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“When I meet with a proposition beyond finite comprehension, I abandon it as I do a weight which human strength cannot lift, and I think ignorance, in these cases, is truly the softest pillow on which I can lay my head.” Thomas Jefferson
Ralph Musgrave - Ralphanomics

Interest rate adjustments are a farce.

I set out a number of weaknesses in interest rate adjustments here six months ago. Another weakness has occurred to me as follows.

Prior to the crunch, too much was being borrowed and invested in over-priced property. Had governments or central banks seen this, they would have most likely responded by raising interest rates. And given that interest rates are particularly important for those wanting to borrow and invest in assets like houses, the interest rate adjustment tool would seem to be thoroughly appropriate.

But wait a minute. Prior to the crunch, demand AS A WHOLE was not grossly excessive: inflation was not out of control. Thus had rates been raised, that would probably have caused unnecessary unemployment (assuming interest rate adjustments have a significant effect on demand, which is debatable).

Put another way, there are two quite separate issues: first what should the rate of interest be, and second what should the level of demand be.

Thus the entire conventional wisdom on how best to regulate demand (adjusting interest rates) would seem to be flawed: it confuses two issues.

The best way, and indeed to obvious way, to increase demand is to give the population more of the stuff that enables them to “demand” goods and services: money. Which you could call a helicopter drop. And conversely, if inflation looks like getting uppity, money can be withdrawn from the private sector.

But heli drops have problems, one of which is that the logistics of actually delivering a bundle of money to every citizen are difficult. A much simpler way of doing the same thing is to channel extra money into peoples’ pockets via the various systems already in place for delivering money into or out of citizens’ pockets. These include the tax and social security system, work related taxes like payroll taxes, and in the case of pensioners, the state pension system. These can all be adjusted without too much difficulty so as to move money into or out of citizens’ pockets. Indeed, earlier in the recession, the UK’s sales tax (VAT) was adjusted for precisely the above reason.

Interest rates.

As regards optimising interest rates, the free market, if left alone will produce some sort of market price for borrowed money. And the only reason for interfering with the free market is where it can be shown there is market failure. Now where is the market failure in the case of interest rates? I don’t know of any and I’ve never come across anyone suggesting there is market failure here. So let’s just leave the market determine interest rates. (Incidentally this policy of leaving interest rates to be determined by market forces is advocated on p.10 here.)

As to demand, that is a different kettle of fish. There is clearly market failure here. That is, it is obvious from the booms and busts over the last few centuries that demand is not stable. Thus assuming governments can intervene and improve matters rather than make them worse (and that is a debable), then there is a case for having government and/or central bank regulate demand.

What if governments just don’t borrow?

As I pointed out here, the arguments for government borrowing are hopeless. That is, the truth is that the main reason for government borrowing is that it enables politicians to buy votes.

Thus if governments start behaving in a half rational manner, they’ just stop borrowing. But in that case they’d lose control of interet rates – shock horror! Well it would seem from the arguments above that it really wouldn’t matter if they did lose control of interest rates!

So Modern Monetary Theory is right.

The above policy, that is, what might be called “central bank funded fiscal expansion” in a recession has long been advocated by MMTers. It was advocated by Abba Lerner here.

MMT: streets ahead of everyone else!

Afterthought, 24th July 2011: I said just above that if governments did not borrow, they (or central banks) would lose control of interest rates. On second thoughts that isn’t true. In a “no government borrowing” scenario there would be nothing to stop a central bank announcing a willingness to lend or borrow at whatever rate it chose. Given the fire-power that central banks have, the markets would quickly fall into line just as they do nowadays when a central bank announces an interest rate adjustment.

This borrowing would take place PURELY so as to raise interest rates: there would be no intention of SPENDING the money concerned, as is the case with traditional government borrowing at present. This form of borrowing (or lending) may well not be legal as the laws of various countries currently stand. But such borrowing and lending would nevertheless make sense, ONE THE ASSUMPTION that deliberately adjusting interest rates is a good idea. But of course I argued above that such adjustments do NOT make sense.

That mistake of mine does not affect the basic argument above (phew, thank God for that).

Ralph Musgrave - Ralphanomics

Author: Ralph Musgrave - Ralphanomics

I wrote a book on unemployment recently with James Galbraith, and others. Galbraith is one of Obama's economic advisers. I love the different cultures that exist in this world. I took an interest in them long before the daft word 'multiculturalism' was widely used. I want to see these cultures preserved. I want to see Tibet staying Tibetan, and Britain staying British.

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