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Sunday, December 13, 2020

Sumner And Endogenous Interest Rates

Scott Sumner has continued his efforts to understand the MMT textbook by Mitchell, Wray, and Watts (which I will summarise as MWW), but he is running into problems. However, those problems just reflect Sumner's Monetarism, which is out of step with modern mainstream and post-Keynesian understanding of interest rates. 

He is concerned about the wording of the textbook, but that textbook has some of the same problems of any discussion of interest rates that takes place in introductory economics textbooks. If we want to discuss interest rates properly, we need to understand the concept of rate expectations and the risk-free yield curve, on top of understanding how private sector interest rates are related to that curve. The mathematics of that understanding is beyond the target audience of an Economics 101 textbook.

Sumner writes:
On page 464, you can see where MMTers’ confused ideas about endogeniety cause them to really go off the rails:

[Quote from MWW] "The fact that the money supply is endogenously determined means that the LM schedule will be horizontal at the policy interest rate. All shifts in the interest rates are thus set by the central bank and funds are supplied elastically at that rate in response to the demand. In this case, shifts in the IS curve would not impact on interest rates. From a policy perspective this means the simple notion that the central bank can solve unemployment by increasing the money supply is flawed." [END EQUOTE]

No, no, a thousand times no!!! The final two sentences absolutely do not follow from the first two sentences, which leads me to believe that MMTers misunderstand the concept of endogeniety.

It’s cheating to claim the money supply is “endogenous” and then completely ignore the fact that the interest rate is also endogenous. In the second sentence they mention that central banks “shift” the interest rate. Yes they do, and they do so to prevent shifts in the IS curve from destabilizing the economy. As a result, shifts in the IS curve absolutely do impact interest rates. A rightward shift in the IS curve right after Trump was elected caused interest rates to go up. I could cite 1000 similar examples. Central banks are like the child that runs out in front of a parade and then has the delusion that he is determining the route of the parade.
Once again, the quoted discussion from MWW is simplified, and Sumner just leaps off and discusses random advanced topics involving interest rates.

If we step back and look at this carefully, we just need to use the index of MWW. On page 363, they write:
MMT shares the view that the central bank cannot control either the money supply or the level of bank reserves. Thus, the supply of reserves is best described as horizontal, at the bank's target rate. That is the endogenous money, horizontal reserve approach, which was developed over the 1970s and 1980s by Moore and other post-Keynesians [references] Most economists regardless of their schools of thought, now accept this is a correct representation of the operating procedures of modern central banks.
That's largely all that should have been said on the topic. They are correct in that most economists accept this view; Sumner is one of the exceptions. However, this just means that Sumner's understanding of central banking is completely out of step with everyone, and so he should be just as confused by any modern treatment of the topic. (Note that Economics 101 textbooks have silly Monetarist models in them, but most neoclassicals will just huff and explain that critics are not supposed to look at Economics 101 textbooks (insert reason here), and look at more advanced texts.)

One may note that MWW does not say that "interest rates are endogenous," that is something that Sumner made up. The best way of understanding interest rates is that the reaction function of the central bank is exogenous, and thus the observed interest rate is thus determined by the conditions of the economy ("endogenous"). However, since the reaction function could be changed, this becomes extremely fuzzy, since the observed interest rate changes along with the reaction function. The endogenous/exogenous distinction that many economists love dropping into conversation is the wrong framing to use.

Note that the "reaction function" terminology is the preferred phrasing of neoclassicals, which might create some arcane objections from some post-Keynesians. However, this is the cleanest way of understanding the concept.

Meanwhile, Sumner jumped ahead to interest rates -- plural -- which is well out of scope for an Economics 101 model with one interest rate. Modern financial theory -- which is compatible with many neoclassical models -- tells us that the risk-free curve is mainly driven by rate expectations. In other words, a market-implied central bank reaction function. This means that the observed rates are in one sense endogenous, but at the same time, the central bank reaction function is exogenous.

Once again, some MMTers and most post-Keynesians will have terminology issues with that characterisation, but I see no major operational differences between what I wrote and advanced MMT discussions of interest rates. (Post-Keynesians are wedded to fairly ancient interest rate models -- e.g., liquidity preference -- and so they are less likely to be happy.) As such, the MMT view towards interest rates is not that different from consensus models within finance, and so should not confuse anyone who has read a text on interest rates written after 1990.

In summary, one needs to grasp the concept of a central bank reaction function to understand modern approaches to interest rates. One could try to replace them with something else, but the reality is that the resulting description will end up being textual hand-waving that is likely to be impossible to relate to observed interest rate behaviour. 

(c) Brian Romanchuk 2020

6 comments:

  1. See the MMT position paper The Natural Rate of Interest is Zero:

    http://moslereconomics.com/wp-content/uploads/2018/04/The-Natural-Rate-of-Interest-is-Zero.pdf

    This paper argues that the monetary policy rate for a fiat sovereign government running a normal budget deficit would be driven to zero unless the government offers instruments that pay interest to sustain a positive non-zero policy rate. Other floating interest rates in the economy are set by market forces.

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  5. Sumner also has a newer article where he describes (correctly I believe) six points that MMT makes that are true in his opinion but which somehow MMT doesn't understand the implications of.

    https://www.econlib.org/that-doesnt-mean-what-you-think-it-means/

    And we get the usual claim (in comments) that economists have understood most of these for many years so nothing new here. I guess it is some sort of progress having Sumner admit MMT is right about its claims even though MMT is just wrong in general. Cause he says so.

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    1. Interesting, but most of the logic is based on Sumner making assertions about monetary policy and interest rates. A lot of which even the mainstream disagrees with.

      It’s also his framing: monetary policy is about changes in the monetary base. Even if the central bank only cares about interest rate, his belief is that what is “really” happening is that the monetary base is being controlled. It’s impossible to argue with a stopped clock.

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