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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


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

    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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  3. Scott Sumner seems to have an interesting way of looking at some things(from the 10 minutes i have spent)-- if i suspend disbelief, but he is looking at unimportant minutiae.

    I've been writing my digital currency platform(for tokenizing your own debt securities), as I have been somewhat chronicling on my blog:

    The most innovative thing (besides generalizing mmt theory to all forms of credit, and precisely describing the accounting reasons why states are ontologically unique, not merely attributing them monetary sovereignty), is a custom database designed to work directly in a CSV format, because for the most part, modern databases are bloat. RAM is cheap, and let's be honest, most people are basic, no need for fanciness.

    SQL, only offers value, if you don't decide how you want to access your data, beforehand. Any row in a table, with proper foresight, only ever needs 1 key. These days, you either do batch processing(so random access is not necessary and you can use any scripting tools on raw data files), or you have a running application. Key Value "No SQL" stores, do a disservice, in that data is not easy to organize schematically. So organized tabular data, WITHOUT special query facilities, is really, the way databases need to evolve.

    This matters because money is an information system. Data technologies are not incidental, but rather central, to accounting systems. The big problem, I am trying to solve, is finding a coherent way to put multiple distinct CSV tables into one coherent file format. I guess, I could just reserve single column rows, to denote a new table, with the following line, being the table headers, so it is still valid CSV.

  4. Now, as for interest rates, we pay taxes, rents, tributes, offer burnt offerings, etc-- No big difference there.

    Most people look at prices in isolation, but you must see the whole system. This is why minutiae like csv formats matter, but people crowing about S&D(supply and demand), are just old whales not long for this world, like the dinosaurs that came before.

    Since discovering/inventing, the rule of 69, where the median time to reach a savings goal, through gambling at fair odds, converges to 69% of the time to save naievely, I have taken on a whole new perspective on financial institutions, in that, a slimmer leaner, governance system, with less counterparty risk, takes the cake. You can gamble instead of save. Only 37% of the time, will it take longer, but 14% of the time, it takes over twice as long.

    Knowing this about gambling, means that any kind of fool's narrative, can be told about interest rates, like the monty hall problem, by relegating bad outcomes, to the unopened doors, and then switching doors before someone can call you out on it. History can never recognize the gamblers when they are good, and they will just claim they new what they were doing all along. Interest is bunk.

    The illusion is just so painfully transparent. It's always just been a story, to justify some people taking, and others getting fleeced. As i like to say "new money should pay for new things", which MMT originally instructed me on with regards to fiscal policy being the more effective monetary facility. It makes sense for financial assets to depreciate.

    The correct ontology of accounting, is that there are living and inert things, and living things do 2 things: replicate and regulate-- in order to impose their accounting system on an environment. New fresh money, should always carry a stronger weight, once it has gotten off the ground. Old money can hold on, but should not earn interest. The total amount of financial wealth can increase, even if all financial assets only ever depreciate... because YOU CAN CREATE NEW MONEY. This is what i mean by "new money buys new things".

    In fact, all asset prices are relative, so appreciation, is just doubly illogical. Not only can we effortlessly create new money, but appreciation of some assets, implies the relative depreciation of others. So if profit is your motive, if you don't realize you can simply write your own money on a piece of paper, you will be motivated to create false scarcity of everything else, by depreciating everything, and leveraging economies of scale to maximize throughput. This just creates false scarcity, because now, so much of the economy cannot even compete at cost-- and they must create new on paper to pay you. So you depreciate assets AND suppress purchasing power at the same time, a potent combination.

    But in the true ontology, where living things replicate and regulate, there are limits. Every mature organism LEARNS to balance their replication and their regulation, to maintain a healthy ecosystem. But the doctrines of finance are specifically constructed to NOT do this.

    None of this is really necessary to understand, beyond what MMTers have already articulated, but whereas previously, it just appeared that the opposition is wrong and should be persuaded, it appears they are steeped in imbecility of their own complexity, we need not persuade anyone, only defy them: "new money pays for new things". No interest.

    Now, am I opposed to charging commissions on loans, when someone does not have the accounting and social wherewithal to organize their own semi-autonomous credit creation? Of course not. But time is irrelevant.

    Suppressing credit reduces effective accounting expression, and thus LOSES any time value. This is why I named my blog "economics now", because we don't have to wait, for XYZ to happen, to start living in the world we want. Like any enterprise or lifestyle, you just start doing it.

  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.

    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.

    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.




