Theory of Constraints and Monetary Policy

It has already been a few years, but I wrote a very brief post about how the Theory of Constraints seems to hold when thinking about the economy. My point as stated was the economy seems to shamble along and grow until it hits some form of constraint.

I wasn’t very clear in the post, didn’t really go into how different constraints might work or play out within the economy.

Monetary policy is based around an entirely different view of the economy. In this view, all constraints facing the economy can be overcome or strengthened by changing the price of money. In this view, any possible constraint facing a decision to borrow money can be influenced by the price of money-  in short, there is always some price at which banks will lend out there money, always some price where businesses will want to borrow money.

But this doesn’t seem to be realistic at all – many businesses will not borrow money to expand no matter what the price of money is, where real estate lending is extremely sensitive to changes in the interest rate. In addition, for many mid-sized businesses, their willingness to expand their footprint and do real estate deals is very sensitive to their medium and long term business expectations.

So we have a few constraints operating within just the realm of monetary policy operating at the micro level. Some of these roll up to the macro level and can be summed up across an economy, but there seems to be other emergent behavior for the economy as a whole which is not driven by individual businesses.

For example, people are debating negative interest rates right now. As Steve Randy Waldman pointed out, debt is the stickiest price, as it is a nominal price and doesn’t change for long periods by contract. What happens under negative rates is lenders pay borrowers to borrow money from them. You can talk around this basic fact, but in the end, you have lenders paying out money to borrowers over time.

There is no way this can make sense across an entire economy, unless there is some constraint which is outside of the normal constraints facing businesses. “Hey borrow this $10 from me, and then I’ll give you $.50 a year, and then pay me back in 5 years” is something no rational person ever thinks. People who are offered deals like this would take this deal. Bankers offering this deal would be insane.

Yet, people are not borrowing, and bankers are trying to lend at terrible rates. This means they are both insane.

In my experience, some people will act insane some of the time. But in general, bankers and entrepreneurs as a group will not act insane in their business transactions. So the constraint on lending can’t really be a constraint related to borrowing and lending money, it has to be some other part of the economy saying “No, this doesn’t work”.

Is the constraint related to balance sheet effects? Is the constraint related to lack of business prospects? In any case, we can be relatively certain there is no real level of monetary policy moves we can do which would solve the constraint.





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15 Comments on "Theory of Constraints and Monetary Policy"

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Richie D

Nothing wrong with the system.
– Globalization drives a disparity in income within countries*
– Surplus of loanable funds from the very rich results in driving interest rates down
– low rates drive debt accumulation
– businesses seeing increased consumer debt from the very poor forecast poor sales in the future when debt has to be repaid (even though profit margins and sales are booming currently)
– to prepare for the future, businesses begin cutting costs now, including labour costs, by laying off workers even while profits are at record highs
– Businesses then see even greater risk from debt default as unemployment increases, which leads to even more cuts
– growth prospects dim as the very rich continue to save and businesses cease investment due to the very poor being seen as only ‘temporary’ customers pending default
– to maintain national growth and prevent a crash that will destroy wealth a small premium is paid to ‘coerce’ maintenance of income re-distribution via debt.

in previous times money was redistributed through
Internal trading and taxation (+government spending) in a closed economy
Inflation in a global economy (tax on lenders)
War that limited global enterprise and led us back to redistribution via point number one (note the current rise of politicians speaking to discontented masses with an ‘us’ against ‘them’ message)

With inflation being enemy number one in the current economic thinking and globalization at an all time high, those mechanisms are not in play. War intense enough to disrupt globalization has been avoided to date leaving only the monetary ‘coercion tax’ on lenders to enable re-distribution.

* There is significant work on globalization driving income disparity within countries and income equalization across countries.


Very nice Richie

Id say you have the narrative just about right


Only thing I’d quibble with is notion of “loanable funds from the rich” but overall a minor quibble.


You are channeling Liebig, arn’t you?
I have read your general post and if this doesn’t remind me of the relationship of plant growth and nutrient availability, nothing does…


As a business owner, I will certainly not expand my business simply because money is cheap. There has to be a prospect for business returns, which the low rates do not guarantee. All they do is lower the theoretical cost of capital on an investment decision, but I am personally not going to spend and expand to earn a low rate of return simply because my hurdle rate has been artificially lowered. Private businesses consist of illiquid assets. What happens when the Fed reverses policy and I have made medium to long-term investments upon a manipulated cost of capital? However, easy money might keep competitors in business who might otherwise have disappeared, thereby lower margins and rates of return within the industry.

As an investor in financial assets (including real estate), lower rates can in fact affect my behavior. But the contrast between my actions as a business owner and private investor is exactly the flaw of Ivory-tower conceived monetary policy. Extreme actions by central banks encourage speculation and divert “investment” from capital formation to capital markets. This is exemplified by public corporations utilizing the capital markets to buy back stock as opposed to fund business growth.

If you look at the composition of the Federal Reserve, it is comprised almost entirely of academics. A generation ago, businessmen and traditional bankers were MUCH more prominent. I think that it is no accident that the Fed seems baffled by the ineffectual nature of their actions, given that few have any real world experience.


. “Hey borrow this $10 from me, and then I’ll give you $.50 a year, and then pay me back in 5 years”

This might not be insane in a scenario where the lender is a banker, and his only other option is to pay a tax on his reserves (negative rates) which is even more than $.50

joe bongiovanni

uummm……. because the bank can lend those reserves and get the vig on the over fifty cent tax?
just curious as to your thinking.
Also because so little discussion on the arithmetically-evolving NIRP phenom.
Maybe the money system is broken.