Was Fisher wrong about rates?

This is the boldest claim by an economist I've read in some time:

Fisher’s theory of the rate of interest cannot be applied to macroeconomic (business cycle) or microeconomic problems (it does not protect against the loss of purchasing power), and does not reflect the empirical reality.

It comes from a new working paper by Cal State economist Éric Tymoigne: Fisher’s Theory of Interest Rates and the Notion of “Real”: A Critique He continues:

...This is true both when the notion of real interest rate is taken as a condition of arbitrage or as a simple definition. Interest rates do not tend to be affected by inflation unless the central bank moves its interest rates in function of inflation. What matters for the setting of interest rates is, thus, not so much inflation, but rather the central bank policy-liquidity matters, not purchasing power. Individuals intervening in the financial markets want to avoid capital losses and problems of solvency induced by borrowing short-term for speculation, or by the need to sale to face some necessary transactions.

This implies also that anticipation of long-term rates becomes of crucial importance for the determination of long-term rates, as the square rule shows. In the end, therefore, long-term rates are a function of expected short-term rates and expected long-term rates.

The preceding also implies that the notion of “real,” defined in the Fisher sense, is inappropriate. What matters is the relationship between cash inflows and cash outflows, and reducing the latter to inflation is misleading (for example higher, inflation does not necessarily decrease the debt burden of debtors) and partial (they are many other sources of cash outflows).

Are you convinced? Comments welcome.

Comments

[Arthur Eckart]

The paper concludes liquidity not purchasing power, or the relationship of cash inflows and outflows, is what matters. The assumption is if wages and inflation double, then there's an improvement in financial power and wealth, i.e. inflows will increase relative to outflows. However, that's true only if there's excess liquidity (or idle capacity) to begin with.

[Dave Iverson]

Arthur E says, "The assumption is if wages and inflation double, then there's an improvement in financial power and wealth...."

I can't draw that conclusion from either Tymoigne's article or his conclusion. Can you help me better understand how you conclude that Tymoigne draws such a seemingly silly conclusion?

PS.. You can find other interesting working papers from Eric Tymoigne at the Levy Economics Institue, here.

[Arthur Eckart]

Dave, there's an example on page 29.

[Dave Iverson]

Thanks Arthur,

Your are right, at least in part. Tymoigne does argue that, all else equal "...if wages and inflation double, then there's an improvement in financial power and wealth." This seems logical if only because bankers have to eat losses for inappropriate forecasts of inflation (when inflation get out ahead of inflationary expectations), and other determinants of the interest rates they charge on outstanding debt. So, all esle equal, it isn't such a "silly conclusion." Just a silly comment by me.

After reading the paper more in-depth, I think that instead of your "The paper concludes liquidity not purchasing power, or the relationship of cash inflows and outflows, is what matters. ," a more appropriate ancillary conclusion from the paper might be stated this way, "In the end, we conclude that economic agents are far more concerned with ...liquidity or solvency ... than with purchasing power.... Not that the latter is ignored or unimportant, but it [is] included into the broader considerations of the former." (p. 2)

You add that this is "true only if there's excess liquidity (or idle capacity) to begin with." Here I am puzzled, as well as 'in over my head' which I usually am in trying to understand this stuff. I might have said something like "This is true only as long as nominal interest rates are rising for long enough to matter in the dance between lenders and borrowers." If my latter statement is correct, how does it relate to yours?

AND, we may be chasing ghosts here. How do you answer the "Are you convinced" question as cast up in the "post"? I tend to buy into a lot of the Minsky-related chatter including this, but am always looking for feedback to help me understand the "error of my ways."

[Arthur Eckart]

Dave, the paper attempts to prove agents are more concerned with liquidity or solvency than purchasing power using an example that works only if there's excess liquidity (or unused liquidity or idle capacity) to begin with. Without excess liquidity, when everything doubles, there's no increase in wealth. However, if there's excess liquidity to begin with, then nominal wealth can increase. So, why would there be more concern about liquidity or solvency than purchasing power when there's excess liquidity to begin with?

[Arthur Eckart]

Also, I may add, liquidity is more important than purchasing power, although linked to other factors, since the U.S. dollar lost so much purchasing power, while U.S. living standards have risen so much.

[Dave Iverson]

Arthur,

I think we are still chasing ghosts. It doesn't matter that "when everything doubles, there's no increase in wealth," at least not to loaners and borrowers trying to "game" their way through life. All that matters to them is who is on the winning/losing side of the plays, from time 1 to time 2 to time n. That is one of the points Tymoigne was trying to make.

It certainly ought to matter to central bankers, since there is no need to inflate for the sake of inflating, and inflation is not neutral: it tends, at minimum to disadvantage those on fixed incomes who aren't smart enough to prudently hedge (and who among us is smart enough). That is another subpoint Tymoigne is trying to make. With the bigger point being what Garrett Hardin calls the second law of ecology: You can never do just one (or two) things. So the Fed ought, according to Tymoigne, Davidson and others, to change the way they deal with interest rates relative to inflation.

So, in your opinion "Was Fisher wrong about rates?" as alleged by Tymoigne?

Finally, and off-topic: As to "the U.S. dollar lost so much purchasing power, while U.S. living standards have risen so much" all I can say is let's see how the picture looks in about a decade. It could be, by then, that we will see a much diminished middle class in the U.S. (after we all realize that the so-called "wealth effect" was really "wealth illusion") with the rich still richer than God, and the U.S. looking more and more like a third world country. So much for rising "living standards" when we seem to be losing one of the important fabrics of a working democracy: the middle class.

But let's wait a decade to have the follow-up discussion. Right now that discussion takes us away from an important discussion about whether or not the FED is operating more like the cartoon character Mr. Magoo or is operating as "wise, benevolent bankers" as David Altig (macroblog) recently pronounced.

[Arthur Eckart]

Dave, the GDP price deflator may be more appropriate than the CPI. However, I suspect, there's omitted variable bias. So, it's uncertain if Fisher was wrong. Regarding your off-topic statement, the ultimate goal of the Fed is to raise U.S. living standards optimally. In the global economy, the best position is to win the most in an expansion and lose the least in a contraction. Optimal choices can be made to maintain the best possible position, given the choices of "the rest of the world." There's extensive mathematical and empirical support that the rest of the world has made "inferior" choices, while Fed policy has countered with near optimal choices. For example, in the U.S. housing market, and free market, when demand exceeds supply, prices rise and there's excess profit. So, new supply is created until excess profit disappears. Also, Say's Law states supply creates its own demand. In the mid-'90s, there was a shortgage of U.S. houses. So, a homebuilding boom began, which was facilitated by financial innovation. Consequently, the U.S. homeownership rate rose to an all-time high recently. Those houses, which are real assets, won't disappear. Rather, some houses will shift between households. So, the U.S. housing boom contributed to higher U.S. living standards.

[Dave Iverson]

Arthur,

All I can do at this point is to disagree emphatically. Say's Law is OK, except in those circumstances when it is not! The worldwide housing bubbles are an instance where it is not.

The so-called "wealth effect" in housing is illusory, and just like in the wake of the 1929 bust I believe we will find that we've created McMansions (earlier they were the stuff of the Great Gatspy housing opulance) that may indeed just prove how stupid and short-sighted we can be, as many of them sell for small fractions of what they do today, else sit boarded up and idle as they did after the "great" bust. Greenspan's folly! See the bulk of my Economics Dreams-Nightmares blog for more. But we'll have to see in a decade which of us proved more correct. All we would do here, if we were to continue to chat, is to babble more from our ideological biases.

For some specifics on what we might call Free Market Fundamentalism, see Economic Fundamentalism and Post Autistic Economics, both from my Ecological Econoimcs blog.

[Arthur Eckart]

Dave, current account deficits are offset by capital account surpluses to keep the balance of payments balanced and negative net exports lower domestic growth. To counter overproduction by export-led economies, the Fed allowed unbridled growth in the U.S. housing market to raise U.S. production. Many of those excess dollars were absorbed in the U.S. housing market and related goods through the balance of payments, which resulted in the creation of real U.S. assets. When the global economy slows, those real assets won't disappear, and both the current and capital accounts will shrink. Consequently, U.S. export growth will be higher than U.S. import growth, which will add to U.S. production. So, some level of U.S. growth can be maintained.

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