Another macroeconomist who is blind

Everyday the major financial newspapers and magazines provide Op Ed space to so-called leading economists. For the majority of the public, it is these Op Ed articles that provide their interaction with my profession. It is a pity. The majority of the reasoning presented by these characters, most who occupied senior positions in US academic departments, is spurious to say the least. The public is thus being poorly educated (to put it mildly) on a daily basis and this represents a major problem for our democracies. Voting in elections is one thing. But when citizens are voting based on faulty understandings that they have derived from these economists, then what is the value of a free vote? Today I consider the views of leading Princeton economist Alan Blinder – who is another macroeconomist who is blind to the way the economy works.

Lets take a step back a few months to an earlier article that Alan Blinder wrote on fiscal policy in the Wall Street Journal (May 21, 2012) – The Long and Short of Fiscal Policy.

In that article, Alan Blinder professes the macroeconomics that you will find in many text books – that:

In the short run-let’s say within a year or so-a larger deficit … boosts economic growth by increasing aggregate demand … [but beyond that time frame] … where the effects of larger deficits are mostly harmful to economic growth. In the jargon, more government borrowing tends to “crowd out” private borrowers by pushing interest rates up. Those crowded-out borrowers include both consumers who want to buy cars and businesses that want to buy equipment. In the latter case, higher government budget deficits take a toll on growth by slowing down capital formation.

And from that you can conclude that Alan Blinder has been perpetuating the standard myths about fiscal policy based on the a perverse macroeconomic framework.

His version of things is what we refer to as the Neo-classical Keynesian synthesis. Please read my blogs – On strategy and compromise and Those bad Keynesians are to blame – for more discussion on this point.

More specificially, in Alan Coddington’s wonderful taxonomy – Alan Blinder is what we refer to as a hydraulic Keynesian, many of which have morphed into a more recent category – New Keynesian.

The 1983 book by the late Alan Coddington – Keynesian Economics: The Search for First Principles – published by George Allen and Unwin, London is an excellent introduction to the different views that parade under the banner of “Keynesian”.

The hydraulics emerged in the Post World War II period as policy makers tried to come to terms with the messages of Keynes and text-book writers started to encapsulate it (simplify) it for students. The emergence of this line of thinking really started in the General Theory itself when in Chapter 2, Keynes left the door open for the neo-classical school to reassert itself.

I refer here to his use of marginal productivity theory of labour demand which was straight mainstream. Soon after the General Theory was published the mainstream set about tinkering with the body of idea and what emerged was the so-called IS-LM model which simplified the ideas to the point of futility (it was a static model with no role for expectations etc).

The IS-LM model attempted to demonstrate a simultaneous equilibrium between the goods market (where aggregate demand for output meets aggregate output supply) and the money market (where the fixed money supply controlled by the central bank meets money demand which depends positively on income and negatively on interest rates).

In this model, the two markets are joined (allowing simultaneity) because investment is negatively related to interest rates (which are determined in the money market by the interplay of money demand against a fixed money supply) and money demand is positively related to income (which is determined in the goods market by the interplay of aggregate demand and supply of goods).

So there is interactivity between the two markets which fitted into the general equilibrium mindset of the neo-classical thinking but allowed for some “Keynesian” ideas to be part of the show – that aggregate demand can drive output under certain conditions.

The hydraulics dominated the debate in the 1950s and 1960s and while retaining a role for discretionary government counter-stabilisation policies introduced all the nonsense about crowding out and debt crises. The static framework did away with the ideas that behavioural relationships (consumption, investment, demand for money etc) were subject to endemic uncertainty and instead assumed they were stable.

The “Keynesian” model was then mathematically expressed (all functions assumed to be stable) and policy analysis was then possible. Increase policy lever X and Y happens. A hydraulic relationship between spending, income and output (and employment) – push spending and the rest change in predictable ways.

Further, they started to distinguish between what might happen immediately (the short-run) and what would happen as some of the adjustments (for example, interest rates) took hold.

From Alan Blinder’s take on fiscal policy we learn, first, that he is happy with deficits as long as the government can borrow cheaply. From that we learn that he adopts the mainstream view that if governments run deficits then they have to borrow. If he was pushed he would admit that the central bank can fund any treasury spending it likes (more on this soon) but that would, inevitably be inflationary – “too much money chasing too few goods”.

Consistent with the mainstream hydraulic (New Keynesian) approach this narrative fails at the most elemental level.

In this narrative, the issuing of debt not only provides the funding necessary for the government to meet its financial constraint (and run a deficit) but also drains purchasing power from the private sector to give the private sector more room to spend without causing inflation.

But what would happen if a sovereign, currency-issuing government (with a flexible exchange rate) ran a budget deficit without issuing debt?

In this situation, like all government spending, the Treasury would credit the reserve accounts held by the commercial bank at the central bank. The commercial bank in question would be where the target of the spending had an account. So the commercial bank’s assets rise and its liabilities also increase because a deposit would be made.

The transactions are clear: The commercial bank’s assets rise and its liabilities also increase because a new deposit has been made. Further, the target of the fiscal initiative enjoys increased assets (bank deposit) and net worth (a liability/equity entry on their balance sheet). Taxation does the opposite and so a deficit (spending greater than taxation) means that reserves increase and private net worth increases.

This means that there are likely to be excess reserves in the “cash system” which then raises issues for the central bank about its liquidity management. The aim of the central bank is to “hit” a target interest rate and so it has to ensure that competitive forces in the interbank market do not compromise that target.

When there are excess reserves there is downward pressure on the overnight interest rate (as banks scurry to seek interest-earning opportunities), the central bank then has to sell government bonds to the banks to soak the excess up and maintain liquidity at a level consistent with the target.

Some central banks offer a return on overnight reserves which reduces the need to sell debt as a liquidity management operation depending on where they set the rate in relation to their target interest rate.

What would happen if there were bond sales? All that happens is that the banks reserves are reduced by the bond sales but this does not reduce the deposits created by the net spending. So the net worth of the private sector is not altered. What is changed is the composition of the asset portfolio held in the non-government sector.

The only difference between the Treasury “borrowing from the central bank” and issuing debt to the private sector is that the central bank has to use different operations to pursue its policy interest rate target. If debt is not issued to match the deficit then it has to either pay interest on excess reserves (which most central banks are doing now anyway) or let the target rate fall to zero (the Japan solution).

There is no difference to the impact of the deficits on net worth in the non-government sector.

Mainstream economists would say that by draining the reserves, the central bank has reduced the ability of banks to lend which then, via the money multiplier, expands the money supply.

However, the reality is that:

• Building bank reserves does not increase the ability of the banks to lend.
• The money multiplier process so loved by the mainstream does not describe the way in which banks make loans.
• Inflation is caused by aggregate demand growing faster than real output capacity. The reserve position of the banks is not functionally related with that process.

Thus, the banks are able to create as much credit as they can find credit-worthy customers to hold irrespective of the operations that accompany government net spending.

This doesn’t lead to the conclusion that deficits do not carry an inflation risk. All components of aggregate demand carry an inflation risk if they become excessive, which can only be defined in terms of the relation between spending and productive capacity.

It is totally fallacious to think that private placement of debt reduces the inflation risk.

We will return to the topic of excess bank reserves and lending soon, when we consider Alan Blinder’s most recent WSJ article.

Second, Alan Blinder recognises that the composition of a fiscal stimulus will have different impacts on job creation outcomes. He talks of a “second layer of subtlety” which:

… recognizes that some types of spending and some types of tax cuts have larger effects on spending than others, and similarly, that some types are more sharply targeted on job creation than others. Such details matter in designing a cost-effective stimulus package.

I agree with that point. The observation that “(h)igher spending or lower taxes speed up growth by adding to demand” is true but crude. Governments have to be mindful of the composition of demand and where extra spending should be targetted.

Third, Alan Blinder thinks that as long as the government is borrowing cheaply, then “productive investments in public capital-such as highways, bridges, and tunnels … with strongly positive net present values … will enhance long-run growth, not retard it.

But then comes the errors.

Fourth, for “other types of spending, and any tax cut that does not boost capital formation enough, will slow down growth. And that’s the fundamental indictment of large deficits”. This is because he considers budget deficits beyond a year that do not add to productive capacity in the private sector will drive up interest rates and stifle demand.

The causality in the macroeconomic models that Alan Blinder is applying here assumes that government spending competes with private uses for finite “savings” in a loanable funds market, which is a aggregate construction of the way financial markets are meant to work in mainstream macroeconomic thinking.

The original conception was designed to explain how aggregate demand could never fall short of aggregate supply because interest rate adjustments would always bring investment and saving into equality.

At the heart of this erroneous hypothesis is a flawed viewed of financial markets. The so-called loanable funds market is constructed by the mainstream economists as serving to mediate saving and investment via interest rate variations.

This is pre-Keynesian thinking and was a central part of the so-called classical model where perfectly flexible prices delivered self-adjusting, market-clearing aggregate markets at all times. If consumption fell, then saving would rise and this would not lead to an oversupply of goods because investment (capital goods production) would rise in proportion with saving.

So while the composition of output might change (workers would be shifted between the consumption goods sector to the capital goods sector), a full employment equilibrium was always maintained as long as price flexibility was not impeded. The interest rate became the vehicle to mediate saving and investment to ensure that there was never any gluts.

So saving (supply of funds) is conceived of as a positive function of the real interest rate because rising rates increase the opportunity cost of current consumption and thus encourage saving. Investment (demand for funds) declines with the interest rate because the costs of funds to invest in (houses, factories, equipment etc) rises.

Changes in the interest rate thus create continuous equilibrium such that aggregate demand always equals aggregate supply and the composition of final demand (between consumption and investment) changes as interest rates adjust.

According to this theory, if there is a rising budget deficit then there is increased demand is placed on the scarce savings (via the alleged need to borrow by the government) and this pushes interest rates to “clear” the loanable funds market. This chokes off investment spending.

So allegedly, when the government borrows to “finance” its budget deficit, it crowds out private borrowers who are trying to finance investment. The mainstream economists conceive of this as the government reducing national saving (by running a budget deficit) and pushing up interest rates which damage private investment.

If you are new to my blog, then this trilogy of blogs will help you understand the intrinsic myths contained in this reasoning – Deficit spending 101 – Part 1 – Deficit spending 101 – Part 2 – Deficit spending 101 – Part 3.

The basic flaws in the mainstream story are that governments just borrow back the net financial assets that they create when they spend.

It is true that the private sector might wish to spread these financial assets across different portfolios. But then the implication is that the private spending component of total demand will rise and there will be a reduced need for net public spending.

Further, they assume that savings are finite and the government spending is financially constrained which means it has to seek “funding” in order to progress their fiscal plans. But government spending by stimulating income also stimulates saving.

Crowding out arguments also fail to understand that bank loans create deposits at any time the banks might choose. As noted above, e banks are limited in their capacity to lend by two things: (a) how much capital they have (under Basel rules adopted by most central banks); and (b) by their ability to attract credit-worthy customers. For a well-capitalised bank, the latter becomes the day-to-day constraint.

One could argue that the number of credit-worthy customers rises when budget deficits drive economic growth. People and firms have higher incomes and there is more commercial opportunities to exploit.

One might argue that the central bank might increase interest rates because they fear that the budget deficits will add to inflation. In other words, one doesn’t have to rely on the loanable funds arguments to justify the crowding out argument.

But this is just an acknowledgement that central banks set the interest rate. Interest rates rise when there are budget surpluses and often fall when there are budget deficits. There is no empirically robust relationship ever been found to show that higher budget deficits are always associated with higher interest rates.

Part of the reason for that lack of relationship is the fact that the budget deficit can rise when times are bad (via the automatic stabilisers).

Further, there is scant evidence to show that the sensitivity of investment to changing interest rates is high independent of expected earnings streams. When aggregate demand is high enough for the central bank to start hiking rates, profits are normally buoyant and earnings strong which encourages more investment.

Now, lets consider Alan Blinder’s most recent effort at professing macroeconomic thought. His Wall Street Article article (July 22, 2012) – How Bernanke Can Get Banks Lending Again.

Consistent with his view that the American economy is in need of stimulus (higher aggregate demand), a view that I share, Alan Blinder thinks that the politics of the Congress leave him to conclude that the boost “won’t come from fiscal policy” and so the question becomes:

Can the Federal Reserve provide it?

This article was presumably written in the context of the appearance by the US Federal Reserve Chairman at the Congress recently where he said that monetary policy had some tricks left in the policy bag to stimulate spending if required.

Alan Blinder considers the effectiveness of the various monetary policy tools that might be manipulated further by the US central bank.

I will leave it to you to consider his analysis.

In summary, Alan Blinder concludes that the “Fed has three weak weapons, one of which will be exhausted by year’s end”. A “pretty grim picture”.

But he proposes “two out-of-the-box suggestions” that will fix the situation – the first of which the current column is devoted to explaining.

Pray tell!

Alan Blinder says:

The simpler option is one I’ve been urging on the Fed for more than two years: Lower the interest rate paid on excess reserves. The basic idea is simple. If the Fed reduces the reward for holding excess reserves, banks will hold less of them-which means they will have to find something else to do with the money, such as lending it out or putting it in the capital markets.

He added that he would do this in “two stages” – first “by cutting the interest on excess reserves … to zero”, and second, “drop it to, say, minus-25 basis points-that is, charge banks a fee for holding their money at the Fed.”

And at that stage you understand that Alan Blinder misrepresents the way fiscal policy functions in the economy (as above) but also misrepresents the way the central banking and commercial banking system operates.

He says that the US Federal Reserve would consider his policy to be “a radical change” but I would rather suggest that the operational managers and operatives within the US central bank know full well that his idea has no merit.

Monetary policy is focused on determining the value of a short-term interest rate given that central banks cannot control the money supply. The theory of endogenous money is central to the horizontal analysis in Modern Monetary Theory (MMT). When we talk about endogenous money we are referring to the outcomes that are arrived at after market participants respond to their own market prospects and central bank policy settings and make decisions about the liquid assets they will hold (deposits) and new liquid assets they will seek (loans).

The essential idea is that the “money supply” in an “entrepreneurial economy” is demand-determined – as the demand for credit expands so does the money supply.

As credit is repaid the money supply shrinks. These flows are going on all the time and the stock measure we choose to call the money supply, say M3 (Currency plus bank current deposits of the private non-bank sector plus all other bank deposits from the private non-bank sector) is just an arbitrary reflection of the credit circuit.

So the supply of money is determined endogenously by the level of GDP, which means it is a dynamic (rather than a static) concept.

Central banks clearly do not determine the volume of deposits held each day. These arise from decisions by commercial banks to make loans. The central bank can determine the price of “money” by setting the interest rate on bank reserves. Further expanding the monetary base (bank reserves) as we have argued in recent blogs – Building bank reserves will not expand credit and Building bank reserves is not inflationary – does not lead to an expansion of credit.

With this background in mind, the next thing is to need to appreciate what reserve balances are.

The New York Federal Reserve Bank’s paper – Divorcing Money from Monetary Policy said that:

… reserve balances are used to make interbank payments; thus, they serve as the final form of settlement for a vast array of transactions. The quantity of reserves needed for payment purposes typically far exceeds the quantity consistent with the central bank’s desired interest rate. As a result, central banks must perform a balancing act, drastically increasing the supply of reserves during the day for payment purposes through the provision of daylight reserves (also called daylight credit) and then shrinking the supply back at the end of the day to be consistent with the desired market interest rate.

The central bank must ensure that all private cheques (that are funded) clear and other interbank transactions occur smoothly as part of its role of maintaining financial stability. But, equally, it must also maintain the bank reserves in aggregate at a level that is consistent with its target policy setting given the relationship between the two.

So operating factors link the level of reserves to the monetary policy setting under certain circumstances. These circumstances require that the return on “excess” reserves held by the banks is below the monetary policy target rate. In addition to setting a lending rate (discount rate), the central bank also sets a support rate which is paid on commercial bank reserves held by the central bank.

Many countries (such as Australia and Canada) maintain a default return on surplus reserve accounts (for example, the Reserve Bank of Australia pays a default return equal to 25 basis points less than the overnight rate on surplus Exchange Settlement accounts). Other countries like the US and Japan have historically offered a zero return on reserves which means persistent excess liquidity would drive the short-term interest rate to zero.

The support rate effectively becomes the interest-rate floor for the economy. If the short-run or operational target interest rate, which represents the current monetary policy stance, is set by the central bank between the discount and support rate. This effectively creates a corridor or a spread within which the short-term interest rates can fluctuate with liquidity variability. It is this spread that the central bank manages in its daily operations.

So the issue then becomes – at what level should the support rate be set?

Commercial banks choose to hold reserves to ensure they can meet all their obligations with respect to the clearing house (payments) system. Because there is considerable uncertainty (for example, late-day payment flows after the interbank market has closed), a bank may find itself short of reserves. Depending on the circumstances, it may choose to keep a buffer stock of reserves just to meet these contingencies.s after

Banks do not lend their reserves to borrowers. They don’t need to. Loans create deposits and the banks then worry about the reserve implications.

Thus, central bank reserves are intrinsic to the payments system where a mass of interbank claims are resolved by manipulating the reserve balances that the banks hold at the central bank. This process has some expectational regularity on a day-to-day basis but stochastic (uncertain) demands for payments also occur which means that banks will hold surplus reserves to avoid paying any penalty arising from having reserve deficiencies at the end of the day (or accounting period).

The central bank charges a “penalty’ rate for loans to banks to cover shortages of reserves. If the interbank rate is at the penalty rate then the banks will be indifferent as to where they access reserves from.

Once the price of reserves falls below the penalty rate, banks will then demand reserves according to their requirements (the legal and the perceived). The higher the market rate of interest, the higher is the opportunity cost of holding reserves and hence the lower will be the demand.

As rates fall, the opportunity costs fall and the demand for reserves increases. But in all cases, banks will only seek to hold (in aggregate) the levels consistent with their requirements.

At low interest rates (say zero) banks will hold the legally-required reserves plus a buffer that ensures there is no risk of falling short during the operation of the payments system.

The central bank has to ensure that it supplies enough reserves to meet demand while still maintaining its policy rate (the monetary policy setting.

The market rate of interest will be determined by the central bank supply of reserves. So the level of reserves supplied by the central bank supply brings the market rate of interest into line with the policy target rate.

The central bank can hit its monetary policy target rate of interest by supplying the banks’ demand for aggregate reserves. So the central bank announces its target rate then undertakes monetary operations (liquidity management operations) to set the supply of reserves to this target level.

Contrary to what the mainstream view endorsed by Alan Blinder says, the reality is that monetary policy is about changing the supply of reserves in such a way that the market rate is equal to the policy rate.

In the absence of paying a support rate, the central bank uses open market operations to manipulate the reserve level and so must be buying and selling government debt to add or drain reserves from the banking system in line with its policy target.

If there are excess reserves in the system and the central bank didn’t intervene then the market rate would drop towards zero and the central bank would lose control over its target rate (that is, monetary policy would be compromised).

As explained in the blog – Understanding central bank operations – the introduction of a support rate payment (deposit rate) whereby the central bank pays the member banks a return on reserves held overnight changes things considerably.

It clearly can – under certain circumstances – eliminate the need for any open-market operations to manage the volume of bank reserves.

With a support rate being paid, the banks can earn overnight interest on their excess reserve holdings and that becomes the minimum market interest rate and defines the lower bound of the corridor within which the market rate can fluctuate without central bank intervention.

The market interest rate is still set by the supply of reserves (given the demand for reserves) and so the central bank still has to manage reserves appropriately to ensure it can hit its policy target.

So if the central bank wants to maintain control over its target rate it can either set a support rate below the desired policy rate (as in Australia) and then use open market operations to ensure the reserve supply is adequate or set the support (deposit) rate equal to the target policy rate.

Please read the following blogs – Building bank reserves will not expand credit and Building bank reserves is not inflationary – for further discussion.

Conclusion

Bank lending is constrained at present by the size of the queue of credit-worthy borrowers. The private sector is trying to run down debt rather than accumulate more (overall).

Further, the credit-worthiness of many potential borrowers is limited by the state of the economy which is constraining the capacity of firms to generate revenue and service new loans. The state of the economy is also the result of a stagnant housing sector and people are struggling with negative equity. Under those conditions, the demand for new loans for housing are naturally very constrained.

That is enough for today!