An excerpt from Chapter 5 of Can Heterodox Economics Make a Difference, published by Edward Elgar in 2020. Here is a link to the Table Of Contents, and a link to the biographies of all those interviewed for the project.
“[Then] there is the question of whether central banks should intervene by controlling the yield curve. … [My] answer is yes and, I would go further. Central banks should control the price of a basket of risky assets. Policies of this kind are not currently in the remit of the Bank of England or the Fed. But they should be. I remain optimistic that my work is leading them in that direction.”
PA: Are you familiar with the credit and state theories of money?
RF: Peripherally. I’ve been following a debate going on right now on Twitter. Some non-mainstream economists, Jo Michell at Bristol is an example, have been critical of textbook theories of money.
You gave us a set of questions we would discuss in this interview. I laughed when I saw question 7 which reads, “Do you consider the quantity of money to be determined exogenously or endogenously?”, to which my answer is “Yes.” Here’s what I mean by that.
I’m a general equilibrium theorist, in the sense that I want to conceive of the things I observe in the macroeconomy – this comes back to methodological individualism – as choices made by individuals in markets. To answer the question of exogeneity, you have to ask, first of all, what money is. That’s a hard question and there are many different ways of thinking about it. If you go back to worlds where there were commodity monies – gold and silver – it’s quite clear that the quantity of money was exogenously determined. At a point in time, the quantity of precious metals is fixed. There have always been trading mechanisms, trade credit for example, whereby other objects would serve as a medium of exchange. In today’s world where gold and silver have been replaced by fiat money provided by national governments, the distinction between exogenous and endogenous money depends very much on the policies that central banks follow.
I’ve never understood the criticism of traditional monetarist thought by advocates of modern monetary theory. Orthodox monetary theorists, and here I would include most of the New Keynesians, would agree with the statement that money is endogenous in modern fiat money systems when the central bank pegs the interest rate on short-term debt. But there is a sense in which asking if money is endogenous is the wrong question. The right question is: what determines the absolute price level? Here there is an active debate centred around the question of uniqueness, or non-uniqueness, of equilibrium in macroeconomic models. In all models where the central bank sets the interest rate, as opposed to the quantity of bank reserves, the quantity of money is endogenous.
Let me return to the question; what is money? A bank is an institution that allows many more objects to be used in exchange than in economies that don’t have banks. In that sense, private banks create money.
If you hold shares in Apple and you go into a car show room and you try to buy a new Honda by offering them shares in Apple, you’re not going to be very successful because the value of the shares in Apple fluctuates on an hourly basis and nobody really knows quite what they’re worth. Now, imagine an institution – a bank – that lends to firms and households. The bank holds liens on machines and factories to back its loans to firms and it holds liens on houses to back its loans to households. The banks acts as a guarantor of the value of these assets.
Take the example of a mortgage. You go to the bank and you borrow money for a mortgage on your house. The bank manager (at least in the past) knew who you were and had a relationship with you and realised that you were capable of repaying the mortgage. The bank manager’s guarantee turns your house into a negotiable asset that appears on the liabilities side of the bank’s balance sheet and the account that is created by lending you money can then be used in exchange. In that sense, banks create money.
Bank lending is profitable because the interest rate earned on long-term loans is higher than the rate that banks must pay on their short-term liabilities. The quantity of money that banks create is limited by the need to hold cash and other liquid assets to meet the needs of their customers. The amount of available liquid assets is limited by central bank actions that control the price of credit by buying and selling assets in the markets for short-term funds. Before the 2008 financial crisis, cash and bank reserves did not pay interest, but short-term government bonds did. In that period, there was a positive opportunity cost of holding money.
Since the financial crisis of 2008, the interest rate on short-term liabilities has been very low and, in some cases zero. And central banks began to pay interest on reserves. In that environment reserves, which are part of the monetary base, become perfect substitutes for short-term government debt and theories of endogenous money come into their own. When the opportunity cost of holding money falls to zero, monetary general equilibrium models have even less to say about the determination of the price level than they do when money is scarce.
When the interest rate is zero, money and bonds become perfect substitutes and there is a continuum of price levels and a continuum of associated values for the stock of money, all of which are equilibrium values in a monetary general equilibrium model. In those environments, the supply of money is determined by the public’s perceptions of future prices. Beliefs become fundamental in the way I described in my books, The Macroeconomics of Self-Fulfilling Prophecies (Farmer, 1993), Expectations Employment and Prices (Farmer, 2010) and Prosperity for All (Farmer, 2016).[1] The same phenomenon occurs when the central bank pays interest on reserves. Although cash is still costly to hold, cash is a shrinking component of the monetary base. When the interest rate on reserves is roughly equal to the interest rate on Treasury bills, the economy is in a liquidity trap similar to the one that characterized much of the period in the 1930s in the United States. The payment of interest on reserves puts us in a whole new world.
PA: I think your interpretation [of monetary theory] is thought-provoking…. I might go slightly away from the original script to a question that’s very interesting from my perspective: when you talk about equilibrium, do you see it as an ‘ultimate end’ of a tendency, like a point that a force that will take you towards but may not actually reach? Or is it a set point that things adjust to and what would be the adjustment speed of the pathway?
RF: To answer that question, let me use the concept of temporary equilibrium theory.
PA: …I think it’s called a ‘traverse’, the idea of how quickly you get there, what happens on the way.
RF: Indeed. In the temporary equilibrium story, we all meet in a market every Saturday. When we meet, there must be a mechanism to determine what gets traded. That could be Walrasian market clearing, it could be sticky price equilibrium, or it could be some version of search theory, for example, ‘Keynesian Search Theory’, a term I coined in my book Prosperity for All. On Saturday we observe the trades that take place, we observe the prices that take place, and we record those trades as a list of numbers on an Excel spreadsheet. Now, if nothing in the world ever changed, our models predict that the list of numbers we record will converge to a constant list. I would call that a steady-state equilibrium. A physicist would simply call it an equilibrium.
The reason that these uses differ is that the word ‘equilibrium’ in economics is used to mean a Nash equilibrium, which is a set of plans and prices that are consistent with each other in a sense that was made precise for temporary equilibrium models by Roy Radner (Radner, 1972). In a Nash equilibrium, the values of the list of numbers in the Excel spreadsheet may be changing from one period to the next. What qualifies them as ‘equilibrium numbers’ is that at each point in time the numbers record prices at which the quantity of each good demanded is equal to the quantity of each good supplied.
PA: You’ve really answered the question about banks, so how would you consider interest rates to be determined in theory and practise? Do you think there’s a disconnect between theory and practise?
RF: Well, there’s at least one interest rate that’s set by central banks, which is the overnight rate. Then there’s a whole spectrum of interest rates that are determined in markets. Traditional monetary theory argued that central banks could control only one interest rate but, in the 2008 financial crisis, central banks appeared to exert influence over a whole range of rates. So, in that sense yes, there was a disconnect between traditional monetary theory and practice.
PA: Would you consider that the central bank could control the spectrum of rates? I’m not saying it should, but if it wanted to, would you think it a feasible thing?
RF: OK, those are two separate questions. I have never subscribed to traditional monetary theories that are set in the context of a single representative agent and in all of my work, central banks can control a whole spectrum of interest rates at different points in the yield curve.
Second; there is the question of whether central banks should intervene by controlling the yield curve. Again, my answer is yes and, I would go further. Central banks should control the price of a basket of risky assets. Policies of this kind are not currently in the remit of the Bank of England or the Fed. But they should be. I remain optimistic that my work is leading them in that direction.
[1] See my entry in the Oxford Research Encyclopedia of Economics and Finance on ‘The Indeterminacy School in Macroeconomics’ (Farmer, 2020). The Indeterminacy School is an approach to macroeconomics that was initiated at the University of Pennsylvania and at CEPREMAP in Paris in the 1980s. It has continued to evolve over the last forty years. The identifying feature of the Indeterminacy School is the willingness to embrace models with multiple equilibria to explain real world phenomena.