dispelled by the third section of Stigler’s paper under the heading: “The Case of Mill.”

John Stuart Mill is a striking example with which to illustrate the foregoing remarks. He is now considered a mediocre economist of unusual literary power; a fluent, flabby echo of Ricardo. This judgement is well-nigh universal: I do not believe that Mill has had a fervent admirer in the twentieth century. I attribute this low reputation to the fact that Mill had the perspective and balance, but not the full powers, of Smith and Marshall. He avoided all the tactics of easy success. He wrote with extraordinary balance, and his own ideas-considering their importance-received unbelievably little emphasis. The bland prose moved sedately over a corpus of knowledge organized with due regard to structure and significance, and hardly at all with regard to parentage. . . .

Yet however one judges Mill, it cannot be denied that he was original. In terms of identifiable theories, he was one of the most original economists in the history of the science.

Stigler went on to list and document the following original contributions of Mill in the area of value theory, ignoring Mill’s contributions to trade theory, “because I cannot be confident of the priorities.”

1 Non-competing Groups

2 Joint Products

3 Alternative Costs

4 The Economics of the Firm

5 Supply and Demand

6 Say’s Law

Stigler concludes his discussion with this assessment of Mill

This is a very respectable list of contributions. But it is also a peculiar list: any one of the contributions could be made independently of all the others. Mill was not trying to build a new system but only to add improvements here and there to the Ricardian system. The fairest of economists, as Schumpeter has properly characterized Mill, unselfishly dedicated his abilities to the advancement of the science. And, yet, Mill’s magisterial quality and conciliatory tone may have served less well than sharp and opinionated controversy in inciting his contemporaries to make advances.

Finally, just to confirm the lack of ideological motivation in Stigler’s discussion, let me quote Stigler’s characteristically ironic and playful conclusion.

These reflections on the nature and role of originality, however, have no utilitarian purpose, or even a propagandistic purpose. If I have a prejudice, it is that we commonly exaggerate the merits of originality in economics–that we are unjust in conferring immortality upon the authors of absurd theories while we forget the fine, if not particularly original, work of others. But I do not propose that we do something about it.

Monetary Theory on the Neo-Fisherite Edge

The week before last, Noah Smith wrote a post “The Neo-Fisherite Rebellion” discussing, rather sympathetically I thought, the contrarian school of monetary thought emerging from the Great American Heartland, according to which, notwithstanding everything monetary economists since Henry Thornton have taught, high interest rates are inflationary and low interest rates deflationary. This view of the relationship between interest rates and inflation was advanced (but later retracted) by Narayana Kocherlakota, President of the Minneapolis Fed in a 2010 lecture, and was embraced and expounded with increased steadfastness by Stephen Williamson of Washington University in St. Louis and the St. Louis Fed in at least one working paper and in a series of posts over the past five or six months (e.g. here, here and here). And John Cochrane of the University of Chicago has picked up on the idea as well in two recent blog posts (here and here). Others seem to be joining the upstart school as well.

The new argument seems simple: given the Fisher equation, in which the nominal interest rate equals the real interest rate plus the (expected) rate of inflation, a central bank can meet its inflation target by setting a fixed nominal interest rate target consistent with its inflation target and keeping it there. Once the central bank sets its target, the long-run neutrality of money, implying that the real interest rate is independent of the nominal targets set by the central bank, ensures that inflation expectations must converge on rates consistent with the nominal interest rate target and the independently determined real interest rate (i.e., the real yield curve), so that the actual and expected rates of inflation adjust to ensure that the Fisher equation is satisfied. If the promise of the central bank to maintain a particular nominal rate over time is believed, the promise will induce a rate of inflation consistent with the nominal interest-rate target and the exogenous real rate.

The novelty of this way of thinking about monetary policy is that monetary theorists have generally assumed that the actual adjustment of the price level or inflation rate depends on whether the target interest rate is greater or less than the real rate plus the expected rate. When the target rate is greater than the real rate plus expected inflation, inflation goes down, and when it is less than the real rate plus expected inflation, inflation goes up. In the conventional treatment, the expected rate of inflation is momentarily fixed, and the (expected) real rate variable. In the Neo-Fisherite school, the (expected) real rate is fixed, and the expected inflation rate is variable. (Just as an aside, I would observe that the idea that expectations about the real rate of interest and the inflation rate cannot occur simultaneously in the short run is not derived from the limited cognitive capacity of economic agents; it can only be derived from the limited intellectual capacity of economic theorists.)

The heretical views expressed by Williamson and Cochrane and earlier by Kocherlakota have understandably elicited scorn and derision from conventional monetary theorists, whether Keynesian, New Keynesian, Monetarist or Market Monetarist. (Williamson having appropriated for himself the New Monetarist label, I regrettably could not preserve an appropriate symmetry in my list of labels for monetary theorists.) As a matter of fact, I wrote a post last December challenging Williamson’s reasoning in arguing that QE had caused a decline in inflation, though in his initial foray into uncharted territory, Williamson was actually making a narrower argument than the more general thesis that he has more recently expounded.

Although deep down, I have no great sympathy for Williamson’s argument, the counterarguments I have seen leave me feeling a bit, shall we say, underwhelmed. That’s not to say that I am becoming a convert to New Monetarism, but I am feeling that we have reached a point at which certain underlying gaps in monetary theory can’t be concealed any longer. To explain what I mean by that remark, let me start by reviewing the historical context in which the ruling doctrine governing central-bank operations via adjustments in the central-bank lending rate evolved. The primary (though historically not the first) source of the doctrine is Henry Thornton in his classic volume The Nature and Effects of the Paper Credit of Great Britain.

Even though Thornton focused on the policy of the Bank of England during the Napoleonic Wars, when Bank of England notes, not gold, were legal tender, his discussion was still in the context of a monetary system in which paper money was generally convertible into either gold or silver. Inconvertible banknotes – aka fiat money — were the exception not the rule. Gold and silver were what Nick Rowe would call alpha money. All other moneys were evaluated in terms of gold and silver, not in terms of a general price level (not yet a widely accepted concept). Even though Bank of England notes became an alternative alpha money during the restriction period of inconvertibility, that situation was generally viewed as temporary, the restoration of convertibility being expected after the war. The value of the paper pound was tracked by the sterling price of gold on the Hamburg exchange. Thus, Ricardo’s first published work was entitled The High Price of Bullion, in which he blamed the high sterling price of bullion at Hamburg on an overissue of banknotes by the Bank of England.

But to get back to Thornton, who was far more concerned with the mechanics of monetary policy than Ricardo, his great contribution was to show that the Bank of England could control the amount of lending (and money creation) by adjusting the interest rate charged to borrowers. If banknotes were depreciating relative to gold, the Bank of England could increase the value of their notes by raising the rate of interest charged on loans.

The point is that if you are a central banker and are trying to target the exchange rate of your currency with respect to an alpha currency, you can do so by adjusting the interest rate that you charge borrowers. Raising the interest rate will cause the exchange value of your currency to rise and reducing the interest rate will cause the exchange value to fall. And if you are operating under strict convertibility, so that you are committed to keep the exchange rate between your currency and an alpha currency at a specified par value, raising that interest rate will cause you to accumulate reserves payable in terms of the alpha currency, and reducing that interest rate will cause you to emit reserves payable in terms of the alpha currency.

So the idea that an increase in the central-bank interest rate tends to increase the exchange value of its currency, or, under a fixed-exchange rate regime, an increase in the foreign exchange reserves of the bank, has a history at least two centuries old, though the doctrine has not exactly been free of misunderstanding or confusion in the course of those two centuries. One of those misunderstandings was about the effect of a change in the central-bank interest rate, under a fixed-exchange rate regime. In fact, as long as the central bank is maintaining a fixed exchange rate between its currency and an alpha currency, changes in the central-bank interest rate don’t affect (at least as a first approximation) either the domestic money supply or the domestic price level; all that changes in the central-bank interest rate can accomplish is to change the bank’s holdings of alpha-currency reserves.

It seems to me that this long well-documented historical association between changes in the central-bank interest rates and the exchange value of currencies and the level of private spending is the basis for the widespread theoretical presumption that raising the central-bank interest rate target is deflationary and reducing it is inflationary. However, the old central-bank doctrine of the Bank Rate was conceived in a world in which gold and silver were the alpha moneys, and central banks – even central banks operating with inconvertible currencies – were beta banks, because the value of a central-bank currency was still reckoned, like the value of inconvertible Bank of England notes in the Napoleonic Wars, in terms of gold and silver.

In the Neo-Fisherite world, central banks rarely peg exchange rates against each other, and there is no longer any outside standard of value to which central banks even nominally commit themselves. In a world without the metallic standard of value in which the conventional theory of central banking developed, do the propositions about the effects of central-bank interest-rate setting still obtain? I am not so sure that they do, not with the analytical tools that we normally deploy when thinking about the effects of central-bank policies. Why not? Because, in a Neo-Fisherite world in which all central banks are alpha banks, I am not so sure that we really know what determines the value of this thing called fiat money. And if we don’t really know what determines the value of a fiat money, how can we really be sure that interest-rate policy works the same way in a Neo-Fisherite world that it used to work when the value of money was determined in relation to a metallic standard? (Just to avoid misunderstanding, I am not – repeat NOT — arguing for restoring the gold standard.)

Why do I say that we don’t know what determines the value of fiat money in a Neo-Fisherite world? Well, consider this. Almost three weeks ago I wrote a post in which I suggested that Bitcoins could be a massive bubble. My explanation for why Bitcoins could be a bubble is that they provide no real (i.e., non-monetary) service, so that their value is totally contingent on, and derived from (or so it seems to me, though I admit that my understanding of Bitcoins is partial and imperfect), the expectation of a positive future resale value. However, it seems certain that the resale value of Bitcoins must eventually fall to zero, so that backward induction implies that Bitcoins, inasmuch as they provide no real service, cannot retain a positive value in the present. On this reasoning, any observed value of a Bitcoin seems inexplicable except as an irrational bubble phenomenon.

Most of the comments I received about that post challenged the relevance of the backward-induction argument. The challenges were mainly of two types: a) the end state, when everyone will certainly stop accepting a Bitcoin in exchange, is very, very far into the future and its date is unknown, and b) the backward-induction argument applies equally to every fiat currency, so my own reasoning, according to my critics, implies that the value of every fiat currency is just as much a bubble phenomenon as the value of a Bitcoin.

My response to the first objection is that even if the strict logic of the backward-induction argument is inconclusive, because of the long and uncertain duration of the time elapse between now and the end state, the argument nevertheless suggests that the value of a Bitcoin is potentially very unsteady and vulnerable to sudden collapse. Those are not generally thought to be desirable attributes in a medium of exchange.

My response to the second objection is that fiat currencies are actually quite different from Bitcoins, because fiat currencies are accepted by governments in discharging the tax liabilities due to them. The discharge of a tax liability is a real (i.e. non-monetary) service, creating a distinct non-monetary demand for fiat currencies, thereby ensuring that fiat currencies retain value, even apart from being accepted as a medium of exchange.

That, at any rate, is my view, which I first heard from Earl Thompson (see his unpublished paper, “A Reformulation of Macroeconomic Theory” pp. 23-25 for a derivation of the value of fiat money when tax liability is a fixed proportion of income). Some other pretty good economists have also held that view, like Abba Lerner, P. H. Wicksteed, and Adam Smith. Georg Friedrich Knapp also held that view, and, in his day, he was certainly well known, but I am unable to pass judgment on whether he was or wasn’t a good economist. But I do know that his views about money were famously misrepresented and caricatured by Ludwig von Mises. However, there are other good economists (Hal Varian for one), apparently unaware of, or untroubled by, the backward induction argument, who don’t think that acceptability in discharging tax liability is required to explain the value of fiat money.

Nor do I think that Thompson’s tax-acceptability theory of the value of money can stand entirely on its own, because it implies a kind of saw-tooth time profile of the price level, so that a fiat currency, earning no liquidity premium, would actually be appreciating between peak tax collection dates, and depreciating immediately following those dates, a pattern not obviously consistent with observed price data, though I do recall that Thompson used to claim that there is a lot of evidence that prices fall just before peak tax-collection dates. I don’t think that anyone has ever tried to combine the tax-acceptability theory with the empirical premise that currency (or base money) does in fact provide significant liquidity services. That, it seems to me, would be a worthwhile endeavor for any eager young researcher to undertake.

What does all of this have to do with the Neo-Fisherite Rebellion? Well, if we don’t have a satisfactory theory of the value of fiat money at hand, which is what another very smart economist Fischer Black – who, to my knowledge never mentioned the tax-liability theory — thought, then the only explanation of the value of fiat money is that, like the value of a Bitcoin, it is whatever people expect it to be. And the rate of inflation is equally inexplicable, being just whatever it is expected to be. So in a Neo-Fisherite world, if the central bank announces that it is reducing its interest-rate target, the effect of the announcement depends entirely on what “the market” reads into the announcement. And that is exactly what Fischer Black believed. See his paper “Active and Passive Monetary Policy in a Neoclassical Model.”

I don’t say that Williamson and his Neo-Fisherite colleagues are correct. Nor have they, to my knowledge, related their arguments to Fischer Black’s work. What I do say (indeed this is a problem I raised almost three years ago in one of my first posts on this blog) is that existing monetary theories of the price level are unable to rule out his result, because the behavior of the price level and inflation seems to depend, more than anything else, on expectations. And it is far from clear to me that there are any fundamentals in which these expectations can be grounded. If you impose the rational expectations assumption, which is almost certainly wrong empirically, maybe you can argue that the central bank provides a focal point for expectations to converge on. The problem, of course, is that in the real world, expectations are all over the place, there being no fundamentals to force the convergence of expectations to a stable equilibrium value.

In other words, it’s just a mess, a bloody mess, and I do not like it, not one little bit.


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.

My new book Studies in the History of Monetary Theory: Controversies and Clarifications has been published by Palgrave Macmillan

Follow me on Twitter @david_glasner

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