Sunday, March 27, 2011

Stocks and Flows: In Response to Grant

In an earlier post Grant asks a question concerning Professor Maclachlan's treatment of savings and the interest rate:

"How could additional savings not affect rates of interest if they do affect bond prices? By definition, the price of a bond reflects its interest rate. Or was Maclachlan only referring to the safe rate of interest (T-bills), and if so, why is that rate necessarily more important in intertemporal coordination than the other rates of interest in bond markets?"

First, Maclachlan states what she means in the chapter entitled "Methodology and Definitions." She there writes that she is concerned with the rate on long-term bonds since "short-term rates can be seen as derivatives from long-term rates." She also argues that it is incorrect to conceive of the real (natural) interest rate apart from money and that it is useful to abstract from default risk, and brokerage (transaction) costs, in addition to the inflationary premium. Recognizing all the problems that follow these assumptions, Maclachlan concludes that "we seek to explain the nominal rate of interest that would exist if the inflationary premia were all zero." This enables Maclachlan to focus on "The theory of interest from an 'essentialist' perspective." Her work is theoretical.

As to the nexus between new savings and the interest rate, let me quote Maclachlan's best passage on this subject:

"On any given trading day, a certain number of bonds are sold to raise money to purchase investment goods and a certain number are bought to serve as a vehicle for new saving. But then there are trades that are unrelated to the current flows of investment and saving. Existing bonds are bought and sold by wealth-holders who are only rearranging their existing portfolios. It is customary to think of the latter type of trading as speculation. The primary motivation behind much of the trading is the expectation of securing a profit from future price changes. ... In an economy in where there are a large number of speculative trades between cash and bonds, there arises the possibility that, in any period, the non-speculative trades arising from saving and investment are overwhelmed to such an extent that they exert little effect. Such a situation could arise when speculators are highly responsive to small changes in the interest rate. Suppose, for instance, that there is a sharp increase in corporate investment causing an influx of new bonds into the loanable funds market. Traditional theory would predict a rise in the interest rate. But if speculators are active, they may see a small change in the interest rate arising from the new bond issues and immediately respond by selling or buying bonds: those who think that the small rise is an indication that bond prices have peaked will sell and those who think that it is an indication that they are on an upward trend will buy. No-one can say a priori whether the bulls or the bears will dominate but what one can say is that the resulting level of the interest rate will probably be different from what it would be if the speculators were not involved."

What a great passage, one of the best available. Maclachlan then spends the next few pages qualifying her statement by introducing several consideration involving elasticity, responsiveness the the state of financial markets. But the message is clear and direct: the loanable funds model is not as simple as it seems.

Other Post Keynesians have written on this subject, and let me quote a few passages:

Greg Hill:

"There is, however, another important dimension to the problem, for the market in which new bonds are issued is the same market in which existing bonds are traded. And the very same scheme of interest rates that must balance the supply and demand for new bonds must also balance the supply and demand for old bonds. What would happen, then, if there were a conflict between (1) the rate of interest that would balance the flows of new saving and investment and (2) the rate of interest that would balance the supply and demand for existing bonds? According to Keynes's account, the outcome will be determined by decisions concerning the existing stock of bonds because, at any given moment in time, the quantity of old bonds that can be released onto the market dwarfs the quantity of new bonds entering the market. ... Against the massive, preexisting stocks of old bonds and of money poised to enter the market in response to a change in the interest rate, the relatively small flows of new lending and borrowing can have little effect."

In another article (one in response to Professor Horwitz), Greg Hill writes:

"If a preponderance of those who hold these assets decide to sell bonds because they believe interest rates are going to rise and bond prices are going to fall, their fears will overwhelm any increase in the flow of saving. Horwitz does not come to grips with this problem (he does not even mention it), but as long as the interest rate remains tethered to the expectations of those who hold the pre-existing stock of financial assets, it cannot effectively carry out the task assigned to it by the neoclassical and Austrian schools." (my emphasis).

Another great economist, Victoria Chick, similarly writes:

"only sales of new issues represents borrowing and lending; the rest is transactions amongst current savers and existing security-holders. ... So long as there are existing as well as new assets, the direct link between saving and lending is broken. ... savings as money-flows were swamped in their effect on the rate of interest by transactions amongst existing wealth-holders."

Is anyone aware of how Austrians have responded to this challenge? I think it is a powerful argument. Greg Hill accuses Horwitz of not even mentioning it in their exchange.

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