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Nick, how do you square this story with your argument that central banks should not announce what they expect the future overnight rate to be? Do you say that the expectational Wicksell is the wrong kind of cumulative process and that the better alternatives are available?

variation on a commitment by the Fed to be imprudent, or reckless, or whatever that phrase was?

TMDB: Good question. Essentially, this post is (implicitly) based on the same model as that previous post. I think the difference is this:

The previous post was about the Canadian case, where the inflation target is reasonably credible. In the absence of additional information, the market will expect the Bank of Canada to get it right. So we don't want to give the market additional information about what the Bank thinks. We want Et[M(t+1)] to be always zero, to minimise the variance of inflation around target.

This post is about the Fed, and the Fed's inflation target is not so credible. The market will not give the Fed the benefit of the doubt. It doesn't even know what the Fed's target is. It has been scared of deflation and recession. So if we want a recovery in the US, we *want* the Et[M(t+1)] term to be positive.

anon: Yep. It's just a lot more credible, if people think you are overly pessimistic, so they think that you think you will be doing the right thing.

Nick, I think I agree with this post insofar as I like multiple equilibria stories.

However, I need to quibble with your terminology. The natural rate is nothing more than whatever real rate balances saving and investment at the full employment income level.

According to that definition the story you're telling is not one where the "true" natural rate has stayed the same but the market perception is that it increased. Your story is one of the natural rate itself increasing while the real rate that prevails in the market stays the same.

Your mistake, if I can really call it that, is here: "Somewhere, deep in the metaphysical vaults of preferences and technology, there exists a true natural rate..."

No, the natural rate always, in any model, depends on expectations as well as preferences and technology. Standard models pin down expectations by assuming them to be rational expectations but they don't *have* to assume this.

The definition I gave above works just as well with any expectations.

Adam: Yep. There's a lot to be said for your way of defining the "natural rate". That's actually how I normally prefer to define it myself. But when I started to write this post, using your definition, I kept tying myself up in verbal knots. It ought to be possible to re-write this post using your definition. But I just couldn't think of any way to do it clearly.

I agree with Adam P.

The natural interest rate is the level of interest rates that coordinates saving and investment. However, I will grant that some use it to refer to the some kind of physical return on capital, of which a more accurate version is technology and tastes.

Still, I see Nick's puzzle. More investment and consumption demand raise the natural interest rate.

Nick, you said:
"The previous post was about the Canadian case, where the inflation target is reasonably credible. In the absence of additional information, the market will expect the Bank of Canada to get it right. So we don't want to give the market additional information about what the Bank thinks. We want Et[M(t+1)] to be always zero, to minimise the variance of inflation around target.

This post is about the Fed, and the Fed's inflation target is not so credible. The market will not give the Fed the benefit of the doubt. It doesn't even know what the Fed's target is. It has been scared of deflation and recession. So if we want a recovery in the US, we *want* the Et[M(t+1)] term to be positive."

But if in 15 years Canada gets into the zero interest rate trap, debates about the comprehensive framework for disclosure of future intentions will delay the recovery. The losses in the zero interest rate trap are much greater than the benefit of low transparency today. So I support the disclosure of the interest rate forecast for Canada.

If we follow your logic, we should get transparency cycles - if monetary policy is good, policymakers should gradually reduce transparency to prolong the period of good monetary performance. But policymakers should increase transparency when macro outcomes are bad. Do we get anything like this in practice?

Hi, Nick. You end your post with a speculation that the Fed may be "deliberately making pessimistic noises". If so, does that undermine the premise of your post, that the Fed is in fact more pessimistic than the market? If the Fed is in fact not as pessimistic as its public signals suggest, would you still be optimistic about the US recovery?

Thank you for sharing your thoughts on the prospect of a US recovery. I hope you are right!

"Since the actual natural rate has not changed, and since the market rate set by the Fed has not changed.."

You are assuming that the Fed sets the cost of capital, but really it lowers the short term funding costs of banks, who do not lend against capital but against land.

By lowering rates (or keeping them low) the CB is subsidizing the acquisition of land, and assuming that this subsidy spills over into capital, rather than impoverishing capital.

It's not clear why this should be the case.

Suppose that households in equilibrium will demand the same return for holding land as they would for holding stock. Say land prices go up 10% because of the lowered rates, as do stock prices.

Now do the higher stock prices reflect investors accepting lower dividends, or do they reflect investor expectations of higher dividend growth rates?

If it's the former, then the CB has succeed in lowering the cost of capital, but in the latter case, the CB may have actually increased the cost of capital.

And you wont be able to tell over the short run whether the cost of capital has increased or decreased.

You only find out that it was the second case when the stock market crash occurs and firms start liquidating when the earnings growth rates are not realized.

It's complex, and heavily dependent on the institutions involved. But even ignoring the capital/land distinction, we can put this cumulative process to a test.

There are some countries in which banks *do* fund capital, because the capital markets are either undeveloped or repressed.

For example, in China, or some of the other asian growth miracle countries.

There, banks primarily fund capital and the government can control the lending rates. So China is an example of the monetarists Utopia in which the central bank actually controls investment rates and you can play with reaction functions in the straight-forward way.

Here, there are clear examples of engineering investment-led booms as a result of low interest rates. But the cumulative process primarily results in asset price inflation, not consumer price inflation, or even capital goods price inflation, and ultimately deflation and/or falling MPK equalize the marginal efficiency of investment to the nominal investment rates, not marginal adjustment costs. At least, this is the case in the asian investment-led growth booms.

So you are assuming too many things here, namely that the cost of capital is some increasing function of central bank policy, and that a rising marginal adjustments costs, rather than falling MPK, are what equalize the investment rate with the nominal rate. All of those assumptions are heavily dependent on the credit market institutions and the production characteristics involved. I don't think they are justified for the case of the U.S.

Nick:

It seems to me that you are essentially saying that confidence in the economy by actors in the economy matters. It's interesting that the relationship between overall confidence and the central bank's confidence might matter too.

But there's something else that matters, and that I think you are leaving out. That is the actual spending power of the economy, related to the money supply. If you could suddenly wipe out the spending power of a whole bunch of people in such a way that "the market" did not notice and confidence was unaffected, you are still going to cause a drop in demand just because there is less total spending power in the economy.

I think that is pretty close to what has happened in the U.S. The economic crisis destroyed a lot of spending power. Many people are not able to spend because they are being forced to pay down debt. Normally, the Fed could correct this by boosting the money supply, but it is up against the zero lower bound, which essentially blocks the way it normally gets the money it creates out into the real economy to boost spending power. It can lower other interest rates by "quantitative easing", but they have a lower bound too, probably considerably above zero because of default risk, so how much good will that do?

I am pessimistic about the U.S. economy. The way around the block would be for the government to borrow money and spend it. It would essentially be borrowing from the Fed because the Fed will create all the money needed to keep interest rates at zero. It gives the Fed a way around the block it faces and allows it to boost overall spending power. But politically, that does not seem about to happen.

I think the U.S. is just repeating all the mistakes Japan made in its "lost decade", and that were made in the 1930's. I expect the result will be similar. But maybe I just read too much Krugman.

TMDB: Hmmm. Maybe. You have a point.

Kien: "If so, does that undermine the premise of your post, that the Fed is in fact more pessimistic than the market? If the Fed is in fact not as pessimistic as its public signals suggest, would you still be optimistic about the US recovery?"

Hmmm. I think so, as long as the market believes the Fed will act *as if* it were more pessimistic about the recovery.

RSJ: it's not the cost of capital; it's the gap between the expected rate of return on capital and the cost. Tobin's Q. But that's not what this post is about.

Paul: shocks to demand happen, and must be offset. But I am persuaded by Scott Sumner's argument that much of the debt crisis was a consequence, not simply a cause, of the expected downturn in demand. So the downturn fed upon itself.

And then a central banker sneezes during a speech and the market picks up this "belief momentum" that an epidemic of mad cow disease is infecting rational thought at the fed. The market rationally decides to think irrationally in order to predict future interest rate moves. This aggregate irrationality, however, is the integral over all persons individual irrationality.

A new pseudo science emerges in academia called "crazy" market theory. Retrospectively has an answer for all macro phenomena. More consistent, because it is not bound by the need to even try to make sense. Unfortunately only predicts future events with random accuracy.

The natural rate of interest is ZERO

http://bilbo.economicoutlook.net/blog/?p=4656

Gizzard. Thanks for the link. But he's wrong.

Really badly wrong.

In a growing economy, or one with a positive rate of time preference, the natural rate will be positive in real terms. Bilbo wants the central bank to set a zero nominal rate. Now economists like Milton Friedman understand that a zero nominal rate might be possible, if we had deflation. Bilbo doesn't. And Bilbo doesn't want deflation either, presumably. Bilbo wants a zero nominal rate, and so a zero or negative real rate, and fiscal policy to prevent inflation getting out of hand. That can be done, for a time, but it would normally mean running very large permanent fiscal surpluses. So the government saves by a large enough amount to offset the gap between private investment and savings. And if the government runs permanent large surpluses, eventually the debt goes to zero, then negative, and eventually the government owns the whole capital stock of the country. So we end up in communism. Now, Bilbo is certainly not a communist, but that's where his preferred policy would lead.

Sorry.

Nick: is that really true? It seems to me that it would be about equivalent to the government earning the risk free rate on the money supply - a role that is currently played by the banks, and then recycling it into the economy as services rather than bank dividends. So they wouldn't own the whole economy (anymore than the banks currently do).

And draining money through taxes and deleting it is not the same thing as owning the capital stock. How does control pass from the shareholders to the prime minister?

A stable zero nominal rate is the same thing as keeping deflation at the rate of growth. It seems to me that over the long run this will be achieved by keeping the money supply constant. So long as we have taxation *and* helicopter drops I really don't see how this is either unstable or the road to communism.

K: Yep. It's true. Consolidate the central bank and the government's balance sheets. The government must be doing a lot of saving (running a surplus), in order to push the equilibrium interest rate down to zero. And the money supply has to rise in line with nominal GDP, so it can't be buying back money with its surplus. Initially the government can buy back government bonds with its surplus. But when the national debt goes to zero, what does it start buying? Commercial bonds, and commercial stocks. Land, houses, anything there is to buy. Eventually the government owns everything. God only knows what happens after that. It starts buying people, maybe?

But the money supply doesn't have to rise or fall if they run deflation at the same rate as GDP. And it's perfectly stable to do that so long as they can do helicopter drops if necessary.

Nick,

While I agree that bilbo is horribly wrong isn't there an even more fundamental misunderstanding here?

What I mean is, is there a natural *nominal* rate of interest? I'd think no, I'd think there can be a natural real rate, which surely would not be zero, but that there'd be no natural nominal rate.

There's no natural nominal rate. I don't think he means it in the same sense as the natural real rate. I assume he just means that it's *natural* the keep the money supply about constant in the long run. Sometimes you have to add some money, and sometimes take some away. In that case the "natural" nominal rate is zero, with deflation equal to the real rate on average. I don't see the problem.

Actually, I am no longer sure what he's saying. I think I read it with a generous mind set on the first pass. On the second pass, I don't see any evidence that he's advocating deflation. He really does seem to be advocating government confiscation to the point where real rates decline to zero. Or something.

Nick

Do you care to address any of DR Mitchells substantive arguments or are you simply dismissing him? He presents a well argued case, understands exactly the origins of Wicksellian theory on interest rates and shows how it doesnt apply to a modern monetary system. I'd be interested in your full critique, not a simple dismissal.

Gizzard,

I'm not trying to preempt a critique from Nick. But here's my objection. Mitchell doesn't offer a mathematical model, so it's really hard to criticize exactly what he is saying because it isn't *exactly* clear. And I don't find the words very clear either, especially on the issues where he most obviously disagrees with "mainstream" economists. If you want to criticize the dominant theory, you have to engage it on it's terms. You can't define new ones and expect everyone to engage you on your playing field. If you want a physicist to consider your perpetual motion machine, you first have to demonstrate using standard scientific methods, why the second law of thermodynamics is wrong. You can't just send some elaborate design, and expect experts to read it.

I happen to agree that the mmters may be onto some really important ideas - in particular the lack of necessity of government debt (other than money). But I can't understand why it's not possible to engage the rest of the community on standard terms.

"What I mean is, is there a natural *nominal* rate of interest? "

Hmm, I would ask, is there such a thing as a "real" rate of interest at all? Real interest rates are artifacts of simple models -- e.g. 1 period models with no yield curve, an assumption of expectations hypothesis, and constant inflation.

I don't think there is even agreement on the definition of what a real interest would be without these assumptions. Perhaps I am wrong.

Suppose that the CPI is 100 in period 1, 120 in period 2, and, 125 in period 3, and 130 in period 4.

I purchase a risk-free bond for $80 in period 1 that pays $5 each period, and repays $100 of principle in period 3.

What is the "real" interest rate of this bond?

Suppose that over the same time period, 1 period zero coupon bills with a face value of $100 cost $90 in period 1, $85 in period 2, and $90 in period 3.

Does that information change your definition of what the real interest rate was?

Gizzard,

The argument for a zero OIR is not "well-argued". The argument is basically this:

1. If the government spent by creating new money, then these would end up as being excess reserves. If the government did not did not sell bonds to drain excess reserves, then the OIR would fall to zero. (all true)

2. Therefore the government has to intervene to keep the OIR above zero. The "natural" rate for OIR is zero.

3. It's good to squeeze rentiers, which a zero rate would accomplish -- why "should" anyone obtain a positive return from making a zero day risk-free capital commitment?


First, the government is "intervening" by creating new money as well. So the intervention to sell bonds is the mirror image of the deficit spending intervention. One is not more natural than the other.

Second, in a growing economy you are going to get a positive risk-free return. You can get that return by buying land, or stocks, or anything else. The profit rate is the growth rate of the economy, assuming fixed price/earnings ratios, and it will be positive regardless of what you feel it "should" be based on some poorly thought out moralistic arguments.

Most importantly, this is not an economic argument at all. It's a philosophical argument to justify a certain economic policy position. The actual policy position should be based on economic reasoning -- e.g. that output and employment will be higher with one policy stance than with another, or that overall welfare will increase. I don't see how subsidizing capital is going to do that.

Adam: the same thought crossed my mind as I was reading it. I couldn't see any evidence that he saw the distinction between real and nominal rates. But I also couldn't be certain that he didn't understand the distinction. So I left it aside. But you're probably right.

Did you notice, by the way, that your recent post on the lack of correlation between money base and inflation applies equally well to Bill's diagrams on the lack of correlation between the overnight rate and inflation?

K: If he were arguing for deflation, to bring the nominal rate down to zero, despite a positive real natural rate, I would understand that. That's what Milton Friedman was arguing for. (Though I disagree with Friedman on this.) But he doesn't mention Friedman, which is surprising, since Friedman is obviously the locus classicus for that argument. And everything else I've read of his says he does not advocate deflation. So the only way I can interpret him is that he wants to use fiscal policy to push the real natural rate to zero (or even below, if he wants small positive inflation). Which can, presumably, be done (though maybe not in a small open economy with capital mobility like Australia?), but would end up with the government owning everything.

Gizzard: Sometimes Bill Mitchell writes interesting stuff. If I were totally dismissive of him, I wouldn't have bothered to read it at all. I did give my argument why I thought he was wrong. I could have said more, as I said in response to Adam above. Real vs nominal rates. And the absence of correlation in the charts he posts are exactly what we would expect to see if a central bank were successfully targeting inflation. But I didn't go through everything he said, point by point. Didn't seem worth it. Yes, if Krugman (say) had written it, I would have gone through it point by point. But there's only so many hours in the day.

As RSJ says (if I re-phrase him slightly), it's not that Bill is saying the natural rate *is* zero. Rather, it's that he *wants* the government to make the OIR zero. And one wonders what would happen to the equilibrium price of land and houses in such an economy.

Gizzard: "Do you care to address any of DR Mitchells substantive arguments or are you simply dismissing him? He presents a well argued case, understands exactly the origins of Wicksellian theory on interest rates and shows how it doesnt apply to a modern monetary system. I'd be interested in your full critique, not a simple dismissal."

I have read that Bilbo post in the past and the basic problem with it is he does *not* present a well argued case, completely *misunderstands* the origins of Wicksellian theory on interest rates and *completely fails* to show it doesn't apply to a modern monetary system.

Bill Mitchell is somewhat like Steve Keen in that his "critiques" of what he sees as maintsream economics are pretty laughable in that they only make clear his understanding of what the mainstream models are saying is less than zero (because he thinks these models say things that they don't). I should add, I'm not in any way claiming either of those two don't have good ideas. I'm just saying they'd be better served just explaining their ideas without the silly attempts to critique the mainstream that pretty much make them seem stupid.

RSJ: "Real interest rates are artifacts of simple models -- e.g. 1 period models with no yield curve, an assumption of expectations hypothesis, and constant inflation. "

That statement doesn't even have a toehold on reality. Not one of the assumptions you've mentioned has anything to do with coherently defining a real interest rate.

One can have a serious discussion of whether or not real interest rates are well defined concepts but not from that starting point.

Nick: Yep, absolutely. His charts are just another example of the same point, that monetary policy reactions are endogenous.

K:
He doesnt offer mathematical models? Thats your criticism? Cmon. How about showing that the standard mathematical models are based on flawed assumptions? Like "money as a neutral veil", "loanable funds market" or the Friedman idea that Central Banks can control the stock of money. He has demonstrated that each of these assumptions, which are necessarily true if the rest of the theory is true, are FALSE. They are false because it can be shown they are untrue under many circumstances. An assumption at the base of a theory, being shown to be untrue, disproves the theory.

You obviously havent read much of Mitchells stuff the engages mainstream myths daily. On their own terms.


RSJ:

Of course the govt is "intervening" to create new money, THATS who creates money. No surprise. Friedman thought the CB "should". Which of course they cant because they only control price not amount. Fiscal authorities can control amount.

And yes you are right that in "growing economy" there are opportunities for profit or return on investment but it requires someone to be adding more than just "credit" to the economy. CB should stop playing the interest rate game and take their regulation of banking operations seriously. THAT is how this policy will improve welfare over the current one! A CB rate of zero does not remove profit opportunities from the system but it removes a whole worthless kabuki theater game being played periodically as the world awaits the words of Ben Bernanke.

Nick:

I dont understand this; "Rather, it's that he *wants* the government to make the OIR zero."

Its the govt that makes it other than zero in the first place! Thats his point. Set it at zero and forget it! Output and returns will adjust to new rates and we never have to wait for "Greenspan to speak". Stop playing these CB games that do NOTHING to enhance economic welfare. Let the market activites have a rate of return, which of course will emerge as some things are shown to be more profitable then others, but stop with these monetarist fiddlings. They dont work and they add uncertainty. Money supply via credit channels is endogenously generated as he has demonstrated time and again, it comes form credit worthy borrowers seeking loans regardless of the amount of reserves in the system. Friedman was wrong that central banks control money supply, people control it via their search for loans. If they have no incomes coming in (like now) they wont be seeking new loans even if the interest were zero.

Gizzard: "Its the govt that makes it other than zero in the first place! Thats his point. Set it at zero and forget it!"

Yes, I understood that that was his point. And that the government should then use fiscal policy to ensure the desired level of aggregate demand. And my point is that he doesn't understand that this would mean much tighter fiscal policy (i.e. bigger surpluses) on average. Higher taxes and/or lower government spending on average, if monetary policy is permanently very loose, and also (a point I didn't mention) much more variable taxes and/or government spending, if monetary policy isn't playing its usual countercyclical role. And if you have permanently higher surpluses, you end up with the government debt going to minus infinity. So the government owns everything. At which point you might say "Hmmm, maybe we need to loosen fiscal policy; which means we need to tighten monetary policy to keep aggregate demand where we want it to be."

Gizzard: I don't think words are enough, especially given Mitchell's informal and somewhat long winded style. I agree with Nick that he needs to fully account for wealth distribution and also output. If he expresses his thoughts concisely in a general equilibrium model, there are enough people who are interested in what he is saying that his model would get serious attention.

Nick,

Something like what RSJ said, and your interpretation of RSJ, and your further comments, and this:

The MMT definition of “natural rate” has nothing to do with the “mainstream” (presumably non-MMT) definition of the natural rate. You are the expert on the latter.

The MMT “natural rate” is a banking system operational construct. The central bank stops issuing bonds, and deficit spending ends up as deposit liabilities and excess reserve assets. The government treasury and central bank balance sheets are effectively fused, with a resulting net liability profile for the combined entity. The big difference is that a net bond liability (usually) now becomes an excess reserve liability. Along with currency, that liability constitutes the cumulative government deficit over time.

From that starting point, the state has a choice about what interest rate to pay on reserves. E.g. it can choose to conduct monetary policy by actively increasing or decreasing the rate paid on reserves, thereby setting a lower bound for the overnight rate, tightening or easing interest rate policy according to whatever indicators and targets it is looking at.

The MMT preference is that this rate be set permanently at zero. The reason is that MMT wants fiscal policy to usurp the function of monetary policy. E.g. MMT would tighten money by reducing spending and/or increasing taxes.

Thus, zero becomes the “natural rate” in the context of the MMT preference for fiscal policy over monetary policy. Ironically, this is an artificial construction of the idea of “natural” in the context of a preconceived ideological preference for fiscal policy. I suspect it has nothing to do with the use of the term “natural rate” in your world.

I see nothing that would preclude Nick Rowe’s natural rate from superseding the MMT natural rate under certain monetary conditions in an MMT world. It might even be inevitable. All it would take is a failure of MMT policy to tighten appropriately via its preferred fiscal channel, in which case the natural rate of your world would overtake the MMT natural rate by forcing monetary policy makers to break the zero rule – by increasing the rate paid on reserves, essentially following the leadership of Nick Rowe’s (more) natural market rate.

"That statement doesn't even have a toehold on reality. Not one of the assumptions you've mentioned has anything to do with coherently defining a real interest rate."

Wow, that's a pretty bombastic statement, apart from being incorrect.

I'd like to see your definition of the "real" rate of interest without relying on any of the above assumptions in order to get a well-defined definition.

That would be pretty interesting, actually.

P.S.

I view the MMT zero natural rate as a peg of sorts. The scenario I described in my final paragraph above probably wouldn’t happen unless the market believed it could force the central bank to abandon the peg.

K: Yep. e.g. Here's my very simple model:

1. Desired private savings depends positively on the real rate of interest and on real income.

2. Desired private investment depends negatively on the real rate of interest and positively on real income.

3. There exists some maximum level of real income Y* beyond which inflation eventually accelerates to undesirably high level.

4. Desired savings equal private plus government savings; desired investment equals private plus government investment.

5. Define the natural rate of interest r* as the real rate at which desired savings equals desired investment at Y*.

Given Canada's history, r* has been positive, and debt/GDP has been roughly stationary. We would have needed bigger government savings or less government investment to have kept r* at zero (or negative, given r=i minus inflation, and Bill wants i=0). And that would have meant a non-stationary declining debt/GDP, declining to negative levels and eventually to the government owning everything.

Actually, my simple model is far too complicated.

Scrap 1, 2, and 4, and replace them with:

1. Real output demanded depends negatively on the real interest rate and on the government budget surplus.

Keep 3.

Replace 5 with:

5'. Define the natural rate of interest as the real rate of interest at which real output demanded equals Y*.

JKH: I think I understood that. And I think it also reflects my understanding of MMT. My contention is that the MMTers don't understand that setting the nominal overnight rate to zero (unless we had steady deflation, so the real overnight rate would be above zero) would mean much tighter fiscal policy than they seem to envisage. And this would imply the debt/GDP ratio falling without limit into negative territory, and keep on falling.

And I can only think of two ways to make sense of the MMT argument:

1. Deny that aggregate demand depends on the real interest rate (vertical IS curve, in which case monetary policy is irrelevant).

2. Assert that real aggregate demand can increase without limit, without ever causing an undesirable level of inflation. Horizontal LRAS or LR Phillips Curve.

RSJ, imagine a world in which everyone consumes the same consumption basket and this basket is known to never change. The nominal price of the basket is our CPI index. There are many periods, as many as you like.

There are default free zero coupon inflation linked bonds traded, one expiry for each future period out to some maximum (say 30 or 50 years). Since we have this unchanging consumption basket that everyone consumes (in varying amounts perhaps) then we can express the prices of the index linked bonds in units of this basket.

The index linked bonds define a rate of transformation of one unit of the consumption basket today for (1+r) units at some date in the future (the maturity date of the bond). This number r is then the real rate between today and the maturity date of the bond (in principle we could have r < 0).

That seems to me to be a well defined real interest rate, in fact an entire term structure of real interest rates, without needing a 1 period model or the expectations hypothesis or constant inflation.

Now, if your complaint was simply that I have a term structure and thus not a single real rate (*the* real rate) then I respond I was using the same language that is typical with respect to nominal rates. We have a term structure and *the* interest rate is taken as the one period rate unless stated otherwise. So, I'll mean the real rate to mean the one period real rate from the one period index linked bond.

Notice however that in no case does the expectations hypothesis or constant inflation play any role.

The point here is that the substantive issues around whether or not there exists a real interest rate have to do with things like differences in consumption baskets. If your and my consumption baskets differ from each other and are both different from the basket of goods whose price index is linked to the bond then neither of us actually views the bond as a real bond, though we may think it pretty close.

Nick,

I think they've considered your point. MMT sets it up this way because their starting view is that fiscal policy is systematically (not just cyclically) too tight. The zero natural rate regime liberates deficit spending from bond financing and allows more deficit spending - not less - until they see inflation in the eye, and pull back on fiscal policy in response. I seem to recall you asking them a question about the Phillips curve at one point. The zero natural rate is all about enabling them to reach full employment more quickly, dealing with inflation after that.

JKH: Australia, and Canada, have had roughly 2% inflation over the last 20 or so years. And the MMTers are saying that they wish *both* fiscal policy *and* monetary policy had been permanently looser?!!!

If that's right, then it's at this point the "Zimbabwean" charge really does start to stick. And I'm going to make it, even though it does piss them off.

:)

Nick,

Question for you:

The MMT zero natural rate concept depends (effectively) on the idea of replacing $ 8 trillion of publicly held government bonds (roughly, in the case of the US) with $ 8 trillion in reserves.

That's a withdrawal of $ 8 trillion of term structure from dollar denominated bond markets.

How would that affect the interpretation of and/or the observation of the real rate of interest?

"How would that affect the interpretation of and/or the observation of the real rate of interest?"

The interpretation would be completely unchanged. Although there is no real one period zero coupon bond traded as a theoretical construct we can just as well talk about the shadow price of such a bond. The shadow price is the price that would clear the market were such a bond traded.

Of course, the observation I guess would get even more difficult insofar as we wouldn't have as liquid a nominal term structure.

On the other hand, before the US treasury was borrowing people used to use the railroads, at the time all AAA, as the default-free nominal term structure. Presumably there are AAA corportates around that would permit some observation of a (nearly) default-free nominal term structure.

"Presumably there are AAA corportates around that would permit some observation of a (nearly) default-free nominal term structure."

Any thoughts on whether/how such a significantly reduced supply of term structure would affect term real rates?

JKH: What Adam said.

I would add this though:

In normal times, outside a ZLB problem, if you replace all the national debt with zero interest currency/reserves, will people *want* to hold all $8 trillion at a 0% nominal interest rate? No way. The price of all private assets, both real and financial, would go through the roof, as people tried, unsuccessfully in aggregate of course, to sell 0% interest government paper for anything they could hold instead. And aggregate demand would go through the roof too.

And the only way to stop AD and inflation going through the roof would be for the government to buy back sufficient of its paper so that the remaining paper were willingly held at 0% interest. How much would that be? My guess would be somewhere around $5 trillion. So you would need a one-time tax of around $5 trillion to prevent AD rising.

Basically, people will hold some currency at 0% nominal interest, because having currency at around 5% of GDP (10% in the US, because of foreigners and druggies) because it makes the shopping easier. But there is no way people will hold (say) 50% of GDP at 0% nominal interest rates, or minus 2% real interest rates. So the only way government could make it happen is through a *very* large tax increase. essentially, confiscate all the bonds that people are unwilling to hold at 0% nominal.

Is that what the MMTers are proposing? God help us if they ever get anywhere near power. Zimbabwe, or confiscate the national debt (excluding currency)? Take your pick.

If you are right in your interpretation of MMT policy, JKH, then I really hadn't realised how totally out of it they are.

Nick,

This is not a boilerplate MMT proposal per se in terms of having uniform acceptance by all MMT’ers. But it may as well be - because it is definitely THE proposal that is actively favoured/promoted by Mitchell and Mosler, who along with Wray are probably the leaders of the public MMT movement.

(E.g. I suspect that Scott Fullwiler would analyze this objectively as a definite option under MMT, while acknowledging that it is not necessarily promoted by all MMT’ers.)

Nevertheless, the fact that a key group of MMT intellectual leaders strongly favours it makes it a very important idea at least. And it has caught on like wildfire on their blogs.

The nuts and bolts implication for the banking system is something I tried to draw out when I was commenting more frequently on their blogs. I think it’s pretty fascinating, because it’s so radical a change.

Because you have previously taken the lead in actively engaging them in discussion, I think it is also important that you understand this central idea about MMT – whether viewed as a specific proposal of their leadership, or as a "viable" structural option by the “rank and file” of MMT’ers. As I say, it is a very important idea in its own right, and your comments about the numbers and related orders of magnitude are very interesting. We need more of that kind of discussion about real system numbers at the macro level.

Keep in mind that this is my reporting on MMT, and is not coming from an MMT’er. But I have 99.99 per cent confidence that my reporting is fundamentally accurate.

"will people *want* to hold all $8 trillion at a 0% nominal interest rate?"

From an MMT operational perspective, people in aggregate have little choice.

The government deficit spends by handing you a check. You deposit in your bank account. Reserves increase.

The only way money supply changes operationally from there is by the banking system altering its own asset liability structure, which could happen if the public attempts to buy assets held by banks.

Or by the government moving from deficit to surplus, as you suggest.

But MMT suggests that there is no operational force of nature that requires either type of adjustment.

JKH: Oh God. Since you read their stuff, and are a careful reader, you are probably right.

I had previously understood MMT as a cyclical doctrine.

"Cyclical MMT": in recessions use money-financed fiscal deficits to increase AD, and in booms use money-financed fiscal surpluses (i.e. reduce the money supply) to reduce AD. Not obviously bad policy, though it may be difficult to change fiscal policy quickly, and there may be microeconomic reasons why you don't want to keep changing tax rates and government spending like that. Cyclical MMT is not obviously stupid.

But what you are describing is "structural MMT". One great big and *permanent* QE2, regardless of whether we are in recession or boom. And that idea is catching on like wildfire on MMT blogs? If so, I take back anything nice I ever said about them (except Warren Mosler makes nice cars). God only knows where to begin. I'm not so sure I *can* engage them in discussion.

Even Abba Lerner would reject structural MMT.

Nick, I think you've misunderstood me. I'll be back with additional interpretation, hopefully clearer.

JKH: "From an MMT operational perspective, people in aggregate have little choice.
The government deficit spends by handing you a check. You deposit in your bank account. Reserves increase."

Of course. But that's just (sorry) the accounting. Monetarists (for example) agree with that. But if people don't *want* to hold $8 trillion in 0% chequing accounts, they will try to spend it. And they will bid up the price of everything else as they *try* to get rid of it. And prices will rise until prices get high enough that they are willing to hold all of that $8 trillion and stop trying to get rid of it. And if they were only willing to hold (say) $1 trillion at 0% at the existing price level, that means, to a first approximation, you need an 8-fold rise in the price level. 700% inflation for one year, say.

OK, it's not *quite* Zimbabwe, but it's getting close.

Nick,

“But what you are describing is "structural MMT". One great big and *permanent* QE2, regardless of whether we are in recession or boom.”

No.

What I’ve tried to describe most recently is structural change in the FORM of deficit financing – not change necessarily in the mix of structural and cyclical deficits, which is a separate conceptual issue using the same vocabulary.

With respect to FORM, instead of issuing bonds, the government allows all net disbursements (deficits) to settle as increase deposits and increased reserves in the banking system.

The “zero natural rate” idea is consistent with the idea that the government/central bank pays no interest on those reserves.

Such a structural form change is an option under MMT, but heavily favoured by Mosler and Wray.

My reference to the $ 8 trillion number in the case of the US can be interpreted in the following way:

Had the MMT “no bonds” proposal been operational already, starting back in the past, the entire deficit would have been “funded” with bank deposits/reserves and currency. Specifically, outstanding bonds would have been replaced by bank deposits and corresponding excess reserves.

In contrast with that, the size of deficits is an entirely separate issue. It’s definitely an issue, but it’s different than the issue of what financial system configuration accommodates those deficits.

I’m using the word “structure” in one way here in the sense of the financial architecture or the financial structure or the macro balance sheet configuration under which the government will run its deficits. I am not referring here to the difference between structural and cyclical deficits.

My earlier comment however was to suggest that this change in financial architecture, MMT’ers argue, makes it easier to “run deficits” in the sense that government financing is not held hostage to bond market hysteria and bond market “vigilantes”, because bonds are no longer issued. I also alluded to the fact that my own interpretation of MMT policy orientation is that it favours if anything an approach that almost always includes deficits – there is no necessary idea of deficits in one environment offset by surpluses in another. They also have views on the issues of structural versus cyclical, which I don’t feel I can comment on here accurately.

Hopefully that’s at least epsilon clearer. Sorry if I confused. No doubt you can translate this into vocabulary that is less ambiguous.

"Of course. But that's just (sorry) the accounting. Monetarists (for example) agree with that. But if people don't *want* to hold $8 trillion in 0% chequing accounts, they will try to spend it. And they will bid up the price of everything else as they *try* to get rid of it. And prices will rise until prices get high enough that they are willing to hold all of that $8 trillion and stop trying to get rid of it. And if they were only willing to hold (say) $1 trillion at 0% at the existing price level, that means, to a first approximation, you need an 8-fold rise in the price level. 700% inflation for one year, say."

I understand that argument.

But this structural (sorry) information about the "no bonds" option that I've apparently revealed to you here gives you additional context for meeting any argument about inflation transmission that MMT'ers might care to present in debate - should you choose to reconvene that debate.

I actually recommended to them that they develop an exposition of how they view their own theory of inflation and elevate it to a much higher level in their public presentation - precisely for the reason that is implicit in you presenting your case. I think their structural option of "no bonds" makes that presentation essential to their overall case. Sadly, I got no response to that particular comment. They've certainly written about it, but in my view it needs a higher profile in their "theory" content (as opposed to their "accounting reality" content) within MMT.

Nick,

On an entirely separate subject, I'd be interested in your thoughts on my comment/question at Sumner's Delong reply post, if you get a chance sometime. Some economics that I probably don't understand (what a surprise):

http://www.themoneyillusion.com/?p=8136#comment-48352

JKH: Yes, that's clearer. That's what I call "cyclical MMT", but with the added proviso that cyclical MMT had always been in place, since the year dot, when governments first started.

What it does is takes away one degree of freedom from government policy. For example, if there's some temporary need for increased government spending (war, floods, new schools for a baby bulge, etc.) and the level of aggregate demand is currently at the desired level, so you don't want to use money-finance, then under MMT the government *must* raise current taxes to keep a balanced budget, rather than spread out the higher taxes as under bond-finance.

It's unwise, because tax rates would be more volatile, so the deadweight costs of taxation would be higher, and also difficult to implement, given lags in changing fiscal policy, but otherwise OK.

On your last point. Yep. They definitely avoid the topic of the LRAS or Long Run Phillips Curve. I tried to draw them out on this about a year ago, but no luck.

Dead weight losses might be higher or lower. Commercial bank seignorage is a huge dead weight loss. So is the existence of income or consumption tax when land value isn't fully taxed. I'm still not certain that MMT isn't at least in part equivalent to full land tax plus government seignorage only, neither of which I consider inefficient.

JKH:

"I actually recommended to them that they develop an exposition of how they view their own theory of inflation and elevate it to a much higher level in their public presentation - precisely for the reason that is implicit in you presenting your case"


What, you mean something as coherent and demonstrable as "Inflations expectations theory"? Winterspeak already adequately exposed the weakness of the inflation expectations paradigm. I know you've been on Mitchells blog frequently. Ive seen you comment a lot. You're quite aware of how they deal with inflation. Just because the average person has no fricking idea about deflation/inflation, believes ZImbabwe and Weimar were just govts printing money and feels better when a monetarist says "we'll just raise rates if we sniff inflation" doesnt mean the subject hasnt been adequately dealt with by the MMT crowd.

Yes the non MMT crowd talk endlessly about inflation. They see it everywhere and obsess continually about it, but they have been horribly wrong in most every prediction made the last decade.

Gizzard,

You seemed to have missed my point, which is not that MMT should kowtow to a mainstream inflation theory, but that they should elevate their communication of why they don't kowtow to it, including more elaboration on their central idea of "real constraints". My point refers to communication emphasis, in the context of the full MMT message, not whether they've developed their argument per se.

Adam P,

The particular problem I was thinking of has to do with longer maturity bonds that pay coupons. There is no "theory-free" way to strip the coupons in real terms, and obtain a single "real" payout when the bond matures. You need some assumptions about the relationships between shorter term rates and longer term rates, as well as re-investment risk. That is what I meant by EH.

Now perhaps you don't care about that, and you are willing to say that a coupon paying bond over n periods is a vector of (n+1) cash-flows, each of which can be divided by the price level at the time the cash-flow is obtained. That would be a an "objective" measurable value in the underlying economy.

But in that case, you have an nxn vector of "real" interest rates, just for coupon paying bonds. Then add in zero coupon bonds and more complicated instruments, etc.

Now in the models, investment decisions are made based on longer term rates, not single period rates. I would argue that savings decisions are also made by the longer term rates. So to the degree that the economy is influenced by real rates, you would have this problem.

Then you have the additional issues of how you would price such a bond given heterogenous preferences -- i.e. can you explain the rate in terms of preferences and endowments. But there you can assume some pricing kernel if you want an EMH framework.

The point is that the cash-flow inputs into that framework need to be directly observable, or known, apart from the framework itself, and then you use people's own utility and beliefs about the likelihood of the state of the world to value the cash-flows. But the cash-flows themselves are nominal, not real; there is no notion of a "real cash-flow" that is not itself model dependent -- as far as I know.

So then the question becomes, if "real rates" are model dependent, then in what sense does the economy have a real rate? Only in the sense that the models converge to accurately describing reality. This is a very strange condition to impose on a price. Prices are directly observable in the economy and exist outside of the model. The model is there to explain the prices.

In the above, I meant to say "in the economy, investment decisions are made by longer term rates", not "in the model" :)

"will people *want* to hold all $8 trillion at a 0% nominal interest rate?"

From an MMT operational perspective, people in aggregate have little choice."

But of course, people do have a choice. So the government would need to take that choice away. In the current framework, banks must compete for deposits and they must obtain funding from the private sector. This is the mechanism that allows households to decrease their deposit holdings and increase their holdings of financial sector bonds, for example.

One can imagine a radically different regulatory environment in which the government allows banks to obtain funding directly from the government rather than from the private sector, and also engages in price-fixing to prevent banks from offering competitive certificates of deposit, etc.

But even then, the government would need to ban money market mutual funds and other institutions that offer longer duration liabilities.

In that case, the resulting framework is one of bank oligopolies and financial repression, which I find very troubling.

Real world examples of such frameworks have not had positive outcomes.

When the government forces interest rates to be excessively low by outlawing or destroying capital markets, the result need not be excessive consumer price inflation, it could be excessive investment and asset price inflation, as well as growing income inequality, because by lowering the rate of discount, you are increasing the endowments of some actors (e.g. those with capital), and unless everyone holds the same amount of capital, this will result in large levels of inequality.

The underlying MMT economic framework assumes that investment and savings are completely interest inelastic, and moreover that the profit rate is equal to the rate of interest by some magic law, rather than by a process of competitively pricing interest rates against equity returns. When interest rates are not competitively determined, the only mechanism to bring down the profit rate to the interest rate is excess capital investment -- e.g. dynamic inefficiency. The outcome of such a policy is going to be falling living standards and growing inequality.

RSJ: "The particular problem I was thinking of has to do with longer maturity bonds that pay coupons. There is no "theory-free" way to strip the coupons in real terms, and obtain a single "real" payout when the bond matures. You need some assumptions about the relationships between shorter term rates and longer term rates, as well as re-investment risk. That is what I meant by EH. "

What your talking about has, again, nothing at all to do with the conceptual problem of defining a real rate of interest. If you have a (coupon) bond with maturity equal to each coupon date then one can bootstrap out a zero coupon curve in a theory free way. If short-selling is allowed then we can even trade the zeros.

But all that is any completely irrelevant to talking about real rates as a theoretical construcct. Everything I said before still stands, the difficulty is getting everyone to agree on the price index that defines the price of their consumption basket. If you could do that then in there will exist a shadow price of the real zero coupon bond.

This definition is in absolutely no way dependent on any model. If today you introduced a new maturity of nominal coupoon paying bond I'm very sure the market would find prices to trade it at. I'm sure of this because it happens all the time.

If today you introduced a zero coupon nominal bond that isn't already trading, I'm sure the market would find the price to trade it at.

If today you introduced a zero coupon real bond, (subject to everyone agreeing it actually is a real bond), then I'm equally sure the market would find prices to trade it at.

This absolutely nothing to do with any model, theory or assumptions about the EH.

As I said above, the substantive problem with trying to define a real rate have to do with defining the consumption basket that everyone agrees on. What you're talking about has absolutely nothing to do with anything.

You can't convert one cash-flow to another in a theory free way.

You can "construct" zero coupon versions of market traded bonds, using theory, but your constructed zero coupon bonds are fictional, and won't trade for the same price as a real zero coupon bond in the marketplace, primarily because stripping assumes that the yield curve is not going to change throughout the life of the bond -- you are assuming that market prices are martingales, which is a big theoretical assumption.

Just to save time, any process that can be described as "valuation" requires theory.

The only theory free thing you can do is make a market for the two cash-flows and watch the relative nominal prices bounce around in the marketplace.

But that indifference price will be a function not just of the two specific cash-flows, but of everything else -- economic outlook, risk aversion, wealth levels, preferences, different market participants, etc -- i.e. it will be time-varying. And you can't untangle these effects without theory.

The market prices that we observe -- at least in a monetary economy -- are nominal prices. Just because everything has a price does not mean that everything has a "real" price.

Only real goods have real prices.

If you cannot objectively measure and/or quantify the good, then you cannot assign a real price to it unless you rely on theory.

I.e., if it costs $5 to purchase a loaf of bread, and $10 to purchase a pound of cheese, we can talk about the price of bread in terms of cheese, i.e. "real" prices.

And we can say that next period, something in the economy changed so that the real price of bread (in terms of cheese) went up.

But implicit in that statement is that you found an identical slice of bread and an identical slice of cheese, and compared the prices.

There needs to be some objective, or price-independent, definition of the bread and cheese, so that you know that you are comparing identical goods from period 1 to period 2.

Now what does it mean to say that the "real" interest rate went up, or went down, from period 1 to period 2? What is your price-independent method of finding an identical bond to compare against the identical slice of cheese? If the economy changes, then you cannot find an identical bond in period 2. You need some assumption -- that risk premia are constant, or that preferences for cheese are constant, or that preferences for bonds are constant, etc.

RSJ,

"You can 'construct' zero coupon versions of market traded bonds, using theory"

Yes. You can also construct them *in practice*.  US treasuries, Canadas, Bunds, Gilts, whatever.  Just strip the bonds.  People do it all the time and in practice they trade where predicted by theory:  At a slight, but for macroeconomic purposes, insignificant discount to the on-the-run curve, for the simple reason that they are not repo special.  Basically they trade right on top of the off-the-run government bond curve.

But even if you don't want to strip bonds you can hedge out the "reinvestment risk" by constructing an appropriate portfolio (long and short) of regular treasuries.  There is just no issue in constructing zero coupon bonds, theoretical or practical.

"stripping assumes that the yield curve is not going to change throughout the life of the bond"

No it doesn't.  It assumes you can strip the bond.  Which you can.

"Just to save time, any process that can be described as "valuation" requires theory."

If by "theory" you mean interpolation.  And whatever interpolation method you use won't make any difference to the zero yield at least for macroeconomic purposes (i.e. within a few basis points).

"you are assuming that market prices are martingales, which is a big theoretical assumption."

No he isn't.  He's probably assuming the law of one price.  But even the EMH does not assume any market to be martingale.  The whole market is usually thought to be a sub-martingale, but in the absence of a risk-free asset, even this is not implied.

K,

I'm not saying that it is difficult in practice to engineer zero coupon bonds out of other bonds. I'm saying that until you let the market price the bond, then any predictions of what the bond price will be are going to be theory-dependent. This is completely independent of whether those predictions tend to be correct or not. It may be that the theory is not too far off.

The "Law of one price" is violated frequently and prominently. Google "Liquidity, Reconstitution, and the Value of U.S. Treasury Strips", but there are many other examples. Now you will say, as do the authors, that this is due to some liquidity premium, which is the whole point, right?

Market prices -- the observables -- are a combination of the cash-flows and preferences. And market prices are the only way to aggregate the cash-flows. Therefore all you can say is that cash-flows + preferences = price. You cannot say cash+flow + objective algorithm = price. The algorithm will need to take preferences into account -- it will be model-dependent.

RSJ,

As K has already pointed out this, "stripping assumes that the yield curve is not going to change throughout the life of the bond -- you are assuming that market prices are martingales, which is a big theoretical assumption." is utter nonesense.

Anyway, I can't really make sense of anything you're saying here and can't see how it's relevant to the original debate so I'll just leave it at that.

We can both remain content with the correctness of our view.

K

re: assuming the curve being constant -- yep, I was totally wrong about that. I kept thinking about re-investment risk, but that's irrelevant here.

Adam,

Sorry, I didn't see your message. Yep -- wrong about the curve being constant. If you don't understand what I am saying about theory-depence, I'll try one last time. Perhaps I am totally wrong there, too?

The claim is that the nominal rates are what are observed in the economy, whereas the real rates are inferred by the model, and are model dependent.

OK, say you *define* the real rate over 1 period as the nominal rate - expected inflation over that period. Say you can observe expected inflation (e.g. by a poll of investors). So you have nominal rate = real rate + expected inflation.

Then you will still end up with discrepancies, in the sense that two different riskless instruments that mature in the same period will have different prices. So you attribute that to a liquidity premium term. Now you have

nominal rate = real rate + expected inflation + liquidity premium.

And then you do some more measurements, and you determine that even instruments that are equally liquid, but perhaps have somewhat different tax-treatments, also have different prices. So now you have

nominal rate = real rate + expected inflation + liquidity premium + tax treatment

Etc.

So the claim is that the nominal rate is the only "real" thing. And the rest of the stuff is model dependent. In the real economy, there are many different bonds and many different interest rates. And attempts to determine a consistent decomposition into more fundamental terms isn't going to be consistent, at least to the degree that you can isolate and independently observe all the constituent factors. All you know is that asset demand will set the price.

OK, that may be vague, but is hopefully sensible.

On my way out of town, but got a Google alert on this, so thought I'd throw in a few points, mostly for clarification of the MMT view for those that are interested (rather than as a critique of anyone commenting here). Apologies for not being able to engage further, but it's off to the in-laws early in the morning. Hope all is well, Nick. Long time, no chat!

1. The discussion of the "natural" rate in the MMT view--Mosler/Forstater's paper (the seminal paper on this) is very clear that the "natural" rate in MMT is not the same thing as the "natural" rate that Nick is speaking of, as JKH noted. One thing missed in the discussion here that is crucial to Mosler/Forstater is that the non-govt sector on average will prefer to net save, given that they are currency users, not currency issuers. Historically, aside from the 1998-2008 period, this has been true (this is partly why MMT'ers were so alarmist about building financial fragility during this period). In that case, aside from a sizeable trade surplus, this will require govt deficits, on average (again, the 1998-2008 period is an exception well-understood by MMT'ers). As such, it is deficits that are "natural" in the argument more so than the zero rate--the "zero rate" is simply along for the ride if the govt doesn't sell bonds or pay interest on reserves. Then there's the policy side advocating the zero rate, but for totally separate reasons. (As an aside, I'm not personally in favor of the "no bonds" proposal that most other MMTer's advocate.)

2. On the real rate, as Nick suggested, MMT'ers reject that real rates matter, as Keynes also did. Jan Kregel has explained this very carefully many times. Eric Tymoigne has done a bit on this recently. There's also a good deal of empirical evidence, at least persuasive to MMT'ers.

3. Regarding inflation, the reason you don't see too much MMT stuff on the specifics of an inflation theory is because in general the PK view is accepted and there's already a good deal of literature there. The PK view relies on a number of things--bottlenecks, pricing power, markups, commodities, bargaining power of labor--but it does generally reject overly strong reliance on inflation expectations, a la Winterspeak. Bill has done a lot of empirical work on unemployment/inflation tradeoffs--he's an econometrician by training. Lavoie/Kreisler have done some work in which they cited several empirical Fed papers on inflation/unemployment that are completely in line with the PK view.

Best,
Scott

Thanks Scott:

I like to try and make sense of various views of economics, even if I don't agree with them.

"One thing missed in the discussion here that is crucial to Mosler/Forstater is that the non-govt sector on average will prefer to net save, given that they are currency users, not currency issuers."

That's the bit that's least clear to me. My guess is that "net save" means something like "savings minus investment", and that what MMTers are saying here is something akin to what I would say this way: "In a growing economy, the desired stock of real currency is growing over time, and the government must satisfy that demand by issuing currency in order to avoid deflation".

On the Phillips Curve: a number of people have noted that the Phillips Curve has disappeared, or "gone flat" over the last 20 years or so. My interpretation is that this is what we should expect in any country where the central bank is targeting inflation reasonably successfully. All fluctuations in inflation should become unforecastable noise, because if any fluctuation were forecastable, the central bank would have done something different to have stopped that fluctuation.

On the vertical IS curve (perfectly interest-inelastic savings and investment): this is the assumption that will bother other economists the most. Because it's like saying (in an intertempoarl context) that relative prices don't affect demand. Demand curves are vertical. Also, if the IS were vertical, yet the Bank of Canada thought it sloped down, we would have seen very large (infinite?) fluctuations in real interest rates. If the Bank of Canada wanted to reduce demand it would raise interest rates, and when it saw it wasn't working it would raise them even more...and so on.

Scott,

I haven’t been exposed to MMT per se for that long, but it’s been long enough to have developed a view as to which points might be emphasized if you and your colleagues really want to get the message out more broadly. Quite apart from the ELR idea, I’d recommend central focus on two main ideas in connection with the purely monetary side of things:

1. Position the “no bonds” IDEA prominently in the main message. I say “idea” rather than “proposal”. My view is that as soon as you begin to touch on the notion of “self-imposed constraints”, you simply can’t avoid referencing the conceptual apparatus that associated with a “no bonds” hypothetical. Whether or not it is an actual proposal favoured by some or not is secondary.

2. Notwithstanding your point regarding inflation, the MMT view of it should still be emphasized. Combined with the idea of constraints, it is essential to the explanation of the MMT approach to deficits. I came to this view about the central importance of the inflation story after viewing the discussions at the link below, which include a number of very interesting conversations about inflation (e.g. Mosler) - that almost emerge as side-stories instead of the main deal (and I’m not referring to Auerback’s hyperinflation presentation):

http://neweconomicperspectives.blogspot.com/2010/10/fiscal-sustainability-teach-in-and.html

This is not to say that these ideas haven’t been covered in great depth already. Obviously they have. I’m just saying, given the not unnoticeable frustration of some MMT’ers that much of the world seems immune to absorbing their message (a frustration that I think was expressed strongly at the conference), I would recommend that these are the two points that should be given prominence in a popular teaching framework. In that regard, I was disappointed there was no response to my comment at the site. And along with that, I have to say that my general impression is also that MMT’ers aren’t all that receptive to constructive criticism about the way in which they present their message. Of course, my recommendations may just be lousy, but I think I understand at least a bit about the underlying monetary concepts.

Nick, should you have some time over the holidays, I recommend sampling these discussions. They’re very high quality in terms of substantive MMT content and differentiation.

JKH: For someone like me, if the MMTers would just write down a simple model, it would be a lot more useful. I would understand that it's a simple model, and like all simple models, would leave stuff out. That's OK. But what it would contain would be the *main* elements that MMTers think are most important. And it would also be helpful if they were very clear on the distinction between real and nominal variables. I keep having to guess at what they mean.

So far, my guess is that their model has a vertical IS curve, a horizontal LM curve, and a reverse-L-shaped AS curve or Phillips Curve. Essentially, it's the old British Keynesian model from the 1960's. It's what I learned as an undergrad, only with a lot of strange terminology and more accounting, none of which really changes the essentials of the model, but does make it harder to understand.

OK, time for one last one this morning--I'm a bit of an addict, so even when I know I'm going to get in trouble for making us late, I still gotta sometimes.

Anyway, all good comments.

On inflation, JKH, I don't disagree at all. The issue is two-fold, perhaps (can't say exactly), for why it's not emphasized. First, inflation isn't the issue right now, though, of course, it's certainly what bothers a lot of our critics. Second, we're only a few handfuls of economists working on MMT. We've done a lot, but we haven't done everything. Our main contributions on framework building, in my view, are to explain how the monetary system works, elaboration and application of the Minskian view of fragility, and Mitchell's very innovative work on labor markets. Beyond those, we've "borrowed" the rest, mostly.

On "no bonds," I've definitely explained a few places the reserves/deposits vs. money issue. Yes, "no bonds" may/may not be front and center, but reserves/deposits vs. bonds is. Again, though, complete framework incorporating inflation and such, maybe not (though we would argue it's not necessary for our purposes).

On Nick's points regarding model, IS-LM won't work for us. There isn't 1 interest rate, there are many, and all of them can "matter" at different times, and for various reasons. IS's elasticity isn't fixed. The point about the real rate is that it isn't necessarily the "real" rate that matters, but other things do--mortgage rates can matter, the overnight rate can matter but might not at all, credit default spreads definitely can matter, cost of capital can matter (but is often swamped by expected cash flow) and so forth. As for LM, same thing--it's way too simple to capture what we're talking about. Yes, banks respond endogenously to demand for credit, but there are issues like capital requirements, and various shift factors (again, credit default spreads, etc.). As for Phillips, roughly horizontal, but not completely, and with many shift factors, again, and we would argue this works for both pre- and post-inflation targeting by CBs.

Best,
Scott

Two solitudes in a way.

(Being Canadian helps to appreciate that reference.)

Somewhere, there's gotta be a concise story about MMT that is a blend of an unusually intense operational focus, combined with another part that is a borrowed/filtered/reworked theory about inflation, etc.

Perhaps the operational side could be told with some assistance by adjusting the lyrics to John Lennon's "Imagine" with the line "Imagine no bonds" thrown in there. It's timely.

Let me throw this out there:

Question. What is they key price or quantity that needs to adjust to ensure macroeconomic equilibrium?

A1. (New Keynesian): The real rate of interest.

A2. (Monetarist): The real stock of money.

A3. (Old British Keynesian): The government budget deficit or surplus (however financed).

A4. (MMT): The (money-financed) government budget deficit or surplus. ?

Nick, yes, it would be A4, though for MMT there is no other type of deficit besides "money financed." In other words, "however financed" for us misses the fact that they are all equivalent, assuming flexible fx and currency issuer. The MMT understanding of the monetary system is very different from that in A3, and A2 for that matter (though MMT's understanding is actually closer to A2 than to the others). A1 (assuming "new consensus" here) doesn't really have a monetary system (or at least not a financial system), just an interest rate.

Scott: Right. I'm glad I'm more or less getting it.

1. In the MMT perspective, if the central bank "does nothing" then government deficits are automatically money-financed.

2. Ignoring 1, one main difference between monetarists and MMTers is this: monetarists say it's the actual *stock* of (real) money that has to adjust to the desired stock; MMTers say it's the actual *flow* of new (real) money that has to adjust to the desired flow. This is not just a semantic or modelling difference. If you took the derivative of the monetarist's stock demand for money function, you would not get something that looked like the MMT flow demand for new money function.

3. Ignoring 1 and 2, when it comes to the flatt(ish) Phillips Curve, and the vertical(ish) IS curve (interest-elasticity pessimism), MMTers are closer to Old British Keynesians than anyone else.

Scott: "A1 (assuming "new consensus" here) doesn't really have a monetary system (or at least not a financial system), just an interest rate."

Yep, assuming "new consensus" here, New Keynesians *think* A1 doesn't have a monetary system, just an interest rate, but it does really, though it's implicit, so they can't see it. I seem to be in a minority in arguing that NK makes no sense in a barter economy. I take it that MMTers agree that MMT would be total rubbish in a barter economy. If (hypothetically) barter did break out, they would throw away MMT and start from scratch.

What if a major bank collapses once Wikileaks exposes their true financial situation, and people start asking what are other banks still hiding on their books? No one on this blog seems to realize that the heart of the current crisis is massive financial fraud and the ongoing coverup by corrupt governments and central bankers.

I would also like to see a simple (non-structural) model. If many interest rates are important, then just start with two rates, and you can describe the interaction. To my mind, there is nothing that prevents MMT from doing this.

I don't think Marc Lavoie is MMT, but he has a model with Wynne Godley,that I sometimes see referenced. May make explicit the old british keynesian/post keynes relationship, I think Godley worked at the uk central bank, back in the day, and was motivated by that to do his work on accounting.

edeast

Lavoie isn't necessarily MMT, but there's not much if anything that he and MMT disagree upon. MMT is strongly evidenced by the Godley/SFC approach and also by horizontalism. Lavoie's understanding of monetary operations (treasury, CB, banks) is essentially identical, as well, to MMT. The only difference I've noticed over the past year is that Lavoie and his colleagues don't find much use for Minsky in the recent financial crisis, whereas Minsky is front and center for MMT.

Nick,

1. Yes, MMT wouldn't apply to barter economy.

2. Regarding, NK/NC and whether they have a financial system or not, I'm referring here to, say, Buiter's critique, but also more importantly to Goodhart's critique of DSGE models (granted, one can be NK/NC without having a preference for DSGE) or the Woodford-type models.

Scott if you're still reading I'd love to see you address this, quite correct, point of Nick's:

"On the vertical IS curve (perfectly interest-inelastic savings and investment): this is the assumption that will bother other economists the most. Because it's like saying (in an intertempoarl context) that relative prices don't affect demand. Demand curves are vertical. Also, if the IS were vertical, yet the Bank of Canada thought it sloped down, we would have seen very large (infinite?) fluctuations in real interest rates. If the Bank of Canada wanted to reduce demand it would raise interest rates, and when it saw it wasn't working it would raise them even more...and so on."

Do MMTers think demand curves are vertical, that relative prices have *no* effect on relative demands?

Of course I'd also be interested to hear any other MMTer (say JKH or Winterspeak) answer...

I’m not an MMTer, but I could list a few things other than rate/price that could influence, or put a limit on demand at the individual level.

Level of current income, level of current expenses, current level of indebtedness, capacity to service existing debt, capacity to borrow more-to financing more spending, confidence in stability of future income, expectations about future increases in fixed expenses, confidence in future value of purchasing power of current savings (if have any), non-existence of any lender calling on their debt, confidence in future positive value of existing savings/investments/net worth, ease of liquidating current savings –to finance current spending, tax implications of using current income/net worth to spend now vs. later, confidence about over-all economy, and how it is being run… the list goes on further.

If the challenge were to simply reduce demand, increasing prices/rates will do. But if the challenge were to increase demand, you also have to address the above

I think Scott's point was not that the IS curve is vertical -- he didn't argue that -- but that there is no such thing as a single economy-wide IS-curve because there are multiple interest rates that matter, and the relative importance of these rates is situation dependent.

Moreover, a lowering of one rate might result in the increasing of another rate. For example, if overnight borrowing becomes cheaper, then inventory financing becomes cheaper and dividend yields may go up, not down. Or at least, there is no reason to believe that dividend yields will fall if overnight rates fall.

There is no micro reason for this, nor is this relationship observed, nor does it described any sort of plausible constraint on investor behavior. It's an arbitrary constraint plucked from thin air and imposed on the economy.

And Scott also argued that the interest elasticity of investment was also varying.

There are no micro-foundations for an economy-wide IS curve, and it may be the wrong constraint to put into the model.

No one is arguing that relative prices have no importance.

RSJ and rogue,

I'm not asking about the IS-LM model. I'm asking about this quote from Scott Fullwiler: "On the real rate, as Nick suggested, MMT'ers reject that real rates matter,"

Which exactly contradicts RSJ's: "No one is arguing that relative prices have no importance."

Scott is arguing that relative prices have no importance along certain dimensions.

I'm looking for some sort of defense of that position.

Adam "I'm looking for some sort of defense of that position."

My guess is that the defence will involve income (wealth) effects offsetting substitution effects.

My own position is that *in macro*, *to a first approximation*, *unless there are good a priori reasons to suppose otherwise* it's the income effects themselves that (*roughly*) cancel out. When interest rates fall, creditors are worse off, and debtors better off, so at the macroeconomic level what's left over is a distribution effect, not an income effect. Plus the substitution effect, of course.

Like Old British Keynesianism, substitution effects are downplayed, and income effects are upplayed in MMT. My guess also fits with the MMT emphasis on accounting. Accounting tells you nothing about substitution effects, but it can be useful to help you sort out income effects.

Nick, Adam P,

"My guess is that the defence will involve income (wealth) effects offsetting substitution effects."

That rang a bell.

See:

http://bilbo.economicoutlook.net/blog/?p=12473

"The worker is conceived of at all times making very complicated calculations – which are described by the mainstream economists as setting the “marginal rate of substitution between consumption and leisure equals to the real wage”. This means that the worker is alleged to have a coherent hour by hour schedule calibrating how much dissatisfaction he/she gets from working and how much satisfaction (utility) he/she gets from not working (enjoying leisure). The real wage is the vehicle to render these two competing uses of time compatible at a work allocation where the worker maximises satisfaction.

What happens when the relative price between C and L changes? The final result looks scientific but is in actual fact a total fudge.

They isolate two separate “effects” of such a real wage change (say a rise): (a) a substitution effect; and (b) an income effect.

So an increase in the real wage (more corn is foregone for an hour of leisure) leads the worker to consume less leisure and to work more. This is the substitution effect. So if the real wage rises, work becomes relatively cheaper (compared to leisure) and the mainstream theory asserts via the so-called law of demand that people demand less of a good when its relative price rises. So real wage up, less leisure, more work.

But there is another effect to consider – the so-called income effect. When the real wage rises, the worker now has more income for a given number of hours of work.

The mainstream theory of normal goods (as opposed to inferior goods – the distinction is just made up largely) tells us that when income rises a consumer will consume more of all normal goods. The opposite is the case for an inferior good.

Leisure is considered to be a normal good as are other consumption goods the worker might buy with the income he/she earns. So as the real wage rises, the income effect suggests that the worker will demand more of all normal goods (because they have higher incomes for a given number of working hours) including leisure. That is the worker will work less and consume more leisure.

What is the net result? No analytical solution is provided. They just assert that the relative price (substitution) effect is stronger than the income effect and so the labour supply curve is upward sloping. It is totally made up result and no robust empirical analysis has supported this assertion. The reason they need to assert this result is because they also assert the demand curve is downward sloping and for an “equilibrium” they need the curves to cross. Simple as that."

JKH, I asked about real interest rates.

I know.

Just Nick then - I thought there might some connection with the answer, if not the question.

Ok then, does Bilbo ever give any reason why the assumption that in the labour supply decision income effects dominate (or equal) substitution effects is any more plausible then the opposite assumption?

JKH: Yes, that's directly related. And Bill makes the standard mistake (he is a long way from being the only one) of forgetting that for every $1 of labour sold, there's $1 of labour bought. So if there were an exogenous change in real wages, (e.g. minimum wage laws change), there would be no aggregate direct change in income, though there would be a change in the distribution of income, and so there could be a distribution effect in either direction. (There will be indirect changes in income, of course, due to the change in quantities of employment and output due to substitution effects.)

It's exactly the same thing, only the real wage is the relative price, not the real interest rate.

Yes Nick, you're quite correct that Bill is using a partial equilibrium argument for a general equilibrium problem.

I was actually leading up to a slightly different point though. If you recall the original competitive labour market type models (like Lucas-Rapping) were about intertemporal labour substitution.

The upward sloping labour supply curve comes from the fact that we are tracing out labour supply vs real wage holding expectations of the future path of wages unchanged. Thus, a higher real wage is to be interpreted as higher relative to future real wages. (We could just easily talk about lowering the expected future wage.) Thus, even at the individual level there is no "income effect" because their is *no* implied change in lifetime income along this curve.

The upward sloping labour supply curve says nothing more then people try to maximize the present value of their lifetime utility by maximizing the present value of lifetime real labour income and the present value of lifetime utility from leisure. This maximization entails a path of labour supply that supplies more labour when real wages are relatively high and less when real wages are relatively low.

In short, this pattern of labour supply behaviour follows directly from the maximization of a lifetime utility function that derives utility from both consumption and leisure. It has nothing at all to do with assumptions regarding the relative strength of income or substitution effects because there are no income effects.

PS: The relative strength of income and substitution effects in the labour supply decision would be relevant if what we were talking about was a rise in all present and future real wages but that would constitute a shift in the entire labour supply curve, not a movement along it. In that case the relative strength of the income and substitution effects would determine in which direction the curve shifted. But this has nothing to do with the fact that the curve slopes up.

^edited to turn italics off!

Adam: "Yes Nick, you're quite correct that Bill is using a partial equilibrium argument for a general equilibrium problem."

That's my point in a nutshell.

OK. I now see your point about intertemporal labour supply elasticities. Hadn't thought of that. If current wages go up $1, and expected future wages go down $1, there's (roughly) no income effect even at the individual level.

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