The natural rate of interest and economic recovery

There has been an eruption of an old debate among mainstream economics bloggers.  The debate is about, first, whether there is a ‘natural rate of interest’ that provides equality between investment and savings in an economy at full employment; and second, whether current interest rates in the major economies are above or below that ‘natural’ rate.

The concept of a ‘natural’ rate where desired investment in new structures, equipment and technology matches desired saving by households and firms in a ‘general equilibrium’ comes from the neoclassical economist of the late 19^th century Knut Wicksell.  He argued that if investment exceeded savings in an economy, the natural rate would rise so that savings would then increase to match investment and vice versa.  If for some reason, the natural rate did not rise, then there would ‘overheating’ in the economy, in the form of inflation.  In the recession example, savings would be greater than investment and if the natural rate did not fall enough to reduce the desire to save, then there would be less than full employment.

Now you can see why this concept of a ‘natural rate’ might be important.  Maybe current market rates are too high compared to the natural rate so that we have a glut of saving (hoarding of money) and not enough investment – stagnation.  But maybe market rates are too low, below the natural rate, so that we have inflation being expressed in a bubble in property and financial assets.  This is the nature of the argument between the conservative neo-classical (Austrians) and the Keynesians.

As leading Keynesian Brad Delong put it: “Bill White, formerly of the Bank for International Settlements, has argued the Wicksellian natural rate must be high and monetary policy too loose because low rates have encouraged all sorts of yield-chasing behavior. But [W]e don’t see businesses dipping into their cash reserves to fund investment; a monetary hot potato; unexpected and rising inflation; and full or over-full employment. Instead, we see elevated unemployment and firms and households adding to their cash reserves. This is what Wicksell expected to see when the natural rate of interest was below the market rate: planned investment would then be lower than desired savings, households and businesses seeking to save would then transfer some of their cash out of transactions balances and treat them as unspendable savings (the “precautionary” or “speculative” demand for money), we would see too little money to buy all the goods and services that would be put on sale at full employment, and we would see no signs of inflation but a depressed economy.  That is the root of our problem: the natural nominal rate of interest … today is less than zero, and so the Federal Reserve cannot push the market nominal rate of interest down low enough.”

But is there a natural rate of interest?  Does this concept help us understand what is happening in an economy, especially in the major capitalist economies right now?  Well, Keynes dismissed the idea arguing that there was not one static natural rate but a series of rates depending on the level of investment, consumption and saving in an economy and the desire to hoard money (liquidity preference).  And there was no reason to assume that the capitalist economy would ‘correct’ any mismatch between investment and savings, particularly in a depression, by market interest rates adjusting back to the ‘natural rate’ in some automatic market process.  That’s because in a depression where investment returns are too low compared to the money rate of interest, capitalists will hoard their money rather than invest in a ‘liquidity trap’.

Marx too denied the concept of a natural rate of interest.  For him, the return on capital, whether exhibited in the interest earned on lending money, or dividends from holding shares, or rents from owning property, came from the surplus-value appropriated from the labour of the working class and appropriated by the productive sectors of capital.  Interest was a part of that surplus value.  The rate of interest would thus fluctuate between zero and the average rate of profit from capitalist production in an economy.  In boom times, it would move towards the average rate of profit and in slumps it would fall towards zero.  But the decisive driver of investment would be profitability, not the interest rate.  If profitability was low, then holders of money would increasingly hoard money or speculate in financial assets rather than invest in productive ones.  What matters is not whether the market rate of interest is above or below some ‘natural’ rate but whether it is so high that it is squeezing any profit for investment in productive assets.

Both Keynes and Marx looked not to a concept of a natural rate of interest’ but to the relation of interest rate for holding money to the profitability (or return) on productive capital.  Actually, so did Wicksell.  According to Wicksell, the natural rate is “never high or low in itself, but only in relation to the profit which people can make with the money in their hands, and this, of course, varies. In good times, when trade is brisk, the rate of profit is high, and, what is of great consequence, is generally expected to remain high; in periods of depression it is low, and expected to remain low.”

More recently, the architect of modern ‘unconventional monetary policy as the solution to the ills of modern capitalism, Ben Bernanke, former chief of the US Fed, agreed.  Bernanke tells us that low interest rates are here to stay, but not because of lax monetary policy, but because the real rate of return on assets (both tangible and financial) are staying low.  They are low not because the Fed and other central banks have pumped too much money into the economy – although that used to be what Ben said he wanted to do.  No, the reason for low interest rates is the low rate of return on capital investment.  “The real interest rate is most relevant for capital investment decisions, for example. The Fed’s ability to affect real rates of return, especially longer-term real rates, is transitory and limited. Except in the short run, real interest rates are determined by a wide range of economic factors, including prospects for economic growth—not by the Fed.” 

Turning to Wicksell, Bernanke says the problem is that the equilibrium real rate is low because “investment opportunities are limited and relatively unprofitable.”… What this tells you is that monetary policy is restricted in its impact by what is going on in the ‘real’ economy, more specifically, the dominant capitalist sector.  “The bottom line is that the state of the economy, not the Fed, ultimately determines the real rate of return attainable by savers and investors.”

Ben’s argument that it is the underlying real rate of return on investment that decides things, not Federal Reserve monetary policy, is really to justify and defend his actions as Fed chair against criticism from the Austrian school and the neoliberal camp that he kept interest rates artificially too low; and from Keynesian camp that he did not intervene enough.  You see, the critics are wrong about Fed policy because the Fed has little say in the underlying growth or otherwise of the US capitalist economy.  That depends on its underlying profitability, or in Wicksell’s language, the ‘equilibrium ‘natural rate of return’. “The state of the economy, not the Fed, is the ultimate determinant of the sustainable level of real returns. This helps explain why real interest rates are low throughout the industrialized world, not just in the United States.”

Of course, there is no discussion of why profitability (or the natural rate of return) is low. Modern mainstream monetary theory has actually forgotten the points made by Wicksell, let alone Keynes or Marx.  The modern proponents actually seem to believe in some natural rate of interest and reckon that boosting the money supply or lowering interest rates to zero (or even negative) will boost consumption and investment.  The barrier of low profitability is ignored.

Previous Fed chair, Alan Greenspan actually reckoned that interest rates should be fixed so that speculation in financial assets could be encouraged and this would boost productive investment and consumption.  Well, his policy led to a credit-fuelled property and stock market boom and bust.  Top monetary economist, Michael Woodford also reckoned that Fed monetary policy could be manipulated so that it increased inflation expectations among households leading them to spend more.

And now the current Fed chair Janet Yellen has gone even further.  She backs Fed economic research that suggests very low interest rates could inspire increased consumption and investment so that demand creates its own supply.  This is the mirror opposite of Say’s law, rebutted by both Marx and Keynes, that supply can create its own demand.  So keep interest rates low or at zero.  But the evidence for this extreme monetarist Keynesianism is poor. And ironically, Yellen is set to hike Fed rates in December.

Both propositions (supply creates demand or demand creates supply) suggest that the capitalist economy can ‘correct’ itself through market processes, either because saving will lead directly to investment (Say) or investment can match saving through fixing interest rates at the ‘natural rate of interest’ (Wicksell).   Neither proposition makes sense or works in an economy where investment is set by profitability.  If the return on productive capital is too low, what happens to the rate of interest or savings will change nothing.