26 June 2011Mr Keynes and the Moderns at a Cambridge University conference commemorating the 75th anniversary of the publication of The General Theory of Employment, Interest and Money.
I am glad to note that he has therein seen fit to address a most curious absence in Keynes (see John Maynard Keynes and the dog that did not bark. Although the Great Depression that began in 1929 was accompanied by the wholesale failure of hundreds of banks, the General Theory published in 1936 did not have a word to say about bank rescues. I suggested that this was not a casual oversight on the part of Keynes but proof not only that he never understood the significance of banks but also that most of his assertions assumed an economy where money consisted entirely of currency and would collapse when banks were introduced into the equation.
Krugman's explanation for the absence of banks in Keynes is half-hearted, as if he himself is not really convinced:
20 June 2011The Obstinacy of Error, Interest Rates Edition.
This is how Krugman's argument goes:
Many private investors -- plus economists and economic commentators who never understood Keynes -- looked at (a) and confidently predicted soaring interest rates. Economists who did get Keynes looked at (b) and said that rates would stay low unless government borrowing was large enough to return the economy to something like full employment, which was unlikely.
The economic argument for rates staying low, by the way, wasn't complicated: it amounted to saying that the IS curve looked like this: [there's a fancy graph here which can be seen at the original link] and that there was no reason for the interest rate to rise, even with large government borrowing, unless that borrowing shifted the IS curve enough to the right to bring the economy above the zero lower bound. The subtlety arose from understanding that at each point on that IS curve the supply and demand for loanable funds are in fact equal, that liquidity preference and loanable funds are both true.
And here we are, two-plus years later, and the interest rate on 10-year U.S. Treasuries is only 2.94 percent. This should count as a triumph of economic analysis: the model was pitted against the intuitions of practical men, making a prediction many people considered ridiculous -- and the model was right.
I thought the idea of ceteris paribus was something well known to every economist. But apparently when fancy graphs fill up the brain, common sense has to make way.
Economists like Krugman, Mark Thoma and Brad deLong remind me of pre-Galilean scholars. Whenever the latter came across a difficult question they went back to Aristotle, who of course had the answer, so no one else needed to think. And thus for two thousand years they believed that heavier objects fell faster than lighter objects and that men have more teeth than women.
Readers might want to read the following paper by Prof Ronald McKinnon of Stanford University: Zero Interest Rates and the Fall in US Bank Lending
19 June 2011
In a speech on June 11, 2011, Economics instruction and the brave new world of monetary policy, John C. Williams, president of the San Francisco Federal Reserve Bank, said: "Let's take a closer look at the classic quantity theory of money: MV = PY. It becomes very tenuous when traditional measures of M make up a smaller and smaller fraction of the value of transactions. For example, the velocity of M1 was around three or four in the 1950s. Now it is about eight -- and that's down from a peak of about 10-1/2 a few years ago. Today's economy uses cash and checking accounts much more efficiently."
17 June 2011
So it is with some trepidation that I present two graphs.
The first one shows how the share of non-farm labour in business income has been steadily decreasing, especially since the 1980s.
The second is a graph of the Federal Funds Rate, which also incidentally has been steadily falling during the same period. [Both graphs use data from the St Louis Federal Reserve Bank site, as always a treasure house of information.]
Is this only an amazing coincidence?
Hardly. In Krugman's world-view low interest rates mean that firms producing real goods and services can borrow at a cheap rate and thus employ more people and presumably ordinary people can borrow money cheaply and live under their own roofs and so on. In other words, low interest rates pave the way to heaven. And yet the graphs lead the other way.
Actually the explanation is quite simple. The entities who really benefit from low interest rates are hedge funds and traders of financial instruments. Typically, they take advantage of mispricings of securities amounting to a few cents. And how do they parlay such tiny mispricings into incomes amounting to tens and hundreds of millions of dollars? By leveraging their equity ten, fifty or a hundred times. And of course they can do that only if money is dirt-cheap.
Equally important, this hurts the producers of real goods and services who are looking for loans. At present the prime rate is around 3.25%. What self-respecting bank would lend at 5% or even 10% and wait a whole year when they can earn more in just a few weeks by trading in financial instruments? If nothing else, the bonuses currently being paid to bankers should make this obvious -- to all but those rendered blind by ideology.
I imagine that whenever another of Krugman's Keep Interest Rates Low articles appears, financial traders gather in the centre of trading floors across the country, utter wild whoops of joy, and shout to the accompaniment of high fives: "Keep it coming, Paul!"
With enemies like Krugman, who needs friends?
14 June 2011
I have long suspected that very few people actually read Keynes's General Theory. But today I am led to wonder whether anyone at all has seriously read Keynes in decades.
The reason for my doubt is an article by James K. Galbraith, Why not Keynes? in The American Conservative magazine.
Galbraith laments that the ideas of Keynes, which seemed set for a new revival just three years ago, are again on the retreat. And for this he blames the "False Keynesians", such as Lawrence Summers and others who occupied high office in the Obama administration. They supported a "stimulus" but one so small that it had no effect at all.
"People who actually read and understood Keynes never came close to power," says Galbraith.
This is a pretty damning statement. The implication, of course, is that Galbraith has both read and understood Keynes.
But has he?
This is what he says later in the article, while complaining that it is the outdated ideas of David Ricardo and Adam Smith that dominate policy-making today:
"The rabbit in Ricardo's hat was the nature of money in his time-- mainly coins and paper backed by gold and silver. The quantity of money thus didn't fall in a glut, and its purchasing power would rise as prices fell. Consumption and investment would take up the slack.
"But we no longer live in that world. In our credit-money economy, purchasing power goes away when banks stop lending, and the money stock falls."
I am, of course, completely in agreement with Galbraith that in today's economy, the money stock falls when banks stop lending.
But Galbraith is terribly in error when he thinks that this was Keynes's understanding.
I suggest that he take up The General Theory and skim through it quickly. To begin with, he should ask himself why Keynes, writing several years after the start of the Great Depression which was characterised by the failure of hundreds of banks, did not have a word to say about bank failures, bank rescues or indeed about banks at all.
The answer is that Keynes did not ascribe any importance to banks. In his model, money consists entirely of currency, exactly as in the Ricardo that Galbraith excoriates. Keynes believed that the quantity of money was fixed and could be changed only by the monetary authority.
Here are a few quotes to prove that.
".. money has, both in the long and in the short period, a zero, or at any rate a very small, elasticity of production, so far as the power of private enterprise is concerned, as distinct from the monetary authority; -- elasticity of production meaning, in this context, the response of the quantity of labour which a unit of it will command. Money, that is to say, cannot be readily produced; -- labour cannot be turned on at will by entrepreneurs to produce money in increasing quantities as its price rises in terms of the wage-unit. In the case of an inconvertible managed currency this condition is strictly satisfied. But in the case of a gold-standard currency it is also approximately so, in the sense that the maximum proportional addition to the quantity of labour which can be thus employed is very small, except indeed in a country of which gold-mining is the major industry.
"Now in the case of assets having an elasticity of production, the reason why we assumed their own-rate of interest to decline was because we assumed the stock of them to increase as the result of a higher rate of output. In the case of money, however -- postponing, for the moment, our consideration of the effects of reducing the wage-unit or of a deliberate increase in its supply by the monetary authority -- the supply is fixed." (Chapter 17)
"Moreover it is impossible for the actual amount of hoarding to change as a result of decisions on the part of the public, so long as we mean by 'hoarding' the actual holding of cash. For the amount of hoarding must be equal to the quantity of money (or -- on some definitions -- to the quantity of money minus what is required to satisfy the transactions-motive); and the quantity of money is not determined by the public." (Chapter 13)
I can quote other chapters and verses but there are limits to what can be inflicted on a general reader.
The absence of banks is the central error of Keynes. The moment banks are introduced into the equation, the entire Keynesian structure -- the speculative motive for liquidity preference, the liquidity trap, the idea that recessions are caused by a failure of aggregate demand -- collapses as I have shown in John Maynard Keynes and the dog that did not bark and Paul Krugman and the liquidity trap
12 June 2011
In a recent article, Money Magic Rajan suggested that low interest rates, far from promoting growth, may be hindering it. There is nothing outlandish about the idea. This decade has seen the lowest extended period of low interest rates and also the longest period of low growth. So any economist who has not absolutely shut his mind would at least consider the possibility of a connection between the two.
But of course not Paul Krugman. In his usual polemic style in which personal attacks are par for the course he accused Rajan of tricking his audience. The attack can be seen at Monetary Calvinball. In what follows I take up one statement by Krugman.
"He [Rajan] simply takes it for granted that there's something unnatural about very low rates right now. But why? It's obvious that desired saving (or rather, the amount people would want to save if we were anywhere near full employment) is currently greater than desired investment. That suggests that the natural rate of interest right now is negative; only the zero lower bound keeps it from going there."
Now why would Krugman think that this is a clinching argument obvious to everyone except rentiers and their henchmen? Rentier, by the way, heads Krugman's current list of swear words.
The only explanation I can think of is that he is arguing by analogy. If the demand for wheat is too low and the supply too high, lowering the price of wheat would bring supply and demand into equilibrium by reducing supply and enhancing demand.
So far, so good. Unfortunately, the analogy does not carry over to money.
One, interest is not the price of money (Rajan too makes this error); it is the rent for money. The entity that lends money expects to get it back unlike the seller of wheat. So the risk of not getting back the money has to be priced into the interest rate. The entity does not buy money at one rate (x, close to zero) and sell it at a slightly higher rate (x plus a small mark-up).
Two, people save in the expectation of rainy days in future, not because of the interest rate. So lowering the interest rate won't persuade people to spend money instead of saving it; this happens during every recession and should be obvious to everyone except the absolutely blinkered like Krugman.
Three, the saver of money is not the lender of money. There is an intermediary, either a bank or some other financial institution. For the same reason that low rents reduce the quantity of housing brought to the market (a fact obvious to every economist), low interest rates discourage banks from lending money to firms. In other words, the exclusion of banks from Krugman's argument makes it appear that low interest rates enhance demand for loans, conveniently ignoring the fact that they diminish the incentive to supply loans. In other words, when it is favourable to Krugman, he ignores the supply side of the equation and considers only the demand side.
I have pointed out elsewhere that the whole Keynesian economic model depends on the absence of banks. The Keynesian model treats money as consisting entirely of currency and as soon as banks are introduced into the model the entire structure collapses. See John Maynard Keynes and the dog that did not mark
The same can be seen in Krugman. As I have pointed out above, his argument depends on the absence of banks and the direct transfer of money from savers to borrowers. In articles like Thinking about the liquidity trap too it can be seen that his models always treat money as cash and that there are no banks.
09 June 2011
The graph for Corrected Money Supply below (using savings figures on 1 April 2011) makes that clear.
The trajectory of the plunge will be much the same as it was the last time. It won't happen because of the debt or the wranglings in Congress but because several banks have engaged in foolish speculation and are on their way to going bust.
As happened last time, expect them to go crawling to the Fed.
But this time it is also to be hoped that a by-product will be the complete jettisoning of worn-out economic theories and defunct economists.
The logic behind the graph can be read at Riddle of money, finally solved
05 June 2011
In other words, artificially raising the price of something to a level higher than it otherwise would have been reduces the demand for it.
The obverse of this is that artificially lowering the price of something to a level lower than it otherwise would have been diminishes its supply.
A good example is rent control. Nearly all economists agree that fixing a ceiling on rents lowers the quantity and quality of housing brought to the rental market.
Yet, when it comes to money, economists seem to forget the basic laws of supply and demand. For nearly three years now the Federal Reserve has artificially pegged interest rates at a level close to zero. First it operated on short-term rates and then on long-term rates. The result is that it has successfully engineered an economic slow-down.
Now why should this be so? It is rent control all over again. When rents are fixed low it is unprofitable for the owner of an apartment to rent it out. Far more profitable to lock up the apartment or employ it as a brothel.
That roughly is what happened with banks. With interest rates at levels close to zero they found it unprofitable to lend money to firms. It was far more profitable to use the money to speculate on various financial assets. Now it is likely that at least some of them have lost money in speculation and discovered that they are on the way to going bust all over again. They have therefore curbed their already low-level of lending which has led to the current slowdown.
For a highly leveraged bank or financial institution even a small fall in the prices of financial assets is sufficient to wipe out its equity. If you leverage yourself 19 times and use the money to invest in a financial asset, then even a 5% fall in the price of that asset is sufficient to wipe out your equity. I am pretty sure that has already happened to several banks. Expect them to be soon crawling to the Fed on their knees.
Even ordinary investors, stuck with interest rates close to zero, and with no alternative safe havens would have decided to have a go at speculation and thus contributed to the growth of financial bubbles.
Most economists seem to think that when Walter Bagehot asked central banks to "lend freely at a high rate, on good collateral" he intended the high rate to serve as some sort of punishment meted out to recalcitrant schoolboys. The real reason of course was not to prevent moral hazard but to discourage speculation and prevent the banks from doing all over again what got them into trouble in the first place.
But how can one expect the Fed to understand this when it has forgotten the basic laws of demand and supply?
When the Fed rediscovers the basics it will realise that low interest rates are a recipe not for ending a recession but for causing the next one.