Thursday, November 9, 2017

Upside-down CAPM, Part 2: The magical elasticity of investment demand

I previously have discussed my skepticism about the idea that monetary policy works by inducing leveraged investment with low interest rates.  I just don't see evidence for it.

But, I don't really even quite get it, theoretically.  The idea is that the Fed lowers interest rates to well below their market rate, and this induces households and firms to borrow.  There are countless examples, which I won't bother to link to here, of either laypeople or financial professionals referring to phantom activities such as firms propping up share values by borrowing cash on the cheap and buying back shares.  There are certainly firms that borrow.  And there are firms that return capital through buy backs.  Sometimes there are firms that do both!  Thus, as with the idea that loose money or loose credit is responsible for high asset prices, this is an idea that will never die for those who are disposed to believing it.  Hey, maybe they are even right about it.  Surely, getting rid of money and credit will solve these supposed problems.  Who could deny it?

It seems to me that there are two basic camps, here.  Austrian business cycle proponents, who attribute the misallocated borrowing to Fed signals, and Minsky-type proponents who attribute the misallocated borrowing to complacency as economic expansions progress.  Some version of this idea seems to be an important part of Fed policy decisions, given comments made by FOMC members on occasion, though I'm not sure if it is the Minsky idea or the Austrian idea that dominates.

In either case, it seems the proscription is the same - nominal stability (which is managed by the Fed) leads to over-leverage, which must eventually lead to a sharp contraction when it becomes clear that loose money or nominal stability can't endure forever and the economy contracts, triggering a debt-spiral.  Thus, the contractionary policy is demanded now, before the over-borrowing becomes larger, so that the contraction will be more muted.  Please correct me in the comments if you feel that I have misrepresented either school of thought.

But, these bubble theories have a wildly uneven sense of elasticity.  Here is a graph of the one year change in Fed assets (before 2008, Fed assets were almost all funded by currency in circulation), and total borrowing in the US.  I have graphed them both as a percentage of GDP in order to maintain scale over time.

It is true, if we look at the graph, that borrowing sometimes rises during periods of declining and cyclically low rates.  It is also true that levels of borrowing were rising during the high inflation 1970s and 1980s, which I touched on in the previous post on this series.

But, if I understand these business cycle theories correctly, the Fed lowers interest rates by purchasing bonds with cash.  The reason this lowers interest rates is because the market for the securities is not very liquid, so that the extra demand represented by the Fed moves the price.  So, the Fed buys bonds worth around 0.3% to 0.4% of GDP each year, and this changes short term interest rates.  (This is pre-QE.)  It may be hard to see, but on the graph, this is the blue line near the x-axis.

So, the idea is that over a period of months or years, the Fed pushes interest rates down by buying bonds totaling less than half a percentage point of GDP.  Now, one could argue that this bond buying uses new cash, which adds more boost than, say, new bank lending.  But, that is a monetarist argument.  That is not an argument from interest rates.  That is an argument from quantity of cash.  It seems perfectly reasonable to me that injecting cash into the economy will boost nominal values, in the long run, proportionately, and some combination of immediate liquidity and expectations of future liquidity will create short term inflation pressures, too.

I should note that there are many complexities here, and even the effect of the quantity of money is hard to pin down.  There isn't much of a systematic relationship between the rate of new bond buying by the Fed and either NGDP growth or inflation.  Lower market rates increase demand for money, which is disinflationary but a lower target rate is inflationary.  So, the monetarist story is difficult to quantify, too.

But, the interest rate approach has a widely referenced mechanism - lower interest rates lead to borrowing.  So, the strange thing, to me, is that 0.3% of GDP worth of lending by the Fed can apparently move interest rates around by several percentage points, and hold them in place for years.  Yet, when the borrowing that this change in interest rates triggers amounts to 5% to 15% of GDP, all that extra borrowing has no effect on interest rates.  That is some magic elasticity.

The same question remains if the cause of new borrowing is low credit spreads.  If complacency causes spreads to tighten, why doesn't the new borrowing push rates back up?

In fact, the new borrowing does push rates back up.  This is where the Upside-down CAPM fits in.  When equity risk premiums are low, credit spreads tend to also be low, and real interest rates tend to be high, as they were in the late 1960s and late 1990s, at the end of long periods of stability.

This seems to be the motivation behind concerns about NGDP targeting, that nominal stability will cause complacency and that low credit spreads will lead to massive over-borrowing which will get out of hand.  This idea relies on interest rates that are insensitive to investment demand.  The idea is that if investors feel confident that stable NGDP growth will keep equity values from collapsing, for instance, they will invest on margin, borrowing at 4% to invest at 7%-10%.

It's true.  If you could do that, it would be tempting.  Too tempting.  So tempting it would be inevitable.  It would also be inevitable, then, that nobody would be lending money at 4%!  But, if you're working with some whacky model that imagines that cyclical surges of investment keep happening without any consequence to interest rates, this may not seem obvious.  In fact, I think one of the many benefits of NGDP targeting would be that fixed income yields would be high, which is exactly what the global economy could use right now.

Can anyone direct me to readings that address this elasticity question?  How can the Fed buying a few T-bills lower interest rates persistently, but when this triggers hundreds of billions of dollars in new borrowing, that doesn't move interest rates back up?  This seems like such a basic question, I am afraid that I am simply exposing some ignorance.  Enlighten me, readers!


  1. I cannot enlighten you. I don't know either.

    There is much in orthodox macroeconomics (particularly on monetary side) that does not stand up to scrutiny, although much of the discipline makes sense (EMH, for example).

    My guess is that the Austrians and Minskyites have to toss EMH out of the window to get their platforms to work. People become irrational in common, and assets or business opportunities become "overpriced."

    But if one makes common widespread irrationality by captains of industry and finance a foundation for macroeconomic policy…well, let's go to central planning.

    I still do not know why the hysteria about moderate rates of inflation. You can read treatises from the St. Louis Fed on inflation that hardly come up with any costs, and even those costs are debatable. "The cost of capital is higher," is one.

    But would not borrowers take on debt knowing they can pay back with cheaper dollars--especially if they can just "hang on" long enough if circumstance go south? So the cost of capital would not deter, in moderate inflation.

    I would be more comfortable borrowing in a 4% inflation zone than in a zero or deflation zone. If I was bank, I might even be more comfortable lending, since loans are repaid in nominal dollars.


    "In fact, I think one of the many benefits of NGDP targeting would be that fixed income yields would be high, which is exactly what the global economy could use right now."--KE

    Not sure about this. Why are high fixed-income yields good?

    I happen to be a market monetarist, though I would err on the side of growth as a rule. That is a 5%-6% NGDPLT.

    But the global supply of capital is enormous. Maybe interest rates "should" be low. The passive investor does not have anything valuable to offer, since capital is abundant, and I suspect, always will be as the globe develops. More savings in higher-income nations.

    1. Well, high yields are usually associated with growing economies. But, also we currently have a problem with pensions that are missing their long-term nominal growth targets, the zero lower bound during recessions, etc.

  2. The idea that nominal stability leads to complacency strikes me as odd. If stability of one important sort is generally expected is it not rational to think risk is lower than otherwise?

    Thinking in terms of interest rates as the sole indicator/instrument of monetary policy is needlessly confusing.

    Oddly enough the only explanation of the "fiscal transmission mechanism" (rather than the monetary one) that makes sense to me is due to interest rates is that increased government borrowing leads to higher interest rates which reduces the demand for money and is therefore expansionary.

    1. Good point. Although, it might even be questionable that public borrowing leads to higher rates. It's certainly not been the experience of the past 20 years in the US.

  3. A few thoughts:

    1) Why are you so focused on bond buying vs setting of the discount rate? Longer-rates are anchored to short-rates within some range so the ability to set the short rate has a powerful impact on other rates. I think that is more meaningful than QE.

    2) I see the business cycle as reflexive. For many (most?) borrowers, credit-worthiness is a function of ability to refinance. When the credit cycle is strong, borrowers are in fact more credit-worthy. This is a self-reinforcing cycle both up and down, leading to booms/busts. It is rational to lend more during periods of low credit spreads...until it isn't.

    3) I'm not sure what NGDP targeting offers over inflation targeting. In theory we'd be targeting future forecasts of NGDP. As best i can tell, those forecasts are highly correlated to future inflation you are in practice targeting the same thing.

    4) My fear on NGDP targeting is largely a political fear. NGDP targeting would require high inflation during periods of low real growth. I see this as politically unsustainable...we are always one election away from a new Fed mandate. If you've structured an entire system around nominal stability (including potentially massive amounts of leverage, as you suggested) you are exposed to massive risks in the event of such a political change. This is the opposite of "antifragile" thinking.

    5) I don't believe nominal stability would change the business cycle. You would just move from nominal cycles to real cycles. This could lead to equally drastic swings in corporate profits as well. Periods of low/negative real growth and high inflation have the potential to be disastrous for corporate profits (or very good). Point being, you'd still have cycles...possibly cycles just as large. My intution is that you'd have lower cyclical volatility but with a higher skew (fewer, deeper recessions): which seems to be what we've experienced since Greenspan (who adopted what i consider to be NGDP-targeting "light").

    6) All this obsession with nominal stability is driven by two simple beliefs: wages are sticky and debt contracts are nominal. Why don't we spend our energy attacking the root problems. It seems to me that wages have become less sticky over time so that problem may solve itself. Why don't we push for reform that would favor equity financing over debt financing? This is so far from current thinking that I see low-hanging fruit everywhere.

    1. Thanks for the thoughtful input:
      1) I'm not sure that long term rates are that anchored to short term rates. Part of the problem in 2004-2006 was that the Fed thought they should be correlated, and was confused by long term rates that remained low when short term rates were hiked.

      2) This is one of many factors that I would put in the category of plausible, even true, but not definitive. This is something that certainly is part of the mix of what is going on, but I don't think it bears out in the data as "the thing that drives the business cycle". This is similar to credit explanations for the housing bubble. Sure, there was credit flowing. Sure, people are drawn to hot markets. Etc. It's a plausible explanation for rising home prices, but plausible isn't enough. It wasn't the cause of market prices for homes that are double or triple their replacement value, and in fact, it is implausible that it could be. But, the seeming plausibility of the story, conceptually, led to its acceptance as the cause of the bubble. Then, work from researchers like Mian and Sufi seemed to provide quantitative cover for that plausibility, even though their work controls away the true causes.

      3) NGDP only correlates with inflation because monetary policy is pro-cyclical.

      4) True. It is also true that if Congress made international trade illegal, it would create a devastating recession, but I don't think we should pre-emptively make trade illegal in order to avoid that. It should be self-evident that we should govern ourselves in the best way possible, even though subsequently governing ourselves less well would be catastrophic.

      5)Even if that was the case, it would be better.

      6) I agree. But, the lowest hanging fruit is self-imposed nominal instability. It is the broken window fallacy applied to macroeconomics.

  4. On Saudi land---

    "The monopolization of this resource limited the amount of urban land available to the masses, pushing up land and home prices, which contributed to massive land and home shortages. Remedying this situation will reduce the cost of home ownership, thereby alleviating a major source of grievance among middle- and lower-class Saudis."

    Oh gee, sounds like America.