Wednesday, December 28, 2016

Noah Smith — Why Low Rates Failed to Boost Business Investment

This type of research is fraught with difficulties, and causality is very hard to determine, so it’s important not to read too much into this. But one conclusion seems clear -- if we want to increase business investment, policies to promote access to capital seem more promising than policies to reduce interest rates. The latter approach has been tried, and it didn’t work. We might want to give the former a chance. That would mean encouraging venture capital, small-business lending and more effort on the part of banks to seek out promising borrowers -- basically, an effort to get more businesses inside the gated community of capital abundance.
"Causality is very hard to determine."

There are several issues surrounding causality. The first is the identifying the relevant assumptions and avoiding hidden assumptions. This determines the relevance of the endeavor by targeting the relevant causal factors and their relationship. These are the variables in equations.

The second is parameter specification that determines the scope and scale of the endeavor. The parameters are the constants. They can be thought of as positions on dials that controls the output. Moving the dial affects the function and its output without affecting the variables.

In a function, inputs determine outputs in accordance with a rule. Dependent variables are affected by independent variables in accordance with the function as rule.

In the simplest situation, a single independent variable is used along with holding other factors equal, which is called ceteris paribus, abbreviated as cet. par.

Many if not most "narrative economics" is based on a simple model like the one Noah Smith employs in the post, first assuming the interest rate as a policy lever and then switching to credit standards as a factor.

However, a society and its economy are not only complicated, that is, multiple factors (variables) are relevant. But they also complex, that is, conditions change owing to feedback.

Causal systems (functions) are based only in past and present inputs, with no future inputs.

As a result it is difficult to construct a set of equations that specify the condition of the economy overall, that is, from the point of view of macroeconomics. Simple models are rarely sufficient where there is no dominant causal factor, and they are useless when they identify the wrong factor as being dominant.

Noah Smith points out shifting credit standards as a factor. This has been observed previously by Post Keynesian and MMT economists, as well as others that pay attention to institutional factors. Demand for credit is affected by the creditworthiness of potential borrowers and credit standards shift with changing financial and economic conditions.

The problem with interest rate based models is the assumption that the interest rate is a lever that always acts the same way. But shifting credit standards imply that the interest rates operates differently in different financial environments.

Conventional economic models don't take this into consideration and therefore see causality when the system is non-causal in this respect. The result is "pushing on a string."

While the interest rate seems to be completely specified by the nominal value, from which the real value can be computed by subtracting the inflation rate, it is not specified completely with respect to lending owing to shifting credit standards that adjust creditworthiness and therefore determine the potential pool of customers.

Interest rates are low during contractions. This correlation results from the mechanism a central bank employs to increase lagging investment by lowering the cost of borrowing and increasing the interest rate to cool the economy as inflation pressure rises, based on the assumption that the interest rate acts similarly across time as lever influencing leverage.

In some cases the interest rate is sufficient to produce a desired result, but in other cases it is insufficient. Simplifying, the difference is usually between ordinary business cycles in which firms' financial position does not change appreciably and economic conditions suggest that loans will be repaid with improving conditions, and financial cycles in which the financial position of firms is adversely affected.

During contractions, the central bank lowers the target rate, which is the baseline rate, resulting in interest charged by lenders declining. However, owing to economic conditions, lenders also tighten credit standards so that creditworthiness declines. Even though there may be notional demand for loans, many desire loans cannot qualify for them.

Noah Smith proposes this as a causal factor and seems to suggest that it may be a dominant one.

But this doesn't seem to be the case, since many of the largest US firms are in a strong financial position, with high retained earnings. Moreover, when these firms borrow to take advantage of low rates, they use the funds for equity buy-backs rather than new investment, indicating a low rage of return on existing opportunity and a lack of confidence in foreseeable economic expansion.

While agreeing that credit standards are causal factors in lending, Keynesians would dispute that credit standards are a dominant factor. Credit standards tighten for the same reason that liquidity preference rises in "bad times," when "animal spirits" are depressed with good reason —lack of sales.

Keynesians would argue that the dominant causal factor here is lagging effective demand, so that the solution is not trying to force or cajole lenders to loosen credit standards when their business is setting credit standards correctly with respect to conditions. The primary solution indicated is to augment effective demand.

"Money" enters the economy in three ways, from the activity of the private sector, the government sector and the external sector. When the private sector is underperforming, relief must therefore come from 1) increasing private sector lending for investment and consumption or disgorging private sector savings, 2) government spending, or 3) increasing exports.

The chief means for increasing private sector borrowing is lowering the interest rate or (inclusive) loosening credit standards. while there is a mechanism to lower interest rates, there is no mechanism to loosen credit standards, which many would regard as a dangerous solution. Moreover, liquidity preference increases in "bad times," prolonging the contraction. So even looser credit standards might not be effective either and loosening might exacerbate the financial issues the economy is facing.

The conventional thinking is that exports can be increased by lowering the exchange rate relative to other countries. This is a beggar thy neighbor strategy and it cannot be used universally, since the surplus of one country must be offset by other countries. This seems to be a preferred strategy, which is not working either.

That leaves the government sector to increase spending, which a currency sovereign is always in the position to do. The only constraint is the availability of real resources to purchase, which is never an issue during a contraction, when the economy can expand to meet increased demand.

Increased demand draws forth increased supply (production) when the economy is under-producing, that is, when there is an output gap and idle labor.

Put most simply, the world economy is capable of producing much more than is demanded. The reason is not lack of notional demand but lagging effective demand. While there is some leakage to saving owing to increased liquidity preference, the major factor seems to be lack of income, other than at the top tier, and top tier spending is not sufficient to break the cycle.

The Keynesian antidote is for government to use its purchasing power as currency issuer to put idle resources to use, both capital goods and labor, simultaneously increasing output and effective demand in order to spur economic expansion and thereby to create opportunity for private investment.

The current conventional predilection for fiscal austerity based on the disproved assumption that this will increase business confidence and spur investment is misguided.

Noah Smith's solution seems to be based on the assumption that the key fundamental of capitalism is capital formation and this is a result of a combination of technology, innovation and investment, so that capital formation must be stimulated artificially since it is not taking place "naturally."

The question is how to do this as effectively and efficiently as possible.

His solution seems to be "encouragement." To be persnickety, "Where's the model?"

Well, at least his moving off interest rates as the lever.

The Keynesian solution is to decrease demand leakage to saving and increase effective demand using the power of the currency issuer. See monetary economics based on sectoral balances and application of functional finance in policy for the model.

Bloomberg View
Why Low Rates Failed to Boost Business Investment
Noah Smith | Bloomberg View columnist

17 comments:

Matt Franko said...

"Causal systems (functions) are based only in past and present inputs,"

Yes but the input can be represented via continuous time model or discrete time model itself... think of an AC source powering a circuit as an input its a sinusoid in continuous time... iow when we do any time domain analysis via continuous time the future is included...

https://en.wikipedia.org/wiki/Discrete_time_and_continuous_time


So once we understand perhaps thru ROTE that "govt spends FIRST and THEN collects the taxes..." we can treat taxes and savings AS A FUNCTION OF govt spending...

So the input would be the govt real (cash basis) withdrawals, and the outputs would be (cash basis) taxes and savings...

T+S = f(Wgov)

We could look at this via continuous time or discrete time... and assign students problems (active methodology) to figure out what (T+S) is with different functions of Wgov...


Tom Hickey said...

iow when we do any time domain analysis via continuous time the future is included...

Assumes ergodicity? (time series ≡ ensemble)

The basic idea is that the variable in a function is a mathematical symbol that remains the same through operations (adding arguments and applying rules).

The variables are connected to the real world through definitions involving descriptions. If the the definitions change based on shifting circumstances in the real world then the variable is no longer a single variable and inconsistency is introduced.

This doesn't happen in science owing to ergodicity, but economics is non-ergodic. Variable shift with shifting conditions.

Tom Hickey said...

So once we understand perhaps thru ROTE that "govt spends FIRST and THEN collects the taxes..." we can treat taxes and savings AS A FUNCTION OF govt spending...

As long as policy remains unchanged.

Matt Franko said...

"The Keynesian antidote is for government to use its purchasing power as currency issuer "

Keynes wrote that "govt is currency issuer" ????

I highly doubt it...

Nobody understands this other than we few....

Tom the response to this is "we're borrowing from our grandchildren!" (think about this statement in time domain! LOL!!!) by the morons... they think we have a time machine!!! LOL! They must think they have to stand there at the light switch rapidly switching the light switch on and on and on every 3 micro seconds in order to light the room!!! LOL!!!! because they are ignorant of continuous time functions in math!! what a bunch of mental douches!!!!

We have to come up with a functional equation of govt withdrawals in relation to Taxes and Savings and Income (and hence with income comes credit creation) in time domain to show these idiots how they are morons and dont know what they are talking about...

Like we have rote "to do a reserve drain you first have to do a reserve add..." but there are scientific ways (ie non-rote) ways to show this in time domain....

Matt Franko said...

"As long as policy remains unchanged."

If the conditions change then you reset t=0 and re-run the function with the new parameters...

Its like switching in a new load onto a circuit...

All parameters matter the effective tax rate, the risk free rate, what the govt withdraws, if system access is allowed to external USD zombies, probably some others....

Matt Franko said...

We have to get away from the stochastic models of the gold standard era and get back to deterministic models under our current numismatic type system...

Matt Franko said...

"based on shifting circumstances in the real world"

Well the morons think "money!" is a shifting circumstance so we are f-ed right there... "Gee I hope we get a lot of taxes in so we can spend some money!!!!" theyre fing idiots...

We can only control what we have authority over, and our currency system is one of the things we have authority over so hence we can control it...

jrbarch said...

I’d like to see the economists and politicians all packed off into a space shuttle and made circle the earth for about six months (hopefully long enough to de-condition them a little). Their assignment is (should they accept the mission) to write an essay on human desire, the thirst for knowledge and the search for self; and how humans turn these essential forces into an unholy mess. Of course if they don’t accept the mission, THEY self-destruct (which is not much of a change really)! Actually ‘self-destruction’ is a pretty good word for human affairs, in a lot of ways.

Tom Hickey said...

Keynes wrote that "govt is currency issuer" ????

Keynes was a Chartalist.

Tom Hickey said...

If the conditions change then you reset t=0 and re-run the function with the new parameters...

Its like switching in a new load onto a circuit...


Right but that is not the way that economists think. They still have not realized the implications of the "new" monetary system that has been in place de facto since 1971 and de jure since 1973. They also don't realize the difference between currency sovereigns and non-sovereigns.

They think that a single causal structure aka "model" applies to economies regardless of institutional differences and changes in conditions.

Matt Franko said...

"I’d like to see the economists and politicians all packed off into a space shuttle"

We could probably make do with just a new Moron Annex added to the facilities down at GITMO... even put in tennis and golf... swimming pools...idc just get 'em outa here for a while...

Tom Hickey said...

We can only control what we have authority over, and our currency system is one of the things we have authority over so hence we can control it...

It's arguable who realizes this and is not letting on and who is in the dark about it. I suspect that at least some in positions of power, especially in banking and finance, know it but are concealing their knowledge of it because it is in their interest for that authority of the state not to be used by the state but delegated to them. When it is broached, they cry "socialism."

A good example is that insolvent banks are required by law to be put into receivership. That didn't happen to the big banks when the crisis struck. As Sen. Dick Durban put it, "The banks own the place," meaning the US Congress.

Postkey said...

' Noah Smith's solution seems to be based on the assumption that the key fundamental of capitalism is capital formation and this is a result of a combination of technology, innovation and investment, so that capital formation must be stimulated artificially since it is not taking place "naturally." '

Back to the G.T.?

“Furthermore, it seems unlikely that the influence of banking policy on the rate of interest will be sufficient by itself to determine an optimum rate of investment. I conceive, therefore, that a somewhat comprehensive socialisation of investment will prove the only means of securing an approximation to full employment; though this need not exclude all manner of compromises and of devices by which public authority will co-operate with private initiative.”
https://ebooks.adelaide.edu.au/k/keynes/john_maynard/k44g/chapter24.html


dave said...

Real World anecdotally, and I can't believe I'm saying this, but on several points I agree more with Noah Smith than you here Tom.

"Noah Smith proposes this as a causal factor and seems to suggest that it may be a dominant one.

But this doesn't seem to be the case, since many of the largest US firms are in a strong financial position, with high retained earnings. "

This may be true now, but during a recession when investment is lowest this is most definitely not the case. It may be that there is demand for loans during recessions but either banks don't trust the businesses balance sheets-even those of the largest companies--or banks themselves are seeking capital and cannot lend. As you say, Increasing the availability of loans for investment is a way of increasing effective demand, as business will use the loan proceeds for investment or consumption. This does not make it an inferior form than federal deficits.

And This continues to be the case for smaller firms without capital buffers to survive a downturn. This doesn't mean they are not credit worthy, but that they don't meet certain criteria. And those criteria do fluctuate significantly based on conditions but really should not change that much.

"there is no criteria for loosening credit standards." Again, I'm not sure I agree here as nearly all banks determine their criteria based on fed regulation. As opposed as I was to the TARP bailout, increasing bank capital will allow for loosening of standards, and applying criteria more uniformly across expansion and recession will also help shorten and eliminate downturns.

There should also be encouragement to lend to smaller businesses with a solid credit profile but maybe not the capital buffer. Often times if declined by a bank at low rates the alternative is a lender who makes the offer to lend on terms that make the investment unprofitable. There should be a middle ground.

I've been saying for years that credit standards are an underrated determinate of booms and busts and have to say I agree with Noah here, and while I'm aware that some PK and MMT economists have said similar things, I don't recall seeing it as explicit as Noah argues here. I don't agree with much that Noah writes, but on this I'm in agreement and I think you've underserved his argument.

Postkey said...

"I've been saying for years that credit standards are an underrated determinate of booms and busts . . . "

This economist agrees with you?

“Importantly for our disaggregated quantity equation, credit creation can be disaggregated, as we can obtain and analyse information about who obtains loans and what use they are put to. Sectoral loan data provide us with information about the direction of purchasing power - something deposit aggregates cannot tell us. By institutional analysis and the use of such disaggregated credit data it can be determined, at least approximately, what share of purchasing power is primarily spent on ‘real’ transactions that are part of GDP and which part is primarily used for financial transactions. Further, transactions contributing to GDP can be divided into ‘productive’ ones that have a lower risk, as they generate income streams to service them (they can thus be referred to as sustainable or productive), and those that do not increase productivity or the stock of goods and services. Data availability is dependent on central bank publication of such data. The identification of transactions that are part of GDP and those that are not is more straight-forward, simply following the NIA rules.”
http://eprints.soton.ac.uk/339271/1/Werner_IRFA_QTC_2012.pdf

Matthew Franko said...

Banks are not interested in raising capital they have too much capital:

http://www.marketwatch.com/story/banks-capital-return-plans-big-stock-buybacks-dividend-increases-2016-06-29

Its all about share count reduction these days there is little income growth from the leading flow increase to leverage... maybe 5% or so...

so the banks are returning capital to shareholders.... ie the system has surplus capital in excess of what is needed to finance the tepid growth ...

The system is deterministic...

Tom Hickey said...

@dave

Points taken. However, I said that I agreed with PKE and MMT economists that credit standards are a causal factor in the crisis, but not the dominant one in recovery. They are a causal factor in the crisis, because tightening credit standards, even among banks themselves, result in a liquidity crisis. That's a job for the cb to handle, and BB was late to the party. And when he joined it, he opened the flood gates for the systemically important institutions but left everyone else handing out to dry.

Admittedly, broad liquidity provision could have avoided the depth of the down turn and prevented the financial crisis from becoming an economic one. But, as a recall, BB denied that doing so was a Fed power and that Congress had to man up with fiscal as the proper course.

The idea was that banks would increase lending as part of the deal in "extend and pretend," that is, loosen credit standards, which they did not do for "the little guy." Small business is still hard pressed to borrow money.

But the dominant factor causing a lagging recovery is not credit standards but rather lagging effective demand. There are many reasons for that but one is income, which underlies qualifying for credit.

In this situation, the job of government is not to force banks to loan or jawbone them into making bad loans. It's addressing lagging effective demand fiscally.

There are many causal factors operative and identifying the dominant one(s) is controversial. NS is sticking with the financial-monetarist explanation based on interest rates and point out why they were likely less effective owing to shifting credit standards.

Without denying that, the PKE and MMT economists are saying that the dominant cause is lagging effective demand and the way to address it is fiscal.

This is the fundamental divide in the debate.