IPE 2010 Leiden University
Session 2 – Agustin Mackinlay
April 8, 2010

An introduction to credit markets
Required reading. Horace W. Brock: “Determinants of interest rates”, in Boris Antl (ed.) Management of Interest Rate Risk (London: Euromoney Publications, 1988).

· The importance of credit markets
· Determinants of interest rates
· Changes in interest rates
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The importance of interest rates
We refer here to long-term interest rates (10 years or more); thus, we need to make a distinction between long-term interest rates, which are set on the largely deregulated and globalized credit market, and overnight interbank money-market rates, which are set by central banks. You don’t build a factory, you don’t buy a home on an overnight loan!

Credit, it has been said, is the lifeblood of the modern economy. The capital resources available to entrepreneurs, the cost of the public debt (and therefore future tax levels), the value of our homes –all depend on the availability of credit and on the level of interest rates.
Credit is power! In his biography of the Duke of Marlborough, Winston Churchill marvels at the power of the City of London to “manufacture” credit and win the war against Louis XIV! More recently, Russia faced a severe credit crisis just as it intervened in Georgia –the war lasted barely a week (summer of 2008). US Democratic strategist James Carville famously stated that he wanted to be “reincarnated as the credit [bond] market because it can intimidate everybody”.

Credit & wage levels. Adam Smith and Greece! Countries that face a high cost of labor and –simultaneously–high interest rates (cost of capital) usually are in deep trouble: Argentina 1999-2001, Greece 2010. This has serious implications in terms of financial diplomacy, as the actions that will be taken will depend on the diagnosis…

Determinants of interest rates
Excellent paper by Horace Brock; we only need to “update” it, and to re-introduce politics into the credit market! Note the reference to “loanable resources”: this reminds the reader that lenders risk real resources (savings); in other words, they are not just pushing a button, as central banks do when they change their target for the discount rate.

How interest rates change: whenever new information alters the behavior of either/or those who demand credit and/or those who supply loanable resources.

Changes in interest rates
As we shall see, long-term interest rates can change for a number of reasons (this is another key difference with short-term central bank rates). By far the funniest case I ever encountered about changing interest rates was when Julius Caesar borrowed so much money to pay bribes (to get elected as Pontifex Maximus in 63 BC), that interest rates jumped to 30% in Rome! [Christian Meier. Caesar. A Biography. New York: Basic Books, 1997).

In chapter XXIII (Book III) of his Principles of Political Economy (“Of the Rate of Interest”) [NOT required reading!], John Stuart Mill writes that “Both the demand and supply of loans fluctuate more incessantly than any other demand or supply whatsoever”. Indeed! We will consider the following cases, with more or less intensity: [1] Budget deficits / [2] Inflation expectations / [3] Innovation / [4] Foreigners / [5] Demographics / [6] Rule of law / [7] Flight-to-safety episodes / [8] Islamic finance.

[1] Budget deficits
A useful distinction: demand for credit from the public sector and demand for credit from the private sector. The demand for credit from the public sector deals with the budget deficit (or surplus) and additional financing needs like debt amortization. Remember: when countries face a budget shortfall, they have to borrow!

Recent massive bank bailout-economic recovery packages have swelled most OECD governments’ financing needs. “By the end of this year, OECD sovereign debt will have exploded by nearly 70 per cent from 44 per cent of GDP in 2006 to 71 per cent” (David Roche: “Watch out for sovereign black holes in the credit universe”, Financial Times, April 1, 2010).

Last week the Irish government has announced a bank bailout package that will allow banks to sell €81bn to the National Asset Management Agency, which in turn will issue up to €51bn in bonds. And this week the US Treasury is set to borrow $82 billion from the credit markets.

From Robert E. Rubin & Jacob Weisberg. In an Uncertain World. Tough Choices form Wall Street to Washington. New York: Random House, 2003, pp. 361-363 [NOT required reading!]

When the government borrows, the pool of savings available for private purposes shrinks and the price of capital ―expressed as the interest rate― rises. If the Treasury ceases to borrowing and instead begins paying down some of its outstanding $3.8 trillion debt, the savings pool available to the private sector increases and interest rates go down. A study by Robert Crumby at Georgetown University and two of his colleagues, completed sometime after the hearing, found a strong correlation between bond market interest rates and expectations about future fiscal conditions. The Cumby paper overcame a serious problem with previous papers that had examined only the relationship between interest rates and current fiscal conditions. Focusing instead in the relationship between interest rates and expected future conditions makes sense: a buyer of a five- or ten-year bond should logically be influenced primarily by expectations about interest rates and bond prices over the life of the asset …

Interest rates are affected by many factors, which makes isolating the impact of fiscal conditions more difficult. Also, though fundamentals win out over time, at any given moment the psychology of the market may be at variance with the fundamentals. For example, when the economy and private demand for capital are sluggish, markets may focus very little on unsound long-term fiscal conditions and interest rates may remain low, as happened in 2002 and the first half of 2003. (Although even during that weak period the historically large spread between higher long-term interest rates and the lower short-term rates the Fed controls suggests that the deficits might have been having some effect).

But whatever the effects may be when the economy is weak, once economic conditions are again healthy, the private demand for capital will increase. Then markets will at some point focus on long-term fiscal conditions, and that increase in private demand will then collide with the government demand for financing to fund its budget deficits. Virtually all mainstream economists agree that there is no fiscal free lunch. Though no one can predict when, interest rates will react strongly to expectations of substantial long-term deficits and the effect of those deficits on the demand to borrow.

Let me put numbers on these concepts, to show how powerfully adverse the effects on our economy could be. When used to look at the effects of tax cuts, the Federal Reserve Board model projects that for each increase in the deficit of 1 percent of GDP, long-term interest rates will increase by 0.5 percent to 0.7 percent. Some analysts use lower estimates of that relationship, so, for purposes of this calculation, I assume that if the deficit increases by 1 percent of GDP, long-term interest rates will increase by 0.4 percent.

[2] Inflation expectations
Not the most exciting of topics, I admit. Nonetheless, it is of critical importance. Only if we understand the dynamics of inflation expectations can we pretend to understand the way the Federal Reserve & the ECB work. Inflation expectations are a key element of the dynamics of credit markets and long-term interest rates. The best way to understand this issue is through … a real-life example!

- Scenario: Mexico 1994. Zapatista movement + presidential candidate assassinated + large bank failures. Can we expect the Mexican government to react in panic, printing lots and lots of money?

- Changes in the demand for credit. If so, one would expected to one’s income rise, at least in nominal terms, as prices increase and wages are adjusted upwards. In such a scenario, would you be willing to demand MORE OR LESS CREDIT, AT A FIXED RATE OF INTEREST?

[DIAGRAM: Increasing inflation expectations lead to MORE demand for credit at each level of the interest rate, as increasing income is used to pay fixed interest costs]

- Changes in the supply of loanable resources. If you have funds to lend at a fixed interest rate, the knowledge that you will get paid back in a currency that is worth less (in terms of purchasing power) will make you be willing to supply MORE OR LESS LOANABLE RESOURCES?

[DIAGRAM: Increasing inflation expectations lead to LESS supply of loanable resources at each level of the interest rate, as lenders are paid back in a currency that is worth less in purchasing power terms].

[DIAGRAM: THE NET RESULT. The net result of an increase in inflation expectations is ALWAYS the same: LONG-TERM interest rates go up!!! Note that there is NO INCREASE IN THE AMOUNT OF CREDIT!!!]

The Political Economy of Inflation Expectations: Central Bank independence.
Largely as a result of the 1995 crisis, Mexico embraced the notion of an independent central bank in the second half of the 1990s. There are de jure and de facto measures of Central Bank Independence (CBI); the latter is usually the turnover rate of a central bank governor over a ten-year period.

. No Argentinean central bank governor has ever completed his term! The last sacking took place in February 2010; guess who’s having an inflation problem right now?

. Just after winning the general election in 1997, Tony Blair and Gordon Brown announced that the Bank of England would independently decide over short-term rates; even thought the BoE raised its target for the short-rate from 6.00% to 6.25%, the move triggered a sharp downward adjustment in long-term interest rates. Why?

One could also argue in terms of separation-of-power issues. Following W.B. Gwyn, we can cite three criteria to justify CBI: (a) efficiency; (b) rule of law and; (c) transparency. A central bank that functions as an alter ego of the Treasury department would perhaps be run in a less efficient and transparent way; this situation would also place a great deal of power in the hands of the executive branch. [NOT required reading! W. B. Gwyn. The Meaning of the Separation of Powers. New Orleans: Tulane University, 1965].

The first point was aptly made by Stefan Ingves, gobernor of the Swedish Riksbank [NOT required reading! Stefan Ingves. “The relationship between the Riksbank and the Riksdag”, Bank for International Settlements, June 2007]. For a recent paper with some empirical evidence, see [NOT required reading!] Christopher Crowe & Ellen Meade: “Central Bank Independence and Transparency: Not just cheap talk”, Vox, July 31, 2008. On central bank transparency, see [NOT required reading] Nergiz Dincer & Barry Eichengreen: “Central Bank Transparency: Where, Why and with What Effects?”, NBER Working Paper W13003,2007].

[3] Innovation & credit markets
Now this is an exciting topic! Joseph A. Schumpeter (1883-1950) is the key pioneer in the field of economics and innovation. Schumpeter wrote the Theory of Economic Development [Google Books] in 1911, almost 100 years ago! Schumpeter on the credit market: “He can only become an entrepreneur by previously becoming a debtor … what he first wants is credit” (Theory of Economic Development, p. 102); from a recent biography [NOT required reading! Thomas K. McCraw. Prophet of Innovation. Joseph Schumpeter and Creative Destruction. Harvard University Press, 2007; web; prologue]: “The core ethos of capitalism looks constantly ahead and relies on credit in launching new ventures. From the Latin root credo —'I believe'— credit represents a wager on a better future ... In the absence of credit, both consumers and entrepreneurs would suffer endless frustrations” (p. 7).

Initially, the emergence of innovative entrepreneurs pushes interest rates higher, as demand for credit shifts upward.

[DIAGRAM. Demand for credit increases at each level of the interest rate!]. The result is a higher level of interest rates…

Now, Schumpeter also praised financial innovation — up to a point. In the case of railroads in the second half of the XIXth century, or the automobile industry, he states that “credit creation” in the form of overdrafts and car loans [i.e credit creation on a large scale] made it possible to finance these innovations.

[DIAGRAM. The supply of loanable resources increase]. Note that the net result is a stable interest rate + more credit!!! This is the kind of result you want to have!
But then he adds: “Some of that lending was granted with almost unbelievable freedom and carelessness”. Does that ring a bell? Sounds familiar? BOOM-AND-BUST IS INDEED PART OF THE PACKAGE!!!!. Schumpeter made a distinction between productive & non-productive financial instruments. When bankers create financial instruments to “play amongst themselves”, then the risk of a bubble increases dramatically. But is it possible to really make that distinction?

Alan Greenspan says so. In his 2007 autobiography, Greenspan —a self-declared Schumpeter fan—had only positive things to say about sub-prime lending: “The gains [he is referring to the percentage of households who own their house] were especially dramatic among Hispanics and blacks, as increasing affluence as well as government encouragement of subprime mortgage programs enabled many members of minority groups to become first-time home buyers” [NOT required reading! Alan Greenspan. The Age of Turbulence. Adventures in a New World. New York: Penguin, 2007, pp. 229-230)]

Any ideas? Obviously, Greenspan got that one wrong… On this topic, see [NOT required reading!] the paper by Charles G. Leathers & J. Patrick Raines: “The Schumpeterian role of financial innovations in the New Economy's business cycle”, Cambridge Journal of Economics, 2004, No. 28, Vol. 5, pp. 667-681.
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Innovation & invention
An innovation is an invention with a proven track record in the market place!
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Schumpeter & Keynes (briefly)
Keynes. In times of crisis & depression, when everybody at the same time wants to get out of debt and sell assets, the state has to intervene to counter the downward movement.
Schumpeter. Innovation provides the solution. Innovation itself stimulates demand, as prices tend to drop, which stimulates demand.

Keynes, adds Schumpeter, is too pessimistic about human creativity. As early as 1919 (The Economic Consequences of Peace), he thought that humans had reached the end of their creative potential. Schumpeter was stunned to note that Keynes’ great 1936 book, the General Theory, did not contain one single mention of a firm or an entrepreneur. The Austrian was right on that score.

Keynes. To which Keynes famously responded: “In the long run where all dead”. And here, of course, he was also right.

MINI-DEBATE: Can we have it both ways? Schumpeter for normal times, Keynes for depressions? Both at the same time?
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Assignment No. 2 – March 8, 2010

Find at least one modern example for each of the five types of Schumpeterian innovation (500-word essay)

[Please cite your sources: books, journals, newspapers, company website, website, etc.]. Please cite (only if available) statistics of market size. Please cite innovations, not just inventions. If you think that an invention does have the potential to become an innovation, briefly state the business case!
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[REQUIRED READING!] Excerpt from Joseph A. Schumpeter. The Theory of Economic Development of Innovation (Cambridge, Massachusetts: Harvard University Press, 1934) [1911], p. 66, as quoted by Thomas K. McCraw (*):

Schumpeter specifies five types of innovation that define the entrepreneurial act. To quote his list directly:

(1) The introduction of a new good –that is one with which consumer are not yet familiar- or of a new quality of a good.

(2) The introduction of a new method of production [or commercialization], that is one not yet tested by experience in the branch of manufacture [or retail trade] concerned.

(3) The opening of a new market, that is a market into which the particular branch of manufacture of the country in question has not previously entered, whether or not this market has existed before.

(4) The conquest of a new source of supply of raw materials or half-manufactured goods, again irrespective of whether this source already exists or whether it has first to be created.

(5) The carrying out of the organization of any industry, like the creation of a monopoly position, or the breaking up of [an existing] monopoly position.

(*) Thomas K. McCraw. Prophet of Innovation. Joseph Schumpeter and Creative Destruction(Harvard University Press, 2007).

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Additional documents [NOT required readings!]

Innovators: a touch of madness? (*)

Most innovations are introduced not by the regimented R&D of established corporations, but by scrappy new firms, twin-born with the invention itself. Willian Baumol, who has been laboring for years to create more space for entrepreneurship and innovation in economic theory, ventures that most breakthroughs arise this way ¾ the offspring of independent minds not incumbent companies. Revolution is a risky endeavor. Of 1,091 Canadian inventions surveyed in 2003 by Thomas Astebro, of the University of Toronto, only 75 reached the market. Six of them earned returns of 1,400%, but 45 lost money. A rational manager will balk at such odds. But the entrepreneur answers to his own dreams and demons. Mr. Baumol thinks a “touch of madness” is probably one of the chief qualifications for the job.

(*) The Economist. “Searching for the invisible man”, March 17, 2006.
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Innovators: a bunch a maniacs? (*)

The typical traits of an entrepreneur:

• He is filled with energy.
• He is flooded with ideas.
• He is driven, restless, and unable to keep still.
• He channels his energy into the achievement of wildly grand ambitions.
• He often works on little sleep.
• He feels brilliant, special, chosen, perhaps even destined to change the world.
• He can be euphoric.
• He becomes easily irritated by minor obstacles.
• He is a risk taker.
• He overspends in both his business and personal life.
• He acts out sexually.
• He sometimes acts impulsively, with poor judgment, in ways that can have painful consequences.
• He is fast-talking.
• He is witty and gregarious.
• His confidence can make him charismatic and persuasive.
• He is also prone to making enemies and feels he is persecuted by those who do not accept his vision and mission.

(*) John Gartner. “America’s Manic Entrepreneurs”, The American Enterprise Online, 2005 http://www.taemag.com/issues/articleid.18583/article_detail.asp
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Steve Jobs (*)

Rocketed heavenwards by Toy Story, floated Pixar, became billionaire, rejoined Apple, took credit for predecessor's work, basked in glow, screwed up a bit, realised error of ways, saw potential of music, bought iTunes, produced iPod, survived cancer (so far), basked some more in new glow. Now sitting pretty on intriguing nexus of computers, animated films and digital music. Has ambitions to do something that will be the terror of all mankind, though none shall know what.

(*) Charles Arthur: “Steve Jobs: smoke and mirrors or iCon?”, The Register, May 2005.
http://www.theregister.co.uk/2005/05/20/jobs_biography/

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[NOT required reading!] From Thomas K. McCraw, pp. 476-479:

[Note: McGraw sums up Schumpeter’s sharply critical views about Keynes].

Schumpeter announced the verdict of his intellectual wrestling match [with Keynes] in his presidential address at the annual meeting of the American Economic Association on December 30, 1948, in Cleveland … He knew he was in danger of offending his listeners, most of whom were themselves Keynesians. But he marched fearlessly on. He said that Keynes’s ideological vision, like Marx’s, had been formed quite early. It did not emerge clearly in print until Keynes was thirty-seven years old, at which time the outlines of what became Keynesianism appeared “in a few thoughtful paragraphs in the introduction to the Consequences of the Peace”. Schumpeter asserted that “these paragraphs created modern stagnationism”. They outlined Keynes’s unshakable conviction that the business system was headed toward a state of permanent inanition. In the future, companies would no longer be able to offer good investment opportunities. Funds accumulated by moneyed interests would go unspent. Wages would not be sufficient to support increased consumption. Without government stimulus, capitalism itself would stagnate. “This vision”, said Schumpeter, “never vanished”. It reappeared in many of Keynes’s other works but “was not implemented analytically” until the publication of The General Theory in 1936.