theory of interest

["Devine, James" <jdevine@xxxxxxx>]

[was: RE: [PEN-L:25923] Re: RE: P.S.]

Gil originally wrote:>>>For what it's worth, mainstream theory suggests
another possible explanation for positive interest rates besides time (and
possibly risk) preference, although it is not one that is typically
emphasized:  interest represents a scarcity rent for capital.  This latter
explanation is both plausible and consistent with the now much-reinforced
empirical finding of interest-inelastic savings.<<<

I wrote:>>This may be a "much-reinforced empirical finding," it is not
treated as such by the intermediate macro textbooks, at least not all of
them. There's one I read -- was it Abel & Bernanke? [YES!! even in the 2001
edition!] -- that (1) said that saving is interest-inelastic and then (2)
consistently drew the supply of saving as upward-sloping, matching the
downward slope of the demand for saving curve (i.e., investment demand).
They did the same for the supply  of labor[power] curve.<<

Gil answers:>Yes, and quite a surprise, isn't it, that textbooks are slow in
catching up with reality? Hall & Taylor is the intermediate macro text I
have on hand, and it notes that the evidence favors a 0-elasticity savings
supply function.  Since that edition the results of a multi-country study
was published, I believe in Review of Economics & Statistics, that strongly
corroborated this funding.<

The conflict between the income (or wealth) effect and the substitution
effect of changing interest rates should have been familiar to economists
back when Keynes wrote THE GENERAL THEORY, since he mentions it (on page 182
of the paperback edition, citing Gustav Cassel), but economists (especially
those of the Chicago ilk) seem to be in love with the substitution effect.
It has something to do with their belief that the economy can be described
as a "price system": if key prices (wages, interest rates) don't have
significant effects on the quantity supplied, then it's hardly a "price
system"...

I'm not sure that textbooks are "slow in catching up with reality." I think
that most of them are _locked into_ unreality and we shouldn't expect them
to "catch up." Orthodox macro textbooks continue to use the aggregate
production function, even though it was discredited 30 years ago and such
folks as "Nobelists" Samuelson and Solow admitted as much. Some textbooks
are marginally better, such as Dornbusch/Fischer/Startz, who use the
aggregate production function but see little or no impact of interest rates
on saving or of wages on labor-power supplies. (I couldn't find the latter
in their 2001 edition, but earlier editions drew the supply of labor-power
as vertical.)

BTW, I don't really believe in the vertical labor-power supply curve:
there's a horizontal "tail" on the left, since if wages go too low it
interferes with the reproduction of labor-power.  So the curve is backward L
shaped. (Of course, the whole idea of an aggregate labor-power supply curve
is an abstraction, one that can easily be abused. Labor-power markets are
inherently heterogeneous and institutional in nature. The Soskice model of
labor-power markets mentioned below is better, since in his model and in
reality the standard labor-power supply curve really represents a constraint
that's hardly ever binding. That is, the existence of unemployment is
normal.)

I wrote: >>BTW, the inelastic saving supply curve fits with Keynes' idea
that interest and profits represent quasi-rents, i.e., temporary scarcity
rents. Of course, that doesn't quite explain why savings never lose their
scarcity value, so that the interest rate zooms to zero.<<

>I agree, and take the latter sentence as a legitimate critical comment on
the former. To label interest or profit as quasi-rents is to posit that in
the "long run,"  these returns can be expected to disappear--or, speaking
more generally, fall to their "reservation" or "opportunity cost" levels.
This is clearly what Adam Smith had in mind when he spoke of the "natural
rate" of profit, and argued the actual profit rates would tend toward their
respective "natural" levels.  But this need not be the case, as Marx's
analysis in KI, Ch. 25 illustrates.<

I'm not a Adam Smith scholar: did he believe that the rate of profit would
go to zero, so that capitalism would be in essence transformed into simple
commodity production? I've usually interpreted the "natural" profit rate as
simply referring to a hypothetical equilibrium level where profit rates are
equalized amongst sectors. (The profit rate of one sector includes so-called
"normal" profits, which correspond to the profit rate attained in other
sectors.) Not having read Marx on the production of surplus-value, Smith
lacked an explanation of why the equalized profit rate would be positive in
most cases. Neoclassicals still lack an understanding of this matter: they
assume that monopoly is only a microeconomic phenomenon, so that for the
economy as a whole, true or "economic" profits = 0, with national income
accounting profits corresponding to the cost of using fixed physical
capital. (Rate of profit = rate of interest = marginal product of capital.
Of course, as mentioned, the idea of an aggregate MP of K can't make any
sense because there's no aggregate production function.)

Gil added:>>>I should have said that mainstream theory suggests another
possible explanation for positive interest rates that, like explanations
based on time or risk preferences, is consistent with the operation of
competitive and complete markets.  Of course nothing ensures that the
relevant markets in which interest rates arise have these "nice" properties.
Leaving that restriction aside, mainstream theory could adduce explanations
based on market power (e.g., collusive rate-setting) or contractual
imperfections (e.g., "efficiency" interest rates, as in the Stiglitz/Weiss
model of credit rationing).<<<

I responded:>>I don't think that these latter explanations that orthodox
theory could adduce help us with the question at hand. They are
microeconomic explanations, that don't explain the general (macro) rate of
interest, perhaps as measured by the yield on a minimum-risk corporate  bond
(or by an average of empirically-existing interest rates). Rather, they
explain differences of interest rates between different lenders or markets.
<<

Gil re-responds:> Maybe, but not necessarily, so long as most markets for
interest-bearing  assets exhibit these features in some degree.<

I doubt that the secondary markets in corporate paper (i.e., not IPOs) have
any taint of market power or of "contractual imperfections." These are very
important markets that have a big effect on financial markets in general. If
I understand it, the Stiglitz/Weiss story applies best to bank loans. In any
event, it's a theory of how lenders need to be compensated for the costs of
incomplete & asymmetric information (moral hazard, adverse selection) rather
than a theory of pure interest. The latter would refer to interest income
_above_ the costs of imperfect information and the like.

Gil:>A parallel case is the relationship between the wage curve (a micro
notion) and the Phillips curve (macro) discussed by Blanchard and Katz.<

I don't remember their writing on this subject very well except for their
article in the JOURNAL OF ECONOMIC PERSPECTIVES. (What's the ref.?)
Blanchflower and Oswald's wage curve -- i.e., that real wages fall as
unemployment rises -- is very much the same as Marx's theory of the reserve
army of labor (except at a micro level, since Marx's is a macro theory).
Because class relations represent a general condition -- i.e., something
that exists on the macro level -- facing proletarians, that means that we
can see it in almost other every labor-power market outside of so-called
internal labor markets and elite "head-hunter markets." The latter are, by
their very nature, clearly segmented away from the usual labor-power
markets. So it's reasonable to see the wage curve as having a macroeconomic
version.

If you mean Blanchard and Katz's 1997 article "What We Know and Do Not Know
about the Natural Rate of Unemployment" (JEP, 11(1) Winter: 51-72), it's
interesting that there they use a theory that my old friend David Soskice
developed without giving him credit. (See Soskice 1983, "Economic Theory and
Unemployment: Progress or Regress since 1936?" INDUSTRIAL RELATIONS, Spring;
see also Wendy Carlin and David Soskice, 1990. _Macroeconomics and the Wage
Bargain: A Modern Approach to Employment, Inflation, and the Exchange Rate_.
Oxford, UK: Oxford University Press.) I don't know if David objected to this
kind of plagiarism or not or whether he even uses that word.

David's basic idea has what has since been called the "wage curve"
determining workers' desired real wages rising as employment rises. The
capitalists' desired real wage is determined by their profit targets, which
in a simple model are constant as employment rises. The intersection of
these two lines determines the equilibrium unemployment rate, i.e., the
NAIRU. This is figure 1 on page 55 of the 1997 Blanchard/Katz article. BTW,
I find Soskice's original treatment to be much more sophisticated. He has a
useful contrast between his own model and the neoclassical one  -- plus the
idea that the wage curve may represent a "zone," allowing for the productive
use of incomes policies. He also brings in Patinkin's demand or sales
constraints on labor-power demand, an idea that neoclassicals seem to have
jettisoned.

Interestingly, B&K have a semi-Marxian view of wages: "If, at a given
unemployment rate, workers keep asking for wage increases corresponding to
the previous higher rate of productivity growth [of the 1960s and early
1970s, e.g.], lower productivity growth will lead to a higher natural [sic]
rate of unemployment until aspirations have adjusted to new realities" (p.
57). In prose, if workers don't accept the capitalist rules of the game
(wages rising with labor productivity), they must be punished with higher
long-term unemployment  (NAIRU). (I don't understand how they can call their
own theory as one of a "natural" rate.) Blanchard and Katz seem to blithely
assume that the employers' desired real wage is determined by a target rate
of profit which is a fixed number. The latter is determined by technology,
perhaps by the mythical marginal product of capital derived from the
aforementioned fallacious aggregate production function. Alternatively, B&K
may simply be assuming that capitalists always have enough power to
eventually impose their wishes on society.

I wrote:>>If I understand Marx's theory correctly, it explains the general
interest rate within the framework of the supply of and demand for loanable
funds, though of course it adds some twists by putting this market into a
societal context (while not assuming full employment as the original
theories of loanable funds did). Interest is one piece of the surplus-value,
so that if workers aren't dominated in society and thus exploited, there is
no production available with which to pay interest. The concept of interest
arises because of the "division of labor" that has developed historically
between industrial capital and money-lending (banking) capital. The
industrial capitalists are willing to share some of the surplus-value that
they've pumped from their workers with the banking capitalists because the
latter provide the service of financial intermediation. ... In this view,
the long-run equilibrium interest rate -- a.k.a. the "natural rate of
interest" of Wicksell _et al_ -- would depend on the relative institutional
power of industrial capital and banking capital and would thus change
between historical eras.<<

> This is consistent with a (bilateral) monopoly story, unless Marx was
insisting that the "relative institutional power" struggles took place
entirely at the collective, political level.<

Bilateral monopoly is a purely micro phenomenon. Relative institutional
power (my phrase, not KM's) might be explained in terms of structural
factors creating needs: for example, before the development of the
Eurodollar markets, US industrial capitalists were more dependent on US
banking capitalists, giving the latter more "institutional power." But when
those markets opened up, along with various non-bank ways of financing, the
institutional power of the banking capitalists shrank. They were less
necessary to financial intermediation, causing a decline in banking profits
-- and eventually all sorts of financial innovations that made the banks
more like non-bank means of intermediation.

Perhaps a clearer example of institutional power can be seen in the origins
of bankers' profits: in the U.S. and most other countries, there are all
sorts of government-imposed barriers to entry into the banking industry. (As
Mishkin's Money & Banking text makes clear, finance is the one of the most
regulated industries in the world.) This keeps the price of bankers'
services above the cost (and the effective supply curve above the potential
one) even though bankers often lack monopoly power and the banking industry
is generally a competitive one, especially given competition from other
financial intermediaries. These artificial barriers to entry mean that the
banking sector as a whole has institutional power even though individual
bankers are often without such power. (Of course, these days, the merger of
banks is giving more and more monopoly power without such help. BTW, ending
these barriers to entry is not a good idea, since we really don't want
gangsters running banks.)
JD