Re: PEN-PKT Challenge

["Prof BJ Moore, Ekonomie, tel 2416" <bjm@xxxxxxxxxxxxxx>]

Per
you are quite correct, I have a large economy model at the back of my
mind. But in my humble view, this is perhaps the main economic reason
for a ECB.


Date:          Thu, 24 Jul 1997 18:16:21 +0200
Reply-to:      pkt@xxxxxxxxxxxxxxxx
From:          "Per Gunnar Berglund" <pgb@xxxxxxxxxxxxxxxxxx>
To:            POST-KEYNESIAN THOUGHT   <pkt@xxxxxxxxxxxxxxxx>
Subject:       PEN-PKT Challenge

Basil,
Some comments are interspersed below,

Best, Per

----------
Prof BJ Moore, Ekonomie, wrote:

> So if it is conceded
> that the CB can set the ST rate, and persuade the markets that it
> will keep them at this low level in the future, so long rates also
> fall,

PGB
This might still be very true for the largest economies, that is US and
Japan (and maybe also Germany), but the CB of smaller countries face
serious obstacles, due to the impact on the currency exchange rate and
cross-border financial transactions.
Yesterday, I wrote a note on the Swedish bond market depression in 1994. My
prime hypothesis is that the crisis was set off by the Swedish Riksbank
(the CB) trying to "peg" the repo rate at 6.92% instead of managing the
exchange rate (the Krona has been floating since the 1992 collapse). The
Riksbank reasoned along the lines you set out here, namely: "if we keep the
short rate at 6.92, sooner or later the markets will adapt the long rates
to this level". Now, what actually happened was that the bondholders lost
confidence in the 6.92% level, and started selling off bonds. Long rates
started climbing in February--March 1994. The Riksbank obviously
interpreted the first climb as a temporary phenomenon, and failed to react.
Economist after economist assured that "no upward trend is discernible" in
long rates, and that there was "no need for action". This unanimous choir
silenced in June, when long rates were reaching 9 percent (the yield curve
had been virtually flat in February). In July, panic was near, with long
rates passing 10%, and in early August, the chief executive of one of the
largest insurance companies declared that he would boycott government bonds
until order was restaured on the market. Long rates immediately hiked
another 100 points, going well over 11 percent. At this stage, the Riksbank
just couldn't sit their and do nothing. The repo rate was raised by 28
points, causing even more turbulence and disruptions.

This story is not a very encouraging example to those who think that
central banks can easily control the long-term rates. In fact, there seems
to be rather little that a small country can do when facing the huge
international and domestic speculative forces. Trying to liquidise might
end up in a currency weakening, feeding back even worse on the long-term
rates, via inflation expectations spurred by higher import prices. The task
of monetary management is not an easy one nowadays.

BJM
> low interest rates must be very powerful as a stimulus to
> consumption and investment spending.

PGB
To consumption, maybe. I think the empirical evidence on this one is
somewhat mixed. Intuitively, one would think that the wealth effect should
be positive, but on the other hand higher rates will cause savings to grow
faster, thus causing higher income flows in the future. All this is
standard analysis, and I am not convinced that the one effect is much
stronger than the other, countervailing one.
As to investment, yes rates are pretty powerful, I think, as a tool to halt
a boom. But they are certainly not very powerful as a stimulative measure
in a slump. I think nearly all empirical evidence, and in particular the
work of such a distinguished Keynesian investment expert as Robert Eisner,
points to the "accelerator" effect of high capacity utilisation far
outweighs the interest rate impact on business investment spending.


Per Gunnar Berglund
Lilla Sallskapets vag 60
127 61  SKARHOLMEN
SWEDEN

Voice/fax +46-(0)8-883065