Whatever the outcome of efforts to resolve severe economic difficulties in Europe and elsewhere, it is becoming increasingly clear that the next big economic crisis may not hinge on interest rates at all. One reason is that the world’s central banks, many of them following something like a Robinsonian “cheap money policy,” have managed to keep interest rates reasonably low in many countries. For example, it seems clear that yields on Spanish and Italian bonds are under control for now, after statements last month by Mario Draghi, the president of the ECB, that he was “ready to do whatever it takes,” to keep interest rates down. As made clear in this interesting and enlightening 2003 book edited by Bell and Nell (Stephanie Bell Kelton and Edward Nell), the theoretical argument for the Eurozone was badly flawed from the beginning.  (Indeed, many in the world of heterodox economics saw these  flaws from the beginning.) But, returning in this post to a key theme in Joan Robinson’s writings on the interest rate, I will offer some of the thoughts of John Maynard Keynes himself, who wrote in 1945 that:

The monetary authorities can have any rate of interest they like.… They can make both the short and long-term [rate] whatever they like, or rather whatever they feel to be right. … Historically the authorities have always determined the rate at their own sweet will and have been influenced almost entirely by balance of trade reasons [Collected Writings*, xxvii, 390–92, quoted from L.–P. Rochon, Credit, Money and Production, page 163 (publisher book link)].

Here in the United States, the Fed has shown its ability as a liquidity provider to keep interest rates on relatively safe investments very low across the maturity spectrum, despite spending much more than it received in tax payments in calendar years 2009–2011, and presumably the current year.  Keynes’s statement, much like the quote from Robinson mentioned above and the one in this earlier post, foretells this outcome.

Hence, recent US experience supports the view that calls for cuts in government spending and/or tax increases cannot be justified by fears that high deficits cause high interest rates at the national or global level.

* Note: The complete set of Keynes’s  works is out of print in hardback and will be reissued as a 30-volume set of paperbacks later this fall, according the Cambridge University Press website. – G.H., September 3

For those who worry that elevated federal deficits and quantitative easing (QE) by the Fed will lead to high inflation, a word about the macroeconomics of the 1970s. The topic came up in the news recently with the passing of economist and former presidential adviser Paul McCracken. In keeping with many orthodox accounts of the era, an obituary in the New York Times cast much of the blame for the stagflation [slow growth combined with high inflation] of the 1970s on “Keynesian” macro policies, in particular large budget deficits:

A wide-ranging thinker, Mr. McCracken was part of a postwar generation of economists who believed that government should play an active role in moderating business cycles, balancing inflation and unemployment, and helping the disadvantaged.

His nearly three years at the White House coincided with a turbulent era marked by rising deficits, rampant inflation, the imposition of wage and price controls, and the breakdown of the system of fixed exchange rates that had governed the world’s currencies since World War II.

As a result, by the early 1980s, Mr. McCracken, like other economists, questioned the Keynesian assumptions that had been dominant since the war. He concluded that high inflation had resulted from “a cumulative paralysis in our will” and called for greater fiscal discipline to limit the growth of government spending — a topic that continues to vex Washington….

Working for Nixon, Mr. McCracken was confronted with an inflation rate that had been rising since 1965, a byproduct of the deficits that the federal government had amassed during the Vietnam War…..

The article paints a picture in which McCracken stood in the middle ground between Keynesian “fine-tuners” of macro policy on the one hand and opponents of “activist” policies, such as Milton Friedman, on the other, who blamed inflation on excessive government spending and erratic growth in the money supply.

The view represented by the Times article is far from the only reasonable account of the causes of the stagflation of the 1970s, in particular the episodes during which the US experienced double-digit inflation (see figure below, in which year-over-year CPI inflation is shown in blue). continue reading…

Randall Wray joined Suzi Weissman for radio KPFK’s Beneath the Surface to discuss monetary policy, financial fraud, and a number of other issues.  The interview kicked off with Wray explaining his skepticism of the effectiveness of monetary policy, and in particular of quantitative easing, under current conditions, touching also on the question of why this long-term bias in favor of monetary over fiscal policy has developed.  The interview turned to LIBOR and the long string of recent financial scandals and outright fraud, with Wray tying it all to a broader (and growing) financialization of the economy.  Elaborating on the dominance of the FIRE sector in our economy, he discussed the increasingly fuzzy boundaries between, say, finance and industry.

Listen to the interview here.

In my last post, I quoted Joan Robinson, the renowned Cambridge University economist, on the determinants of long-term interest rates. The mention of Robinson was made in the context of a comment on the Fed open market committee meeting earlier this week and Chairman Ben Bernanke’s press conference on Wednesday. For those who might be curious, here is the “cheap money” scenario from Robinson that I mentioned in the earlier post; astute readers will notice parallels in recent Fed history:

The first move in the campaign is for the Central Bank to dose the banks with cash, by open market purchases. The amount of advances the banks can make is limited by the demand from good borrowers. The demand is very inelastic (though it shifts violently up and down with the state of trade), so the banks, between whom competition is highly imperfect, see no advantage in cheapening their price. The redundant cash reserve must go into bills. Any rate of return is better than none. The banks with redundant cash find themselves in much the same position as a group of firms with surplus capacity and zero prime costs. If perfect competition prevailed, the bill rate would go to next to nothing and the banks could not cover their costs. They therefore fix up a gentlemen’s agreement which keeps the bill rate steady at a low level. The bill rate is maintained at this low level by the Central Banks giving another dose of cash whenever it threatens to rise.

If the Central Bank is operating in the old orthodox manner, its power ends here, and the authorities must rely on the dealers in credit to bring the long rates down. Nowadays the authorities reinforce the action of the banking system by going into the bond market directly. If necessary, they issue bills in order to buy bonds, the quantity of money being adjusted to whatever level is required to keep the bill rate at its bottom stop. The low interest rates may slow down the velocity of active circulation so that money, as the saying is, stagnates in pools. Long hoards are swollen by the fall in current rates and bear hoards by the fact that expected future rates are not yet revised.

As time goes by, experience of a long rate that is persistently somewhat lower than the expected rate lowers the expected rate and so lowers the actual rate further. The yield on shares falls in sympathy with the bond rate. Thus the whole complex of rates gradually falls through time. If the authorities take it gently and do now try to push the rate down too fast, and if they stick consistently to the policy, once begun, so that the market never has the experience of today’s rate being higher than yesterday’s, it is hard to discern any limit to the possible fall in interest rates (except the mere technical costs of dealing) so long as the full-employment interest rate is below the actual level of rates or is held below it by a budget surplus or other means.

Joan Robinson, in “The Rate of Interest” (1951) from The Generalization of the General Theory and Other Essays, published by St. Martin’s Press, New York, 1979, pages 163–64. (The date of the original article was stated as 1952 in my earlier post; that is the publication date of the first edition of the book, which appeared under the title The Rate of Interest and Other Essays. My apologies for any inconvenience caused by this error.)

As I write, markets are wondering what Fed Chairman Ben Bernanke will say about interest rates in a press conference taking place this afternoon. Many economists, including some on the Federal Reserve’s rate-setting committee, are arguing that the Chairman is courting inflation with his policies of keeping interest rates low. He has been using three main approaches to this task:

(1) keeping short-term interest rates low through open market operations;

(2) buying and holding medium- and long-term bonds in a direct bid to keep longer-term rates low; and

(3) saying that it is likely to keep the federal funds rate near zero for an extended period of time.

Task (1) has been the usual approach of the Fed in modern times (since the early 1950s perhaps); task (2) has been important since the Fed’s response to the financial crisis beginning in 2008 or so. The current version of task (2) consists largely of a “twist” operation in which short-term securities are sold to pay for purchases of long-term securities. Task (3) is a commitment of sorts about short-term rates that helps to keep longer-term rates down. Tasks (2) and (3) are the most directly relevant to mortgage and auto loan rates, which are longer-term rates.

Economists, including critics of the Fed’s expansionary policies, sometimes refer to this three-pronged approach as a “cheap money policy,” but many who oppose “cheap money” have claimed that it would not be possible to maintain such a policy for very long (economic laws, or perhaps the bond markets’ worries about future inflation, would prevent this).

In a 1952 essay, Joan Robinson argued that a modern central bank could achieve a low long-term interest rate, but that it would take a long time to do so, in comparison to the quasi-real-time control the Fed enjoys over the federal funds rate. continue reading…

An update on the distressing state of fiscal and monetary policy in the United States and Europe:

Chairman of the Federal Reserve to Congress:  “I’d be much more comfortable, in fact, if Congress would take some of this burden from us ….”

Congress to Bernanke:  No thanks.  And while we’re on the subject, we would be much more comfortable, in fact, if you’d just stop carrying the load entirely. Kindly leave the economy in the ditch right there.  Or as Binyamin Appelbaum put it in his NYTimes report:

Republicans on the committee pressed repeatedly for Mr. Bernanke to make a clear commitment that the Fed would take no further action to stimulate growth.  “I wish you would look the markets in the eye and say that the Fed has done too much,” Representative Kevin Brady of Texas told Mr. Bernanke.  Democrats, by contrast, inquired politely after the Fed’s plans and showed surprisingly little interest in urging the Fed to expand its efforts.

Perhaps the private sector can muddle through on its own?  Here’s a graph from the Levy Institute’s Strategic Analysis showing employment and unemployment rates going back to 2000:

To fill the gap in the employment rate represented by that orange area, according to the macro team “the nation needs to find jobs for about 6 percent of the working-age population, or roughly 15 million people. Since the working age population has been growing on average by 2.4 million people per year, or 205,000 each month, job creation that barely reaches a threshold of that number multiplied by the current employment-population ratio of about .59 will not narrow the gap.”  Last month the economy generated an estimated 69,000 new jobs.  You don’t need your calculator to figure out that won’t narrow the gap.

And how are things in Euroland?  continue reading…

Congressman Ron Paul held a subcommittee hearing on reform of the Federal Reserve system a couple days ago that featured testimony from Senior Scholar James Galbraith, Alice Rivlin, John Taylor, Jeffrey Herbener, and Peter Klein.  There were a wide variety of topics addressed, including the size of the Fed’s balance sheet, proposals to make the Fed an arm of the Treasury, and changes to FOMC governance.

Also raised was the question of whether to (formally) drop the employment side of the Fed’s dual mandate (because with unemployment at the dangerously low level of 8 percent and inflation sky high around 2 percent, clearly we’d be better off if the Fed were more like the ECB …).  As Galbraith recounts, he himself was part of the team that drafted the Humphrey-Hawkins Act (“at a time of acute theoretical conflict in economics,” he points out), and he offers his defense of the dual mandate here:

As for the decided and observable tilt toward the price stability arm of the dual mandate, Galbraith collaborated on a working paper a few years back that identified the “real reaction function” of the Fed:  an aversion to full employment (“after 1983 the Federal Reserve largely ceased reacting to inflation or high unemployment, but continued to react when unemployment fell ‘too low.'”).  Although the working paper only covers the period 1984-2003, it raises an interesting contemporary question: even if Congress produced a substantial fiscal stimulus or managed to keep public employment levels anywhere close to where they were in 2008, to what extent would the Fed accommodate the expansionary effects?

Update:  Galbraith’s statement before the subcommittee can be read here.

If there is a pundit on the topic of the Federal Reserve, surely William Greider is one. (Recall his famous book, Secrets of the Temple.) This recent piece from Greider in the progressive magazine the Nation offers  some helpful historical perspective on the role of the nation’s central bank in recent years.

The Nation notes that austerity policies in Europe have proved to be very damaging to economic growth in the region, and points out that after adhering to IMF and EU austerity programs since last May, Portugal is “even deeper in the hole. The austerity has only increased its debt, as it has spread more suffering.”

The editorial goes on to point out that the euro countries have also been hindered by their unified currency system. This system currently makes it difficult for member governments to see to it that there is a market for their bonds and other securities—namely, their central banks. Taking exception to Republican fears of a “Greek-type collapse,” the Nation emphasizes that the “sovereign currency” possessed by the American government has always allowed it to avoid difficulties making payments on its debt. (A web version of the editorial is here. A similar Washington Post opinion piece is posted here.) Compare this with the current financial problems experienced by many state and local governments, as documented by recent articles in the New York Times (“Deficits Push New York Cities and Counties to Desperation”) and the Wall Street Journal (“States Keep Axes Sharpened”).

Many things can go wrong in an economy, even one with a smoothly running monetary system.  But the Nation’s argument remains crucial for the U.S.—first, that deficit-financed stimulus programs have helped keep our economy going; and second, that a government with its own currency is almost unable to default.

Quick note: In an interesting op-ed piece, Martin Wolf of the Financial Times notes that U.S. budget deficits have allowed the  private sector to deleverage a bit: “If the public sector does not sustain spending as the private sector  cuts back, the latter will go too far, causing unnecessarily deep damage to the economy.” He contrasts the U.S. situation with the crisis in the United Kingdom and Spain, where deleveraging has not gone as far. He points out that Spain’s lack of a sovereign currency has prevented its government from helping along the private-sector deleveraging process.

Philip Pilkington shares a discussion he had with Dean Baker about, among other things, the Post-Keynesian take on the limitations of some conventional economic models (of the “LM” part of IS-LM, in particular.  And if that just looks like an arbitrary string of letters to you, Pilkington has an accessible explanation at the beginning of his post).  His description of the “self-justifying” dynamics of the IS-LM view of money and central banking is worth quoting:

By assuming an upward-sloping LM-curve – that is, a fixed supply of funds – there is an implicit assumption that actions on the part of the central bank are somehow neutral. ISLM enthusiasts implicitly assume that the central bank is simply responding to some otherwise ‘equilibrating’ market conditions and adjusting its rates in line with this. …

… [The standard ISLM model] buries the fact that the central bank is actually taking a specific stance on policy and then tries to pass off this stance as a sort of quasi-market response (i.e. as if there were a market for a fixed supply of funds). But the central bank’s policy stance is nothing of the sort. Instead it is a sort of a simulation of what a market response is thought to be. Thought to be by whom? By economists that adhere to models similar to the ISLM, of course!

In a related vein, Greg Hannsgen points me to the latest volume of essays published in honor of Wynne Godley, “Contributions to Stock-Flow Modeling,” in which Marc Lavoie highlights this Godley quotation on the fixed stock of funds assumption in IS-LM:

Godley was always puzzled by the standard neoclassical assumption, found in both the IS/LM model and among monetarists, of an exogenous or fixed stock of money, the worse example of which is Friedman’s money helicopter drop. As Godley says, ‘governments can no more control stocks of either bank money or cash than a gardener can control the direction of a hosepipe by grabbing at the water jet’.