Tag: Knut Wicksell

We Are so S—ed. Econ 1-Level Edition

Posted on by Brad DeLong

As I told my undergraduates yesterday:

Y = μ[co + Io + NX] + μG – μIrr

where:

  • Y is real GDP
  • μ = 1/(1-cy) is the Keynesian multiplier
  • co is consumer confidence
  • cy is the marginal propensity to consume
  • C = co + cyY is the consumption function–how households’ spending on consumption goods and services varies with consumer confidence, with their income which is equal to real GDP Y, and with the marginal propensity to consume
  • Io is businesses’ and banks’ “animal spirits”–their confidence in enterprise
  • r is “the” long-term risky real interest rate r
  • Ir is the sensitivity of business investment to r
  • NX is foreigners’ net demand for our exports
  • And G is government purchases.

And as I am going to tell them next Monday, real GDP Y will be equal to potential output Y* whenever “the” interest rate r is equal to the Wicksellian neutral rate r*, which by simple algebra is:

r* = [co + Io + NX]/Ir + G/Ir – Y*/μIr

If interest rates are low and inflation is not rising it is not because monetary policy is too easy, but because r* is low–and r* can be low because:

  • consumers are terrified (co low)
  • investors’ animal spirits are depressed (Io low)
  • foreigners’ demand for our exports inadequate (NX low)
  • or fiscal policy too contractionary (G low)

for the economy’s productive potential Y*.

The central bank’s task in the long run is to try to do what it can to stabilize psychology and so reduce fluctuations in r. the central bank’s task in the short run is to adjust the short-term safe nominal interest rate it controls i in such a way as to match the market rate of interest r to r. For only then will Say’s Law, false in theory, be true in practice:

Martin Wolf: Negative Rates Not Central Banks’ Fault: “It is hard to understand the obsession with limiting public debt when it is as cheap as it is today…

…Almost nine years after the west’s financial crisis started, interest rates remain ultra-low. Indeed, a quarter of the world economy now suffers negative interest rates. This condition is as worrying as the policies themselves are unpopular. Larry Fink, chief executive of BlackRock, the asset manager, argues that low rates prevent savers from getting the returns they need for retirement. As a result, they are forced to divert money from current spending into savings. Wolfgang Schäuble, Germany’s finance minister, has even put much of the blame for the rise of Alternative für Deutschland, a nationalist party, and on policies introduced by the European Central Bank. ‘Save the savers’ is an understandable complaint by an asset manager or finance minister of a creditor nation. But this does not mean the objection makes sense. The world economy is suffering from a glut of savings relative to investment opportunities. The monetary authorities are helping to ensure that interest rates are consistent with this fact….

The savings glut (or investment dearth, if one prefers) is the result of developments both before and after the crisis…. Some will object that the decline in real interest rates is solely the result of monetary policy, not real forces. This is wrong. Monetary policy does indeed determine short-term nominal rates and influences longer-term ones. But the objective of price stability means that policy is aimed at balancing aggregate demand with potential supply. The central banks have merely discovered that ultra-low rates are needed to achieve this objective…. We must regard ultra-low rates as symptoms of our disease, not its cause….

[But is] the monetary treatment employed… the best one[?]…. Given the nature of banking institutions, negative rates are unlikely to be passed on to depositors and… so are likely to damage the banks…. There is a limit to how negative rates can go without limiting the convertibility of deposits into cash…. And this policy might do more damage than good. Even supporters agree there are limits…. [Does] this mean monetary policy is exhausted? Not at all. Monetary policy’s ability to raise inflation is essentially unlimited. The danger is rather that calibrating monetary policy is more difficult the more extreme it becomes. For this reason, fiscal policy should have come into play more aggressively….

The best policies would be a combination of raising potential supply and sustaining aggregate demand. Important elements would be structural reforms and aggressive monetary and fiscal expansion…. Monetary policy cannot be for the benefit of creditors alone. A policy that stabilises the eurozone must help the debtors, too. Furthermore, the overreliance on monetary policy is a result of choices, particularly over fiscal policy, on which Germany has strongly insisted. It is also the result of excess savings, to which Germany has substantially contributed…

One way of looking at it is that two things went wrong in 2008-9:

  • Asset prices collapsed.
  • And so spending collapsed and unemployment rose.

The collapse in asset prices impoverished the plutocracy. The collapse in spending and the rise in unemployment impoverished the working class. Central banks responded by reducing interest rates. That restored asset prices, so making the plutocracy whole. But while that helped, that did not do enough to restore the working class.

Then the plutocracy had a complaint: although their asset values and their wealth had been restored, the return on their assets and so their incomes had not be. And so they called for austerity: cut government spending so that governments can then cut our taxes and so restore our incomes as well as our wealth.

But, of course, cutting government spending further impoverished the working class, and put still more downward pressure on the Wicksellian neutral interest rate r* consistent with full employment and potential output.

And here we sit.

John Maynard Keynes in His High Wicksellian Mode in 1937: Today’s History of Economic Thought

Posted on by Brad DeLong

Today’s History of Economic Thought: Here we have John Maynard Keynes in his High Wicksellian mode:

  • The natural rate of interest depends on unstable and flutuating opinions about the future yield of capital-assets.
  • The market rate of interest depends on the supply of money and the unstable and fluctuating propensity to hoard–liquidity preference.
  • Thus we have large-scale fluctuations in investment (unless a central bank can neutralize fluctuations in liquidity preference and also make the market rate dance in time with the fluctuating natural rate)
  • Add in the multiplier, and we have unemployment business cycles.

This was, I think, the article that made the Swedes whimper: “Why are the citations to Knut Wicksell missing?”

John Maynard Keynes (1937): The General Theory of Employment: “Money, it is well known, serves two principal purposes…

…By acting as a money of account it facilitates exchanges without its being necessary that it should ever itself come into the picture as a substantive object. In this respect it is a convenience which is devoid of significance or real influence. In the second place,it is a store of wealth.

So we are told, without a smile on the face. But in the world of the classical economy, what an insane use to which to put it! For it is a recognized characteristic of money as a store of wealth that it is barren; whereas practically every other form of storing wealth yields some interest or profit.

Why should anyone outside a lunatic asylum wish to use money as a store of wealth? Because, partly on reasonable and partly on instinctive grounds, our desire to hold Money as a store of wealth is a barometer of the degree of our distrust of our own calculations and conventions concerning the future. Even though this feeling about Money is itself conventional or instinctive, it operates, so to speak, at a deeper level of our motivation. It takes charge at the moments when the higher, more precarious conventions have weakened. The possession of actual money lulls our disquietude; and the premium which we require to make us part with money is the measure of the degree of our disquietude.

The significance of this characteristic of money has usually been overlooked; and in so far as it has been noticed, the essential nature of the phenomenon has been misdescribed. For what has attracted attention has been the quantity of money which has been hoarded; and importance has been attached to this because it has been supposed to have a direct proportionate effect on the price-level through affecting the velocity of circulation. But the quantity of hoards can only be altered either if the total quantity of money is changed or if the quantity of current money-income (I speak broadly) is changed; whereas fluctuations in the degree of confidence are capable of having quite a different effect, namely, in modifying not the amount that is actually hoarded, but the amount of the premium which has to be offered to induce people not to hoard. And changes in the propensity to hoard, or in the state of liquidity-preference as I have called it, primarily affect, not prices, but the rate of interest; any effect on prices being produced by repercussion as an ultimate consequence of a change in the rate of interest.

This, expressed in a very general way, is my theory of the rate of interest. The rate of interest obviously measures–just as the books on arithmetic say it does–the premium which has to be offered to induce people to hold their wealth in some form other than hoarded money. The quantity of money and the amount of it required in the active circulation for the transaction of current business (mainly depending on the level of money-income) determine how much is available for inactive balances, i.e. for hoards. The rate of interest is the factor which adjusts at the margin the demand for hoards to the supply of hoards.

Now let us proceed to the next stage of the argument. The owner of wealth, who has been induced not to hold his wealth in the shape of hoarded money, still has two alternatives between which to choose. He can lend his money at the current rate of money-interest, or he can purchase some kind of capital-asset. Clearly in equilibrium these two alternatives must offer an equal advantage to the marginal investor in each of them. This is brought about by shifts in the money-prices of capital-assets relative to the prices of money-loans. The prices of capital-assets move until, having regard to their prospective yields and account being taken of all those elements of doubt and uncertainty, interested and disinterested advice, fashion, convention and what else you will which affect the mind of the investor, they offer an equal apparent advantage to the marginal investor who is wavering between one kind of investment and another.

This, then, is the first repercussion of the rate of interest, as fixed by the quantity of money and the propensity to hoard, namely, on the prices of capital-assets. This does not mean, of course,that the rate of interest is the only fluctuating influence on these prices. Opinions as to their prospective yield are themselves subject to sharp fluctuations, precisely for the reason already given, namely, the flimsiness of the basis of knowledge on which they depend. It is these opinions taken in conjunction with the rate of interest which fix their price.

Now for stage three. Capital-assets are capable, in general, of being newly produced. The scale on which they are produced depends, of course, on the relation between their costs of production and the prices which they are expected to realize in the market. Thus if the level of the rate of interest taken in conjunction with opinions about their prospective yield raise the prices of capital-assets, the volume of current investment (meaning by this the value of the output of newly produced capital-assets) will be increased; while if, on the other hand, these influences reduce the prices of capital-assets, the volume of current investment will be diminished.

It is not surprising that the volume of investment, thus determined, should fluctuate widely from time to time. For it depends on two sets of judgments about the future, neither of which rests on an adequate or secure foundation–on the propensity to hoard, and on opinions of the future yield of capital-assets. Nor is there any reason to suppose that the fluctuations in one of these factors will tend to offset the fluctuations in the other. When a more pessimistic view is taken about future yields, that is no reason why there should be a diminished propensity to hoard. Indeed, the conditions which aggravate the one factor tend, as a rule, to aggravate the other. For the same circumstances which lead to pessimistic views about future yields are apt to increase the propensity to hoard.

The only element of self-righting in the system arises at a much later stage and in an uncertain degree. If a decline in investment leads to a decline in output as a whole, this may result (for more reasons than one) in a reduction of the amount of money required for the active circulation, which will release a larger quantity of money for the inactive circulation, which will satisfy the propensity to hoard at a lower level of the rate of interest, which will raise the prices of capital-assets, which will increase the scale of investment, which will restore in some measure the level of output as a whole.

This completes the first chapter of the argument, namely, the liability of the scale of investment to fluctuate for reasons quite distinct (a) from those which determine the propensity of the individual to save out of a given income and (b) from those physical conditions of technical capacity to aid production which have usually been supposed hitherto to be the chief influence governing the marginal efficiency of capital.

If, on the other hand, our knowledge of the future was calculable and not subject to sudden changes, it might be justifiable to assume that the liquidity-preference curve was both stable and very inelastic. In this case a small decline in money-income would lead to a large fall in the rate of interest, probably sufficient to raise output and employment to the full. In these conditions we might reasonably suppose that the whole of the available resources would normally be employed;and the conditions required by the orthodox theory wouldbe satisfied.

My next difference from the traditional theory concerns its apparent conviction that there is no necessity to work out a theory of the demand and supply of output as a whole. Will a fluctuation in investment, arising for the reasons just described,have any effect on the demand for output as a whole, and consequently on the scale of output and employment? What answer can the traditional theory make to this question? I believe that it makes no answer at all, never having given the matter a single thought; the theory of effective demand,that is the demand for output as a whole, having been entirely neglected for more than a hundred years.

My own answer to this question involves fresh considerations. I say that effective demand is made up of two items–investment-expenditure determined in the manner just explained, and consumption-expenditure. Now what governs the amount of consumption-expenditure? It depends mainly on the level of income. People’s propensity to spend (as I call it) is influenced by many factors, such as the distribution of income, their normal attitude to the future and-though probably in a minor degree–by the rate of interest. But in the main the prevailing psychological law seems to be that when aggregate income increases, consumption-expenditure will also increase, but to a somewhat lesser extent. This is a very obvious conclusion…

John Maynard Keynes (1937), “The General Theory of Employment”, Quarterly Journal of Economics 51:2 (February), pp. 209-223 http://www.jstor.org/stable/1882087

Must-Read: Alan Greenspan (1994): Testimony before the Subcommittee on Economic Growth and Credit Formation of the Committee on Banking, Finance and Urban Affairs, U S House of Representatives, July 20

Posted on by Brad DeLong

Must-Read: July 20, 1994: Alan Greenspan reintroduces Knut Wicksell’s 1898 Geldzins und Güterpreise, and so shifts America’s macroeconomic discussion from the quantity of money to the natural (or equilibrium, or neutral) rate of interest.

As I remember it, I then spent my lunchtime seated at my computer in my office on the third floor of the U.S. Treasury, frantically writing up just what Alan Greenspan was talking about. For over in the Capitol, Greenspan had just said:

  1. Pay no attention to Federal Reserve policy forecasts of M2.
  2. Instead, pay attention to our assessments of the relationship of interest rates to an equilibrium interest rate.

In Greenspan’s view:

[the] equilibrium interest rate [is]… the real rate… if maintained, [that] would keep the economy at its production potential…. Rates persisting above that level, history tells us, tend to be associated with slack, disinflation, and economic stagnation–below that level with eventual resource bottlenecks and rising inflation…

And I said: this is Wicksell. Greenspan is announcing that the Fed is no longer asking in a Friedmanite mode “do we have the right quantity of money?”, but rather asking in a Wicksellian mode “do we have the right configuration of interest rates”:

Alan Greenspan (1994): Testimony before the Subcommittee on Economic Growth and Credit Formation of the Committee on Banking, Finance and Urban Affairs, U S House of Representatives, July 20: “In addition to focusing on the outlook for the economy at its July meeting…

…the FOMC, as required by the Humphrey-Hawkins Act, set ranges for the growth of money and debt for this year and, on a preliminary basis, for 1994…. The FOMC lowered the 1993 ranges for M2 and M3–to 1 to 5 percent and 0 to 4 percent, respectively…. The lowering of the ranges is purely a technical matter, it does not indicate, nor should it be perceived as, a shift of monetary policy in the direction of restraint It is indicative merely of the state of our knowledge about the factors depressing the growth of the aggregates relative to spending….

In reading the longer-run intentions of the FOMC, the specific ranges need to be interpreted cautiously The historical relationships between money and income, and between money and the price level have largely broken down, depriving the aggregates of much of their usefulness as guides to policy. At least for the time being, M2 has been downgraded as a reliable indicator of financial conditions in the economy, and no single variable has yet been identified to take its place. At one time, M2 was useful both to guide Federal Reserve policy and to communicate the thrust of monetary policy to others. Even then, however, a wide range of data was routinely evaluated to assure ourselves that M2 was capturing the important elements in the financial system that would affect the economy…. The so-called “P-star” model, developed in the late 1980s, embodied a long-run relationship between M2 and prices that could anchor policy over extended periods of time But that long-run relationship also seems to have broken down with the persistent rise an M2 velocity.

M2 and P-star may reemerge as reliable indicators of income and prices…. In the meantime, the process of probing a variety of data to ascertain underlying economic and financial conditions has become even more essential to formulating sound monetary policy….

In assessing real rates, the central issue is their relationship to an equilibrium interest rate, specifically the real rate level that, if maintained, would keep the economy at its production potential over time. Rates persisting above that level, history tells us, tend to be associated with slack, disinflation, and economic stagnation–below that level with eventual resource bottlenecks and rising inflation, which ultimately engenders economic contraction. Maintaining the real rate around its equilibrium level should have a stabilizing effect on the economy, directing production toward its long-term potential.

The level of the equilibrium real rate–or more appropriately the equilibrium term structure of real rates–cannot be estimated with a great deal of confidence, though with enough to be useful for monetary policy. Real rates, of course, are not directly observable, but must be inferred from nominal interest rates and estimates of inflation expectations. The most important real rates for private spending decisions almost surely are the longer maturities. Moreover, the equilibrium rate structure responds to the ebb and flow of underlying forces affecting spending. So, for example, in recent years the appropriate real rate structure doubtless has been depressed by the head winds of balance sheet restructuring and fiscal
retrenchment.

Despite the uncertainties about the levels of equilibrium and actual real interest rates, rough judgments about these variables can be made and used in conjunction with other indicators in the monetary policy process. Currently, short-term real rates, most directly affected by the Federal Reserve, are not far from zero; long-term rates, set primarily by the market, are appreciably higher, judging from the steep slope of the yield curve and reasonable suppositions about inflation expectations. This configuration indicates that market participants anticipate that short-term real rates will have to rise as the head winds diminish, if substantial inflationary imbalances are to be avoided

While the guides we have for policy may have changed recently, our goals have not. As I have indicated many times to this Committee, the Federal Reserve seeks to foster maximum sustainable economic growth and rising standards of living. And in that endeavor, the most productive function the central bank can perform is to achieve and maintain price stability…

Cracking the Hard Shell of the Macroeconomic Knut: “Keynesian”, “Friedmanite”, and “Wicksellian” Epistemes in Macroeconomics

Posted on by Brad DeLong

The very-sharp Tyler Cowen gets one, I think, more wrong than right. He writes:

Tyler Cowen: What’s the Natural Rate of Interest?: “I… find all this talk of natural rates of interest…

…historically strange. A few points: (1) David Davidson and Knut Wicksell debated the… concept very early in the twentieth century, in Swedish…. Most people believe Davidson won…. (2) Keynes devoted a great deal of effort to knocking down the natural rate of interest…. There could be multiple natural rates… [or] no rate of interest whatsoever…. (3) In postwar economics, the Keynesians worked to keep natural rates of interest concepts out….

(4) The older natural rate of interest used to truly be about price stability… [not] “two percent inflation a year.”… (5) Milton Friedman warned (pdf) not to assign too much importance to interest rates…. (6) When Sraffa debated Hayek and argued the natural rate of interest was not such a meaningful concept, it seems Sraffa won…. (7) I sometimes read these days that the “natural [real] rate of interest” consistent with full employment is negative. To me that makes no sense in a world with positive economic growth and a positive marginal productivity of capital….

Of course economic theory can change, and if the idea of a natural rate of interest makes a deserved comeback we should not oppose that development per se. But I don’t see that these earlier conceptual objections have been rebutted, rather there is simply now a Kalman filter procedure for coming up with a number…. In any case, this is an interesting case study of how weak or previously rebutted ideas can work their way back into economics. I don’t object to what most of the people working on this right now actually are trying to say. Yet I see the use of the term acquiring a life of its own, and as it is morphing into common usage some appropriately modest claims are taking on an awful lot of baggage from the historical connotations of the term…

In my view, all (7) of these are more than debatable. For example, (7): “[That] the ‘natural [real] rate of interest’ consistent with full employment is negative… makes no sense in a world with positive economic growth and a positive marginal productivity of capital…” misses the wedge–the wedge between the (positive) expected real rate of return from risky investments in capital and the (positive) temporal slope to the expected inverse marginal utility of consumption, on the one hand; and the (negative) equilibrium real low-risk interest rate, on the other hand.

In a world that is all of a global savings-glut world with large actors seeking portfolios that provide them with various kinds of political risk insurance, risk-tolerance gravely impaired by the financial crisis and the resulting deleveraging debt supercycle, moral hazard that makes the remobilization of societal risk-bearing capacity difficult and lengthly, and reduced demographic and technological supports for economic growth, it seems to me highly plausible that this wedge can be large enough to make the low-risk ‘natural [real] rate of interest’ consistent with full employment negative alongside positive economic growth and a positive marginal productivity of capital.

And the bond market agrees with me in email:

Graph Long Term Government Bond Yields 10 year Main Including Benchmark for Germany© FRED St Louis Fed Graph 10 Year Treasury Inflation Indexed Security Constant Maturity FRED St Louis Fed

And (2): “Keynes devoted a great deal of effort to knocking down the natural rate of interest…” Indeed he did Keynes saw the natural rate of interest as part of a wrong loanable-funds theory of interest rates: that, given the level of spending Y, supply-and-demand for bonds determined the interest rate. Keynes thought that people must reject that wrong theory before they could adopt what he saw as the right, liquidity-preference, theory of interest rates: that, given the level of spending Y and the speculative demand for money S, supply-and-demand for money determined the interest rate.

I think Keynes was wrong. I think Keynes made an analytical mistake.

Hicks (1937) established that Keynes was wrong when he believed that you had to choose. You don’t. Because spending Y is not given but is rather jointly determined with the interest rate, you can do both. Indeed, you have to do both. Liquidity-preference without loanable-funds is just one blade of the scissors: it cannot tell you what the interest rate is. And loanable-funds without liquidity-preference is just the other blade of the scissors: it, too, cannot tell you what the interest rate is. You need both.

More important, however, in thinking about our present concern with the natural (“neutral”) (“equilibrium”) real rate of interest is knowledge of the historical path by which we arrived at our current intellectual situation. Alan Greenspan did it. On July 20, 1994, Alan Greenspan announced that the Federal Reserve was not a “Keynesian” institution, focused on getting the volume of the categories of aggregate demand–C, I, G, NX–right. He announced that the Federal Reserve was not a “Friedmanite” institution, focused on getting the quantity of money right. He announced that the Federal Reserve was now a “Wicksellian” institution, focused on getting the configuration of asset prices right:

Alan Greenspan (1994): Testimony before the Subcommittee on Economic Growth and Credit Formation of the Committee on Banking, Finance and Urban Affairs, U S House of Representatives, July 20: “The FOMC, as required by the Humphrey-Hawkins Act…

…set[s] ranges for the growth of money and debt…. M2 has been downgraded as a reliable indicator…. [The] relationship between M2 and prices that could anchor policy over extended periods of time… [has] broken down…. M2 and P-star may reemerge as reliable indicators of income and prices….

In the meantime… in assessing real rates [of interest], the central issue is their relationship to an equilibrium interest rate, specifically the real rate level that, if maintained, would keep the economy at its production potential over time. Rates persisting above that level, history tells us, tend to be associated with slack, disinflation, and economic stagnation–below that level with eventual resource bottlenecks and rising inflation, which ultimately engenders economic contraction. Maintaining the real rate around its equilibrium level should have a stabilizing effect…. The level of the equilibrium real rate… [can] be estimated… [well] enough to be useful for monetary policy…. While the guides we have for policy may have changed recently, our goals have not…

Greenspan thus shifted the focus of America’s macroeconomic discussion away from the level of spending and the quantity of money to the configuration of asset prices. In some ways this is no big deal: “Keynesian”, “Friedmanite”, and “Wicksellian” frameworks are all perfectly-fine ways to think about macroeconomic policy. They are different–some ideas and some factors are much easier to express and focus on and are much more intuitive in one of the frameworks than in the others. But they are not untranslateable–I have not found any point that you can express in one framework that cannot be more-or-less adequately translated into the others.

The point, after all, is to find a macroeconomic policy that will make Say’s Law, false in theory, true enough in practice for government work. You can start this task by focusing your analysis first on either spending, or liquidity, or the slope of the intertemporal price structure. You will almost surely have to dig deeper into the guts of the economy in order to understand why the current emergent macro properties of the system are what they are. But any one of the languages will do as a place to start. Greenspan in the mid-1990s judged that the Wicksellian language provided the best way to communicate. And, looking back over the past 25 years, I cannot really disagree.

But at the time, back in 1994, the shift to a Wicksellian episteme led to substantial confusion. As I remember it, I spent my lunchtime on July 20, 1994, seated at my computer in my office on the third floor of the U.S. Treasury, frantically writing up just what Alan Greenspan was talking about when he said (1) pay no attention to Federal Reserve policy forecasts of M2; instead, (2) pay attention to our assessments of the relationship of interest rates to an equilibrium interest rate. Greenspan announced that the Fed was no longer asking in a Friedmanite mode “do we have the right quantity of money?”, but rather was asking in a Wicksellian mode “do we have the right configuration of interest rates”. And that still does not seem to me to be a bad place to be.