Monetary Policy At War With Itself

July 3, 2009

by Mario Rizzo  

It is well-known that John Maynard Keynes favored permanently low interest rates in order to foster adequate and stable investment demand. Let us first focus on stability and then we’ll see a connection to adequacy.

 What happens when counter-cyclical policy (aka Lerner’s “functional finance”) is practiced?  

The Wall Street Journal ran an excellent small article by Richard Barley, focused mainly on the UK, that makes interesting general points. Investors must try to figure out when the current policies of quantitative easing will be reversed. Those who are long (or plan to be long) in the securities which central banks have bought are quite interested in timing. 

First, consider what Keynes had to say on the subject in early 1937:  

“A low enough long-term rate of interest cannot be achieved if we allow it to be believed that better terms will be obtainable from time to time by those who keep their resources liquid. The long-term rate of interest must be kept continuously as near as possible to what we believe to be the long-term optimum. It is not suitable to be used as a short-period weapon.” (“How to Avoid a Slump,” The Times, Jan. 13, 1937, p.13).  

This is because if people expect interest rates to rise they will hold money rather than buy all sorts of assets, that is, “invest.”  

Now let us look at what the Wall Street Journal is saying: 

 “The snag is that some government-bond markets are so potentially distorted by central-bank programs that it is hard to feel confident of where prices should be…  

Moreover, investors also need to second-guess both when and how central banks will decide to call time on quantitative easing…  

If the BOE [Bank of England] calls a halt to quantitative easing once the program is complete, the best bet is that issues that have seen heavy central-bank buying will become relatively illiquid and hence unattractive…”   

So when economists, like Paul Krugman, say that there is not enough investment spending and attribute this to a “liquidity trap” they fail to see how the central bank is contributing to the very problem they are complaining about.  

Let me be clear that I do not advocate, as Keynes did, permanently low interest rates. But the problem we are facing is that the Fed (and BOE) has expanded the amount and types of securities it buys with the result that current interest rates are distorted. I well understand that, from a simple aggregate demand perspective, policymakers are desperate to stimulate investment spending. But when one realizes that we do not live in a one-period model, expectations matter. They do not always cooperate in the way that produces the desired result.   

The fundamental problem that got us where we are is the distortion of interest rates induced by poor monetary policy. In a different way, the distortion of interest rates continues.

8 Responses to “Monetary Policy At War With Itself”

  1. Lee Kelly Says:

    Okay, I don’t think I understand, but I’ll give it a shot:

    The quantity of credit demanded rises as interest rates fall, but if interest rates fall too far, then there is a shortage of credit. But with a central bank, (like the Fed or BoE), a shortage of credit can be “papered over” without bringing into existence any additional resources.

    The idea of “quantitive easing” is for a central bank to buy securities from investors, with the intent of increasing the supply of credit and keeping interest rates low. However, since investors expect quantitive easing to cease, and, therefore, interest rates to rise in the near future, they will sit on the money received from the central banks. In other words, investors’ expectation that quantitive easing will soon cease is an incentive to hold money until interest rates rise, and so quantitive easing will either not work as intended or be reduced in its effect.

    The general lesson is that central planning is stupid enough when economic actors are unaware of the central planner, but quite impossible when the system itself begins to plan on the central planner.

    Is that right?

  2. Lee Kelly Says:

    [Note concerning my previous comment]

    The people holding money might not actually be those who received it from the central bank. All that matters is that some people hold more money in anticipation of future high interest rates. I wrote it otherwise because sometimes simplicity is preferable to accuracy, especially in the comments of a blog, but have now reconsidered.

  3. smoron Says:

    Cemtral to the notion of a liquidity trap is the speculative motive of Keynes. This motive is based on the idea that investors will hold more money when they expect asset value to fall. There seems to be little evidence for this. Recent expereience shows that interest rates can be negative, if only briefly. Instead of going all the way to money, investors go to shorter term securities.

    Lurking behind all this argument there seems to be the notion of a natural rate of interest. There is no such thing. Economists do not seem to be aware of the difference between the marginal and the average rate. The marginal rate is of course the current rate, but the average rate is the effective rate on all outstanding debt. Capital gains tend to obscure this average rate by making all returns equal to the marginal rate. but they do not affect yield to maturity. This average rate is not the same thing as a natural rate, something determined by physical forces.

    In Keynes’ chapter on interest, there are three distinct theories of interest, the liquidity preference theory, the own rate theory, and the scarcity theory. The scarcity theory was set forth with great elegance by Lange in an article a few months after the general theory. But it very firmly denies that interest is determined by capital productivity.


  4. I appreciate Mario’s efforts to remind us what Keynes actually said. The idea of liquidity preference goes back at least to Keynes’ Treatise on Money and the “bear speculators” who keep long-term interest rates too high. “Money” in Keynes includes short-term securities. The idea of “pump priming” — government spending to stimulate private investment — had its origin in the Chicago School of the 1930s. Keynes incorporated it in the GT.


  5. On current policy, highbrow macrotheory has become useless for policy. (How can you discuss monetary policy in models without money? Or models in which money has no real effects.) Politicians want to do something and spending is the default option. Economists who know better (or perhaps don’t) rationalize the spending with Keynesian hydraulics.

  6. Mario Rizzo Says:

    Perhaps I should have made this clear: The point of view I am adopting in the post is that of Keynes to show that Krugman and others who believe that we are in a liquidity trap have forgotten an important consideration. *If* we are in a liquidity trap, then — according to Keynes’s analysis — one reason is likely to be the countercyclical use of interest rate policy.

  7. Drewfuss Says:

    It’s interesting that Keynes’ policy prescription for permanently ultra-low interest rates and the socialization of investment was never adopted as official Keynesian theory, for practicable and political reasons – we got Lernerism instead.

    But as we probably all realize, in the last few years that is precisely the direction that has been taken, even more so lately. And there are calls for bank nationalization, which would be the simplest way of directing investment without large scale nationalization of capital.

    Is Keynes smiling in his grave?

  8. smoron Says:

    Milton Friedman had an interesting comment on the Keynesian Revolution. Keynes was most readily accepted at those schools that were the most Austrian, like LSE and Harvard.
    The Austrians gave an important role to credit, but Keynes ignored it almost entirely. But the important thing is that Austrians believed that nothing could or should be done about depressions. Althougth said nothing about the Austrians, they might be considered his primary target.


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