Low interest rates /= easy money

The impact of monetary expansion on nominal interest rates is unclear. The liquidity effect implies that in the short run they will fall. However the Fisher effect implies that in the long run they will rise. Whether the monetary expansion ultimately leads to a nominal interest rate that is higher or lower than the original rate depends on the relative strength of these effects. If the liquidity effect dominates the Fisher effect then expansionary policy will cause rates to fall. If the Fisher effect dominates the liquidity effect then the expansionary policy will cause rates to rise. (I'm neglecting several things, but I hope the above still makes sense).

This is important, because whether or not a low interest rate is a sign of expansionary monetary policy depends on inflation expectations.

Ben Southwood discusses a fascinating 1998 paper by Ellingsen and Soderstrom. From the abstract:

if monetary policy reveals information about economic developments, interest rates of all maturities move in the same direction in response to a policy innovation. If, on the other hand, monetary policy reveals information about the central bank's policy preferences, short and long interest rates move in opposite directions.

My interpreration of this is that when there is a policy surprise the Fisher effect dominates the liquidity effect. But this poses two really interesting questions:

1. Is there anything important about the surprise, other than its impact on inflation expectations?

2. Does this adhere to the Lucas critique?

Update: I've just seen that Samuel Hammond and Ben had a disagreement about what the paper implies about the liquidity and Fisher effects on Twitter. I would love to see a longer discussion.


Do Cantillon effects matter?

A couple of years ago there was a big blogosphere debate about Cantillon effects. It was prompted by Sheldon Richman's claim that:

Since Fed-created money reaches particular privileged interests before it filters through the economy, early recipients—banks, securities dealers, government contractors—have the benefit of increased purchasing power before prices rise.

Scott Sumner argued that "it makes very little difference how new money is injected" (see Sumner's follow up post here, see Robert Murphy's attempted resolution, and see Sumner's response.)

This debate struck me as a classic argument between comparative statics and market process theory. The process by which monetary expansion occurs will cause some prices to change. Whilst prices adjust, some groups will benefit and some will lose out. It seems uncontroversial to me.

Perhap's the problem is with immediately turning this into a debate as to whether "Cantillon effects" exist. We can think of them in two ways. The first is whether there's a wealth effect on the part of the early recipients of freshly created money. The second is the consequences of the relative price effect. Note that Sumner is challenging Sheldon's account of the former, whilst it is the latter is the really important contribution of Austrian monetary theory (i.e. the interplay between non-neutrality of money, relative price changes, and the capital structure).

Having read through the debate, I believe that the following statements are correct:

  • There is a perceived wealth effect for the specific first receivers (in other words the first receivers gain a consumer surplus from their mutually beneficial voluntary transaction. Mario Rizzo made this point here).
  • There is a wealth effect to some people across the economy as a whole

It is not necessarily the case that:

  • There is a wealth effect for the specific first receivers - because as Sumner points out, they are receiving the market rate for their asset.

I was prompted to look at that debate having read through a couple of old papers by Richard Wagner. One of them, (co-authored with Steve Daley), emphasises the relatiohip between the preferences of the recipients and the impact on relative prices:

"if money is injected at points where the recipients have particularly high demands for goods with relatively inelastic supply, those particular prices will rise further than they would under some alternative locus of monetary injection"

The other article is about Georg Simmel’s Philosophy of Money. Wagner argues that the essence of a Cantillon effect is that "the process of monetary injection will influence the concrete pattern of activities within a society". Whilst a comparative statics approach may dismiss the result as "mere distributional effects", Wagner argues that:

This dismissal arises out of a frame of reference where all that matters is the state of some aggregate economic variables. Yet the dynamic forces that are at work at shaping societies precisely work their way through those micro channels; the aggregate resultants are objects neither of choice nor of desire

In my "Choose your own financial crisis" I grappled with implied counterfactuals. I think a similar issue needs to be made explicit when discussing Cantillon effects. The question is: What is the implied counterfactual?

Bob Murphy was almost right to treat it as a semantic debate about what constitutes fiscal policy. The key point is that Austrian monetary economics rests on the far broader calculation debate. Cantillon effects are important not so much because of non-neutrality (i.e. a monetary reason), but because they disrupt the price mechanism. Incidently, I also think this is how to resolve Jeff Hummel's neglected criticism of ABC. He argues that Austrians have failed to clarify why they assume that monetary expansion should escalate. Whilst an ever increasing growth rate in the money supply will indeed lead to a necessary crash, why assume that a constant growth rate would inevitably escalate? I think the solution requires us to consider how new money is being spent, and the implication for economic calculation. Consider the government subsidies that went to Solyndra. There is no arithmetic reason to say that they should need to rise over time, but our understanding of the economic calculation debate tells us that it is unsustainable. The boom is unsustainable because it is an example of government intervention. Whether that should be considered monetary policy, or fiscal policy, is a separate issue. It's political economy.


M4 Lending and Divisia measures of the money supply

The last few years seems to have provided strong evidence that bank lending is not a pre-requisite for economic growth. Getting the banks to lend has been difficult, and yet the economy has been performing strongly. This is an important empirical contribution to a passionate theoretical debate.

The chart below shows two measures for M4 lending:

One possible explanation is de-leveraging - if individuals and companies are paying off debt we should expect lending to be subdued.

Another explanation is that lending is taking place outside of traditional channels. Perhaps the economic recovery has required lending, but not necessarily bank lending. Sources such as crowd funding, peer-to-peer lending or pay day loans have seemed to constitute a larger share of households access to finance (and has led to more regulatory attention to peer-to-peer lending. This economic activity should be captured in standard measures of broad money, so the argument isn't that the money supply is growing by more than official figures imply. However it is economically pertinent because:

1. It could show how changes in the composition of macroeconomic aggregates matters

2. It could show how financial innovation can reduce the demand for money (and thus increase velocity)

I'm not sure which of these avenues is most useful, and need to read more.

One interpretation is that broad money measures can mask a lot of important activity. This might lead to a greater focus on narrower measures (such as MA) or weighted measures such as Divisia. I have mentioned Divisia measures before, and here's a current look:

Whilst the growth rate for private non-financial corporations remains in the 12%-16% range, household Divisia has been steadily slowing. This is causing me to reduce the weight that I put on them - I felt that strong Divisia growth in 2013 was a sign of economic expansion, but NGDP growth tailed off (this is using series VTSR):


The interest rate should be almost 3% by now

Last year I made an estimate of the natural rate of interest, and I thought it was time to update it. Using the same methods the real neutral interest rate is currently 2.3%.

I also wanted to use this as an input to make a judgment about the monetary stance. To calculate the nominal neutral rate I used the GDP deflator (a quarterly measure of inflation expectations would be better, but I'm not aware of any). I then compared the implied nominal neutral rate with the actual nominal rate (given by Sterling Overnight Index Average, SONIA). The difference gives an indication of the monetary stance - a positive difference implies policy is too tight, a negative difference is too loose.

As of Q2 2015 the nominal neutral rate is 2.86%, and with an actual rate of 0.46% this provides a stance measure of -2.40%.

I'm holding off on providing too much interpretation until I'm more confident with the compilation method. Please contact me if you have any comments or queries. 

Note: If annual growth rates are used, the neutral rate is 1.9%:

This implies a stance of -2.43%:


Choose your own financial crisis

Do you remember those "Choose your own adventure" stories from your childhood? For some time I've intended to write one about the 2007-2008 financial crisis. I was recently invited to present a paper at the Workshop in Philosophy, Politics and Economics at George Mason University, and decided that this was the opportunity to start work on it.
It's called "Choose your own financial crisis", and here's the abstract:

On a recent trip to London you decided to visit the Bank of England museum, and played the infamous “Monetary Policy Balloon game”. In fact, you played it so well an alarm sounded and several men wearing black suits asked you to accompany them “upstairs”. You are told that the Governor, Mervyn King, has taken ill and they are looking for a stand-in. You have the high score, so they turned to you. The future of the British economy is in your hands. Academics, policymakers, the media and the general public will depend on YOU to do the right thing. But what is it? 

Many economists and economic commentators are critical of how the Bnak of England handled events, and seem to believe that things would have turned out different (and better), if only they had been in charge. For Austrian economists this presents an interesting dilemma - pervasive knowledge problems make monetary policy decisions almost impossible to get right, but surely decisions aren't all equally wrong? As a member of the IEA's Shadow Monetary Policy Committee this is something I grapple with on a monthly basis. 
The article is intended to be a bit of fun. You can download it here and I welcome comments and criticisms.
There is supposed to be a central plotline that mirrors actual events, so see if you can find it. I'm especially interested if any city economists have tried something similar. Thus far I'm staggered by the lack of explicit counterfactual reasoning and scenario analysis. But maybe I'm just oblivious.
In case you think this is a joke, I am serious about the methodological basis for this article. It is a genuine piece of economic research, building on an important tradition of counterfactual "historic fiction" and Austrian school attention to thought experiments and comparative analysis. For that reason I've also written a version that contains a methodological note.
Update: Just received this wonderfully relevant Mises quote courtesy of Solomon Stein:
It is vain to meditate what prices would have been if some of their determinants had been different. Such fantastic designs are no more sensible than whimsical speculations about what the course of history would have been if Napoleon had been killed in the battle of Arcole or if Lincoln had ordered Major Anderson to withdraw from Fort Sumter.
Human Action (1949 [1996], p. 395)
Update 2: I've turned the paper into an app. Download it hee: