Monetary Realism

Understanding The Modern Monetary System…

Not wanting Bad Investments does not equal Socialism

Matt Yglesias is having a problem with a column by Larry Summers:

“He’s saying that in a low interest rate environment we dare not leave investment decisions up to the private sector, which is going to just blow the money on boondoggles and white elephants—the state needs to step in and plan the economy. Socialism, in other words. But does Summers really think that? It sure doesn’t sound like something he thinks.”

Here is the problem paragraph by Summers:

“However, one has to wonder how much investment businesses are unwilling to undertake at extraordinarily low interest rates that they would be willing to undertake with rates reduced by yet another 25 or 50 basis points. It is also worth querying the quality of projects that businesses judge unprofitable at a -60 basis point real interest rate but choose to undertake at a still more negative real interest rate. There is also the question of whether extremely low safe real interest rates promote bubbles of various kinds.”

I don’t see much of a problem here. This is an entirely reasonable statement.

It’s worth stating clearly: negative interest rates involve paying the borrower to borrow money. In a negative interest rate environment, the lender is paying money to the borrower so they will borrow money.

Usually, people and companies have to pay to borrow money. You go to the bank, get a loan, and pay the entire amount of the loan back, with extra money in addition to the money you borrowed.

This extra money is a way to compensate the lender for the risk of possible default, non-payment, or delayed payments. Negative interest rates turn this relationship on its head, so that the borrower is being paid for the trouble of actually borrowing money.

You can think of negative interest rates as borrowing money, and then paying back less than you borrowed, keeping some of the money you borrowed as your own.

What types of investments have such poor future returns someone would have to pay you to make the investment? Well, risky investments with poor certainty of returns. Or possibly, investments which don’t entirely cover lending costs.

The first – poor certainty of returns – seems like a bad investment anyway, and probably not ones we should choose for our economy.

The second reason – investments which do not cover lending costs – is the definition of ponzi finance for Minsky. Ponzi finance is where the investment does not generate enough cash flows to cover lending costs, so the investment asset must go up in value to create a profitable investment opportunity. It’s the final stage before a credit bubble breaks and causes disaster.

If you are talking about the Financial Instability Hypothesis as a possible reason of what happened to cause the crisis, then you don’t want to spur anyone to make investments which are almost certainly going to cause another credit crisis.

It’s entirely reasonable for anyone – even a jackass like Larry Summers – to question what types of investments are so terrible someone needs to shove cash money into your hands so you will do the investment. It’s also reasonable to think forcing companies to take loans could lead to another bubble.

There is a case to be made that we should be giving private businesses and people money to promote investment. I’ve made this argument before. And, paying people to take out loans is a way to give people money, so let’s force them to take out loans, right?

However, if we have a choice between giving people money in the form of loans, or simply giving people cash money, I strongly prefer cash money. We do have this choice, so we should probably prefer just giving people money over incenting them to take out loans.

Making people take out loans exposes them to another problem. James Monitor hints at the problem in his latest: 

However, today we see something very different. As Exhibit 2 shows, today’s opportunity set is characterized by almost everything being expensive. As I noted in “The 13th Labour of Hercules,”2 this is a direct effect of the quantitative easing policies being pursued by the Federal Reserve and their ilk around the world.

“The Fed has been unusually transparent in explaining its thoughts on the impact of quantitative easing. Brian Sack of the New York Fed wrote in December of 2009 (bold emphasis added):

A primary channel through which this effect takes place is by narrowing the risk premiums on the assets being purchased. By purchasing a particular asset, the Fed reduces the amount of the security that the private sector holds, displacing some investors and reducing the holdings of others. In order for investors to be willing to make those adjustments, the expected return on the security has to fall. Put differently, the purchases bid up the price of the asset and hence lower its yield. These effects would be expected to spill over into other assets that are similar in nature, to the extent that investors are willing to substitute between the assets. These patterns describe what researchers often refer to as the portfolio balance channel.

Market participants have (at least until the last month) reacted to this situation by “reaching for yield” as witnessed by the more detailed fixed income forecasts in Exhibit 3. This could be described as a “near rational” bubble (inasmuch as investors are reacting to the very low cash returns, which they expect to last for a long time). I’ve described it as a “foie gras” bubble as investors are being force-fed higher risk assets at low prices.

A “foie gras” bubble! That’s a good one. I wish I had thought of it.

Still, he gets close to a problem of high asset prices. His concern in the paper is about investing – it’s hard to make money in a market where the expected future returns are very low. The problem with low expected future returns is this means there is a higher possibility of losses in the asset class, and those losses are potentially larger.

We are concerned with something other than returns – we are concerned with the stability of our economy.

You may have heard the phrase “priced for perfection”. In the investing world, this means the asset price is using the best possible scenario as the base case, and any possible negative scenarios are ignored.

I’d argue this is exactly what a reliance on excessive QE does for the market, and what paying people to take out loans does to investments. It forces them to be priced for perfection, where banks are making loans on projects which only make sense if everything works out perfectly.
Banks are smart to be unwilling to loan to projects which are close to being priced for perfection. It’s a reasonable and market driven response to the current situation. High asset prices (and the related low future returns) increase the risk of default and non-payment of loans, and banks are smart to be unwilling to make loans for these projects.
The issues of the FIH (Summers problem #2) and the balance sheet recession (Monitor problem) are related but different problems. The FIH issue relates to causing a bubble, covering cash flows for investments, and the aftermath of the bubble. The balance sheet recession problem relates to the reasonable unwillingness of banks to lend when asset prices are very high.

I think Yglesias whiffed on this one. I am not a huge Larry Summers fan for lots of reasons, but his column from 2012 is actually pretty good.




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74 Responses

  1. stone says

    I think it is important to have at the forefront of our minds that risky investments are needed but that risk needs to be enterprise risk not market risk. Its vital to avoid conflating efforts to develop a new technology with bidding up the value of overpriced pre-existing assets.
    Imagine a situation where creating a new enterprise has an equal chance of causing a 50% gain or a 40% loss. That would be a winning tactic in aggregate but would be stupid for an individual because a 50% gain does not get you back to even after a 40% loss. If everyone were repeatedly taking such risks, we would all prosper in aggregate but the winnings would all go to a few people.
    I’ve had a go posting about this:

  2. Tom Hickey says

    Thanks, JKH. Look forward to it.

  3. JKH says


    I understand the proposals are optional rather than necessary.

    You’re right on too terse. It’s a habit I have of periodically reminding myself quickly in writing of an idea that’s on the back burner. This one’s been there for a long time. I expect I’ll do a fairly lengthy post on it sometime next year.

    What I’d be getting at is that I think there’s a logical structure to the entire suite of MMT proposals – an interconnectedness – and that zero rates is the most powerful proposal of all (on the pure monetary side – i.e. apart from JG).

    In fact, I’m uncomfortable with no bonds in the absence of zero rates, which is one piece.

    So in that sense, I view zero rates as providing more integrity to the proposal for no bonds (i.e. either reserves or short bills instead of term bonds).

    But then I’m uncomfortable with zero rates for an entirely different reason.

    A bit messy to get into now.

    But they’re both very interesting ideas.

  4. JKH says

    thanks – I should probably spend additional time reviewing OMF et al in more detail as well

  5. Tom Hickey says

    JKH, I asked Warren and Scott about your comment. Not their view about the necessity of setting the rate to zero. In their view, setting the rate to zero is a policy recommendation (Warren’s), not a necessity for MMT to work. Warren says the once you understand how the monetary system works and observe the data, then you see that there is no point in interfering with the natural rate of zero where there are continuously excess rb.

    But your statement is too terse to discern your meaning. Not sure what you mean by “That’s actually the critical proposal that is required for the rest of MMT to have integrity as a ‘theory’. I think very few people are aware of this – although this is just my view on MMT.” Maybe you want to break this out.

    Scott, as usual, agrees with the operational analysis.

  6. joe bongiovanni says

    Thanks again.
    Please understand that wanting a permanent overnight interest rate at or near zero is among the few foundational policy initiatives with which I agree with Warren, my MMT adherence being limited to public purpose money – therefore, public money.
    And we rather disagree on how to achieve same.
    My preference is for the monetary authority to set adequate money metrics to achieve GDP-potential inflation-free, and those money-quantity metrics being met by fiscal-monetary actions such as Turner’s somewhat limited OMF proposal.
    I prefer the more comprehensive mechanisms laid out in the Kucinich Bill.

    With adequate money issued debt-free and in circulation to meet the demands of commerce, there is no need for an interest rate policy mechanism, whether IOR or OM operations. Private financial intermediation should establish the borrowing and lending rate of interest, which would have no effect on the real economy.

    More to your point though, is it really the OMF money-issuance initiative that causes the bloated balance sheet of the DIs at the CB? It seems, rather, the vacuous CB policy initiative itself, that of joining QE and IOR that portend the effects of an RE-lite on OMF.

    Considering that these CB policy initiatives are meant to advance the same macroeconomic goal as Turner’s OMF – this being to advance aggregate demand to its non-inflationary potential – the two systemic alternatives deserve an objective comparing and contrasting.

    Turner sees his OMF proposal as limited to the steps necessary to get the economy back on track. However, none of the originators of this policy mechanism – not Simons, Fisher nor Friedman, and especially not its originator in Frederick Soddy – saw it as working in tandem with a more limited continuation of the debt-based money system, colloquially a.k.a. fractional-reserve banking.

    Absent fractional-reserve banking, thereby absent private money-creation as debt, the observations in the ‘original’ quote would become valid. That they are not absent, and their absence not called for in his OMF proposal, I see as Turner’s Conundrum.
    Thanks for pointing that out.

  7. beowulf says

    Clinton walking into the GOP’s sucker punch is forgivable, Obama walking into the exact same sucker punch 16 years later, not so much. Obama needed to frontload his agenda, Clinton’s biggest mistake was not putting healthcare reform in the 1993 reconciliation bill and putting tax hikes ahead of stimulus. In both cases he was pushed, by Sen. Byrd to limit (filibuster-proof) reconciliation bill focused on taxes and by Fed Chairman Greenspan who conditioned interest rate cuts on Clinton cutting the deficit. Obama had neither of those constraints, Byrd had loosened up and Bernanke literally couldn’t cut rates any lower.

  8. JKH says

    ‘Reserves’ is indeed a very misleading and unfortunate term for what we’re talking about.

    So is ‘settlement balances’ for that matter.

    Basically, if the government spends money into existence, and if it does that using a private banking system as the intermediary, then the banking system is going to end up with bloated deposit balances (also called reserves or settlement balances) at the central bank.

    And if the central bank wants to manage interest rates proactively, it has to pay interest on reserves. And that basically makes reserves not much different from interest paying government debt.

    And that’s why the most important proposal that MMT/Warren Mosler has is a permanent interest rate of zero.

    That’s actually the critical proposal that is required for the rest of MMT to have integrity as a ‘theory’.

    I think very few people are aware of this – although this is just my view on MMT.

    But if you assume that, then what you’re saying starts to fall into place.

  9. joe bongiovanni says

    Thanks a lot for the explanation.
    I see the gist of the original quote as pointing out the ‘permanent’ nature of using newly-created money to finance government deficits: as OMF.

    As permanent money, OMF avoids, or evades, the claims of either the crowding-out or RE antagonists. They are simply not an issue as an ‘offset to stimulus’, as the funding source for OMF is neither debt nor taxes. I would agree with that statement, as far as it goes.

    Importantly, you say that ‘because’ the BS effect at the CB is to increase (excess) reserves, and, therefore, the present IOER policy requires ‘an offset to stimulus’ equivalent to that IOER cost – so like one-quarter of one percent of the stimulus, again if I am understanding correctly.

    I’m still trying to figure out why that needs to be the case with OMF funding.
    But, even if so, IOER is a policy initiative that may or may not exist in the future, and all of the OMF funding has a hidden “P” integrated (as OPMF) which makes the fiscal stimulus ‘permanent’.
    IOW, being permanent money obviates the need for any reserves for any CB policy purpose, and perhaps the accounting results from OMF financing should be to decrease, rather than increase, the bank’s required reserves. TOL.

    We operate under a system where all money additions add to reserves.
    But that system itself is a throwback to the gold standard and the use of gold as reserves, a system designed to provide an operating mechanism for the debt-based system of money, where all money comes into existence as a debt issued by a bank. It is antiquated.

    Permanent debt-free money financing of fiscal deficits should not require any reserves. What is there to ‘reserve’ against?

    “The cost of the term structure component is a valid point, but reserves will still require a non-zero rate when the central bank moves off the zero bound.”

    This statement, while both true and realistic, should also provide pause to the paradox of that which comes to the surface in consideration of the public policy initiative of debt-free money. What should be the cost of a permanent term-structure component?

    Thanks a lot.

  10. Philip Diehl says

    You’re definitely on to something, beo. I was Treasury liaison with the WH in the first eight months of the Clinton administration when so much went wrong. He and the WH youngsters had so little DC experience they were bound to have a rocky beginning. But coming from a small southern state and knocking off an incumbent, war-winning president everyone said was unbeatable, that went to their heads.

    Clinton was a monster AA hitter. But in AA he had feasted on fast balls. When he jumped to the Show, he found himself flailing at cutters, sliders, and 67 mph curve balls. But the boy was smart. He adjusted and hit Gingrich’s spitball into the mezzanine.

    I wasn’t as young as the WH kids, but I might have made some of the same mistakes, except I had spent two years with Lloyd Bentsen, who learned DC as a protege of Sam Rayburn. I can tell stories of him calling in his senior staff to give our advise on how he should vote on the Persian Gulf war resolution and the Clarence Thomas nomination after the Anita Hill explosion. He listened as we all gave him basically the same advice. Then he did pretty much the opposite. It didn’t take long for us to see he was right.

    All those years of experience were irrelevant to Clinton and his entourage, and we paid the price: the loss of the House in the “Gingrich Revolution” which led to the GOP we know and love today.

  11. beowulf says

    “But no matter who was Tres Sec, O never would have rocked the Wall Street boat in 2009. ”

    Yeah, and that’s probably why he didn’t pick Bra– I mean, Volcker. Tall Paul would have insisted on kicking the thieves out of the temple and wouldn’t hesitate to resign if the President overruled him (which would have been calamitous politically). Obama didn’t want that kind of trouble.

    I have this theory that Democrats tend to nominate their presidential candidates a cycle too early and the Republicans nominate theirs a cycle too late. Carter, Clinton and Obama would all probably done better running for show, or even better, serving as VP before winning the WH (though Clinton was a damn fast learner). On the GOP side, Reagan, Bush, Dole & McCain all lost a step physically or mentally between their penultimate run (76, 80, 88, 00) and winning the nomination (80, 88, 96, 08). Poor Al Gore, if he were a Republican, as a two term VP losing a close race, he’d come back and win the WH 8 years later (which is, after all, what Nixon did).

  12. beowulf says

    “b) Start commenting in the posts (through admin)”
    This. Also, if Philip wants to post here, we can set him up with admin acct as well.

  13. JKH says

    OK, so to get in on the fun with greater intensity and focus, the two options I see for myself are:

    a) Start posting in the comments
    b) Start commenting in the posts (through admin)


  14. JKH says

    Irrespective of how one feels about the integrity of Ricardian equivalence as an idea (and it’s a very questionable idea), the quote suggests that Ricardian equivalence if true is a function of interest bearing debt.

    But money financed deficits require the creation of excess reserves, which requires payment of interest on reserves, especially when the central bank lifts rates off the zero bound.

    The only significant difference is the term structure of interest rates on debt versus a presumably short term rate on IOR, mirroring the fed funds target. The cost of the term structure component is a valid point, but reserves will still require a non-zero rate when the central bank moves off the zero bound.

    So my point there was that you can’t falsify (or neutralize) Ricardian equivalence with that sort of argument.

    The general case for Ricardian equivalence is arguably falsifiable, for a few reasons and depending on interpretation, but not with that argument. So I suggested that such a false argument attempting to falsify (or neutralize) Ricardian equivalence is a kind of Ricardian bewilderment.

    I think the crowding out argument is a bit separate, but also falsifiable, if based on purely monetary considerations as opposed to real considerations – and money financed deficits versus bond financed deficits should have no bearing on that either.

  15. Philip Diehl says

    Ha! Both an apt and a disturbing analogy. I think Geithner probably had the job on his first meeting/interview with Obama. They’re very simpatico. Volker is old school and hot. Geithner is O’s age and cool. But no matter who was Tres Sec, O never would have rocked the Wall Street boat in 2009.

    Clinton brought Bentsen in as his eminence grise and then used him as a Senate lobbyist. Obama didn’t feel the need for one at all.

    I would have had Simon Johnson and Krugman on the short list along with Volker. Geithner did not fit the Team of Rivals O professed to be his model. In fact, who on the cabinet fits that model?

  16. Philip Diehl says

    Cool! Damn, that’s a big number.

  17. Michael Sankowski says

    Congratulations Philip – that was our 13,000th comment here at MR! :)

    Thanks everyone for making this blog what it is! The comments section is where the real action is at MR.

  18. beowulf says

    Did you read Ron Suskind’s fantastic book Confidence Men?

    Larry’s re-appt to Tsy apparently was waylaid by Hillary Clinton accepting State. Obama didn’t like the optics of having another Clinton retread in his cabinet. The astonishing thing is that when forced to pick a Tsy Sec from between Paul Volcker (who very much wanted the job) and Tim Geithner, Obama decided Geithner was the man for the job.

    The closest analogy I can think of to as to how terrible a decision this was (whether on the metric of experience, public reputation or basic competence) would be if, tomorrow, Bill Belichick announced he was benching Tom Brady and naming Tim Tebow as New England’s starting QB.

  19. Philip Diehl says

    Do you think there’s an implied comparison here?

    HAMILTON: Yellen as a person. “Yellen is brilliant and tough. She displays this not by needing to prove to you that she’s the smartest person in the room, but instead by always asking the right questions. If someone disagrees with her, her first instinct is not to try to bully them, but instead to try to understand why they have reached a different conclusion than she has. Because of this attribute, Yellen is one of the people I would trust most to be able to sort out what the key problems are and what needs to be done in any new situation.” James D. Hamilton on the Econbrowser blog.

  20. joe bongiovanni says

    I know your comment was responsive to MS, but are you quoting Turner there, and can you say why ‘interest on reserves’ is relevant to either the notions of ‘crowding out’ or RE, or in any way as an ‘offset to the OMF proposal ?
    The quote seems to be parrying against these knee-jerk responses being raised, simply because no debt is issued and no taxpayer funding required.

  21. Philip Diehl says

    USPS is a good example. In the 1980s Reagan and the GOP Congress ended the USPS monopoly on package delivery, handing the business to their GOP allies, the founders of UPS and FedEx. I can’t remember their names.

    There were some good things that came out of this. But it set off an inevitable deterioration of USPS service and finances. Since the 19th century, USPS had provided universal mail service wherever you lived, subsidizing higher-cost rural package delivery and rural and urban mail service with profits from urban package delivery.

    As soon as the market was opened, UPS and FedEx cherry picked the lowest cost urban package market and then began a relentless devouring of the next lowest cost markets as they tapped economies of scale and scope. USPS was forced to return to Congress repeatedly for increases in postal rates, each time giving the GOP an opportunity to pillory the postal unions, who they blamed for deteriorating service and rising rates. 20 years earlier they wouldn’t have gotten away with it because the postman was a person who came to your door. No more. With the change in American lifestyles, mail delivery became anonymous and USPS lost its human face for most Americans.

    I actually ran the numbers on this a few months ago but I don’t have them at hand. Adjusted for inflation, since the early 1980s the cost of 1st class mail has risen very modestly, the cost of package delivery has fallen substantially, and the earning of postal workers has fallen.

  22. Philip Diehl says

    Ha! Yes, maybe Marie was following “her” own advice about letting them eat cake. Do the Asians even eat cake?

  23. JKH says

    “But unlike the funded fiscal policy stimulus considered in Section 6, the stimulative effect of a money financed increase in fiscal deficit will not be offset by crowding out or Ricardian equivalence effects, since no new interest bearing debt needs to be publicly issued, and no increased debt burden has to be serviced in future.”

    Overlooks interest on reserves.

    Presumably those who believe in Ricardian equivalence should also believe in the market’s ability to figure out how a central bank balance sheet works.

    Or should we call that failure Ricardian bewilderment?


  24. beowulf says

    He’s tight with Brad DeLong who’s been moving in that direction the last few years.