I have a funny way of relaxing. For the past few days when childcare duties have allowed I have spent an hour or so a day reading Mishkin’s “The Economics of Money, Banking and Financial Markets”. It is a fantastic introduction to the topic of money, and useful signpost to the significant works of the past: the scaffolding of Fisher, Keynes, Tobin, Friedman and beyond upon which the theories are built.
There is plenty in the book about interest rates, how they are determined, their relation with other economic variables, their effect on activity. But if there is one lesson to be taken from the study of Mishkin, it is that analysing monetary or even financial conditions purely through the workings of interest rates is extremely incomplete, at times misleading, and often plain wrong. The most obvious is through ignoring the Fisher relation: how growing incomes means higher rates: Scott Sumner and others have been emphasizing Friedman’s observation about tight money meaning low rates for as long as they have been blogging. Within government, that ugly term “monetary activism” always translates into “lowering interest rates for someone or other”, a terrible misapprehension, wrongly equating monetary with credit policy, and usually leading to the Treasury trying to dress up essentially fiscal interventions like Help To Buy as “monetary” policy.
Bob Hetzel in his great volume observes (Kindle location 6653) that 80 years ago they understood how the central bank does monetary policy, you create the Reconstruction Finance Corporation if you want credit policy. I am not convinced most of the UK’s Treasury gets this difference – or they think it is a purist eccentricity of the Bank.
But what I think is most annoying is that by removing the question of “money” from the story you undermine a common-sense narrative of how economic distress and recessions occur. I have seen it closer with a large industrial concern in distress. People run out of money. Suppliers demand earlier payment. Customers start dragging their feet in paying up. Assets become harder to sell. The need for an equity infusion or bond sale grows. And, yes, they start having pleading conversations with their banks, hoping for a credit line: because they need MONEY.
Money becomes tight for the entity in distress. Everyone around them starts preferring to hold something solid and reliable – a cash balance with a good bank, say – over something more remunerative and uncertain – working capital, say. When everyone is feeling this way, and the problem becomes general, you have a macro-economic event brewing.
You can tell the entire story without interest rates at all. Sure, there will be interest rate effects. A bank will want a higher rate to lend to a firm in distress. But the rate is an epiphenomenon of the underlying problem – a lack of the right liquid assets. Not enough money …
And the Bank of England gets this! Look at this publication about Macroeconomic Uncertainty. How is uncertainty expressed? Table A: Households uncertain about labour income. Firms uncertain about sales. These are quantitative uncertainties – not about the future price of credit. When someone came in to BIS to present this result, and showed how expectations of future nominal income are the indicator of uncertainty, I asked, naively, “SO why don’t you try to give forward guidance on that, hmm? Why all this forward guidance about interest rates?”*
To tell the story of a period of economic distress like 2008-10 or even 2011-12, you need to talk about risk, about growing uncertainty about future incomes, about “animal spirits” if you like. Talking about interest rates confuses people – after all, interest rates for the sterling area fell from mid 2011 to end 2012, when uncertainty and economic weakness grew worse.
All of these are in the various theories of money. I think macro debates need lots of little stories told (like Mark does on this excellently named blog) rather than lots of models written. Just because things get far trickier at the zero lower bound, is no reason to ignore the stuff that makes the world go round.
*his answer was to blather on about how we don’t know what productivity might do so we should just stick with inflation.