Yves here. Philip Pilkington makes an interesting argument in this post, namely, that the method preferred among mainstream economists for managing the economy encourages investors to speculate in financial instruments rather than invest in real economy assets and projects.
By Philip Pilkington, a writer and research assistant at Kingston University in London. You can follow him on Twitter @pilkingtonphil
Metaphysics is a use of language that conveys no factual information, describes no logical relations nor gives precise constructions and yet is calculated to affect conduct.
– Joan Robinson
After the Reagan and Thatcher governments experimented with monetarism in the late-1970s and early-1980s, something fundamental changed in the way most economies in the world were managed. This era has become known to many as that of “neoliberalism” and is usually thought to be characterised by free-market dogmatism, a hostility to labour, financialisation and trade liberalisation.
All of this is true, of course, but it is not widely known outside of economic circles what changed in the minds of economists. After all, monetarism soon faded into the ether – a failed superstition. What replaced it was, in fact, a regime based on interest rate targeting. Economists and central bankers became generally suspicious of governments’ ability to manage their economies and instead invested heavily in the notion that independent central banks could do the job better.
The truth of the matter? Much more likely that this was a power-grab – after all, it was generally economists that ran the central banks. But what is interesting for our purposes is the rot that the economists used to justify this state of affairs; rot that, at the very same time, ensured that they would not bear any responsibility for their actions and recommendations. What they needed, of course, was a metaphysical law and it is to this that we now turn.
This economic theory today, as it prevails in the pseudo-sophisticated minds of most central bankers and economists, is tortured in its assumptions, absurd in its axioms. But like all good metaphysical constructions, it comes with a rather simple message. The message is that fiscal policy – that is government spending and taxation – is largely ineffective and only results in inflation over any sustained period of time (that is, the mysterious “long run” of the neoclassicals). Instead then we must look to monetary policy and especially the control of interest rates for salvation. The idea is that there exists, at any given moment in time, a certain interest rate that will perfectly balance all forces in the economy; a great harmonising principle that must be upheld with devotion and awe.
This theory, although it is its modern form exerts fascination on most economists, is actually quite old. Already shades of it could be detected in the 19th century, but it was finally formalised by the Swedish economist Knut Wicksell in 1898. Wicksell claimed that there were two distinct rates of interest. First, there is the “money rate of interest”; this is the worldly rate of interest that we all see and it effectively sets the price of borrowed money. More fundamentally however, there is the “natural rate of interest”; this is an altogether metaphysical construction that can only be shown to exist in highly abstract models built on extremely unrealistic assumptions. The categorical imperative then becomes to divine the natural rate through exercises in metaphysical speculation and force the money rate into line with it. By doing this we will, apparently, achieve economic salvation.
The natural rate of old came under attack in the 1920s and 1930s by John Maynard Keynes and Piero Sraffa, but there is no need to go into that here. (A refutation of the more modern “natural rate” hypothesis can be found in this paper by Philip Arestis and Malcolm Sawyer). What is important for us to understand is the unworldly nature of the theory.
The economists and the central bankers build their metaphysical models out of which they derive a natural rate of interest. (Of course, to use the term “derive” here is slightly misleading as they are, as good metaphysicians, only deriving something which they themselves have constructed – that is, they are engaged in building self-contained metaphysical systems out of tautological statements). They then assume that their extremely unrealistic metaphysical models are a near perfect approximation of the real world. Finally, they seek to bring their metaphysical models down from heaven to earth by engaging in pseudo-empirical estimations of the natural rate of interest with which they then (in theory, at least) use as a benchmark to set the money rate of interest – in the US this would be the short-term overnight interest rate or the Federal Funds rate.
So why, they must think, are we not today delivered to an economic paradise? There are a great many get-out-of-jail-free clauses the sophist can throw around to insulate themselves from criticism; from central bank incompetence to estimation error. The mutterings of charlatans do not here interest us, however, but we shall return to the benefits that accrue to economists who adhere to this dogma later. For now let us now turn to the reality of interest rate targeting – that is, its actual effects on our very worldly economies.
For our purposes we will take the United States as an example of an economy that has, in the past 45 or so years, been run largely on the principles of interest rate targeting. We will look at the post-WWII era which we will roughly divide into two phases.
The first phase, running from approximately 1945 to 1969, we will refer to as the “Keynesian era”. This is the era in which economies were largely run based on rational, practical policies and economists broadly accepted that government played a large role in stabilising the economy. The second phase, running approximately from 1969 to today, we will refer to as the “monetary policy era”. This is the era in which economists and central bankers broadly agreed that attempts by governments to stabilise their economies would only yield negative results and that it was up to the central banks to steer the economy. (These are slightly different periodisations than those usually associated with Keynesian policy versus monetary policy; we shall discuss this further below).
I. Diminishing Returns
Monetary policy came back into fashion in the US around 1969, but from then up until around 1982 it was basically used as a means to (attempt to) control inflation – it was also justified with an altogether different batch of metaphysics, but the effects were nonetheless the same.
Was it successful? Some economists think that it was but in fact, as we have shown elsewhere before, it was basically a disaster. Because at this stage of the game, the central bankers and their ideologues in academia had yet to find their particular Holy Grail – that is, interest rate targeting – and instead they tried to justify their high interest rate policies with monetarist voodoo. Nothing worked out as it was supposed to. The central bankers proved completely unable to target the rate of growth of the money supply – which was, of course, what they claimed they were doing – but after their dismal failure and their throwing the economy into the most serious recession since the Great Depression, they were more than happy to take credit for the fall in inflation that resulted from falling oil prices (rising prices being the key cause of the prior inflation).
After the Federal Reserve and other central bankers took credit for the falling inflation a founding myth was born: namely, that of the omnipotent central banker; the Master of the Universe; the Maestro – and so on. It was out of this myth that the metaphysics of interest rate targeting would be used to solidify the new era. There is an irony here, of course. Because it was out of the failure of their stated policies that central bankers began claiming that they alone were competent enough to steer the economy. And what emerged from this great lie? Paradise? Utopia? Not quite.
The simple fact is that the era of interest rate targeting has been, well, something of a disaster. That this would have been the case would not have surprised the old Post-Keynesian economists. As Steve Randy Waldman has pointed out over at his excellent Interfluidity blog, the Polish economist Michal Kalecki predicted what would likely happen should central bank’s begin to rely on monetary policy as their primary tool of choice. In 1943 – yes, 1943! – Kalecki wrote:
The rate of interest or income tax [might be] reduced in a slump but not increased in the subsequent boom. In this case the boom will last longer, but it must end in a new slump: one reduction in the rate of interest or income tax does not, of course, eliminate the forces which cause cyclical fluctuations in a capitalist economy. In the new slump it will be necessary to reduce the rate of interest or income tax again and so on. Thus in the not too remote future, the rate of interest would have to be negative and income tax would have to be replaced by an income subsidy. The same would arise if it were attempted to maintain full employment by stimulating private investment: the rate of interest and income tax would have to be reduced continuously.
And after 1982 when interest rates began to be used to stimulate economic activity this is precisely what happened. Waldman provides us with this rather stark graph in order to illustrate the confirmation of Kalecki’s thesis:
Yes, the Federal Reserve was able to keep the economy on a growth path – albeit one that was vastly inferior to that during the Keynesian era – but in order to do so they basically had to keep dropping the interest rate after every recession and not bring it back to its previous level after the recovery had set in. What we got then was seriously diminishing returns from monetary policy right up until after the 2008 financial crisis when interest rate targeting became completely ineffective as a means to return the economy to anything resembling full employment.
II. Increased Uncertainty
One of the other, often overlooked, negative consequences of using monetary policy as the key tool of macroeconomic stabilisation is that it is, by definition, a tool that uses instability to try to generate stability and this has serious consequences for economic development. Whereas fiscal policy seeks to glide the economy to full employment through delicately balancing effective spending, monetary policy relies on “shocking” the economy in the desired direction. Naturally, this greatly heightens uncertainty amongst the business community.
Imagine a representative firm earning a rate of profit on their investments of 8% per year. Now, if the central bank raises interest rates to stall the economy this will have two negative consequences for the firm in question. First of all, any outstanding debt that the firm has will cost more to service. Secondly, and perhaps more importantly, their prior investments will start looking a lot less promising. If the interest rate is set at, say, 3% then the firm could make 3% merely by buying perfectly safe government bonds. Now, the spread between their rate of profit and this rate of interest – in our example, 8% – 3% = 5% – may be sufficient to compensate for any risk the firm incurs through its investments. But if the rate of interest rises to, say, 4%, these investments may no longer appear worthwhile because the spread between the rate of profit and the risk free rate of interest will be only 4%.
What this means is that firms have to price into their investments the likelihood that the central bank will raise interest rates in the coming year. Thus, as the British Post-Keynesian economists Nicholas Kaldor knew well, if an economy is being stabilised through interest rate manipulation alone, firms will be far more cautious about making real productive investments and will favour speculating in bond and other financial markets. Kaldor put it as such in his seminal 1958 paper “Monetary Policy, Economic Stability and Growth”:
If bond prices were subject to vast and rapid fluctuations [due to the central bank manipulating the interest rate to steer the economy], the speculative risks involved in long-term loans of any kind would be very much greater than they are now [i.e. in the Keynesian era], and the average price for parting with liquidity would be considerably higher. The capital market would become far more speculative, and would function far less efficiently as an instrument for allocating savings – new issues would be more difficult to launch, and long-run considerations of profitability would play a subordinate role in the allocation of funds. As Keynes said, when the capital investment of a country “becomes a by-product of the activity of a casino, the job is likely to be ill-done”.
And things have gone exactly as Kaldor predicted that they would. In our era of monetary policy primacy investors have become far less inclined to pour funds into real investment, as can clearly be seen in the case of the US in the below graph.
The reader can probably make out from that chart that prior to 1969 the average growth in the rate of investment (red line) was significantly higher than after 1969 when monetary policy (blue line) became an increasingly important tool to manage the economy. The average growth in the rate of investment between 1947 and 1968 was 1.31% per year while the average growth in the rate of investment between 1969 and 2012 was 0.9% – a decline of over 31%. If we take the monetary policy era as having started in 1979 rather than in 1969 – we mention this only because it is the typical periodisation, whereas if we look at the data it’s clear that monetary policy came into favour in 1969 – but if we take the year 1979 as our starting point we achieve broadly the same, if not an even more dramatic, result: between 1947 and 1979 the average growth in the rate of investment was 1.25% per year, while between 1979 and 2012 it was 0.78% – a decline of over 37%.
Meanwhile, the capital markets have indeed turned into a giant speculative casino. Interest rate targeting is, of course, not wholly to blame for these shifts, but it absolutely is a key factor. And indeed, most economists and policymakers would claim that this era’s prosperity (or lack thereof), which they refer to as the “Great Moderation”, is a result of the new “scientific” interest rate targeting policies. In reality, by using monetary policy shocks to steer the economy central banks are driving out the good investment and encouraging speculative Ponzi rubbish in the financial markets.
In light of these considerations why then do economists and central bankers continue to favour monetary policy targets based on their phantom natural rate of interest? Well, first of all most are not properly aware of the above considerations because they do not fit into their metaphysical models. But even if they were made aware it is more than likely that they would dismiss them and cling to their models.
Why? One reason is because the profession is largely dominated by unimaginative technocrats and bean-counters. The models give them a strict set of rules that they can follow. And Lord knows that technocrats love rules! Rules not only insulate the weak-willed from blame but they also give them enormous power; namely, the power to implement the rules. How much guilt has been absolved over the course of human history through an appeal to a person “only following the rules”? One can imagine, quite a bit.
Thus, the profession can spend its time teaching nonsense on the basis that it is internally consistent nonsense and central bankers can spend their time chasing metaphysical phantoms by running econometric regressions based on spuriously constructed theories. This is not a bad way to live; clinging to power, yet insulated from reality and blame through recourse to divinely inspired rules.
The reader should not underestimate the power of rules in this regard. Rules allow policymakers and economists to wield enormous power without incurring any responsibility. After all, a man can be fired for his incompetence – but if he was just following the rules… well… Likewise, a teacher can be criticised for not understanding his subject sufficiently to wield the position he wields – but if he can follow the curriculum… well… Rules allow incompetent fools to grasp the reins of power and hold them fast.
The Place of Monetary Policy in an Enlightened Society
If, however, the profession were to one day take responsibility for their actions, what would we do with regards monetary policy? Well, if we were to begin running our economies as they were run in the Keynesian era monetary policy would have to take a back seat to fiscal measures. Let us now turn to consider two alternative uses of monetary policy as they might implemented in an enlightened society.
I. ZIRP: The MMT Approach
The Zero Interest Rate Policy (ZIRP) approach to monetary policy is that which is generally supported by Modern Monetary Theorists (MMTers). They argue – best articulated in Warren Mosler and Mathew Forstater’s 2005 paper – that the “natural rate of interest” is, in fact, zero. This is because, as they rightly point out, if the government did not voluntarily issue debt and instead simply spent newly created money the short-term interest rate would fall to zero (a very different conception of the “natural rate of interest” than that held by the metaphysicians who run our central banks and economics departments!).
The idea underlying this is that the main tool of economic management should be fiscal policy. If the economy is operating with significant excess capacity (i.e. high levels of unemployment) the government should cut taxes and increase spending. Whereas, if the economy is operating close to full capacity (i.e. at full employment) government spending should be cut and taxes increased. In such an environment, they argue, there would be no need for using interest rate shocks to steer the economy.
The elegance of this approach is that it essentially strangles the free-loading rentier who relies on shifts in monetary policy to collect government-subsidised cash in the form of interest payments on government debt. If the economy were consistently run at zero-level interest rates, investors would be forced to invest in real goods and services rather than in government and related debt instruments. Given that the economy would also be being run at close to full employment the risks that potential real investors would have to bear would be substantially lower as they could be sure that the government was always guaranteeing that there would be a market for their goods and services. Finally, the interest repayments on borrowing by productive investors would be extremely low, giving even more of an incentive to invest in tangible goods and services.
II. Fine-Tuning: The Kaldor Approach
The other approach that might be taken to monetary policy in a society not run by metaphysicians and haruspices would be the “Kadorian” or “fine-tuning” approach. In his previously cited 1958 paper, Kaldor noted that although Keynesian policies were extremely good at maintaining a steady rate of investment and growth, they could not deal with fluctuations in the level of inventories.
Capitalists tend to increase investment in inventories when they think an uncertain event might be around the corner – the simplest example of this being a rise in the price of raw materials due to weather conditions. This would cause them to borrow at the short-term rate of interest in order to avail of the lower prices of production, increase their holding of inventories and buffer themselves against future rises in production costs. The problem with this was that if the economy was running close to full capacity (i.e. full employment) any sudden increase in production needed to build up inventories would lead to a squeeze on resources and possible inflation.
Kaldor thus suggested that because capitalists borrowed almost exclusively at the short-term rate of interest to build inventories, it could be increased at times when central banks thought that capitalists were about to build inventory while the economy was at full capacity. Kaldor wrote:
[The] function of credit control [i.e. monetary policy] should be sought in stabilising investment in stocks (i.e. in offsetting spontaneous tendencies to instability in inventory investment), and not in the control of investment in fixed capital or the control of consumption which can far more appropriately be secured by other instruments.
Kaldor’s comments can be seen today in light of the fact that it was indeed an external shock to the prices of raw materials (oil) which in the 1970s set off an uncontrollable inflation. But even in his classic essay he remained sceptical that monetary policy alone could secure price stability in case of rises in the price of raw materials. For this reason he also advocated that countries work together to secure buffer stocks of raw materials in case of shortfalls. Today, in light of the events that took place in the 1970s, he might have added policymakers should be mindful of the domestic economic effects their foreign policy decisions might have.
In truth there is merit in both the MMT and the Kaldorian approach. And one might also add to them that monetary policy might be used to target a country’s exchange rate. Moving into the future we already see ZIRP in place and some economists have become dimly aware that inventory accumulation is an important potential component of macroeconomic destabilisation. However, for as long as the economists and the central bankers continue to believe in their monetary policy metaphysics, in their “natural rate of interest”, and in the powers wielded in the money markets, we will, at best, stumble from success to success or, more probably, trip over failure after failure.