Tuesday, December 18, 2012

Sound Money

Market Monetarists advocate sound money.   We favor a monetary regime where the quantity of money adjusts with the demand to hold money, resulting in spending on output growing at a slow steady rate.   We believe that such a monetary regime creates the least bad environment for microeconomic coordination.   Yes, that is microeconomic coordination.  It includes creative destruction, inter-temporal coordination and so on.

Unfortunately, too many advocates of the free market blindly accept the wrongheaded framing of the Federal Reserve itself.    Monetary policy is identified with interest rates and lending.    The discussion appears innocent of even the fundamentals of economic analysis.

The fundamental forces that determine the level of interest rates are saving and investment.   If we assume these are constant and that the current interest rate coordinates them, then any "monetary policy" that involves changing interest rates must be distortionary.  

However, saving and investment are not fixed and unchanging.   In particular, worries about the future can easily lead to an increase in the supply of saving and decrease in the demand for investment.   This requires a decrease in the interest rate to bring them back to equilibrium.  

An increase in saving is a decrease in consumption--spending on consumer goods.   A decrease in investment is a decrease in spending on capital goods.   The direct effect of these decreases in spending is reduced sales, production, and employment.   However, the lower interest rate decreases the quantity of saving supplied--it stimulates spending on consumer goods.   And the lower interest rate stimulates spending on capital goods.

How low should interest rates go?   Until saving and investment are equal.   That means that any decrease in investment spending is offset by an increase in consumption spending.  Or any decrease in consumption spending is offset by an increase in investment spending.   It is even possible that investment and consumption spending would remain the same.

It is a travesty that supposed advocates of the free market are complaining that interest rates are too low and so are harming savers.     Yes, it is true that if saving supply rises and investment demand falls, then saving is less attractive.   That is how market prices work.   If the supply of corn rises and the demand falls, then the price of corn falls, and growing corn is less remunerative.

What about "blowing up bubbles?"   When interest rates are lower, the present value of future flows of income is higher.   This tends to raise the fundamental values of financial assets like stocks and also capital goods, including single family homes.    This is one of the ways in which lower interest rates cause a decrease in the quantity of saving supplied and increase in the quantity of investment demanded so that they return to equilibrium.    This is a coordinating adjustment.

Now, it is possible that foolish momentum traders will project past price increases into the future, and pay too much for assets.   It is even possible that clever traders will also buy such assets, planning to sell to a greater fool.   However, this is not a reason to prevent interest rates from coordinating saving and investment.    It is not a reason to keep asset prices from rising despite lower equilibrium interest rates.

To repeat, when saving rises and investment falls, the market process that prevents this from causing a decrease in spending is lower interest rates.   Complaining about lower interest rates in such a circumstance is simply anti-market propaganda.


  1. "The fundamental forces that determine the level of interest rates is saving and investment"

    Actually, the Cambridge CapitalDebates demonstrated that this is an invalid theory of the rate of interest. It's false. It's a zombie idea

    A more fruitful approach is Keynes's liquidity preference theory of the rate of interest

  2. I find this post confusing. I agree that many free-market types (of which I am one) don't fully understand the role of interest rates, but I can't quite figure out what you are arguing here, so I will try to push back a little.

    I don't think many free-market supporters have an issue with interest rates being low, they (we) have an issue with interest rates being set (or at least manipulated) by a central authority rather than in a market, and we tend to think that that central authority makes them lower than the market would.

    The argument in this post seems to be that, because interest rates are set in the market, they must be the "right" rate and arguing against them is "anti-market." And it's true that they are determined in a market with supply and demand (savings and investment) but both of these are influenced heavily by Fed policy and expectations of future Fed policy.

    So if the Fed's actions affect interest rates, which market monetarists seem to believe, and this in turn affects the mix of consumption/investment, then isn't it possible for Fed policy to be "distortionary?"

    Part of the problem is defining "distortionary," I don't think there is a way to conceive of "noninterventionist" Fed policy, so it's difficult to tell what a "natural" consumption/investment mix would be but whatever it is, if we believe that the Fed can change it by changing the willingness to save/invest, then doesn't it stand to reason that they could be distorting it away from that?

    So assuming that you aren't arguing that the Fed doesn't affect interest rates (which doesn't seem to be a MM position) are you arguing that, somehow, no matter what they do, the interest rate will always adjust to some level that sets consumption and investment equal to their "natural" levels given the Fed's policy? If so I don't follow the argument.

    Oh, and also, isn't it still true that lower rates (assuming this means lower real rates) do hurt savers regardless of how they come about and without making any statement about the morality of this?

  3. "when saving rises and investment falls, the market process that prevents this from causing a decrease in spending is lower interest rates. Complaining about lower interest rates in such a circumstance is simply anti-market propaganda."

    I'm not an economist, just an interested observer, but I'm not sure I'm understanding you...

    I get the point that with an excess of savings over investment, a free market will produce a fall in interest rates. But are you suggesting that the fall reflects *only* that market process and has nothing to do with intervention by the central bank? Are you saying therefore there is simply no such thing as interest rates that are too low?

  4. JCE:

    The nothing that interest rates coordinate saving and investment is not the same thing as the theory that the interest rate depends only on the marginal physical product of capital.

    The Cambidge controversies involved that notion.

    There is plenty of empirical evidence that investment--spending by firms on capital goods--is negatively related to interest rates.

    That some production processes might be relatively more profitable depending on low or high interest rates appears consistent with a negative relationship between real interest rates and real expenditures on capital goods.

    The liquidity preference approach is very institution specific. What happens when all money bears competitive interest?

  5. Mike F.:

    I disagree with the notion that Federal Reserve policy means that interest rates are "too low."

    If saving is greater than investment, then interest rates are too high.

    If we observe shortages of resources because firms are trying to expand purchases of capital goods (investing more) and households are trying to spend more on consumer goods, then saving is less than investment. Households are not saving enough to freeing up resources sufficient to produce the capital goods that firms want to buy.

    Of course, Market Monetarists, including me, point out that monetary policy has other impacts than just on interest rates. Expectations of the impact of monetary policy can raise investment demand and lower saving supply. This raises the intrerest rate where saving and investment are equal. In my view, this requires a change in the regime.

    But my point reduced spending on output due to increased saving or reduced investment should result in lower interest rates. This is a bit sad for creditors and happy for debtors, but focusing on that role of prices (lower prices are bad for sellers and good for buyers) completely ignores the essential coordinating role of prices and is the source of the most foolishing and ignorant forms of anticapitalism.

    Hard money advocates have been guilty of promoting this anti-capitalist nonsense.

    1. OK, so if I understand you, you are not saying that Fed policy can't be "distortionary" but merely that it isn't clear that they cause rates to be too low. I actually think they do cause rates to be too low (market monetarists seem to agree with me, whether or not they would be "too low" in a regime of NGDPLT is a separate questions) but I agree that the issue is more complicated than most free market supporters appreciate.

  6. Markmthomson:

    I think interest rates can be too low. That is when investment--spending on capital goods--is greater than saving--that part of income not spent on consumer goods. Starting from a point of equilibrium, where the interest rate is coordinating saving and investment, this results in excessive spending--more spending on consumer goods and capital goods than can be produced. Because of scarcity, there are not enough resources to both produce the additional consumer goods and the additional capital goods.

    If you believe interest rates are too low, I would ask, where are the shortages and bottlenecks? How are firms unable to expand the production of consumer goods or captial goods?

  7. Okay, agreed with everything posted, but the elephant in the room question; What happens in zero bound?

    Is QE necessary? I think it is.

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