In reply to Jim Devine:
<<what is meant by "neutral" with respect to interest rates?>>
I mean that the Fed would stop its search for the holy grail of the perfect
interest rate at any given moment of time. The Fed would not focus on the
bond market, unemployment, capacity utilization, or any other piece of
economic information that they think is important. The Fed would have one
purpose in life -- look at the market price of gold and act accordingly.
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<<In the usual Keynesian system, nominal interest rates are affect not only
by the money supply but also from the demand for money. Nominal interest
rates can't be lowered if there's a "liquidity trap" (if scared speculators
are willing to hold large amounts of money to avoid the capital losses that
are feared on other paper assets) or if the nominal rate approximates zero
(i.e., zero plus the premium because non-money paper assets aren't as
liquid as money). I don't see any "confusion" there with respect to the GS.
Eventually, if the economy is hitting supply constraints, pumping up the
money supply will encourage inflation (assuming that the Fed actually
controls the money supply), which would raise nominal rates again. That's
why Greenspan _et al_ restrain the money supply (or keep nominal rates from
falling). Modern Keynesianism (1) admits that lower interest rates can
stimulate the economy, as with the housing boom these days but (2) avoid
such polices when perceived "full employment" has been attained. I have my
criticisms of this view. What are yours?>>
I have created a little fable for your enjoyment.
Let's assume, for purposes of argument, a perfectly working gold standard.
In other words, there is no monetary inflation or deflation in the economy.
An ounce of gold buys you a $350 treasury note from the Fed now and forever
and everybody has complete confidence that the Fed is committed to the
benchmark. What will the interest rate be? The rate will be determined by
the market for borrowed funds, which will reflect a myriad of factors and
considerations of the borrowers and lenders, but it will not reflect any
monetary inflationary or deflationary expectations. In such a world,
therefore, there will be no distinction between the nominal and actual
interest rate. Historically, when there is a strong committment to the gold
standard, such as the 19th Century, the actual interest rate can be as low
as 1-2%, and people will buy 100 year bonds with that rate of interest.
However, the rate will fluctuate because of fiscal policy, regulatory
policy, war, revolution, technological change (but specifically not
including the inherent business cycle of capitalism), all of which will have
a complex affect on decisions to consume vs. invest, which is what
determines the interest rate.
Now, suspend your disbelief some more, and assume that the "PEN-L" party is
elected, who immediately institute a 90% tax rate on income over $100,000
and all loopholes are eliminated, which they argue will be good for the
economy. After all, rich people have a "targeted" income, and will be
willing to work extra hard to reach that income, right? And to make sure
that the rich don't evade the just and equitable tax, the capital gains tax
is also raised to 90% so that income isn't recharacterized. Now, suspend
your belief just a little bit more, and imagine that (and I know it is hard
to believe) the economy slows down immediately thereafter as rich people
stop investing and stop working, and simply consume their assets. What to
do to encourage investment? Well interest rates are, say, 5%. So Paul
Krugman, who Treasury Secretary Jim Devine has appointed as his special
assistant (and also is appointed to determine who is a mainstream economist
and who is a fringe lunatic), suggests lowering the interest rate to
encourage investment. So Jim Devine instructs the democratically elected
Fed to lower interests rates. So the Fed lowers the discount rate to 1%.
The member banks borrow as much money as the Fed will print (figuratively)
and lend it to borrowers at 3%. Therefore, the interest rate is now 3%.
Now, what is going to happen? The increased dollars are going to work their
way through the economy. There will be an immediate increase in business
activity as the first borrowers of the new dollars spend the dollars as
investment or consumption. But those dollars do not represent an increase
in assets -- they are simply an increase in the currency that acts as the
unit of account for all the "real" assets. Therefore, as the currency has
increased, but the underlying assets have not, prices are going to increase,
including the price of gold.
The moment of truth has arrived. What should the Fed do as it sees gold go
up to $355? The gold standard people will say -- "Hey, Fed! The market is
saying you are creating too much money and there is a monetary inflation!
Sell bonds and suck dollars out of the economy!" But Paul Krugman say --
"No! If we do that, that will defeat the entire purpose of increasing the
dollars. We need the dollars to be out in the economy to keep interest
rates low. Look at all the increased business activity since we lowered
interest rates."
So Treasury Secretary Devine announces that we are going off the gold
standard, which is obviously a tool of capital oppression. So the Fed keeps
pumping out the dollars, lending them to member banks, who in turn loan the
funds.
After awhile, lenders start noticing something. If they buy a $1,000 bond
from a company when gold is at $360, and receive 3% interest in a year, they
will receive back $1,030. But they also notice that in a year that the gold
price has gone up to $370, so while $1,000 in year one could buy 2.77 ounces
of gold, $1,030 in year two only buys 2.78 ounces, which means that the
lender has not made any money. The lender then figures out, notwithstanding
the easy money tumbling out of the Fed, that if he wants to receive an
actual return, he is going to have to demand a higher interest rate on his
bond to compensate for the monetary inflation.
The whole point of the exercise is a con. The actual interest rate is
determined by a myriad of factors unrelated to the money supply. The
ability of the government to "lower/increasing interest rates" is simply
shorthand for increasing/decreasing the money supply, which will not affect
the myriad of factors determining the actual rate. The increase of the
money supply can only affect nominal interest rates. Printing the dollars
will stimulate the economy, but only in the sense that a counterfeiter
stimulates an economy. There will be activity in response to the false
signal, but eventually the price increases will work its way through the
economy. The winners and losers will depend on how early in the process the
increased dollars made it through the entity.
Back to reality. Please explain what I am misunderstanding.
David Shemano
