Axel Leijonhufvud had a tremendous impact on my understanding of macroeconomics. Admittedly, I was first exposed to him by Yeager, and I still have a "Keynesian Diversion" take on "Keynesian Economics and the Economics of Keynes." Still, I am probably one of the more "Keynesian" of the quasi-monetarists. Interest rates play a much larger role in my version of monetary disequilibrium than that of Scott Sumner, or Yeager, for that matter.
So, what to make of Leijonhuvud's rant about the social injustice of the low short term interest rates? He argues that banks are borrowing at very low rates, approximately 1 percent. They are holding government bonds that are paying 3 or 4 percent. They are making a large margin, and this is unjust, I guess to the depositors who are only earning 1%.
At first pass, I was a bit horrified. So, the Fed should do some open market sales, worsen the existing excess demand for money, and hope that a liquidity effect raises short term interest rates? Banks will have to raise deposit rates to compete, and their excess profits from investing in government bonds will shrink? What a disaster. Worsen the recession to make sure that depositors earn high interest rates. (I hate to admit it, but I worry sometimes about special pleading by great, retired economists whose late stage of life asset portfolios may be earning very low yields.)
The Fed's job should be to keep money expenditures on a stable growth path. If short term interest rates fall to very low levels, then so be it. If bank lending rates fall by less, so that bank margins rise, that should be no concern of the Fed.
I suppose it might be a concern for anti-trust policy, but to me, the key issue would be entry. If banking currently is providing excessively high profits, and there are people who want to organize banks, then let them. As they bid for deposits and invest the funds, then the margin that banks earn will fall. If regulators are blocking new entry into banking until existing banks make up for losses from lending against overpriced houses, I will complain as well.
Of course, Leijonhufvud then claims that this situation of banks paying low rates on deposits and purchasing higher yield government bonds is risky and could lead to a future banking crises. Why? If interest rates on government bonds should rise, then the banks will suffer capital losses on their portfolios of government bonds.
To me, this argument contradicts the claim that banks are making excessive profits. Once the risk of capital loss is taken into account, perhaps the gap between the interest rates banks pay and what they earn is reasonable. In other words, the banks may be very competitive, and if they expected the current rates on longer tem government bonds to persist, then they would bid up the yields on deposits and/or bid up the prices of long term government bonds and lower their yields. Perhaps the risk adjusted yield on bank asset portfolios isn't that much higher than what banks pay on deposits.
However, there are two ways in which government policy could reduce the gap between bank deposit rates and the interest rates on government bonds. In the debate about QE2, some, like Robert Barro, have argued that with low yield T-bills being more or less a perfect substitute for base money, open market operations with T-bills have no effect. When the Fed purchases long term bonds, on the other hand, this does have an effect, because long term government bonds with 3 to 4 percent yields are not perfect substitutes for base money. Some have pointed out that this implies that having the Treasury refinance the national debt by selling more T-bills and using the proceeds to pay off longer term bonds as they come due, or even purchasing the longer term bonds on the market would have the same effect as QE2.
This argument seems sound. When Barro and others express disbelief that the composition of the national debt could possibly have much effect on money expenditures, it seems to me they just failed to understand their own argument. If T-bills are the same as base money, then a shift in the composition of the national debt is the same thing as creating more money.
Anyway, if the Treasury did refinance the national debt by selling more T-bills and paying off longer term government bonds, the result (ceteris paribus) should be a higher yield on T-bills and lower yields on the long term government bonds. Banks would have to raise deposit rates to match the higher yields on T-bills, and their earnings on long term government bonds would fall. The "excess" profits earned by banks would fall. Presumably, banks would either shrink both sides of their balance sheet or shift from holding government bonds to making more commercial loans.
Why doesn't the Treasury follow this policy? Presumably because they want to lock in relatively low long term interest rates. If they borrow with T-bills, when short term rates (and expected long term rates) rise, they will have to pay more right away. In other words, by having the Fed and banks purchase long term government bonds, this risk is shifted to them. Of course, treating the Fed as independent of the rest of the government is a complete illusion, and with deposit insurance, much of the commercial banking system is little different.
A second issue is more narrowly focused on Fed policy. Following neo-Keynesian precepts, the Fed's solution to the lower bound on its target interest rate was first and foremost to promise that short term interest rates will stay low for an extended period. This policy does seem like it will leave banks with low borrowing rates for this extended period. The policy of QE2, on the other hand, involves purchasing long term government bonds. As I have explained before, it could actually raise interest rates on long term bonds, but to the degree expectations of future growth in money expenditures remain depressed, it would lower long term rates on government bonds. This would reduce the gap that so concerns Leijonhufvud.
My view is that the Fed should cease targeting interest rates altogether. It should instead target a growth path for money expenditures and commit to expand the quantity of money enough to reach that target. Interest rates should depend on market forces (and I would like monetary institutions that make negative nominal interest rates on short term government debt possible.) If expectations of recovery result in higher long term interest rates and lower demands for short term government bonds and other safe financial assets, then it would be a mistake for the Fed to have made some kind of promise to keep short term interest rates low.
In other words, if expansionary Fed policy raises short term rates, and so what bank depositors earn, then great! On the other hand, if expansionary Fed policy lowers those rates, then so be it. Fed policy should be aimed at keeping money expenditures on a target growth path, and short term interest rates and bank profits should not be its concern.