Liquidity Preference, Loanable Funds, and Interest Rate Spreads

Paul Krugman:

The Obstinacy of Error, Interest Rates Edition - NYTimes.com: Brad DeLong reposts something he wrote two years ago about interest rates; it was, I think, at least in part a followup to my slightly earlier post on liquidity preference and loanable funds.... The economic argument for [interest] rates staying low [in spite of enormous government deficits]... wasn’t complicated: it amounted to saying that the IS curve looked like this:

and that there was no reason for the interest rate to rise, even with large government borrowing, unless that borrowing shifted the IS curve enough to the right to bring the economy above the zero lower bound.... [H]ere we are, two-plus years later, and the interest rate on 10-year U.S. Treasuries is only 2.94 percent. This should count as a triumph of economic analysis: the model was pitted against the intuitions of practical men, making a prediction many people considered ridiculous – and the model was right. And nobody noticed; economic discourse – and even a lot of investment strategy — continues to rely on the supply-and-demand-for-bonds view, even though it has been thoroughly discredited by experience.

How is this possible?

One answer is that the Greeks muddied the waters. The solvency problems of the Greek government actually have nothing to do with the notion that we’ll face crowding out because the government is selling too many bonds, even with the economy depressed; but many of the original crowding-out prophets nonetheless seized on Greece and claimed that it vindicated their views. More broadly, I guess it turns out that Hicks/Keynes analysis is harder than it looks, and that even smart people – many of them with economics PhDs – just can’t wrap their minds around the notion that sometimes just doing supply and demand isn’t enough. The result – that one theory has been proved wrong, another proved right, yet the world continues to believe in Theory #1 – is frustrating. It’s also tragic, because that intellectual obstinacy is contributing to the “new normal” of permanently high unemployment.

The Hicksian liquidity-trap model that Paul is working in (and that I find myself working in these days, almost in spite of myself) is about the simplest possible general equilibrium model with three goods: money M, bonds B, and currently-produced goods and services on which people spend their incomes Y.

It has two equilibrium conditions.

The first is that the level of total economy-wide spending Y and the interest rate i on bonds must be such as to make people happy to hold the economy's current stock of safe liquid cash--of money M:

M = L(Y, i)

with the proviso that if the interest rate i on bonds is very low people may be happy holding enormous amounts of money M even if the economy-wide level of total spending Y is low.

The second is that the interest rate i and the level of total economy-wide spending Y must be such as to make people happy to hold the economy's current stock of financial assets--bonds B plus money M--so that planned spending on currently-produced goods and services is equal to income.

B + M = S(Y, i)

If spending is less than income, inventories are piling up and firms are firing people and cutting prices--and so spending is shrinking. If spending is more than income, inventories are being drawn down and firms are hiring people and raising prices--and so spending is growing.

Three commodities--currently-produced goods and services, safe short-term nominal bonds, and liquid cash money. Two equilibrium conditions--that the amount of money some people wish to trade for bonds must be equal to the amount of bonds other people wish to trade for money, and that the amount of financial assets people want to hold is equal to the amount of financial assets in existence. Two adjustment processes--that the interest rate adjusts instantaneously to clear the money-bond market and that spending adjusts over a longer period to clear the financial assets-currently-produced goods and services market.

And from this the conclusion follows: as long as the central bank is keeping the money stock M high enough to keep you at the zero-lower bound where the interest elasticity of money demand is well-approximated by +∞, fiscal expansion--having the government print more bonds B and spend the proceeds on currently-produced goods and services--raises Y and has no effect on i.

Note that it is not just the ignorant, the uncurious, and the slow-of-thought among economic Ph.D.s who do not buy this argument: who cannot believe the argument that more expansionary fiscal policy is what the world needs right now. Why, just yesterday it was IMF chief economist Olivier Blanchard, smarter than whom on these issues there is nobody alive--who taught me this stuff--who wrote:

Department of "Huh?!": Speed of the Recovery Edition - Grasping Reality with Both Hands: Policy inertia is not an option. This is especially true in the advanced economies.... Fiscal repair is also essential. A key priority for advanced economies is to continue the process of fiscal adjustment that most of them initiated.... [T]he US and Japan... have not yet started along this path. They should put in place as soon as possible credible consolidation plans that are specific in terms of not only goals, but also the tools to achieve them. The pace of fiscal consolidation should be set with a keen eye on growth and employment. Too slow will kill credibility, but too fast will kill growth...

Olivier is, implicitly at least, working with a more complicated model than Hicksian IS-LM. Let us see if we can figure out what it is...

The first thing to notice is the bonds in Hicks's setup: Hicks assumes that the bonds are short-term safe nominal bonds. Or, perhaps, Hicks assumes that all the bond spreads--the expected inflation spread between nominal and real interest rates, the default spread, the risk spread, and the term spread--are constant. This matters: the interest rate that clears the money-bonds market may well be the short-term safe nominal interest rate that is Hicks's i; but the interest rate that clears the financial assets-spending market is pretty clearly a long-term real risky interest rate--call it r.

So let's introduce a wedge between i and r--plotting both i and r on the vertical axis of our IS-LM curve. Then we can at least start to see what worries Olivier. We start here, at a low level of spending and at the zero nominal interest rate bound with a wedge between i and r:

We do another round of expansionary fiscal policy and wind up here, worse off than we were before:

Why? Because the printing-up of extra government bonds to pay for the wave of expanded government spending has cracked the government bond's status as a safe asset and thus greatly diminished the market value of financial assets. Because bondholders don't want to hold risky assets but rather safe financial assets--they price risky financial assets at an enormous discount--and with the shift of medium- and long-term government bonds from the safe asset to the risky asset box, spreads spike. And as spreads spike and the market value of government and corporate bonds collapse, the economy finds itself not with abundant financial assets but with a shortage of financial assets, and so spending Y does not rise but falls.

Could happen. Happened in Austria in 1931. This is the argument of Reinhart and Rogoff: that in the aftermath of a financial crisis the economy is on the verge of a sovereign debt crisis, and fiscal consolidation is essential to avoid fear of such a sovereign debt crisis take hold--for once markets begin to fear that there might be such a crisis the fact of such a crisis is inescapable.

From the Reinhart and Rogoff--and the Blanchard--perspective, the question is not: "will further fiscal expansion crack the status of the government bond as a safe asset and cause an explosion of spreads?" It will, someday. The question is: "when will further fiscal expansion crack the status of the government bond as a safe asset and cause an explosion of spreads, and why hasn't it happened already?"

And, indeed, the global market's willingness to swallow unbelievably large tranches of U.S. government debt without a burp is extraordinary: