Social Structure And The Determination Of Interest Rates

In The Reformation of Economics, Philip Pilkington argues that societal structure determines the power of creditors and therefore interest rates. He then attacks mainstream financial and economic theories about interest rate formation. Although I agree that institutions matter for the determination of the power of creditors, I see mainstream theories of interest rate formation as adequate within the current institutional structure of developed countries. (Link to my review of The Reformation in Economics.)

 My Summary of Pilkington's Arguments

This article is based on some of the contents of Chapter 9 of the book -- Finance and Investment. As an initial disclaimer, I want to emphasise that I am going to summarise some of the points that Philip Pilkington makes there, but I am not attempting to discuss the entirety of his arguments.

He is highly dismissive of mainstream economics and finance, and the use of the Efficient Markets Hypothesis with respect to interest rate formation. I agree with some of his criticisms, but I rely upon the efficient market hypothesis in my analysis of interest rate determination (rate expectations theory). The divergence in views can be viewed as the result of looking at different questions.

Firstly, the discussion of interest rates in classical economic theory is utterly worthless. My disagreement with Pilkington on that score is that I think the entire topic should be ignored as an intellectual embarrassment, whereas he argues that "Wicksell is no relic" (page 253) [Update: Typo fixed; thanks to Calgacus.] . I come from an academic background where we do not waste time on dead theories; for example, I could find no mention of optimal control in a quick scan of the standard robust control theory textbook Feedback Control Theory, by Doyle, Francis, and Tannenbaum. This is despite the fact that there is an obvious mathematical linkage between optimal and robust control. (The Kalman Filter is one of the few relics left behind from optimal control theory.) As an ex-academic, I understand the concerns regarding originality, but at the same time, we cannot cripple our ability to advance economic theory by wasting time worrying what Wicksell -- or Keynes -- really meant.

Modern financial theory argues that we can decompose the interest rate of any instrument into three components (assuming there is no embedded optionality, such as the ability to prepay, convert, call, or put the instrument back to the issuer):

1. The expected "average" of the short-term credit risk-free rate (usually the policy rate) over the maturity of the instrument. (Technically, a geometric average.) 
2. The term premium for credit risk-free instruments (e.g., Treasury bonds in the United States) associated with the term of the instrument.
3. A credit spread.

(If you want to get finicky, there are second-order effects, such as the effect of being able to fund a bond cheap at a special repo rate, as well as benchmark or liquidity premia. The liquidity premium is a particularly confusing concept in this context, as Philip Pilkington prefers Keynes' liquidity preference theory. His concept of a liquidity premium is what I would call the term premium; the liquidity premium under my definition is how much more expensive a benchmark bond is relative to a fitted curve.)

In my view, modern mainstream models (i.e., Dynamic Stochastic General Equilibrium) are largely consistent with this version of financial theory, although they contain other elements that are the source of problems (the embedded assumption how interest rates affect economic dynamics).

Conversely, Philip Pilkington argues that borrower's interest rates are determined by two factors.

1. Institutional structure of the economy.
2. Liquidity preferences of investors.

I will discuss these in turn.

Institutional Factors

The modern financial theory decomposition of interest rates makes sense in the modern institutional context, where we have large dedicated fixed income investors and a well-defined bond market. It would probably be of little use in analysing lending in ancient Rome. 

Pilkington argues that interest rates depend upon the power of creditors. This is arguably true; we no longer have debt slavery or debtors' prisons (although some political groups seem to be sneaking debtors' prisons back under the door). Therefore, I have no argument that the "total cost" of borrowing (when we take into account the risk of being thrown into prison) depends upon institutional factors. However, does this have much to say about market interest rates in the developed economies over the past few decades? It is very hard to see trajectory of interest rates from the post-war lows, to the early 1980s peak, and back to the current lows as being the result of changes to the power of creditors as a class.

He raises the question of loan sharks. They can charge exorbitant rates of interest, as their demands are backed by the threat of violence. That said, it is very hard to see the effect of loan sharks on national economic data. (Other illegal activity can leave a mark that is picked up in the national accounts, such cigarette smuggling in Canada, or the narcotics trade in Vancouver.) I cannot recall any Fortune 500 corporation declaring bankruptcy (or getting its kneecaps broken) as a result of an unfortunate run-in with loan sharks.

In other words, power considerations matter for social researchers, but are not something that a fixed income analyst is going to spend a lot of time on.

Liquidity Preference

Although it may not help my reputation among post-Keynesians, I am not a fan of "liquidity preference" when discussing interest rate formation. 

I would summarise Pilkington's discussion of the liquidity preference is that he (like Keynes) is interested in the interest rate faced by the private sector, which it needs to take into account when making financing and capital investment decisions. (He notes that the rate of interest is not too important when making those capital investment decisions.) Investors are taking risk by lending long-term to the private sector, and they need to weight that risk versus investing in safe "cash" assets. (Cash is not just economist's "money," it includes all short-term instruments that are viewed as safe; "money good.") The extra interest demanded rises and falls in line with investor's desires to hold cash.

In my view, that is mingling four separate effects:

1. expected path of short rates changing;
2. the (risk-free) term premium changing;
3. credit spreads changing;
4. ability to finance positions changing. 

The final factor (changing financing conditions) is the least familiar, and I will only discuss it briefly. During the Financial Crisis, a great many large investors had financed positions using short-term repo financing in any number of instruments. Once that crisis hit, that repo financing disappeared. The most extreme example in (non-euro) sovereign bond space that I can remember was the case of long-dated index-linked gilts: they were trading at LIBOR+150 basis points. That pricing was stupidly cheap, and did not reflect anyone's beliefs about the credit quality of the gilts in question. However, everyone knew that there were a lot of big investors who were stuck with index-linked gilt positions that they could no longer finance, and so pricing was set at stupidly cheap levels. (Since my firm had not traded those instruments before the crisis, we were unlikely to start then. However, if we were to do so, I would certainly recommended buying them near LIBOR + 125 basis points, even though "fair value" by any of my models was almost certainly below LIBOR.) In summary, positioning can matter for bond pricing; but this is normally a short-term issue that will eventually be worked out.

Returning to the more standard decomposition of rates, I believe that we need to firmly distinguish credit spread movements from the movements of the risk-free curve (which includes both rate expectations and the term premium; I will ignore the term premium here for interests of space). The explanation is straightforward: they can move in the opposite directions. For highly-rated instruments (like pfandbriefe), this is typically not enough to allow the all-in yield on the credit instrument and a government bond to move in opposite directions, but this does happen with credits with wider spreads. If long-term government bond yields are falling, and long-term industrial BBB yields are rising, it is hard to see how a single "liquidity preference" factor can help explain that situation. 

Of course, mainstream economic theory is going to be fairly useless in explaining why credit spreads move. That said, the models that incorporate credit spreads do not even try to do so: credit spreads are one of those magical exogenous shocks that allow newer DSGE models to "explain" the Financial Crisis. I subscribe to a fairly crude version of the Efficient Markets Hypothesis: it is difficult to outperform markets consistently. If this hypothesis is correct, we should not expect to find an economic model that can predict credit spreads accurately, and so we should not warp our economic modelling strategies trying to do so.

(c) Brian Romanchuk 2017