How could I resist responding to Stroppy the Wonder Dog? In my post last week on time is money, and how that temporality is becoming a bizarre circus in the capital markets, Stroppy, or Strop to his mates, said this:
Should the Fed just start raising rates? Would that be a positive signal to the economy, irrespective of the state of the underlying economy? That is what gets me. I don’t see how i-rates at near 0 are good for anyone. At some point the rate is simply lowwwwww (1.5%? maybe) and cutting further won’t encourage borrowing for real investment.
Now this is a fair question. When I talk to economists (I am neither an economist nor economic historian, a source of some considerable personal pride) they immediately dismiss this as illogical. And surely they are right, it is illogical. To get the system moving again making money easy to get should be the key (although economists tell me that in America at least, the problem is that bankers are unwilling to lend, not that they are put off by interest rates — how could they be?). Japan’s “failure” to act fast enough in the 1990s to reduce the cost of money is routinely cited as evidence of what not to do.
But consider this. Capital is not, these days, a quantity of “stuff” like water, it is mostly agreements to transact, based on mutually agreed rules. The anthropologist David Graeber puts it this way:
Money has, for most of its history, been a strange hybrid entity that takes on aspects of both commodity (object) and credit (social relation.) What I think I’ve managed to add to that is the historical realization that while money has always been both, it swings back and forth – there are periods where credit is primary, and everyone adopts more or less Chartalist theories of money and others where cash tends to predominate and commodity theories of money instead come to the fore. We tend to forget that in, say, the Middle Ages, from France to China, Chartalism was just common sense: money was just a social convention; in practice, it was whatever the king was willing to accept in taxes.
We are very definitely in a social relation era of money, when money is not a finite quantity of stuff, like gold, it is based on agreements — agreements that can go on indefinitely. Hence we have a stock (notice the physicality of the metaphor) of derivatives that is twice the capital stock of the world.
Viewing money as a commodity is the fundamental error in so much of the contemporary discussion of finance. Money is analysed as “stuff” — “we have a shortage of capital, we have an excess of capital, it is flowing into the wrong places” etc — when it is mostly social relations. More than that, it is heavily MATHEMATICISED social relations, coded into computers. (I have some sympathy with this who argue for the reintroduction of the gold standard, because some reversion to money as stuff would probably reintroduce some balance in this extreme situation, but that does not stop it being Arcadian wishful thinking.)
In this semiotic world of mathematicised social relations, this era of meta-money, symbols have enormous value. And the symbol sent by zero, or near zero US, German, UK and Japanese 1-year government bonds is that risk is extremely high, one should not borrow and one should run for the hills when necessary. That is hardly the signal that is supposed to be sent by such low interest rates, the point that the president of the Dallas Fed was recently making:
Moreover, you (a business owner) might now say to yourself, “I understand from the Federal Reserve that I don’t have to worry about the cost of borrowing for another two years. Given that I don’t know how I am going to be hit by whatever new initiatives the Congress will come up with, but I do know that credit will remain cheap through the next election, what incentive do I have to invest and expand now? Why shouldn’t I wait until the sky is clear?
The signal does not just go to business owners. It goes to the whole panoply of traders and investors in the financial system, and all the algorithms and mathematical formulae that sit on top of their activities. What is clear about financial systems is that when they are pushed to extremes, they start to lose their underlying logic. For example, if one took the price of US equity capital from the current US government bond rate (I am not saying one should, I am just considering the relation) then the cost of equity capital should be almost infinitely low. Which means an investor should be willing to wait centuries after they are dead for the shares to repay their value. A nonsense result, in other words.
There is some academic analysis that looks at this issue in the Great Depression, by Gauti Eggertson and the gloriously named Benjamin Pugsley in a paper called “The Mistake of 1937” (find it in full below):
This paper addresses the “mistake of 1937,” which reversed the tide of the recovery from the Great Depression in 1933–37 into a short but sharp recession from 1937–38. Between May 1937 and June 1938, GNP contracted by 9 percent and industrial production by 32 percent. The general price level took a tumble as well. The index of wholesale prices, for example, fell by more than 11 percent, several leading commodity prices collapsed, and the stock market lost almost half of its value.
The mistake of 1937 was in essence a poor communication policy. At the time, President Franklin Delano Roosevelt (FDR), his administration, and the Federal Reserve all offered confusing signals about the objectives of government policy, especially as it related to their goals for inflation. In the first year of his presidency, FDR had vowed to fight the drop in prices and to reflate them back to their pre-depression levels (the reference point was often understood to be the price level in 1926). By every indication, the public believed this commitment. But by 1937, the administration began expressing its alarm over excessive inflation despite the fact that prices had not yet reached their 1926 target. Vague and confusing signals about future policy created pessimistic expectations of future growth and price inflation that fed into both an expected and an actual deflation. We leave it open to question whether this communication was due to a deliberate change in policy or due to confusing signals (see the discussion in Section VII, where we propose two alternative interpretations), but we argue that regardless of the reason, the ultimate effect was a shift in beliefs about future policy. Nominal rigidities helped propagate the shift in beliefs into an output contraction and a collapse in prices.
We show that this propagation mechanism is particularly damaging at zero interest rates by constructing a stylized dynamic stochastic general equilibrium (DSGE) model in which the zero bound on the short-term interest rate is binding due to temporary real shocks that make the natural rate of interest temporarily negative. We simulate this model and show that at zero interest rates, both inflation and output are extremely sensitive to signals about future policy. By “extremely,” we mean that if the public’s beliefs about the probability of a future regime change by only a few percentage points, there are very large effects on inflation and output. This effect is independent of any change in the current short-term interest rate, which we assume remains at zero.
In the Great Recession, when signals and signal value matter even more, the possibly counter productive effect of near zero interest rates is well worth examination.