The political economy of rate hike-ism

Net interest margins, tightening demands, and epistemic communities

Noah Smith writes that since the loudest grumbling about low interest rates tends to come from the financial industry, much thought has gone into the question of why Wall Street hates easy money. Recently, some commentators say they believe that they have hit upon the answer – it’s all about net interest margins, or the spread between a bank’s borrowing costs and lending rates. When this difference narrows, bank profits get squeezed. Paul Krugman writes that commercial bankers really dislike a very low interest rate environment, because it’s hard for them to make profits. So bankers keep demanding higher rates, and inventing stories about why that would make sense despite low inflation.

Paul Krugman writes that it’s an interest group that has a lot of clout among central bankers; because these are people they see every day. Peter Gourevitch writes that what political scientists call this “epistemic communities”: communities in which people think in the same ways and have the same opinions. Bankers and regulators see each other all the time at meetings, and social functions, talk the same talk, often come from similar backgrounds, and have similar ways of thinking.

Broader and narrower interest groups

Paul Krugman writes that the demand for higher rates is coming from a narrow business interest group, not the one percent in general. Krugman initially tried to understand demands that rates go up despite the absence of inflation pressure in terms of broad class interests. The trouble is that it’s not at all clear where these interests lie. The wealthy get a lot of interest income, which means that they are hurt by low rates; but they also own a lot of assets, whose prices go up when monetary policy is easy. You can try to figure out the net effect, but what matters for the politics is perception, and that’s surely murky.

Paul Krugman writes that the same political economy applied to trade in the past. If you try to understand the political economy of trade policy, what you see is much narrower interests at play — not capital in general but the owners of textile factories or sugar plantations. Blessed are the cheesemakers, not any manufacturers of dairy products. And the right model to think about this is the specific factors model of trade, in which capital is temporarily stuck in a particular industry; in the long run it may be fungible, but lobbyists don’t worry about that.

Difficulties with the banking profit squeeze idea

David Henry writes that rising rates allow banks to charge higher rates on their loans, which can boost their income. But higher rates can also increase a bank's costs, in particular, the interest that they have to pay depositors. Noah Smith writes that if we simply look at the history of interest rates and net interest margins, we don’t see much of a link. The fed funds rate has been falling since the early 1980s, but until the mid-1990s, net interest margins actually rose. After 1994, net interest began a steady but very slow decline that continues to this day. During this whole time, the fed funds rate has gyrated dramatically, but net interest has barely budged in response to those swings.

Paul Krugman writes that you can argue, as Brad DeLong does, that easy money is in the long-run interest of commercial banks — that in the end the nominal interest rate depends on the rate of inflation, and that locking us into a lowflation or deflation world would be very bad for the banks. But nobody has ever accused bankers of being especially clear about macroeconomics, and in any case what matters for today’s bank executives is not the long run but the next few years, during which they either will or won’t be getting big bonuses; in the long run they are all full-time golfers.

Dean Baker writes that it’s not hard to make an alternative case for banks' self-interest in following a tight money policy, which does not rely on net interest margins. An unexpected rise in the inflation rate is clearly harmful to banks' bottom line. This will lead to a rise in long-term interest rates and loss in the value of their outstanding debt. While we can agree that such a jump in inflation is highly unlikely in the current economic situation, it is not zero. They are faced with a trade-off between a greater risk of something they really fear and something to which they are largely indifferent. It shouldn't be surprising that they want to the Fed to act to ensure the event they really fear (higher inflation) does not happen.

Regulatory capture and the monetary contraction of 1932

Philip Coelho and G.J. Santon write that Epstein and Ferguson draw on the theory of regulatory capture and focus on the relationship between the Fed and its member banks to explain why the Federal Reserve system ignored in the 1930s its broader responsibilities to the public, instead tailoring its policies to benefit the banking industry. Epstein and Ferguson contend that the Fed initiated and then abandoned an attempt to reverse the Great Contraction because the attempt was perceived to be damaging to the interests of member banks.

Gerald Epstein and Thomas Ferguson write that the campaign of open-market purchases, which started in the Spring of 1932, ended almost as quickly as it began. With expansionary open market operations and reductions in nominal income moving short-term rates to extremely low levels a squeeze on bank earnings developed. Of course, rate reductions would not have impaired current earnings if rates on the money banks borrowed and other expenses had fallen just as rapidly. But while rates on borrowed money did decline, there were pitfalls here. These developments led to growing opposition to the open market campaign that brought it to an end.

Brad DeLong writes that we really need to rebalance the Federal Reserve System to lessen the influence of commercial bankers within it. Carter Glass and company made a good try to set up a central bank that would administer finance in the general rather than in the bankers’ interest, but the past decade would have certainly taught us that they did not do a good enough job.