Malinvestment and the Liquidity Effect

Austrian theorists typically downplay or dismiss the "liquidity effect" of monetary disequilibrium on market interest rates. Instead, they champion a loanable funds explanation of interest rates, with an excess supply of money impacting interest rates by creating a matching increase in the supply of credit. This is sometimes called the "injection effect" of money on credit and interest rates.

New Keynesian economists, on the other hand, make the liquidity effect of money on interest rates central to their very understanding of money. It seems that the dominant perspective somehow identifies money with the short term interest rates set by central banks.

This divergence in perspective hit home recently due to two books I am reading. The difference is obvious in the introductions in Steve Horwitz's Microfoundations and Macroeconomics: An Austrian Perspective, and Michael Woodford's Interest and Prices.

Horwitz criticizes IS-LM analysis in a way that I found too dismissive of the liquidity effect of monetary disequilibrium. Similarly, I recently read a chapter by Roger Garrison explaining the "loanable funds" approach to interest. While he mentions that saved funds might not be lent out, his approach is to give reasons why the hoarding of money should be minimal.

Woodford, on the other hand, defends his modeling strategy of ignoring the quantity of money and just treating Federal Reserve policy as setting short term interest rates. He mentions that a money demand function can be appended to the model, and that would determine the quantity of money. Presumably, the model "determines" the quantity of money that creates whatever liquidity effect necessary to keep the short term interest rate where the central bank wants it.

Woodford also discusses cashless payments systems, and argues that if such a system actually develops, then the quantity of money will become meaningless and the only way a central bank could implement policy is through targeting the interest rate. He explains that a "channel" policy, where the central bank sets a lending rate and pays interest on reserve balances will keep short term rates in the channel between those rates, even if there is no money.

Cashless payments systems have been a special interest of mine, and I believe that they do have money. Woodford, however, seems to identify money as some asset or assets that will be subject to a liquidity effect. To him, "cashlessness" seems to mean the absence of an asset that people will hold even though its yield is less than the yield on other sorts of securities.

In my discussion of the disequilibrium version of the Austrian cycle theory, I described what I understand to be the injection effect. Given appropriate institutional assumptions, an excess supply of money will be matched by an increase in the real supply of credit. This increase in the real supply of credit will result in a lower market interest rate. I have asserted that this effect is ephemeral, because it only exists as long as there is an excess supply of money. And doesn't an excess supply of money mean that people are holding more money than they want to hold? How long can that last? People holding more money than they want to hold spend it.

Suppose that this injection effect is understood in the context of the liquidity effect. The liquidity effect also depends on institutional assumptions. The most important one is that the nominal interest rate that can be earned on money is "sticky." With conventional, tangible, hand-to-hand currency the nominal interest rate is stuck at zero. To the degree that issuing deposit money requires banks to hold vault cash made up of zero interest currency, or clearing balances with interest stuck at zero or some other rate (or even sticky) then some of the characteristics of the interest (or lack thereof) on currency will be partially transferred to the interest rate paid on deposits. If government regulations prohibit the payment of interest on various classes of deposits, and the "rents" provided by this anti-competitive regulation can only be dissipated through quality competition, an even greater stickiness is assured. And, of course, it is possible that competing private banks would offer deposits that pay interest that is only periodically adjusted. The stickiness of the interest rate paid on money could be a market phenomenon.

If there is some source of stickiness in the interest rate paid on money, then changes in market interest rates impact the opportunity cost of money and should be negatively related to the demand to hold money. If, on the other hand, the interest rates paid on monetary assets moved with other interest rates, then this effect would not exist. If the interest rates paid on money are sticky, then the interest rate elasticity of the demand for money could be significant in the short run, but then dissipate over time.

Even if the demand for money was perfectly inelastic with respect to interest rates, perhaps because the interest rates paid on money adjusted instantaneously, there would still be an injection effect of an excess supply of money. However, suppose that the interest rates on money are sticky, so that as the increase in the real supply of credit reduces market interest rates, it also reduces the opportunity cost of holding money. The amount of money demanded rises to match the expanded supply. People are satisfied with the existing quantity of money. The only problem is that the market interest rate is below the natural interest rate. That is, saving is less than investment.

In an earlier post I discussed the liquidity effect and explained my view that an excess supply of money exists when the quantity of money is greater than what the demand for money would be given the existing interest rate paid on money and a market interest rate is equal to the natural interest rate. That market interest rates may be distorted so that they do not properly coordinate saving and investment is one of symptoms and negative consequences of monetary disequilibrium.

If the institutional conditions hold for both an injection effect and a liquidity effect, it seems plausible that a persistent effect on market interest rates is possible. Only as lower market interest rates begin to impact savings (and so consumption) and investment, does the monetary disequilibrium begin to impact aggregate demand for final goods and services. And, of course, this plausibly impacts the composition of demand, in the end, based upon the interest elasticities of demand for various goods and services.

Perhaps this is just a situation where I have unusual intuitions, but the idea that people are simply holding more money than they want seems unlikely to last long. People will spend the money. But that people may take time to respond to changes in interest rates is much more plausible. And at least one requirement for malinvestment to be a problem is for monetary disequilibrium to have a persistent impact on market interest rates.