Friday, June 1, 2012

A strange post from Jonathan Catalan

The other day I noted that Sumner seems to view Keynesians as obsessed with interest rates when it comes to monetary policy, when in fact it's not unfair to say they're obsessed with expectations and monetary policy. Keynes talked about both. Hicks and Samuelson focused on the interest rates, and the New Keynesians brought expectations back in (with Krugman's Japan paper explicitly noting that in a liquidity trap what we're really working through is the expectations channel). That's 70 years of history of economic thought in a nutshell.

Jonathan picks up on this dichotomization of the ways of thinking about monetary policy. He starts by saying that my argument relies on entrepreneurial expectations of deflation, which it doesn't at all. Horrendous as policy has been, I'm not particularly worried about long bouts of deflation per se. The monetary authority can fiddle while Rome burns at one or two or three percent, but I'm fairly confident deflation will get them motivated to do something. I think most entrepreneurs share this expectation. That means that our understanding of the monetary policy reaction function is such that we're not expecting deflation. So, no Jonathan.

He then says that my point that the interest rate channel is a no-go "assumes that the “marginal efficiency of capital” is lower than the rate of interest, but there is no evidence that entrepreneurs perceive a lack of profitable investment opportunities [!!!!!!].

"There are three stronger explanations (which can work in conjunction):
  1. Incentives against lending: Banks’ excess reserves have risen as a result of Federal Reserve policy — namely, paying interest on reserves (Todd Keister and James J. McAndrews, “Why Are Banks Holding So Many Excess Reserves?”);
  2. Asset weakness:  I am not sure this applies to American banks, but Spanish banks have had trouble extending liquidity to new borrowers, because much of their available liquidity has been lent to maintain non-performing assets.  This allows banks to avoid a panic amongst investors;
  3. Regime Uncertainty:  The expected profitability of investment is not just derived from the “marginal efficiency of capital,” but also from the expectation that the project will be completed and left intact by government interference.  There may also be some element of what many have used to criticize Austrian business cycle theory: expectations of another fluctuation."
OK... what!?!? On the first point, Jonathan, citing Keister and McAndrews, is saying that interest rates are sufficiently high that banks find it preferable to hold reserves as opposed to investing and earning a return.

In other words - exactly the MEC argument!!!!

On the second point, I think it's helpful to first remember that supply and demand is a schedule, not (just) a quantity. Jonathan points out that banks decide to loan out less money to new borrowers because they're trying to avoid a run by maintaining current assets. To put it another way, the return on new investments is not high enough to entice banks to lend money to those new investors.

Not exactly the MEC argument as it is usually composed (since we are not exactly comparing MEC to a liquidity premium in this case), but pretty close to the MEC argument!!!!

And the third point is bonkers as an alternative. That is a statement about MEC! Investors ask themselves "given the cost of this purchase of a piece of capital, what is the discount rate that produces a net present value of my expected future earnings equal to the cost I am paying today? Is it higher or lower than the interest rate?". If anything lowers those expected future earnings (such as something uncertain about the policy regime or the economy), you get a lower MEC.

Since Keynes's primary argument for why MEC might drop dramatically was uncertainty about the future, you can't get much more Keynesian than discussions about regime uncertainty (whether regime uncertainty is actually the problem in a given situation is of course an open question).

And all this talk about expectations brings us full circle to my initial point: expectations are the primary channel through which monetary policy is working right now.


  1. Desolation JonesJune 1, 2012 at 7:49 PM

    Lars Christensen has an excellent post where he makes a similar point about regime uncertainty basically being Keynesian in nature. And comes to the conclusion that regime uncertainty is mainly an issue if it effects monetary uncertainty. (ie: expectations)

    I once joked that that regime uncertainty multiplier is zero when the fed targets inflation, which is pretty much the same point.

  2. I didn't say interest rates were higher than the MEC; I said that the interest paid on reserves by the Fed is higher than the expected returns on the market, especially since it's a much safer bet during a period of high regime uncertainty. My argument and the one you interpreted are two completely different things. The same goes for the argument about banks funding bad assets to avoid scaring investors; this has nothing to do with MEC. It only has to do with the fact that certain investments are better than others, and given malinvestment and Fed policy investments that tie liquidity are found to be better than ones that lead to new production. With regards to regime uncertainty, then the policy prescription isn't reducing the rate of interest or massive monetary inflation, but reducing regime uncertainty!

    1. Jonathan - "certain investments having a higher expected return than others" is exactly what the MEC argument is. It's not two different arguments. MEC is just a way of talking about expected returns that are strewn out over time. People are used to comparing PDVs. MEC is similar it just lets you compare it to other rates of return (like interest rates).

      re: "With regards to regime uncertainty, then the policy prescription isn't reducing the rate of interest or massive monetary inflation, but reducing regime uncertainty!"

      Exactly - IF it's the regime uncertainty that's lowering expectations! But all evidence points to the fact that expected returns are low because of demand issues, not regime uncertainty.

  3. Various Keynesian and Monetarists stimulus programs have been tried and failed since 2008 and the response of their advocates to their failure is always "the level of stimulus didn't go far enough - lets have more please".

    What the advocates of these forms of stimulus have in common is a belief that the recession is somehow caused by nominal factors (not enough money) or confidence factors (future expectations too low) rather than real factors. This seems inconsistent with the facts. There was a large drop in RGDP in 2008 accompanied by a fall in NGDP and levels of employment. Since then NGDP has risen more or less in line with its long-term trends while employment has increased much more slowly. If this was nominal wouldn't we have expected a more significant recovery in employment as NGDP has increased substantially since 2008 ?

    To my mind this looks like something real happened in 2008 from which we have not yet recovered - perhaps there was a realization (doesn't really matter what it was for the purposes this post) that year that something fundamental has changed that would render a proportion of investment unprofitable ?

    What would we have expected to see happen if this was the case.

    - A sudden drop in RGDP and employment as these unprofitable lines of business were terminated accompanied by a fall in NGDP as effective demand is reduced
    - A reduced demand for labor that if not resulting in lower real wages would result in higher long-term unemployment
    - If effective demand has fallen but wages have not then there will be less profitable investment opportunities. This will increase savings and reduce borrowing and lead to a fall in IR potentially to zero and a "liquidity trap" that will again cause NGDP to fall.

    This chain events is consistent with what has happened. What then will be the effect of an attempt of the monetary authorities to set expectations that NGDP will increase at a higher rate in the future? It will depend upon how businesses expect this increased money supply to affect relative prices - in particular the wage level relative to the price of final goods. In the best case scenario then this will cause real wages to fall and allow investment to increase. Even here though the effect will be via inflation which will affect different goods differently and disrupt the price mechanism. Based on the experience since 2008 though the increased money supply will cause real wages to rise almost as much as final goods. We will get higher inflation and only a marginal effect on employment. This is stagflation and will quickly wipe out any beneficial effects of the marginal lower real wages.

  4. You guys want to have your confidence fairy and eat it.


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