Abstract
Keynes argued that the central bank can influence the long-term interest rate on government bonds and the shape of the yield curve mainly through the short-term interest rate. Several recent empirical studies that examine the dynamics of government bond yields not only substantiate Keynes’s view that the long-term interest rate responds markedly to the short-term interest rate but also have relevance for macroeconomic theory and policy. This article relates Keynes’s discussions of money, the state theory of money, financial markets, investors’ expectations, uncertainty, and liquidity preference to the dynamics of government bond yields for countries with monetary sovereignty. Investors’ psychology, herding behavior in financial markets, and uncertainty about the future reinforce the effects of the short-term interest rate and the central bank’s monetary policy actions on the long-term interest rate.
Keywords
Introduction
John Maynard Keynes held that the central bank influences the long-term interest rate on government and the shape of the yield curve through the short-term interest rate. Several recent empirical studies on the dynamics of government bond yields document that the strong connection between the current short-term interest rate and the long-term interest rate, after controlling for appropriate macroeconomic and financial variables, substantiate Keynes’s contention. These findings are relevant for macroeconomic theory and policy.
This article relates John Maynard Keynes’s discussion of money, the state theory of money, financial markets, investors’ expectations, uncertainty, and liquidity preference to the dynamics of government bond yields for countries with monetary sovereignty. A state with monetary sovereignty almost always retains the operational ability to service its government debt. Investors’ psychology, herding behavior in financial markets, and uncertainty about the future reinforce the effects of the short-term interest rate and the central bank’s monetary policy actions on the long-term interest rate.
The Outline of the Paper
The article is structured as follows. The first section reports the findings of several studies that give credence to Keynes’s views on the drivers of the long-term interest rate on government bonds. The second section examines what monetary sovereignty means for government debt. The third section discusses the state theory of money. The fourth section presents the Keynesian perspective on financial markets, investors’ expectation, and interest rates. It also ties the Keynes’s views to the dynamics of government bond yields. The fifth section sets forth the theoretical and policy implications of the findings from the empirical literature on government yields based on the Keynesian perspective. The final section concludes.
Findings on Government Bond Yields
The standard neoclassical view is that higher government deficit and debt ratios lead to higher government bond yields, increased inflation, currency depreciation, and an increase in the probability of debt default (Elmendorf & Mankiw, 1998). Moreover, the standard view is that investors in financial markets are concerned about runaway inflation or hyperinflation or currency depreciation and that investors will become worried about debt default by sovereign authorities if government deficit or debt ratios increase.
The standard neoclassical view of interest rate determination is based on the loanable funds theory. The rate of interest is determined by the demand for loans and the supply of loans in an economy, according to the loanable funds theory. The demand for loanable funds arises from investment, hoarding, and dissaving, while the supply of loan funds is due to savings, dishoarding, disinvestment, and bank credit. The equilibrium interest rate is the one in which quantity demand for loan funds in equality to the quantity supplied of loan funds, as reflected in the intersection of the demand and the supply schedules in a diagram.
The standard view is epitomized by Reinhart and Rogoff (2009). It has also been articulated by economists in various empirical studies, such as Baldacci and Kumar (2010), Cebula (2014), Gruber and Kamin (2012), Hansen and İmrohoroğlu (2013), Horioka et al. (2014), Hoshi and Ito (2013, 2014), Lam and Tokuoka (2013), Poghosyan (2014), Tokuoka (2010), Tkačevs and Vilerts (2019), and many others. However, if (a) Keynes’s view that the central bank controls or influences the long-term interest rate on government bonds and (b) Keynes’s arguments have empirical support, then the obsession with higher debt or deficit ratios and the worry about government debt default in its own currency are largely misplaced. This is not to claim that debt or deficit ratios are unimportant or economically irrelevant. Under certain circumstances, higher debt ratios can be inflationary and lead to exchange rate depreciation. Nevertheless, there is no reason to doubt that a state with monetary sovereignty can service its debt. Moreover, the central bank can influence the long-term interest rates through the short-term interest rates and various monetary policy tools including asset purchases.
A spate of recent literature on the dynamics of government bonds supports the Keynesian perspective. This literature provides empirical models of government bond yields for different countries and regions. The dynamic of government bond yields has been examined for several advanced countries. Akram and Li (2017, 2020c) and Akram and Das (2019a) modeled Treasury yields for the United States. Akram and Das (2014) and Akram and Li (2020a, 2020d, 2020e) examine the dynamics of Japanese government bonds, while Akram (2014, 2019) provides economic analysis on the impact of the Bank of Japan’s monetary policy on government bond yields. Akram and Das (2017) investigate the behavior of government bond yields for several eurozone countries. Akram and Li (2020b) has modeled the effects of the short-term interest rate on long-term interest rate on gilts in the United Kingdom. Das and Akram (2020) explore the relationship between the long-term interest rate on government bond yields and the short-term interest rate in Canada. Akram and Das (2020) explore the bond yields for the commonwealth of Australia. There are also some papers on the dynamics of government bond yields in some emerging markets written from a Keynesian perspective. Vinod et al. (2014), Chakraborty (2016), and Akram and Das (2015, 2019b) analyze government bond yields for India. Simoski (2019) considers the dynamics of government bond yields in several Latin American countries, while Akram and Uddin (2020) specifically consider the case of Brazil.
This literature on government bonds from the Keynesian perspective addresses three key questions:
What drives government bond yields in countries with monetary sovereignty?
Does the short-term interest rate, after controlling for key variables, explain the long-term interest rate on government bonds?
Do debt and/or fiscal deficit ratios matter?
The main findings of the Keynesian literature on government bond yields are as follows:
The most important driver of the long-term interest rate on government bonds is the short-term interest rate. High (low) short-term interest rates lead to high (low) long-term interest rates.
Other variables, such as inflation and industrial production, sometimes matter, but not always. Usually, high (low) inflation is associated with higher (lower) government bond yields. Similarly, the expansion (contraction) of industrial production is often associated with high (low) government bond yields. The effects of inflation and industrial production on government bonds are mitigated because the short-term interest rate increases (declines) when inflationary pressures or the pace of activity rises (declines). The central bank raises (lowers) the policy rate in anticipation of upward (downward) inflationary pressure and industrial activity. Thus, the effect of inflation and industrial production can sometimes be indirect rather than direct.
The effect of the fiscal variable, such as the debt ratio and the fiscal deficit ratio, on the long-term interest rate is mixed. The conventional view that higher debt ratio would lead to higher government bond yields does not necessarily hold. Indeed, higher debt or deficit ratio is often associated with lower government bond yields. For example, in Japan, higher debt and deficit ratios are associated with lower government bond yields, contrary to the standard view (Akram & Das, 2014; Akram & Li, 2020a, 2020d, 2020e).
The findings from some recent empirical analyses merit mention:
Levrero and Deleidi (2019, 2020) examines the ability of the central banks to affect the structure of interest rates. They use structural vector autoregressive (SVAR) models to find that monetary policy is able to permanently affect long-term interest rates over a long temporal horizon.
Malliaropulos and Migiakis (2018) report the existence of a global monetary policy factor in sovereign bond yields in a panel of 45 countries, consisting of both developed and emerging market. They find that large-scale asset purchases and liquidity provision of major central banks following the global financial crisis have contributed to a significant and permanent decline in long-term yields globally.
The overall findings from several empirical studies shore up evidence for the Keynesian perspective, even though the predominant opinion is that, in the final analysis, higher fiscal deficit and government debt ratios would have adverse consequences, such as elevated bond yields, runaway inflation, markedly depreciated currency or outright debt default. The value of empirical literature from the Keynesian perspective is that it raises skepticism about the standard view that higher debt or deficit ratios necessarily lead to higher government bond yields because it shows the questionable empirical basis of such assertions.
Monetary Sovereignty and Government Debt
A state is deemed to have monetary sovereignty if it has the following characteristics (Wray, 2012, pp. 42–45):
It issues its own currency.
It has the legitimacy, the authority, and the capability to tax and spend in its own currency.
It has a floating exchange rate system.
A state that issues its own currency and borrows in the same currency always retains the operational ability to service its sovereign debt as long as it has the authority and the ability to tax residents in its domicile in its currency and enforce its state authority, and it does not have any currency peg. It is highly unlikely that such a state would default on its own debt issued in its own currency. It is worth reiterating that this claim holds true only for a state with complete monetary sovereignty as defined above. Countries with aforementioned characteristics, such as Japan, the United Kingdom and the United States, can be regarded as countries with complete monetary sovereignty, whereas countries, states, provinces, and regions that do not have these characteristics, such as Greece, California, or Gujrat, are entities without any monetary sovereignty. The United States has complete monetary sovereignty, whereas China has partial monetary sovereignty because it does not have a fully floating exchange rate regime, and Greece has no monetary sovereignty because it satisfies none of the three criteria. Like other euro zone countries, France and Germany also do not possess monetary sovereignty because they do not issue their own currency and their central government taxes and spends in the euro rather than their own national currency.
Greece’s faced a debt crisis because its debt was issued in euro, its debt ratios was high and kept rising over the past decade due to many years large of budget deficit ratios, and the country did not have the ability to service its debt. Investors’ fear that the country would not be able to service its debt led to higher government bond yields. The country’s ability to finance itself eroded over time. Greece was provided funding from the European Union and the IMF only after it agreed to conditions that imposed severe austerity. Greece had adopted the euro as its currency and its government debt was issued in euro. However, it lacked the ability to service its debt in euro. The country’s tax collection was inadequate, whereas its government expenditure was high. Unlike countries with monetary sovereignty, Greece could not issue its own currency to service its euro-denominated government debt. It could not let the exchange rate of its currency to depreciate to increase its international competitiveness. It was forced to accept austerity measures imposed by the EU authorities, resulting in a severe multiyear contraction of its economy.
Modern money theorists have emphasized the operational ability of the state with complete monetary sovereignty to service its government debt (Mosler, 1995; Wray, 1998/2003, 2012). This important point is now recognized by several mainstream macroeconomists. This is illustrated by citations from two leading macroeconomists, Christopher Sims and Michael Woodford.
Sims (2012, 2013) has argued the following:
“[T]he combination of a treasury that issues fiat-currency debt and a central bank that can conduct open market operations provides a uniquely powerful lender of last resort” (Sims, 2012, p. 218).
“[A] central bank that issues fiat money can make loans denominated in fiat currency without any risk that its liabilities (reserve deposit and currency) might not be payable on demand, since they are only promises to pay fiat money” (Sims, 2012, p. 220).
“[A] central bank can ‘print money’—offer deposits as payment for its bills. It will not be subject to the usual sort of run, then, in which creditors fear not being paid and hence demand immediate payment. Its liabilities are denominated in government paper, which it can produce at will” (Sims, 2013, p. 566).
“[N]ominal sovereign debt promises only future payments of government paper, which is always available” (Sims, 2013, p. 567).
“Nominal [sovereign] debt is (almost) non-defaultable” (Sims, 2013, p. 569).
“Economists and journalists sometimes treat inflation as a form of default, but it is not. Default is a situation where the contracted payments cannot be delivered, and the contract does not specify what happens in that eventuality” (Sims, 2013, p. 569).
“[A] central bank, backed by a treasury that can run primary surpluses and issue nominal debt, is an ideal lender of last resort. Because it can create reserve money, it need never default” (Sims, 2013, p. 570).
Regarding the debt servicing capability of the state that issues bonds in its own currency, Woodford (2001) has surmised:
“[A] government that issues debt denominated in its own currency is in a different situation than from that of private borrowers, in that its debt is a promise only to deliver more of its own liabilities. (A Treasury bond is simply a promise to pay dollars at various future dates, but these dollars are simply additional government liabilities, that happen to be non-interest-earning.) There is thus no possible doubt about the government’s technical ability to deliver what it has promised; this is not an implausible reason for financial markets to treat government debt issues in a different way than the issuance of private debt obligations” (Woodford, 2001, p. 693).
“The other crucial special feature of a national government is that prices are commonly quoted in units of its liabilities, that is, in terms of the national currency” (Woodford, 2001, p. 696).
However, the fact that a state with monetary sovereignty has the operational ability to service its debt does not imply that such a state should necessarily run large fiscal deficits as a share of nominal gross domestic product (GDP) or have a high government debt ratio. Fiscal deficit ratios and debt ratios are—and should be—outcomes that are a matter of economic conditions and state policy decisions and deliberations, preferably democratic and well-informed public choices that are appropriate for the circumstances of a state in question. Just because a state has complete monetary sovereignty, that is, the operational ability to service its debt, does not necessarily mean it will do so, and does not necessarily imply that it has the political willingness to do so.
The political willingness to service the state’s debt may not exist, even if the state has the operational ability to service its debt. Even if a state has complete monetary sovereignty, it may choose not to exercise its capacity or may not have the political will do so. For example, the U.S. Congress could refuse to raise the government debt ceiling. The Federal Reserve could choose to let government bond yields become elevated if the Federal Open Market Committee (FOMC) decides that this serves it overall goals. In essence, even if the state has the complete operational ability to service its debt and control the long-term interest rate on government bonds, it does not follow that it will exercise its ability to do so. It is a matter of political choice and willingness to do so.
The State Theory of Money
For Keynes understanding money is at the core of monetary theory. He wrote: “Money-of-account, namely that in which Debts and Prices and General Purchasing Power are expressed, is the primary concept of a Theory of Money” (Keynes, 1930, p. I:3).
Keynes believed that the origin of money is closely tied to credit and debt. He stated: A Money-of-Account comes into existence along with Debts, which are contracts for deferred payments and Price-List, which are offers of contracts of sale or purchases. Such Debts and Price Lists, . . . can only be expressed in terms of a Money of Account (Keynes, 1930, p. I: 3).
Furthermore, Keynes claimed: Money itself, namely that by delivery of which debt-contracts and price-contracts are discharged, and in the shape of which a store of General Purchasing Power is held, derives its character from its relationship to the Money-of-Account, since the debts and prices must first have been expressed in terms of the latter. Something which is merely used as convenient medium of exchange on the spot may approach to being Money, in as much as it may represent a means of holding General Purchasing Power. But if this is all, we have scarcely emerged from the stage of Barter. Money-Proper in the full sense of the term can only exist in relation to a Money-of-Account. (Keynes, 1930, p. I: 3)
Keynes drew a distinction between money-of-account and money as follows: “[T]he money-of-account itself is the description or title and money is the thing which answers to the description” (Keynes, 1930, pp. I: 3–4). An example can illustrate this distinction. Whereas the Queen of England is the description or title, Elizabeth II is the person that answers to the description (as of December 26, 2020).
Keynes understood the importance of the state in monetary affairs. He said: [I]t is a peculiar characteristic of money contracts that it is the State or Community not only which enforces delivery, but also which decides what it is that must be delivered as a lawful or customary discharge of a contract which has been concluded in terms of the Money-of-Account. (Keynes, 1930, p. I:4)
Keynes argued that the state determines what serves as the money-of-account as well as dictates what “thing” will be accepted as money. He stated: The State, therefore, comes in first of all as the authority of law which enforces the payment of the thing which corresponds to the name or description in the contracts. But it comes in doubly when, in addition, it claims the right to determine and declare what thing corresponds to the name, and to vary its declaration from time to time—when, that is to say, it claims the right to re-edit the dictionary. This right is claimed by all modern states and has been so claimed for some four thousand years at least. (Keynes, 1930, p. I:4)
For Keynes, modern money is essentially state money. He opined: The Age of Chartalist or State Money was reached when the State claimed the right to declare what thing should answer as money to the current money-of-account—when it claimed the right not only to enforce the dictionary but also to write the dictionary. (Keynes, 1930, p. I:5)
Keynes, however, took an encompassing and pragmatic view of what constitutes state money based on its acceptability as tax or other payments to the state as well as the state’s commitment to maintain a smoothly functioning payment system and financial stability. He wrote: “I proposed to include as State-Money not only money which is itself compulsory legal-tender but also money which the State or the Central Bank undertake to accept in payments to itself or to exchange for compulsory legal-tender money” (Keynes, 1930, p. I:6).
Keynes’s views on money is based on the state theory of money. Keynes recognized that modern money consists of not just the central bank’s money, but also commercial banks’ money, nonbank financial institutions’ money, and so forth. He held that in advanced capitalist countries, bank money is the primary form of money. He ascertained: [T]he use of Bank-Money is now so dominant that much less confusion will be caused by treating this as typical and the use of other kinds of currency as secondary, than by treating State-Money as typical and bringing in Bank-Money as a subsequent complication. (Keynes, 1930, pp. I:31–33)
The state theory of money has a long and distinguished pedigree, including Smith (1832), Innes (1913, 1914), and Knapp (1926/1973). Keynes’s conception of money built on this tradition of the state theory of money. He extended the state theory of money while underscoring ontological uncertainty and liquidity preference, along with the social basis for money, financial assets, and financial markets and institutions.
After Keynes, Lerner (1943, 1947) was the leading proponent of the state theory of money. Lerner provided a lucid and succinct analysis of the state theory of money when he declared: “[I]n a normal well-working economy, money is a creature of the state. Its general acceptability, which is its all-important attribute, stands or fails by its acceptability by the state” (Lerner, 1947, p. 313). Lerner advanced the following arguments supporting the claim regarding the role of the state at the genesis of money: The modern state can make anything it chooses generally acceptable as money . . . It is true that a simple declaration that such and such is money will not do, even if backed by the most convincing constitutional evidence of the state’s absolute sovereignty. But if the state is willing to accept the proposed money in payment of taxes and other obligations to itself, the trick is done. Everyone who has obligations to the state will be willing to accept the pieces of paper with which he can settle the obligations, and all other people will be willing to accept these pieces of paper because they know that the taxpayers, and so on, will accept them in turn. (Lerner, 1947, p. 313)
In recent decades, the state theory of money has been reinvigorated in the modern money theory (MMT). The first articulation of MMT comes from Warren Mosler (1995). Subsequently, Wray (1998/2003; 2012) has provided a definitive academic exposition of MMT. Goodhart (1998) has contrasted the “chartalist” conception of money with the “metalist” conception of money—under which the value of money comes from the purchasing power of the commodity, such as a gold, upon which it is based—with a prescient application to the euro zone economies.
Keynes on the Dynamics of Government Bond Yields
Keynes had unique and insightful perspectives on the dynamics of government bond yields, grounded in his theory of money, investor expectations, uncertainty, and liquidity preference. His insights are based on his astute knowledge of financial markets and institutions, and investors’ behavior. He recognized the central bank’s important role in financial markets, understanding both its scope and limits.
Keynes (1930) underscored the role of the central bank in setting the policy rate for financial markets. He argued:
“The efficacy of Bank-rate for the management of a managed money was a great discovery and also a most novel one . . . while the practical efficacy of bank-rate becomes not merely familiar but an article of faith and dogma, its precise modus operandi and the varying results to be expected from its application in varying conditions were not clearly understood and have not been clearly understood . . . down to this day” (Keynes, 1930, p. I:17).
“But there is no simple or invariable relation between the effect of an alteration of bank-rate on the price level . . . and the associated alteration in the quantity of bank-money” (Keynes, 1930, p. I:216).
Keynes maintained that monetary policy drives the long-term interest rate on government bonds through the short-term interest rate. He keenly observed the following:
“[T]he influence of the short-term rate of interest on the long-term rate is much greater than anyone . . . would have expected” (Keynes, 1930, p. II:315).
“[T]here is no reason to doubt the ability of a central bank to make its short-term rate of interest effective in the [government bond] market” (Keynes, 1930, p. II:324).
Keynes acknowledged it is counterintuitive that the current short-term interest rate is the main driver of the long-term interest rate. He realized: For whilst it is reasonable that long-term rates should bear a definite relation to the prospective short-term rates, quarter-by-quarter, over the years to come, the contribution of the current three-monthly period to this aggregate expectation should be insignificant in amount—so one might suppose. It may, therefore, seem illogical that the rate of interest fixed for a period of three months should have any noticeable effect on the terms asked for loans of twenty years or more. (Keynes, 1930, pp. II: 352–353)
First, Keynes argued that the empirical evidence shows that not only does the short-term interest rate influence the long-term interest rate, but that the change in the short-term interest rate also influences the change in the long-term interest rate. The empirical basis of the claim originated from the statistical analysis of government bond yields in the United States in the 1920s that Riefler (1930) conducted. It is also based on Keynes’s (1930, pp. II:355–356) own analysis of the behavior of U.K. government bond yields during the same period.
Second, Keynes (1930; 1936/2007) argued that there is a theoretical basis for the short-term interest rate to influence the long-term interest rate. The theoretical basis of his argument draws from the Keynesian perspective on investors’ sentiments, animal spirits, expectations, herding in financial markets, ontological uncertainty, and liquidity preference.
The Theoretical Basis of Keynes’s Argument
Keynes believed that in the final analysis, the foundation of interest rates lies in human psychology, social convention, and liquidity preference, even though the central bank’s actions—particularly its setting of the policy rate—drives the short-term interest rate that in turn influences the long-term interest rate on government bonds.
Keynes (1930, pp. II:357–358) noted various institutional and financial reasons for the short-term interest rate’s decisive influence on the long-term interest rate. When the short-term interest rate is lower than the long-term interest rate, it is profitable to borrow (lend) on a short-term basis and lend (borrow) on a long-term basis, as long as the value of long-term securities do not decline (rise). When the short-term interest rate is high, short-term securities are attractive to investors because of their safety and liquidity. This causes long-term bonds to sell off as investors shift from long-term bonds to short-term securities. However, when short-term interest rates are low, investors are willing to shift to long-term bonds, which causes long-term bonds to rally as investors shift from short-term securities to long-term bonds. Various features of the ecosystem of the financial institutions along with the search for yields, arbitrage opportunities, and investors’ behavior, cause the short-term interest rate and the long-term interest rate to be well aligned. These also usually result in the same directional co-movements or changes in the short-term interest rate and the long-term interest rate. Keynes believed that “initial small price” changes in the bond market could “become large ones” because investors fear that they may “miss the bus” when changes occur in interest rates.
Ontological uncertainty and liquidity preference are central to Keynes’s view of the determinants of the long-term interest rate. Since investors have very little information about the long-term future, it is impossible for investors to have well-formulated mathematical expectations about the future. Investors cannot rely on well-defined expectations of future short-term interest rates because they do have not a reasonable basis to assign probability weights to them or have any reliable forecast of them. Hence, investors in practice resort to “the apparent certainties of the short period, however deceptive” (Keynes, 1930, p. II:361). As a result, even for well-informed investors, decisions about investments tend to be “oversensitive . . . to the near future” because “in truth, we know almost nothing about the more remote future . . . [T]he ignorance about . . . the remote future is much greater than knowledge” about the current state of affairs. Hence, investors are “forced to seek a clue mainly here to trends further ahead.” Moreover, “as long as a crowd can be relied on to act in a certain way, even if it is misguided, it will be to the advantage of the better-informed professional to act in the same way—a short period ahead” (Keynes, 1930, pp. II: 357–358).
Keynes conjectures (Keynes, 1930, pp. II:359–363) that investors actually “know almost nothing about the remote future,” and that “the ignorance . . . about the more remote future is much greater than his knowledge” about the current condition and the near-term outlook. As a result, investors’ views are influenced by matters and events that are “certain, or almost for certain about the recent past and the near future.” Investors are “forced to see a clue mainly here to trends further ahead.” Investors do not actually have a basis of “valid judgement” about the future outlook. Hence, he maintained that investors are subject to “the prey of hopes and fears easily aroused by transient events and as easily dispelled.”
Keynes (1936/2007, p. 148) held that the long-term outlook is uncertain because there is insufficient information and only limited knowledge about the future. Hence, “it would be foolish, in forming our expectations, to attach great weight to matters which are very uncertain” (p. 148). Keynes conjectured that investors extrapolate current trends in forming their outlook about the future. He asserted: [I]t is reasonable . . . to be guided to a considerable degree by the facts about which we feel somewhat confident, even though they may be less decisively relevant to the issues than other facts about which our knowledge is vague and scant. For this reason, the facts of the existing situation enter, in a sense disproportionately, into the formation of our long-term expectations; our usual practice being to take the existing situation and to project it into the future, modified only to the extent that we have more or less definite reasons for expecting a change. (Keynes, 1936/2007, p. 148)
Keynes (1936/2007, p. 149) emphasized ontological uncertainly due to “the extreme precariousness of the basis of knowledge” regarding the calculation of prospective yields of investments in the future. He stated: Our knowledge of the factors which will govern the yields of an investment some years hence is usually very slight and often negligible . . . In fact those who seriously attempt to make any such estimates are often so much in the minority that their behavior does not govern the market. (p. 150)
Regarding financial markets, Keynes (1936/2007, p. 151) shrewdly observed that “certain classes of investment are governed by the average expectation of those who deal on the Stock Exchanges as revealed in the prices of shares, rather than by the genuine expectations of the professional entrepreneur.” Keynes (1936/2007, p. 152) recognized that investors often “fall back on what is . . . a convention,” when investors depend “on the maintenance of the convention . . . the only risk . . . is that of a genuine change in the news over the near future,” as long as the investor can assume that there is “no breakdown in the convention” (Keynes, 1936/2007, p. 153). However, Keynes (1936/2007, p. 154) noted that “a conventional valuation which is established as the outcome of the mass psychology . . . is liable to change violently” particularly during “abnormal times” when the prospect of “continuance of the existing state of affairs is less plausible.” In such circumstances, “the market will be subject to waves of optimistic and pessimistic sentiment, which are unreasoning and yet in a sense legitimate where no solid basis exists for a reasonable calculation.”
Keynes (1936/2007, p. 161) pinpointed that “a large portion of our positive activities depend on spontaneous optimism rather than on a mathematical expectation” claiming that our decision to do something positive . . . can only be taken as a result of animal spirits—of a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities. (161)
He cautioned that this does not imply that “everything depends on the waves of irrational psychology.” Keynes (1936/2007, p. 163) asserted that “human decisions affecting the future, whether personal or political or economic, cannot be dependent on strict mathematical expectation, since the basis for making such calculations does not exist.” Rather, “it is our innate urge to activity which makes the wheels go around.”
Keynes recognized that investors’ expectations are not derived from any type of mathematical expectations but rather have a flimsy and weak foundation characterized by uncertainty. He asserted that “by uncertainty I do not mean the same thing as ‘very improbable’,” (Keynes, 1936/2007, p. 148). Investors, he believed, instead rely on tactic conventions, rules of thumb, beauty contests, and current information for the decision making. This can sometimes lead to herding among investors. Keynes (1936/2007, p. 148) declared that investors’ “usual practice” is “to take the existing situation and to project it into the future, modified only to the extent that [there are] . . . more or less definite reasons for expecting a change.”
The ontological uncertainty regarding the future compels investors to often rely on the current economic outlook as a gauge for the future outlook. This can serve to keep the long-term interest rate largely aligned with the short-term interest rate. Similarly, factors that cause a change in the short-term interest rate also cause a change in the long-term interest rate. The same arguments hold regarding other crucial variables, such as core inflation, economic growth, earnings, credit risks, and loss given default.
Keynes’s view on investors’ expectations is different from rational expectations or efficient market formulations. However, it is not inconsistent with broader conceptions of rationality as articulated by Arrow (1951, 1986, 1994). The literature on bounded rationality (Simon, 1957, 1978, 1984) and barriers to rationality (Foley, 1998) and behavioral economics (Akerlof & Shiller, 2009; Arrow 1986; Schwartz, 1998). Arrow (1986, p. S385) has noted that “rationality is not a property of the individual alone . . . [r]ather it gathers not only its force but also its very meaning from the social context in which it is embedded.” Furthermore, Arrow (1994) has remarked that “individual behavior is always mediated by social relations,” and “social variables, not attached to particular individuals, are essential in studying the economy or any other social system.” The literature on bounded rationality and barriers to rationality has furnished ample evidence showing the limitations of informational and computational capabilities that affect human decision-making. These findings bolster Keynes’s hypothesis that investors’ view of the future is often based on analysis of past and current conditions rather than on perfect foresight or the mathematical expectation of a future that is ontologically uncertain. Mathematical probabilities of unforeseen events in an ontologically uncertain future invariably cannot be estimated.
Keynes’s views on the role of the central bank in influencing the long-term interest rate is reinforced in the post-Keynesian theoretical literature. Fullwiler (2008/2017), Lavoie (2014), Kregel (2011), and Wray (1998/2003; 2012) maintain that the central bank has a crucial and decisive role in influencing the long-term interest rate.
Liquidity Preference, Interest Rate, and the Central Bank
Liquidity preference is central to Keynes’s theory of interest and money, as Kregel (2019) has reiterated. For Keynes (1936/2007):
“[T]he rate of interest at any time, being the reward for parting with liquidity, is a measure of unwillingness of those who possess money to part with their liquid control over it” (p. 167).
“Liquidity-preference . . . fixes the quantity of money which the public will hold when the rate of interest is given” (p. 168).
While classical economists regarded the interest rate as “the reward for not-spending,” Keynes regards the interest rate as “the reward for non-hoarding” where hoarding means “the actual holding of cash” including bank money (p. 174). Even though he initially states that “the rate of interest is a highly psychologically phenomenon” (p. 202), Keynes reformulates this view insisting that actually “the rate of interest is a highly conventional, rather than a highly psychological, phenomenon” (p. 203).
The main question for Keynes is: “Why should anyone prefer to hold his wealth in a form which yields little or no interest to holding it in a form which yields interest?” He answers this with “the existence of uncertainty as to the future rate of interest, that is, as to the complex rates of interest of varying maturity which will rule at future dates” (p. 168).
Keynes argued that “in any given state of expectation” in which the public’s liquidity preference is fixed, the central bank’s policy stance will be a primary driver of investors’ price actions. As a result, the central bank has the ability to establish “a determinate rate of interest or, more strictly, a determinate of a complex rate of interest for debts of different maturities” (p. 205). Specifically, if it is “prepared to deal both ways on specified terms in debts maturities” and “debt of varying degrees of risk,” then “the relationship between the complex of rates of interest and the quantity of money would be direct” (p. 205). Hence, a complex offer by the central bank to buy and sell at stated prices gilt-edged bonds of all maturities, in pace of the single bank rate for short-term bills, is the most important practical improvement which can be made in the technique of monetary management. (p. 206)
Keynes stated that the effectiveness of the central bank’s actions may vary that there are asymmetrical effects of large-scale asset purchases and sales, and that most central banks generally tend to focus on short-term securities and risk-free sovereign debt to influence the short-term interest rate rather than long-term securities and risker debts. He realized the long-term interest rate was not merely a function of the current stance of monetary policy but also reflects investors’ expectation of the path of future policy (202). He acknowledged that “the short-term rate of interest is easily controlled” by the central bank while the long-term interest rate may prove to be “more recalcitrant,” particularly when “it has fallen to a level which . . . is considered ‘unsafe’ by representative opinion” (203). Thus, the credibility of the central bank is paramount for achieving its objectives. Although Keynes did not specifically mention it, coordination between the Treasury and the central bank is often essential to setting and maintaining the interest rate target and other monetary policy objectives.
Keynes was acutely aware of the potential of the central bank’s balance sheet policy. He recognized the central bank’s ability to influence long-term interest rates and the shape of the yield curve well before Ben Bernanke. However, by the time Keynes wrote the General Theory, he was deeply convinced that direct employment creation through state actions and fiscal policy measures are more effective and efficacious responses to a chronic short-fall in aggregate demand. Thus, he viewed monetary policy as a supplementary rather than the primary means for achieving full employment, price stability, sustained economic growth, and financial stability (Kregel, 2011).
Government Fiscal Variables and the Long-Term Interest Rate
The standard view, which is based on the loanable funds theory, is that higher government deficit and debt, as share of nominal GDP, leads to higher government bond yields. This occurs because higher government spending and borrowing reduces the volume of funds available for the private sector’s borrowing and lending in the loanable funds market. In the standard view, the interest rate reflects the marginal productivity of capital, investors’ time preference, and risk premiums.
Keynes rejected the loanable funds theory and its implications. Following Keynes, the proponents of MMT (Wray, 1998/2003, pp. 74–96; Wray, 2012, 110–147) and endogenous money (Lavoie, 2014), and the experts on the analysis of actual operational realities of the treasury, the central bank, and financial system (Bindseil, 2004; Fullwiler, 2008, 2016) reject the loanable funds theory.
Keynes (1987, p. 80) did not object to Hick’s IS-LM model. Keynes wrote that he “found it very interesting” and had “really nothing to say by way of criticism.” However, the IS-LM model simplifies Keynes’s complex and subtle analysis. It is based on the loanable funds theory that Keynes refutes in the General Theory, neglects fundamental uncertainty and animal spirits which are central to investors’ decision making. Hicks (1980) himself had second thoughts about the appropriateness of the IS-LM as representing Keynes’s General Theory.
Models of the Long-Term Interest Rate Based on the Keynesian View
The Keynesian perspective provides a basis for modeling the dynamics of government bond yields. Formal models of government bond yields, based on an interpretation of Keynes’ views, are developed in Akram and Das (2014) and Akram and Li (2017). A simple two-period version of these models appears in a study by Akram and Das (2019b). In these models, the long-term interest rate depends on the current short-term interest rate and an appropriate forward rate. The basic mechanism of these models is briefly described here.
There are two different views on what drives the forward rate. The Hicksian view is that the forward rate is driven solely by the pure (mathematical) expectation of future short-term interest rates (Hicks, 1939/2001, pp. 141–170). The Kaleckian view is that the forward rate is driven not just by the pure expectations of future short-term interest rates, but also by a margin of safety (Kalecki, 1954/2010, pp. 73–88). In most models in financial economics, the forward rate is based on expected short-term interest rates in the future and the term premium, which is defined as some added compensation required to induce investors to hold long-term government bonds.
If the central bank follows the Taylor (1993, 2007) rule, the expected future short-term interest rates and the term premium would mainly depend on the expected inflation and the expected growth rate. In a world characterized by rational expectations, the expected rate of inflation and the expected growth rate would respectively amount to the mathematical expectations of the possible growth rates and the possible rates of inflation in various states of the world. However, in a world characterized by ontological uncertainty (Davidson, 2011, 2015), the probability of unknown events is incalculable. Investors are much more sensitive to current conditions than to the distant future. Hence, investors are forced to take cues about the expected inflation and expected growth rates from the current conditions. The current inflation rate provides the best guess for the expected inflation rate. Similarly, the current estimate of the economy’s potential growth rate provides the best cue for the expected growth rate.
If the Keynesian view of expectations is correct, and if investors are mainly guided by animal spirits, the forward rate would depend on the current inflation and current growth rates rather than the future inflation and future growth rates because investors do not have any reliable information about the future. This implies that the long-term interest rate is based on the current short-term interest rate, current inflation and the current growth rate. This also implies that the change in the long-term interest rate is based on the change in the short-term interest rate, the change in current inflation and the change in the growth rate.
If the government’s current fiscal variable is thought to affect the long-term interest rate—perhaps through influencing the forward rate—then this variable could be incorporated in the model. The long-term interest rate would depend on the short-term interest rate, current inflation, the current growth rate, and the government fiscal variable. Similarly, the change in the long-term interest rate would depend on the changes in these variables. The government fiscal variable can be some appropriate measure of the government’s position, such as fiscal balance, as a share of nominal GDP, or the government’s gross or net debt as a share of nominal GDP.
Policy Implications
If the empirical findings in the literature on government bond yields based on the Keynesian perspectives are valid and sound, then there are definite implications that are pertinent for macroeconomic theory and policy.
First, in countries with monetary sovereignty, the central bank’s policy rate and other actions have a decisive effect on long-term government bond yields. A higher (lower) short-term interest rate is associated with higher (lower) long-term interest rate. By keeping the short-term interest rates high (low) by setting the policy rate, the central bank can keep the long-term interest rate high (low). The central bank can influence the long-term interest rate on government bonds through the policy rate, open market operations, purchases of long-duration government bonds and other securities, calendar-based and information-contingent conditional forward guidance, yield curve control, and policy announcements.
Second, the central bank in countries with monetary sovereignty can control government bonds’ nominal yields and the shape of the yield curve, irrespective of the ratios of government debt and deficit to nominal GDP. Interest payments on the government debt, as a share of nominal GDP, are—at the very least—a partial outcome of the central bank’s policy stance.
Third, the size of the balance sheet and the quantity of outstanding reserves balances are mainly determined by the central bank’s stance regarding its policy rate and other aspects of monetary policy.
Fourth, a state with monetary sovereignty has the operational ability to service its debt and meet its interest payment obligations without any operational hurdles. A state with (almost) complete monetary sovereignty is quite different from other entities, such as businesses, households, and state and municipal governments, because the state issues debt that is repayable in its own liabilities, whereas other entities issue debt that is repayable primarily in terms of state-money (and/or bank money) liabilities, as defined by Keynes (1930, p. I:6). Hence, in conjunction with its central bank, a state with monetary sovereignty can exercise substantial control over government bond yields through setting the policy rate and assorted monetary policy actions.
Conclusion
Keynes’s view on the dynamics of government bond yields is based on his analysis of money, the state theory of money, financial markets and financial institutions, investors’ expectations, ontological uncertainty, liquidity preference, and the general theory of interest rates. Keynes argued that the central bank can influence the long-term interest rate on government bonds through setting the policy rate and various monetary policy measures. He believed that the central bank’s policy rate determines the short-term interest rate, which in turn influences the long-term interest rate.
Keynes’s view provides a useful framework for analyzing government bond market dynamics. It can serve as a framework to discern and interpret the empirical regularities in the government bond market and assess the effects of the central bank’s policy, the government’s fiscal stance and other variables on government bond yields. A state with complete monetary sovereignty has substantial policy space, contrary to widely held belief, because the treasury and the central bank can—and indeed most often do—engage in monetary-fiscal coordination.
Keynes’s assertion that the short-term interest rate is a primary driver of the long-term interest rate is well supported by the empirical evidence for many economies with monetary sovereignty. This empirical regularity is quite relevant for contemporary policy discussions and controversies in economic theory regarding the effectiveness of fiscal stimulus, the monetary transmission mechanism, fiscal-monetary coordination, and government debt management. Further theoretical and empirical research based on the Keynesian perspective can contribute meaningfully to advancing policy debates and macroeconomic theories related to fiscal policy, monetary policy, fiscal theory of price, functional finance, financial markets, and chartalism.
Footnotes
Acknowledgments
The author thanks the editor, the associated editor, and the referee for their useful comments. He also thanks Ms. Elizabeth Dunn and Ms. Mary Rafferty for their editorial support.
Author’s Note
Views expressed are solely those of the author. Institutional affiliations are provided for identification purposes only.
Disclaimer
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Declaration of Conflicting Interests
The author(s) declared no potential conflicts of interest with respect to the research, authorship, and/or publication of this article.
Funding
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