Sunday, December 20, 2015

David Glasner — Keynes on the Theory of the Rate of Interest

I have been writing recently about Keynes and his theory of the rate of interest (here, here, here, and here). Perhaps unjustly – but perhaps not — I attribute to him a theory in which the rate of interest is determined exclusively by monetary forces: the interaction of the liquidity preference of the public with the policy of the monetary authorities. In other words, the rate of interest, at least as an approximation, can be modeled in terms of a single market for holding money, the demand to hold money reflecting the liquidity preference of the public and the stock of money being directly controlled by the monetary authority. Because liquidity preference is a function of the rate of interest, the rate of interest adjusts until the stock of money made available by the monetary authority is held willingly by the public.
I have been struggling with Keynes’s liquidity preference theory of interest, which evidently led him to deny the Fisher effect, thus denying that there is a margin of substitution between holding money and holding real assets, because he explicitly recognizes in Chapter 17 of the General Theory that there is a margin of substitution between money and real assets, the expected net returns from holding all assets (including expected appreciation and the net service flows generated by the assets) being equal in equilibrium. And it was that logic which led Keynes to one of his most important pre-General Theory contributions — the covered-interest-arbitrage theorem in chapter 3 of his Tract on Monetary Reform. The equality of expected returns on all assets was the key to Irving Fisher’s 1896 derivation of the Fisher Effect in Appreciation and Interest, restated in 1907 in The Rate of Interest, and in 1930 in The Theory of Interest...
Uneasy Money
Keynes on the Theory of the Rate of Interest
David Glasner | Economist at the Federal Trade Commission

1 comment:

Random said...

This is all utterly mad and divorced from reality.

It is entirely neoclassical bullshit based on the idea that there is a wicksellian rate and real interest rates are set by the market.

What has happened is government policy created/is creating a private debt bubble.

This seems to have happened mostly in anglo-american culture countries run by conservative governments who share vote-buying strategies.

In a first stage a debt bubble is created mostly by low interest rates making buying assets on margin quite cheap in absolute terms, and a relaxation in lending standards to enable a significant amount of small scale fraud.

The second stage after asset prices have already started to zoom up is regulatory relaxation of leverage ratios and accounting enforcement to enable systemic fraud; low interest rates no longer matter, as long as interest rates are lower than expected asset price rises, as Galbraith noted of the 1929 bubble.

The third stage is government financed laundering of the profits of reckless and fraudulent borrowing and lending, by buying worthless securities at par, lending direct to bankrupt financial companies at way-below-market interest rates to create fat spreads, and even direct capital injections to refill their bonus pools, accompanied by grinding currency devaluation and constant inflation to redistribute income from industrial sectors to asset speculators.

The recipe above has been followed many times in history mostly in third world countries.

Where a debt boom generates a boom in the prices of the assets used as collateral for that debt, which makes the balance sheets of both borrowers and lenders look stronger, which drives a new debt boom, and so on and so on, endless prosperity for asset owners and for the management of financial businesses.

Sponsored economists and central banks hate the (grossly misnamed) wage-price spiral, when wage earners try to fight increases in consumer prices by trying to negotiate partially compensatory wage rises, thus reducing the profit potential of the "deserving wealth-creators" of the economy.

But the same sponsored economists and central banks absolutely love the debt-collateral spiral, because it results in ever greater profits for deserving, wealth-creating rentiers and financial business exectutives, with no risk: because if collateral prices go up as fast as debt, there is no net increase in exposure. As history proves, as Minsky abundantly demonstrated :)

More seriously, the political purpose of the current, 20–25 years old debt-collateral spiral in anglo-american countries seems to me to be the asset stripping of first-world economies. I cannot emphasise enough.

The sponsors of economists and central banks have started looking at whole anglo-american countries through the perspective of the Bain Consulting Matrix, and they came up as “cash cows” (in part) or “dogs” (mostly), and the prescription any MBA gives for “dogs” is asset stripping. Extended to whole countries.