The Natural Rate of Interest (3)

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Continued from here.

What makes the theory of the natural interest rate erroneous is the assumption of an  (actually non existing) equilibrating mechanism that ensures a balance between savings and investments. The interest rate is supposed to provide the equilibrating impetus. If consumption falls (because saving rises), the interest rate (in the loanable funds market) falls (excess supply of loans) and investment rises to fill the gap left by the fall in consumption. If consumption increases (because saving declines), the interest rate (in the loanable funds market) increases (tightening supply of loans) and investment is restrained accommodating the rise in consumption.

But, money (loanable funds) is endogenously determined i.  banls create it at will), independent of an exogenous source such as the market for loanable funds or the central bank. To accommodate the need of investors for funds, the banks are not dependent on savers willing to save or a central bank to provide them with bank reserves upfront. The banks create money as long as creditworthy investors are willing to borrow from them (at terms acceptable, i. e. profitable to the latter).

There is no automatic and benign mechanism of equilibration. Banks may create money and lend it out to investors for projects that drive unsustainable bubbles. Lending may create imbalances by supporting the large-scale misallocation of resources which will disequilibrate the economy causing crises of overproduction and unemployment. 

Money can be used to create housing bubbles, bubbles in the securities markets or bubbles of malinvestment like in the dot-come episode at the turn of the century.

And money can be created to support productive investments.

In both capacities, money affects the real economy rather than being a mere veil laid over an economy effectively working on the basis of barter.

Writes Bill Mitchell:

In his classic book – Interest and Prices (1936 edition published by Macmillan and Co) – Wicksell defined a “natural interest rate” as follows (page 102):

There is a certain rate of interest on loans which is neutral in respect to commodity prices, and tend neither to raise nor to lower them. This is necessarily the same as the rate of interest which would be determined by supply and demand if no use were made of money and all lending were effected in the form of real capital goods. It comes to much the same thing to describe it as the current value of the natural rate of interest on capital (emphasis in original).

So consistent with the view held in those times that the loanable funds market brought savers together with investors, the natural rate of interest is that rate where the real demand for investment funds equals the real supply of savings.

Wicksell also differentiated the interest rate in financial markets which is determined by the demand and supply of money and the interest rate that would mediate “real intertemporal transfers” in a world without money. So this meant that “money” had no impact on the “natural interest rate” which reflects only real (not nominal) factors.

He wrote (page 104):

Now if money is loaned at this same rate of interest, it serves as nothing more than a cloak to cover a procedure which, from the purely formal point of view, could have been carried on equally well without it. The conditions of economic equilibrium are fulfilled in precisely the same manner.

All this reasoning is consistent with the idea that classical idea that money is a “veil over the real economy”, that it only affects the price level. The way in which this occurs in Wicksellian thought is that the deviation between the interest rate determined in the financial markets and the natural rate impacts on the price level.

So when the money interest rate is below the natural rate, investment exceeds saving and aggregate demand exceeds aggregate supply. Bank loans create new money to finance the investment gap and inflation results (and vice versa, for money interest rates above the natural rate).

I could write at length outlining why this conception is inapplicable to a modern monetary economy but that isn’t the purpose of this blog.

With the natural rate of interest an unobservable imaginative construct, Wicksell claimed that the link between price level movements and the gap between the two interest rates provided the clue for policy makers.

He wrote (p.189) that:

This does not mean that the banks ought actually to ascertain the natural rate before fixing their own rates of interest. That would, of course, be impracticable, and would also be quite unnecessary. For the current level of commodity prices provides a reliable test of the agreement of diversion of the two rates. The procedure should rather be simply as follows: So long as prices remain unaltered the banks’ rate of interest is to remain unaltered. If prices rise, the rate of interest is to be raised; and if prices fall, the rate of interest is to be lowered; and the rate of interest is henceforth to be maintained at its new level until a further movement of prices calls for a further change in one direction or the other. (emphasis in original).

So you can see the genesis of the natural rate concept that central bankers still hold onto – but now prefer to refer to it as the “neutral rate of interest”.

In this vein, there was an important speech given by former Federal Reserve Chairman Alan Greenspan in 1993 which elevated this concept back into mainstream policy considerations. Central bankers in the 1980s had been beguiled by Milton Friedman’s view that they needed to control the stock of money if they were to maintain price stability. As a consequence monetary targetting was pursued and soon after turned out to be a total failure.

It was obvious that the stock of money could not be controlled by the central bank given it was endogenously determined by the demand for credit. Modern monetary theory never considered money to be exogenously determined – which is the main presumption in mainstream macroeconomics textbooks.

Anyway, to fill the gap, central bankers shifted ground. In his Statement to the Congress, on July 20, 1993 (published in the Federal Reserve Bulletin, September 1993, pages 849-855, Greenspan told the Congress that:

In assessing real rates, the central issue is their relationship to an equilibrium interest rate, specifically the real rate level that, if maintained, would keep the economy at its production potential over time. Rates persisting above that level, history tells us, tend to be associated with … disinflation … and rates below that level tend to be associated with eventual resource bottlenecks and rising inflation, which ultimately engender economic contraction.

This was an important break from the money targeting period and marked the beginnings of inflation targeting whereby central banks would announce or imply a target rate of inflation and then adjust the interest rate up or down to manipulate (so they thought) aggregate demand and hence prices. This ap[p]roach explicitly used unemployment as a policy tool to suppress inflation – high unemployment was maintained over this period to suppress aggregate demand as part of the “inflation-first” macroeconomic strategy.

You can see that Greenspan’s “equilibrium interest rate” is just a replay of Wicksell’s “natural interest rate” theory which was dominant in the days before the Great Depression. However, to advocate Wicksell’s theory you have to buy into the whole theoretical box-and-dice – in all its inanity and inconsistency.

Accordingly, you have to consider markets equilibrate through price adjustments and the economy tends to full employment (meaning there cannot be a deficiency of aggregate demand). So if consumption falls (because saving rises), the interest rate (in the loanable funds market) falls (excess supply of loans) and investment rises to fill the gap left by the fall in consumption. This is Say’s Law which is restated as Walras’ Law when multiple markets are introduced.

So the interest rate adjusts to the natural interest rate where the full-employment level of savings equals investment and all is well. There is never a shortage of investment projects but their introduction is impacted upon by the cost of funds. There is never unemployment!

Continued here.