2.5 Does interest-rate policy compensate for ineffective quantity policy?
According to Sargent, "it has often been argued that the proper function of the monetary authorities is to set the interest rate at some reasonable level, allowing the money supply to be whatever it must be to ensure that the demand for money at that interest rate is satisfied." [1] Sargent understood this as a reformulation of the real-bills doctrine. In any case it is the doctrine held by MMT. It was common central-bank practice until WWI and is again since the 1990s. It is based on a short-term interest rate doctrine, a present-day variant of the real-bills doctrine indeed. Its counterpart is the reserve position doctrine. [2]
The reserve position doctrine characterised the monetary policy of the Fed from 1920 to the 1980s. It was the most widespread monetary policy of central banks after WWII (except the Bank of England). Keynes, as lateron Friedman, basically supported that policy.[3] A reserve position policy sets quantity targets of reserves and monetary aggregates (M1, M2, M3). The goal is to control banks' credit and deposit creation by steering the reserves available to banks. This was based on the multiplier model as developed since 1920. /29/ For achieving the task, the transmission mechanism between quantities of reserves (or reserve interest rates, respectively) and quantities of M1/M2/M3 is of central importance. But despite the numerous efforts made to get a grip on monetary transmission, and to understand how the reserve quantity or interest rate affects the multiplier, the ways in which the supposed transmission works have remained somewhat elusive.
In practice, the reserve position doctrine as well as the multiplier model proved inadequate. Central banks do not exert pro-active control, but re-act to the banks' initiative. It is the banks who determine the money supply. As a result, reserve-based quantity policy did not work satisfactorily, aside from the fact that the Fed's commitment to implement quantity policy in earnest remained rather weak.[4]
Quantity policy was withdrawn on the quiet from the 1980s and replaced with outright interest-rate policy again. The stated purpose of this is to control the interbank lending rate as well as consumer price inflation in general by setting the central-bank base rate and by steering the interbank rate through open market operations (repos for the most part). The question of how the interbank rate is supposed to translate into some inflation rate is usually not dealt with in depth, even less how this might affect the money supply. Substitution of interest-rate policy for quantity policy since the 1980s up to the present day has apparently not contributed to a more effective central-bank control over banks' credit and deposit creation. Besides, academic textbooks are still about multiplier and transmission models anyway.[5]
Interest-rate policy and monetary quantity policy are considered to be incompatible with each other. Nonetheless, quantity policy will entail a certain range of interest rates, as interest-rate policy will entail certain quantities of money. So, even if the money supply and monetary aggregates are no longer targeted, any interest-rate policy tacitly still implies an impact on banks' credit and deposit creation. 'Price vs quantity' is a long-standing economic policy issue. The two sides, however, are not easily interchangeable. If it is true that prices reflect quantitative 'scarcity' rather than 'scarcity' being a result of prices, than interest-rate policy can be expected to be a weaker control lever than quantity policy. /30/ The matter seems to be complicated, but in the end the simple truth might be that under conditions of fractional reserve banking—with nonbank money circulation on the basis of demand deposits more than semi-detached from the interbank circulation on the basis of reserves—effective monetary control is mission impossible.
With regard to ineffective reserve position policy and its silent downgrading to short-term interest-rate policy, MMT is fully state of the art, including rejection of the multiplier model and an informed vagueness with regard to interest-related transmission problems. MMT does not explicitly introduce base-rate policy as a substitute for ineffective quantity policy. It might even seem as if MMT treats base-rate policy as an end in itself. The central bank provides reserves to the banks, or absorbs reserves through open market operations, as may be necessary to maintain the base rate or the interbank rate, respectively, which the central bank sets as a target. In particular, the central bank buys government bonds from the banks in order to provide reserves and bring interbank rates down, and sells government bonds to absorb reserves and drive interbank rates up.[6] This is a nicely designed market-compatible mechanism. But what is it for? Fullwiler/Kelton/Wray deem central-bank interest-rate policy of such importance that to them it is the main argument for a central bank to always provide the reserves banks demand:
"Any central bank that administers an overnight interest rate target must supply reserves on demand – for otherwise it would lose control of the interest rate. In the postkeynesian literature, it is said that central-bank policy always 'accommodates' the demand for reserves. Given that this demand is highly interest-inelastic, there is little room for 'error' by the central bank. ... Modern central banks operate with an overnight interest rate target and accommodate bank demand for reserves in order to continuously achieve it." [7]
One is tempted to think that MMT yet sees the base rate as the central control lever, in that the actual demand for reserves is assumed to clear the market at that interest rate. According to Mosler, and in line with contemporary common wisdom, the overnight interest rate indeed 'indirectly determines the quantity' of the money supply and 'is the primary tool of monetary policy'.[8] /31/ The matter is puzzling, though, as MMT assumes the demand for reserves to be 'highly interest-inelastic' – an assumption I endorse. But if demand for reserves is not that sensitive to interest, what then is the purpose and the alleged importance of setting a base rate and achieving an interbank-rate target for reserves, such as the Fed Funds Rate in the US or the EURIBOR and LIBOR in Europe?
Is it aimed at increasing or decreasing a central bank's interest-borne seigniorage, i.e. draining or adding to banks' profits? This certainly results to a certain degree from the policies pursued, but can hardly be seen as a functional rationale for interest-rate policies. What else, then, can a functional rationale of a central bank interest-rate policy be, if not in fact to serve as an instrument of indirect control of the quantity of banks' credit and deposit creation, as most economists and 'the markets' assume. As with any interest rate and any price, the base rate can of course be seen as a control variable. But the next question is what it does control, and to what extent. Is a central bank's base rate actually an independent variable, or is it not in fact a dependent variable at the same time, adapting to what is going on rather than being a contributive factor to bringing it about?
Most importantly, how should a base rate and interbank
rate on about
2.5–12 per cent of the money supply transmit itself onto the 100% it is
supposed to control? Interest rates on reserves certainly alter the final
margin profit of banks, and this is why they react to it, even though with quite
limited elasticity. But as long as interest margins and other profits which
banks can make from creating credit are sufficiently higher than the fractional
refinancing costs they have to bear, they will certainly not refrain from
creating credit and deposits. Under this aspect, the alleged all-determining
impact of the base rate appears to be mystifyingly exaggerated. One may ask
whether the base-rate lever is not just another piece of model-world economics,
in glaring contradiction to the perpetually overshooting, inflationary and
above all asset-inflationary credit creation of recent decades. MMT ultimately
does not provide an explanation for the key role which the base rate plays in
its system. The message it conveys, nevertheless, is that the central bank has
things under control, and banks do what they are supposed to.
/32/ On the basis of the ill-understood relation between deposits and reserves, i.e. between nonbank and interbank circulation, the media recurrently raise a standard criticism of banks' interest-rate policies. When the central bank raises the base rate, banks take this as an excuse to promptly raise customers' borrowing interest. But when the central bank lowers the base rate, banks are reluctant to follow suit. The public, and quite a number of experts, think that interbank rates would have a direct and comprehensive effect on banks' loan and deposit rates. But under fractional reserve banking, rising base and interbank rates (relevant to refinancing just about 2.5–12% of the money supply) do not represent a compelling cost increase, nor do falling interbank rates represent a tremendous cost relief.
EU politicians, feeling exasperated with the situation without actually having a well-defended reason, decreed a mechanical link of 1 to 1+x between the interbank three-month EURIBOR and the banks' consumer credit rates. Since June 2010 bank lending rates thus go down or up in mechanical step with EURIBOR. This is nothing but to admit the low effectiveness of interest-rates policies―and to react by resorting to the big sticks of centrally planned economy, in this case by resorting to price administration.
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[1] Sargent 1979 pp92–95, cited in Poitras 1998 480.
[2] The term Reserve position Doctrine (RPD) was coined by Meigs in 1962. Cf. Bindseil 2004 pp7, pp9, pp15.
[3] What Keynes put forth in his Tract on Monetary Reform 1923 wasn't a plan for restructuring currency and credit creation. It was an outline of central-bank monetary policy as it became implemented in many countries in the course of the 20th century.
[4] Bindseil 2004 19–30.
[5] For a detailed criticism of the Reserve Position Doctrine see Häring 2013, Bindseil 2004.
[6] Mosler 1995 2, p5, p21, Wray 2012 124.
[7] Fullwiler/Kelton/Wray 2012 2.
[8] Mosler 1995 2.