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 19th 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.

7 Responses to “The natural rate of interest and economic recovery”

  1. Boffy Says:

    Michael,

    You say,

    “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.”

    I can see why as a summary you would set Marx’s view out in this way, but it is rather a simplification that thereby mis-states Marx’s actual position. For example, although its true that Marx’s basic position is that the rate of interest is the market price of capital, i.e. it is the market price paid for the use value of capital as capital (the ability to self-expand), and as capital as capital, he shows has no value (its not a product of labour) this market price, can only be determined by the supply and demand for that capital, (incidentally he also shows that this is not just for money-capital, but capital itself) and as a consequence, the lenders of this capital will not lend it for nothing, whilst those demanding it will not pay more than the profit they can obtain from its use.

    However, in setting out the relation of the interest rate cycle to the business cycle, Marx makes clear that it is far more complex than just when the rate of profit rises, the demand for capital rises, so interest rates rise and vice versa.

    In fact, as he sets out, the point where interest rates are highest, is where the crisis breaks out, and profits have collapsed. The reason being that at this point, businesses demand capital, and will be prepared to pay almost any price for it, including higher than the rate of profit, simply to stay afloat. It is the difference as Marx describes, and which the bourgeois economists didn’t seem to grasp , between demanding capital for expansion, and demanding money simply to be able to pay bills.

    Moreover, as Marx sets out, at points where the rate of profit is high or rising, the rate of interest may actually be falling, because although the higher rate of profit may cause the demand for capital to rise, that very same higher rate and mass of profit, provides an added supply of loanable money-capital too. A firm, for example, that realises a large mass of profit, may utilise it for internal accumulation of productive-capital at a faster pace, and yet still have additional profit, that it cannot currently utilise, which it throws into the money market, thereby acting to reduce interest rates.

    Marx also sets out that the situation is also made more complex, because it depends upon the stock of loanable capital as well as this flow, so more mature societies, with a larger number of rich people, particularly those who have retired from productivity activity, have a stock of loanable money-capital available to throw into circulation, which younger societies may lack.

    But, you are correct, that Marx shows that for all these reasons there is no natural rate of interest. Where the value of labour-power is an objectively determinable quantum based upon the labour-time required for its reproduction, on the basis of an objectively determined, average workers’ lifespan, and objectively determined normal working day, and where the value produced by labour, during that normal working day, is also thereby objectively determined, so that the mass and rate of profit, is thereby, as Marx sets out in Theories of Surplus Value, also objectively determined, that is not the case for the rate of interest, which is a function of this interplay of demand and supply, which sets its market price, accordingly.

  2. Stephen Hinton Says:

    Great analysis. I was wondering about energy intensity and energy costs as percentage of Gdp. Could it be that it gets hard to squeeze out more profit from capital when the energy costs.to operate said capital rise?

    Same can be said of other natural resources. As scarcity and extraction costs rise.

    Profits are.low because we just went through a hit of.high energy.prices and now there’s no money.around.to demand the.energy.

    Hitting.a.resource wall in other words. Wicksell and.Marx.lived.in times where nature.was.just.another.frontier.to.go get cheap resources.

    Just.wondering.

  3. Boffy Says:

    Michael,

    “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.”

    From the late 1980’s, the rate of profit was rising, and from the late 90’s, as economic activity expanded, that translated also into even greater rises in the mass of profit. Yet, during all this time, the average rate of interest was falling, despite massive rises also in productive investment, .e.g. the growth of China, and whole new industries in technology. That is pretty identical to the situation Marx describes of the boom period after 1843, when the rate and mass of profit was rising rapidly, but when the vast amount of realised profits thrown into the money markets caused interest rates to fall, and speculation (Railway Mania) to result in bubbles and financial crashes.

    What is interesting at the moment, is that no one can seriously believe that interest rates cannot rise above near zero, because it would wipe out profits! Nor would it have any noticeable effect on investment. The only reason that central banks are keeping official interest rates at near zero – and this is not the case already in many parts of the global economy, where official interest rates are already at 12% plus – is purely to keep financial bubbles inflated.

    That is why, CNBC and others repeatedly talk about “Bad news being good news”, i.e. if jobs growth is a bit below hyped expectations and so on, that is an excuse for Yellen and the Fed to not raise official rates, and so keep the stock market bubble inflated.

  4. Boffy Says:

    The large increase in US jobs last month, up by 270,000, is of course, good news, if not good news for the speculators.

    For Marx, capital is a social relation between capital and wage labour, and the expansion of capital is an expansion of that relation, which is also creates the conditions for labour to best assert its interests.

    “The reproduction of a mass of labour power, which must incessantly re-incorporate itself with capital for that capital’s self-expansion; which cannot get free from capital, and whose enslavement to capital is only concealed by the variety of individual capitalists to whom it sells itself, this reproduction of labour power forms, in fact, an essential of the reproduction of capital itself. Accumulation of capital is, therefore, increase of the proletariat.”

    This increase in the US workforce, has also been matched by an increase in employment in Canada. As one commentator put it on CNBC yesterday, the rise in employment in Canada last month, was the equivalent of a rise in US employment of around 450,000, if the different populations of the two countries is taken into consideration.

    Given that these rises in employment are taking place at a time when past investment in new technologies has acted to raise productivity levels, and thereby to reduce relatively the increase in the mass of labour employed relative to the mass of constant capital, this suggests a sizeable underlying increase in the expansion of capital, on the basis of Marx’s definition above.

    • sartesian Says:

      Well, sure thing. Who could ever disagree with the Little Mary of the Perpetual Sunshine of the Endless Summer of the Catch that Long Wave of Eternal Capitalism, our very own Boffy?

      Only those who pay attention to things, actually relations, like labor force participation rates; temporary and part-time employment rates; capital spending; overall trends in global merchandise trade, etc. etc.

      Good news is truly dripping out of the pores of capitalism. Why just the other day I read that the unemployment rate in the EU had dropped below 11%!!!! Praise the lord and pass the quantitative easing.

      We can look forward to the very, very near future, when, because of the good and improving condition of capital, labor will best assert its interests. Sure thing. Hopefully, labor around the world will take a lesson from the Air France workers who stripped bare the emissaries of restructuring sent from corporate headquarters sent to announce the good news.

      Pay no attention to the slowing global economic growth which is barely above “official” recession levels; the slowing rail and maritime traffic.

      Pay no attention to the man behind the curtain, the great and powerful Oz has spoken.

  5. vallebaeza Says:

    Reblogged this on Econo Marx 21.

  6. Karl Martel Says:

    Reblogged this on Reconstruction communiste Comité Québec and commented:
    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.”

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