INTEREST RATE OPERATING PROCEDURES AND INCOME DISTRIBUTION. John Smithin York University

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1 DRAFT OF DECEMBER 2003 INTEREST RATE OPERATING PROCEDURES AND INCOME DISTRIBUTION John Smithin York University Department of Economics and the Schulich School of Business, York University, Toronto, Canada, M3J 1P3 tel: +1 (416) ext , fax: +1 (416) ,

2 Interest rate operating procedures and income distribution John Smithin, York University Introduction One of the more remarkable features of the orthodox theory of monetary policy in recent times is the extent to which it is now recognized that monetary policy decisions have to do mainly with the setting of interest rates rather than the nominal quantity of money per se. This is exactly the opposite of the orthodoxy of a generation ago, which held not only that the manipulation of interest rates was an undesirable policy, but also that it was in some sense an unattainable or impossible goal, because it would lead to the indeterminacy of the nominal price level (Sargent and Wallace 1975, Sargent 1979). Such views have had to yield over time to the practical realities of the way monetary policy is conducted, and Friedman (2000) has expressed this point as follows: 1 [in the late 1960s] the Federal Reserve, like most central banks at that time, conducted monetary policy by setting interest rates. The same is once again true today. In retrospect, much of the intervening experience proved to be a historical detour. In many ways, of course, this change of stance reaffirms the position of the Post Keynesian horizontalist school who had made the same argument much earlier (Kaldor 1982, Moore 1988, Lavoie 1992). However, as discussed by Lavoie (2004) and Setterfield (2004) there is little reference to this current of thought in any of the contemporary mainstream literature on the "new consensus" in macroeconomics. Further, it is unlikely that this reversion to an interest rate focus was a particularly welcome development from the point of view of mainstream or neoclassical economic theory. One of the most important aspects of the latter is its performative role (Searle 1995, 1998) in attempting to 1

3 persuade the public, via an essentially technocratic style of argument, that policy decisions seeming on the face of it to favour one class or group of income recipients at the expense of another are in fact to the benefit of the whole society. This is evidently the role of such concepts as inflation targets, the NAIRU, 2 natural rates of growth and interest rates, balanced budget norms, etc. It would seem to be a problem for this project, however, if achieving these goals directly involves changing interest rates. This tends to give the game away in a fairly obvious manner. The impact on income distribution, and specifically on the share of the rentier or financial interests, is immediately apparent. The purpose of this chapter is to pursue these themes via a more detailed examination of one of the most popular descriptive accounts of contemporary interest rate operating procedures. The reference is to the so-called Taylor rule, after Taylor (1993), which by now has become a key component of the new consensus (Taylor 2000). In addition to its descriptive characteristics, some writers have also claimed optimality properties for such a type of central bank reaction function. However, in this chapter an alternative and very simple benchmark for the setting of interest rates is suggested. A version of the Taylor rule One version of the Taylor rule, as expounded, for example, in the textbook by Lewis and Mizen (2000), is as follows: (1) i(t) = θ0 + θ1[y(t-1) θ - y*(t-1)] + θ2[π( [π(t-1) - π ] + (θ3)π( )π(t-1) 2

4 where i(t) is the policy-related interest rate (a nominal interest rate), y(t-1) is the logarithm of the most recently observed level of real GDP (that is in t-1), y* is the logarithm of the supposed natural rate of output in the same period, π(t-1) is the most recently observed inflation rate, and π is the chosen inflation target. The coefficients θ1 and θ 2 are the weights to be applied by the policy-maker to the deviations from the inflation and full employment targets respectively. Meanwhile, θ0, on a conventional understanding, must be the equilibrium real interest rate (Lewis and Mizen 2000). This corresponds to what Wicksell (1898) called the natural rate of interest. The remaining coefficient on the right-hand side of equation (1), that is θ3, is placed in brackets. This is because it seems to be common ground on all sides that its value should be θ3 = 1. 1 Τo avoid outright inflationary instability (Moore 1988, ch.11, Smithin 1994) it is usually agreed that the Taylor rule or equivalent should be written in real terms, with the term π(t-1) explicitly serving as proxy for expected inflation (Taylor 1993). If this is the case, then in theoretical principle the Taylor rule is actually: (2) r(t) = θ0 + θ1[y(t-1) θ - y*(t-1)] + θ2[π( [π(t-1) - π ] In other words, the central bank is supposed to raise real interest rates if actual GDP is greater than the supposed natural rate (that is if the economy is overheating ), and/or if the actual inflation rate is seen to be greater than an arbitrary inflation target, and/or if the natural rate of interest is believed to have increased for some reason. From the point of view of the strictest neoclassical orthodoxy, of course, achieving the inflation target would ultimately be the only real item of concern. On this view, the natural rate of output simply is what it is, and cannot be changed by policy initiatives (at 3

5 least not by monetary policy initiatives). To reconsider these arguments from an alternative point of view, however, suppose that equation (2) is re-written as follows: (3) r(t) = {θ0 θ1 y*(t-1) - θ 2π } + θ1 y(t-1) + θ 2π( π(t-1) The point to notice in equation (3) is that, looked at from an outside position to the standard paradigm, it becomes apparent that none of the items grouped in brackets (in the first term on the right-hand-side) is an observable variable in the sense in which statistical estimates of actual GDP or inflation might be. They are simply social constructs (Lawson 1997, Searle 1998) of one sort or another. This is obviously true in the case of the arbitrarily chosen inflation target, whatever that happens to be. More subtly, but still unmistakeably so, the same arguments can be made of θ0 and y*, the natural rate of interest and the natural rate of output. These are, after all, are just the postulates of one particular type of economic theory and do not necessarily correspond to anything extant in reality. Looked from such a sceptical point of view, arguments to the effect that the natural rate of interest has risen, that the natural rate of output has fallen, or that the inflation target should be lowered, might all be seen simply as excuses to raise interest rates. It would not be possible, of course, just to choose any three arbitrary targets for θ0, y* and π and expect to hit them all. However, in practice, estimates of y* (for example) at any point in time are merely some weighted average of past actual results for GDP. So, when and if a deflationary policy is pursued the estimated y* will tend to fall over time, and hence validate the pessimism. Vice versa for an expansionary (or low interest rate) policy. Moreover, this does seem to be what occurs in reality (for example, in both of the decades of the 1980s and the 1990s in the USA, in opposite directions), with the natural rate of unemployment or NAIRU simply tracking the actual rate (Solow 1998, 4

6 Stiglitz 2002). Similarly, it is always possible to explain away any actual increases in real interest rates over time on the grounds that the natural rate has risen. 3 An optimal interest rate policy? Presumably, any discussion of the optimality of an interest rate rule would entail discovering the correct values for each of the θi coefficients in equation (2). In the original contribution by Taylor (1993) both θ1 and θ 2 were both given an arbitrary value of 0.5, but this was only intended descriptively, suggesting that in practice policy-makers give equal weight to both inflation and unemployment. Subsequent discussion however, has tended to imply that something of the sort is in fact a desirable policy. Mankiw (2001, 2003), for example, has laid particular stress on the socalled Taylor principle (as opposed to Taylor rule) in dealing with inflation. That is simply that nominal interest rates should be raised by more than one-for-one with observed inflation. The implication is that θ2 must be a positive fraction. The position taken in this paper, however, is the opposite to this. Namely that in logic it is hard to justify any values other than zero for both θ1 and θ2. Moreover, it is argued that this conclusion can be reached either through an internal critique of the neoclassical position on its own terms, or (a fortiori) if we take the alternative view of monetary policy (that is as affecting primarily income distribution, and via this route the profit share and incentives for growth). In short, it is suggested that the optimal monetary policy would have: (4) θ1 = θ 2 = 0 5

7 In fact, the idea that θ1 should be any different from zero seems to be a contradiction even in terms of the neoclassical model itself. From this point of view, the market mechanism is supposedly selfadjusting, and any attempt at fine-tuning simply worsens economic performance. Therefore, it is anomalous that in this one particular context of interest rate operating procedures fine-tuning somehow re-emerges as a legitimate item on the agenda. Moreover, there is definite element of overkill in arguing, for example, that real interest rates should be raised when output rises above some arbitrary estimate of the natural rate. The only plausible rationale for this is that such overheating leads to inflation. However, this outcome is presumably already taken care of, in the present context, by the Taylor principle itself. From the point of view of a critic outside the standard paradigm, it can be argued even more strongly that the raising of real interest rates in the boom is simply destructive, a case of eliminating the business cycle by flattening the peaks rather than filling in the valleys. There may be a better case, from this angle, for cutting interest rates in a recession, but even this would be redundant if the general level of real interest rates was always low in the first place. Moreover, from such a starting point there would be a danger of real interest rates dropping into negative territory if the rule is strictly adhered to. Turning now to the arguments regarding the value of θ2, in this case, given the existence of at least a short-run trade-off (as is conceded on all sides), it is clear that a non-zero value of the coefficient must also tend to choke off any putative booms in the real economy, also altering income distribution in real time for as long as the boom would otherwise have lasted. Therefore, the standard argument must be that this is worth it in some sense in order to hit the inflation target. Hence, even in this context it is hard to avoid explicit recognition that inflation targeting is simply a proxy for the debate over income distribution. One pertinent rebuttal to the official position on this issue would to be that if the objective is simply to preserve the accumulated value of financial 6

8 capital, then this can basically be achieved in the contemporary credit economy simply via a commitment that real interest rates should not drop below zero (that is, the θ0 coefficient should be non-zero, in addition to value of unity for θ3 in equation (1)). This would mean, in turn, that the rate of return on financial capital is at least positive. But, if this is the case, then an additional argument that there should also be an explicit reaction to deviations of actual inflation from any arbitrary target also clearly carries the implication that the rentier share will actually be increased, for as long as this condition obtains. 4 In short, if what is at stake is genuinely a question of aggregate economic performance, rather than income distribution, then the coefficients θ1 and θ2 should both be zero. Or, to put the point another way, only these values would be consistent with a central bank reaction function that is neutral with respect to income distribution. Is there a natural rate of interest? If the above argument is accepted, all that would be left of the orthodox stance on monetary policy is the age-old argument due to Wicksell (1898), and 100 years before that to Thornton (1802), that the policy-related interested rate should be set equal to the natural rate. The only change is that this is up-dated somewhat by being explicitly cast in real terms (Smithin 2003). In the current notation: (5) r(t) = θ 0 Reducing the matter to these terms, however, must then immediately raise the question of whether the notion of a natural rate itself is either an empirically valid or theoretically meaningful concept. 7

9 In fact, although such an idea is ubiquitous in the neoclassical literature, it cannot be legitimately defended on either ground. In one sense this position has long been a commonplace of the heterodox literature, even if it can be argued that the full implications of this have not always been realized. In Rogers (1989), for example, there is a rigorous demonstration, drawing on an earlier paper by Petri (1978), that the results of the capital theory debate make nonsense of the idea that the interest rate is determined by the marginal physical productivity of capital, or, indeed, that any coherent meaning can be given to the latter concept. There is also another method in neoclassical theory for imposing a natural rate of interest in a macroeconomic model, namely to employ a representative agent framework with a constant rate of time preference. This, in turn, uniquely determines what the equilibrium real rate of interest should be, and this is therefore the assumption invariably used in the vast literature stemming from Sidrauski (1967). 5 However, a constant rate of time preference is also unviable as a general theoretical proposition. In principle, the rate of time preference should be an endogenous rather than an exogenous variable (Kam 2000, Smithin 2003). Even on more general or commonsense grounds it can be argued that the natural rate assumption is not particularly plausible in a genuine credit economy or monetary production economy. It amounts to assuming that the interest rate is determined on (purely fictitious) barter capital markets, in which savings are embodied in concrete physical commodities and can be traded to investors for use as capital goods in specific production processes. Furthermore, that this already unrealistic picture is in no way altered by the actual existence of monetary payments systems and sophisticated credit mechanisms. If, alternatively, monetary institutions and practices, including the establishment of the money of account, the network of commercial banks and central banks, credit creation and so on, are seen definitively as a system of social relations (Ingham 1999, 2000, 2001), 8

10 then the more reasonable conception is that the rate of interest is determined in the first instance in the monetary or financial sector, with prices elsewhere adjusting to this standard. Moreover the existence of such a system of social relations may be seen as the precondition for economic activities such as buying and selling (for money), and production for sale in the market, to take place at all. The role of money becomes simply a question of collectively assigned status functions (Searle 1995, 1998) or continually reproduced social interdependencies (Lawson 1997). As such it is hard to see what, in the final analysis, the real interest rate on money can be, other than simply the nominal rate set by those charged with the provision of this social technology, as compared to consensus of inflation expectations shared by other actors in the system. More basically, the setting of the interest rate is ultimately part of the struggle for economic existence (Weber 1978, Ingham 2004), for instance between rentiers and industrial capitalists, as mediated by the state. The long-run Phillips curve (a.k.a. the Mundell-Tobin effect) If the level of the real rate of interest finally boils down to a target chosen by the central bank for this variable, or to the particular financial settlement imposed by the monetary authorities, the question remains, what should the target be? From the point of view of the rentier interests considered in isolation, a tempting answer might be as high a possible, but this may ultimately prove self-defeating if the system itself is not sustainable on such terms. Similarly, from the side of either entrepreneurs or labour a short-term response might be as low as possible (not excluding negative real rates), but again there is a serious question as to whether the latter would be a viable social contract under capitalism. 9

11 Elsewhere, Smithin (1997, 2002, 2003), and also MacKinnon and Smithin (1993), in a variety of contexts, have shown that the most likely macroeconomic outcome of a lower real interest rate target, is not only a higher inflation rate, but also a higher rate of economic growth, and (not coincidentally) both a higher entrepreneurial profit share and higher real wages. 6 The average product of labour must resolve itself into three shares in the functional distribution of income, the entrepreneurial profit share or mark-up, the real interest rate, and real wages. A lower real interest rate will initially allow a higher profit share, which in turn stimulates more investment and growth. The latter will tend to reduce unemployment, improve the bargaining power of labour, and in turn will increase real wages, thus cutting into the improved profit share at least to some extent. However, there is space for both of the latter to grow at the (relative) expense of the rentiers. The inflation rate meanwhile tends to increase as a by-product of the credit creation associated with this process. So there does remain an element of the original Wicksellian result in these constructions, but in the absence of a natural rate, the higher inflation rate is offset by a higher economic growth rate. Also, (as in fact in Wicksell) it can be shown that the inflation rate is not unstable or everaccelerating. It will simply be higher. We are therefore back precisely in the realm of the long-run Phillips curve (LRPC) trade-off, which orthodox economics at one stage thought had been safely abolished. Moreover, this result is actually quite intelligible even in terms of mainstream theory, as what used to be called the Mundell-Tobin effect, after Mundell (1963) and Tobin (1965). There is a detailed exposition of this, taking into account later rational expectations arguments in Begg (1980). In that literature, a higher rate of monetary growth is the policy instrument, which in turn leads to inflation, and also via a classic forced saving argument to a higher capital stock, 7 and a lower real rate of interest. Interestingly enough, the only way in which this could be ruled out is by invoking a constant rate of time preference, which has already been dismissed in the discussion 10

12 above (Kam 2000). Although the capital theoretic elements in the Mundell-Tobin literature remain dubious, practically speaking introducing the idea of a real interest rate target into that model really just switches the policy instrument and explicitly introduces endogenous money. The basic result stands, lower real rates are associated with higher inflation and higher output or growth, albeit by a slightly different mechanism to the previously mentioned beneficial impact of a lower rentier share on the entrepreneurial profit share. A long-run trade-off? So, to summarize, we have dg/dr < 0, dπ/dr < 0 (and hence dg/dθ0 < 0, dπ/dθ0 < 0), implying dg/dπ π > 0. 0 These results, therefore, would seem to lend themselves directly to the usual type of optimization exercise whereby the social planner assigns weights to the losses incurred by low growth versus high inflation respectively, minimizing a loss function, which yields the optimal setting of the interest rate. However, the simplicity of such an exercise would be illusory unless some more plausible sources of the losses from inflation can be suggested than those usually found in the mainstream literature. Once again, it may be suggested that as long as the real interest rate target is a positive number, financial capital is already effectively indexed for inflation, and similarly there could be no objection to the introduction of other forms of indexation (for example of the tax system), to deal with the other distributional inequities that might arise due to various institutional quirks and rigidities in the social system. There seems therefore to be no valid reason why the real interest rate should not simply be set as low as can practicably be achieved, provided that it is not allowed to become negative. Theoretically, in fact, if growth (and high employment) is good, and stagnation (and high unemployment) is bad, and no further costs of inflation can be identified, the optimal monetary policy would seem to be: 11

13 (6) r(t) = θ 0 = 0 This would not actually constitute the euthanasia of the rentier (Keynes 1936), as it is not the nominal interest rate that is set at zero but the real rate, so that accumulated financial capital at least retains its original real value. 8 A more practical stance than this, however, might be to suggest that the real interest rate target should be low but still positive (Smithin 1994, 1996). This is for two main reasons. First that if capitalism is to persist as a social order the social contract must include the financial interests as well as non-financial business and labour. Second, that (as ironically with the orthodox zero inflation policy) zero is too precarious a target and gives no leeway for mistakes in the wrong direction. In other words, the policy should be: (7) r(t) = θ 0 = small positive constant Note that what is actually being suggested is actually an incomes policy of a sort, except that is an incomes policy for rentiers rather than for labour or entrepreneurs. It should finally be mentioned that both the suggestion of a theoretical norm of zero for the real interest rate, and the practical norm of a small positive constant, are different from the alternative concept of the fair interest rate originally due to Pasinetti (1981), which has been discussed by Lavoie and Seccarreccia (1988, 1999). This fair rate would set the real interest rate equal to "the rate of increase in the productivity of the total amount of labor required to produce consumption goods and increase productive capacity" (Lavoie and Seccareccia 1999). In short the idea is that the real interest rate, for fairness, should equal the rate of growth of "total 12

14 factor productivity", as it would be expressed in more conventional language. The difference between this and equations (6) and (7) really turns only on value judgements as to what constitutes "fairness" in this particular context. It involves many of the same issues that arise in the debates between the adherents of the productivity norm versus zero inflation in the orthodox literature on the costs of inflation (Smithin 1994, 2003). The "fair" interest rate essentially allows the possessors of existing financial capital a share in the rewards from current increases in productivity. On the other hand a constant, or at a minimum zero real interest rate, simply preserves (or slightly enhances) the original purchasing power of accumulated financial capital. Now, if accumulated financial capital is conceived of as representing the proceeds of past productive activity, whereas the essential contribution to ongoing production is that of the entrepreneurs plus workers (who in turn will accumulate financial capital if their efforts succeed), the latter rather than the former is arguably the more fair. It might be objected to this that there would need to be some further incentive for new lending if the productive process itself is to continue, but in an economic system characterized by the continual creation and destruction of capitalist credit money (Ingham 2004), the essential motive for credit creation on the part of banks is the differential between lending and borrowing rates (i.e., another species of mark-up ) rather than the level of interest rates per se. The basic function of the interest rate, on this view, is the preservation of the existing value of financial capital, (including but not limited to the deposits on the liabilities side of bank balance sheets) and in that sense preserving the balance between the past and the future. Conclusion In terms of the perennial rules versus discretion debate in monetary policy, the guidelines for policy suggested by the above are actually in the nature of a rule, but not of the type usually 13

15 favoured by the rules party (Leeson 2003). The suggestion is that the real rate of interest set by the monetary authorities should be "low" but still positive. It is a cheap money rule, where cheap is explicitly understood to mean cheap in real terms. Such a rule would indeed prevent the type of inflationary instability that occurs when real interest rates become negative (Moore 1988, Smithin 1994). Also, under such a rule financial capital itself would be indexed against whatever inflation does occur. However, clearly the rule will not eliminate inflation as such, and this point should be clearly recognized. Any further anti-inflationary measures would, by definition, have to be nonmonetary (for example, measures to improve productivity). Note also that the monetary policy suggested would resemble contemporary practice in the sense that the nominal policy rate would still have to be raised one-for-one with observed inflation. Therefore there would be no drastic break in the policy regime from the point of the view of the markets. However, the Taylor principle Mankiw (2003), which is that nominal interest rates should always be raised more than one-for-one with observed inflation, is explicitly rejected. As for the real side of the economy, it is asserted that the cheap money rule will tend to promote higher growth, higher employment and higher real wages (as well as higher industrial profits), and there seems to be no reason in logic why these should not be pursued to the maximum extent consistent with preserving the basic fabric of the existing financial settlement. 14

16 Acknowledgements With the usual disclaimer, I would like to thank the editors, Marc Lavoie and Mario Seccareccia, and also participants at the 1st Bi-Annual Canada/US Eastern Border Post Keynesian Workshop, in Ottawa, September 2003, for many helpful comments and suggestions that have improved this chapter. Notes 1 See also Mankiw (2001) and Taylor (2000). 2 That is the Non-Accelerating Inflation Rate of Unemployment. 3 Increases in the natural rate do occur in the new consensus model, for example, when there is permanent fiscal expansion. Interestingly enough, however, this does not come about by "market forces" but by an explicit policy response on the side of monetary policy (Arestis and Sawyer 2002, Lavoie 2004). 4 As already indicated in footnote 3 above, Lavoie (2004) points out that if, starting from an equilibrium position, an increase in inflation arises from a permanent increase in demand, actual inflation will always be above the target. There is nothing in the new consensus model to eliminate this. Hence the reaction function will continue to impose a higher interest rate. 5 This Sidrauski model remains the basic framework for the monetary theory of the long-run, as it appears in graduate level textbooks such as Blanchard and Fischer (1989), Walsh (1998), Turnovsky (1999), etc. 6 There is in fact a theoretical case in which a lower real interest rate can actually lead to lower rather than higher inflation. This, however, would entail that the system be highly technically progressive in a particular sense. Essentially, there must be endogenous productivity growth as output growth increases, and of greater magnitude than the ongoing increase in real wages (see Smithin 2003). 7 This in the context of a static neoclassical capital-theoretic model. 8 Even in Keynes (1936, ch.16) it is clear that what is envisioned is simply that the value of accumulated financial capital should not grow, not that it should be wiped out entirely. The reference to Pope's father and his chest of guineas in that chapter suffices to establish the point. 15

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