Sunday, September 25, 2011

Are We Now in a Pure Credit Economy?

Are we now in a pure credit economy?

Tyler Cowen asked this question, linking to a post by Ashwin Parameswaran.

The post discussed Wicksell and and quoted Leijonhufvud, two of my favorites.

And I have always been interest in a "pure credit," or "pure inside" monetary order.

What is important about a pure inside monetary order is that there is no "pigou" effect from a lower price level. Even if the quantity of money is somehow given, the only real balance effect of a lower price level is a portfolio effect of lower nominal interest rates. Further, if the expected price level is somehow bounded, then a lower price level creates expectations of inflation, and so a lower real interest rate. There is no increase in real wealth, reduction in saving, and increase in real consumption.

However, Parameswaran has another concern:

There is ample reason to believe that reduced real rates across the curve have perverse and counterproductive effects, especially when real rates are pushed to negative levels

What are these perverse and counterproductive effects?

Prolonged periods of negative real rates may trigger increased savings and reduced consumption in an attempt to reach fixed real savings goals in the future...

Market monetarists argue that an expansionary monetary policy can raise real interest rates.

Sumner insists that the way an expansionary monetary policy works is through expectations of increased money expenditures on output in the future. Nick Rowe has suggested a positively-sloped IS curve to show how real interest rates can rise with real output and income in the face of an expansion in the quantity of money.

Naturally, market monetarists complain when the Fed explains the purpose of quantitative easing or operation twist as an effort to reduce long term interest rates. And we insist that the key to solving aggregate demand problems is a target for a growth path for nominal expenditures on output.

However, if the "confidence fairy" is not enough, I do think that lower real interest rates play a key role in raising current real and nominal expenditures. Given current expectations of future nominal expenditures, lower real interest rates raise current real and nominal consumption expenditures and current real and nominal investment expenditures.

More importantly, for improved confidence to raise both real and nominal expenditures, it is important for firms and households to believe that lower real interest rates will raise real and nominal expenditures. And while we can imagine it still working despite a false belief, certainly the more sure approach would be for lower real interest rates to be able to raise real expenditures given current expectations of future nominal expenditure. It is firms and households recognizing this and expecting that the Fed will purchase whatever amount of assets needed to make it happen, that raises expectations of future expenditures, and so motivates increased current expenditures.

If lower real interest rates reduce consumption expenditures, this would foreclose one avenue by which open market operations now and in the future can raise and be expected to raise real and nominal expenditure. However, focusing on the income effect for one segment of the market is an error. While it is possible that the income effect might be larger than the substitution effect so that consumption falls for those currently saving, debtors and borrowers both have opposite income effects that should raise current consumption. (Those living off of accumulated savings will almost certainly reduce consumer expenditures due to the income effect.)

While nominal interest rates may be subject to a zero bound, real interest rates have no such bound. It is difficult to believe that there is no real interest rate sufficiently negative to motivate reduced saving and increased consumption. The persistent saver willing to give up ever greater amounts of current consumption in exchange for less and less future consumption is implausible enough. However, when added to the rentier forced to dissave to maintain some consumption, the borrower tempted by obtaining more and more consumer goods today for a smaller sacrifice of future consumption, along with the debtor able to reduced real debt while consuming all of current income and even more, suggests a quite different result.

More importantly, the notion that investment can be approximated by perfect interest inelasticity becomes difficult to maintain when real interest rates can turn negative.

Shackle was skeptical about the impact of lower interest rates in stimulating business investment. He noted that businessmen when asked rarely noted at the level of interest rates as a critical determinant. In an uncertain environment, estimated profits “must greatly exceed the cost of borrowing if the investment in question is to be made”.

What negative real interest rates usually mean is that the nominal revenues generated by the investment greatly exceed the nominal costs of the project. And the nominal interest rate doesn't offset this large nominal profit.

Do businessmen usually focus on interest rates when making investment decisions? Presumably small changes in interest rates only have a small impact on investment decisions. However, if businessmen were asked if a 50% real interest rate would impact their investment behavior, what would they say? If, like Keynes or Shackle, you are wondering whether a modest decrease in a nominal interest will result in much of an increase in investment in the context of a stable price level, perhaps skepticism is in order. But when large decreases in real interest rates are considered, perhaps a different conclusion is appropriate.

Of course, if real interest rates must become highly negative to significantly expand real expenditure, then a zero nominal bound on nominal interest rates would imply high inflation and rapid growth in nominal expenditure. This is hardly consistent with slow steady growth of nominal GDP.

If significantly negative real interest rates are necessary to generate sufficient real expenditure so that nominal expenditures will return to target, then breaking the zero nominal bound would be a possibility. However, I believe that targeting nominal GDP and committing to purchase whatever quantity of assets necessary to reach that target will generate the expectations needed to put nominal GDP on target. If and when there is a discussion of whether the Fed should purchase blue-chip stocks, then perhaps the view that low long term interest rates result in less consumption and no more investment must be taken more seriously.


  1. Bill - Thanks for the comments.

    My post was just trying to highlight the perverse effects of negative real rates on some of the conventional channels. Michael Pettis has noted the role of negative real rates in increased savings in China and the same could be said for India at various times in its economic history.

    Although I'm not convinced that targeting NGDP is a straightforward process (primarily because I don't believe in strong-form efficient markets), this is not key to my argument. My main argument is that I'd rather that monetary intervention take other forms than buying assets from the market, namely Steve Waldman's idea of direct transfers - the current practise of monetary policy is biased towards propping up the incumbent corporate and banking structure something which causes havoc to the Schumpeterian dynamism of the economy.

    So for example, I'd rather that the Fed institutes new firm funding/interest rate subsidies rather than buying blue chip stocks of existing firms.

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