Saturday, June 18, 2011

Austrian Business Cycle Theory (ABCT) and the Natural Rate of Interest

The Austrian business cycle/trade cycle theory that Hayek proposed in the early 1930s took up Knut Wicksell’s hypothetical “natural rate of interest” and uses that concept in its analysis. In ABCT, the market rate of interest (a monetary rate) falls below the natural rate (the return on capital). As resources are drawn away from production in lower-order stages that produce consumer goods, there is inflation in consumer goods relative to capital goods, and then interest rates rise. This supposedly causes a crisis as many investments in higher-order stages of production cannot be profitably maintained, resulting in liquidation and higher unemployment.

What does the “natural rate of interest” mean? It can have different meanings:
“Earlier writers defined the natural rate of interest concept in various ways. Hayek originally defined the natural rate as the rate of interest that would prevail if savings and investment were made in natura; that is, without any distortionary monetary effects [i.e., without money]. Mises (1978, p. 124) defined the natural rate of interest as the equilibrium rate for the capital structure.* Later treatments defined the natural rate as the real marginal productivity of capital or as the interest rate which equalizes ex ante savings and investment” (Cowen 1997: 95).
* This can be found in Mises 2002 [1978]: 129–130.
In the early work of Hayek, he used a Wicksellian definition of the natural rate of interest, and we can cite Knut Wicksell’s explanation of the concept and how monetary equilibrium occurs:
The rate of interest at which the demand for loan capital and the supply of savings exactly agree, and which more or less corresponds to the expected yields on the newly created real capital, will then be the normal or natural rate. It is essentially variable. If the prospects of employment of capital become more promising, demand will increase and will at first exceed supply; interest rates will then rise as the demand from entrepreneurs contracts until a new equilibrium is reached at a slightly higher rate of interest. At the same time equilibrium must ipso facto obtain—broadly speaking, and if it is not disturbed by other causes—in the market for goods and services, so that wages and prices remain unchanged” (Wicksell 1934: 193).
The natural rate or “the expected yields on the newly created real capital” is the analogue of the marginal efficiency of capital (Uhr 1994: 94).

The concept of the Wicksellian natural rate is defined by Frank Shostak:
“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.”
Shostak, F. 2008. “The Myth of the Neutral Interest Rate Policy,”, February 8
Philippe Burger provides another explantion:
“Wicksell ... defines the natural interest rate as: ‘The rate of interest at which the demand for loan capital and the supply of savings exactly agree, and which more or less corresponds to the expected yield on the newly created capital, will then be the normal or natural real rate.’ ... The natural interest rate equals the marginal product of capital at full employment. A reduction in the market rate (through an increase in the money supply) below the natural rate may stimulate investment. However, as the economy is assumed to be at full employment (everyone willing to accept a wage equal to the marginal product of labour has employment), it also causes inflation for the period during which the natural rate exceeds the market rate” (Burger 2003: 63).
If the natural rate is conceived in real terms (or, in Latin, in natura), we have a barter economy where real commodities are loaned out and repaid in kind, and the supply of real commodities for loan equals the amount demanded. In a monetary economy, credit money via fractional reserve banking and the fiduciary media it creates create a media that provides real resources but without freeing up those resources in real terms. Now one problem with this analysis is that the natural interest rate concept depends on the assumption that an economy has no significant idle resources and it has full employment. In reality, economies frequently have unused capacity, idle resources and unemployment, and an economy open to trade will be able to import both factor inputs and capital goods, which can ease inflationary pressures.

But moving to historical criticisms of Hayek’s influential presentation of ABCT in Prices and Production (London, 1931), there was an important exchange between Sraffa and Hayek that can be read in Sraffa (1932a), Hayek (1932), and Sraffa (1932b). (For Kaldor’s attack on Hayek, see Kaldor 1939, 1940, 1942.)

One important criticism of Sraffa was as follows:
“Dr. Hayek’s theory of the relation of money to the rate of interest is mainly given by way of criticism and development of the theory of Wicksell. He states his own position as far as it agrees with Wicksell’s as follows: ‘In a money economy, the actual or money rate of interest may differ from the equilibrium or natural rate, because the demand for and the supply of capital do not meet in their natural form but in the form of money, the quantity of which available for capital purposes may be arbitrarily changed by the banks.’ An essential confusion, which appears clearly from this statement, is the belief that the divergence of rates is a characteristic of a money economy: and the confusion is implied in the very terminology adopted, which identifies the ‘actual’ with the ‘money’ rate, and the ‘equilibrium’ with the ‘natural’ rate. If money did not exist, and loans were made in terms of all sorts of commodities, there would be a single rate which satisfies the conditions of equilibrium, but there might be at any one moment as many ‘natural’ rates of interest as there are commodities, though they would not be ‘equilibrium’ rates. The ‘arbitrary’ action of the banks is by no means a necessary condition for the divergence; if loans were made in wheat and farmers (or for that matter the weather) ‘arbitrarily changed’ the quantity of wheat produced, the actual rate of interest on loans in terms of wheat would diverge from the rate on other commodities and there would be no single equilibrium rate. In order to realise this we need not stretch our imagination and think of an organised loan market amongst savages bartering deer for beavers. Loans are currently made in the present world in terms of every commodity for which there is a forward market. When a cotton spinner borrows a sum of money for three months and uses the proceeds to purchase spot, a quantity of raw cotton which he simultaneously sells three months forward, he is actually ‘borrowing cotton’ for that period. The rate of interest which he pays, per hundred bales of cotton, is the number of bales that can be purchased with the following sum of money: the interest on the money required to buy spot 100 bales, plus the excess (or minus the deficiency) of the spot over the forward prices of the 100 bales. In equilibrium the spot and forward price coincide, for cotton as for any other commodity; and all the ‘natural’ or commodity rates are equal to one another, and to the money rate. But if, for any reason, the supply and the demand for a commodity are not in equilibrium (i.e. its market price exceeds or falls short of its cost of production), its spot and forward prices diverge, and the ‘natural’ rate of interest on that commodity diverges from the ‘natural’ rates on other commodities.” (Sraffa 1932a: 49).
Thus there could only be a single “natural rate of interest” in a one commodity economy, and, in an expanding economy, equating a market rate with a natural rate has no meaning. When an economy is not in equilibrium, where it is moving from one equilibrium to another, there will be as many natural rates as commodities and “under free competition, this divergence of rates is as essential to the effecting of the transition as is the divergence of prices from the costs of production; it is, in fact, another aspect of the same thing” (Sraffa 1932a: 50). Hayek appeared to acknowledge this:
“Mr. Sraffa denies that the possibility of a divergence between the equilibrium rate of interest and the actual rate is a peculiar characteristic of a money economy. And he thinks that ‘if money did not exist, and loans were made in terms of all sorts of commodities, there would be a single rate which satisfies the conditions of equilibrium, but there might, at any moment, be as many “natural” rates of interest as there are commodities, though they would not be equilibrium rates.’ I think it would be truer to say that, in this situation, there would be no single rate which, applied to all commodities, would satisfy the conditions of equilibrium rates, but there might, at any moment, be as many 'natural' rates of interest as there are commodities, all of which would be equilibrium rates; and which would all be the combined result of the factors affecting the present and future supply of the individual commodities, and of the factors usually regarded as determining the rate of interest” (Hayek 1932).
In reply, Sraffa noted:
“Dr. Hayek now acknowledges the multiplicity of the ‘natural’ rates, but he has nothing more to say on this specific point than that they ‘all would be equilibrium rates’. The only meaning (if it be a meaning) I can attach to this is that his maxim of policy now requires that the money rate should be equal to all these divergent natural rates” (Sraffa 1932b).
If the market rate of interest in an expanding economy must equal the “natural rate of interest,” how can it do so if there are many natural rates? Yet this is the central element of ABCT, even in modern expositions of it, as in R. W. Garrison (1997):
“The natural rate of interest is the rate that equates saving with investment. The bank rate diverges from the natural rate as a result of credit expansion” (Garrison 1997: 24).
A bank rate (market rate) can only diverge from a natural rate, if there was one natural rate of interest. But the concept of the natural rate of interest requires that there be multiple such “natural rates.” That this is a serious problem for the Hayekian version of the Austrian business cycle theory is acknowledged by Lachmann
“What is much less clear to us is to what extent Hayek was aware that by admitting that there might be no single rate he was making a fatal concession to his opponent. If there is a multitude of commodity rates, it is evidently possible for the money rate of interest to be lower than some but higher than others. What, then, becomes of monetary equilibrium?” (Lachmann 1994: 154).
And what becomes of ABCT? In order for natural rates to obtain, money and modern banking would have to be abolished, and the loans conducted in real commodities. This in fact appears to Lachmann’s solution to the conundrum:
“It is not difficult, however, to close this particular breach in the Austrian rampart. In a barter economy with free competition commodity arbitrage would tend to establish an overall equilibrium rate of interest. Otherwise, if the wheat rate were the highest and the barley rate the lowest of interest rates, it would be profitable to borrow in barley and lend in wheat. Inter-market arbitrage will tend to establish an overall equilibrium in the loan market such that, in terms of a third commodity serving as numéraire, say steel, it is no more profitable to lend in wheat than in barley. This does not mean that actual own-rates must all be equal, but that their disparities are exactly offset by disparities between forward prices. The case is exactly parallel to the way in which international arbitrage produces equilibrium in the international money market, where differences in local interest rates are offset by disparities in forward rates” (Lachmann 1994: 154).
In other words, the solution is a barter economy where modern banking is dismantled and goods are loaned out, and, if one commodity comes to serve as a numéraire, it will no longer have a store of value function and only function as a medium of exchange – a totally unrealistic world.

Finally, we can note how Hayek seems to have changed his defintion of the natural interest rate in later work:
“Hayek ... in his later and most systematic statement of capital theory, appears to accept this criticism of Sraffa’s and to abandon the strict in natura definition he had offered in earlier writings” (Cowen 1997: 95, n. 16).
And his attempt to devise a trade cycle theory free from the problems identified by his critics must be judged a failure:
“The combined effect was to start Hayek on a long process of rethinking his views. He hoped to reconstruct a more suitable capital-theoretic foundation, then turn to the problem with which he started, explicating the role of money in a dynamic capital-using economy. After seven years of work, he produced a four-hundred-page book, The Pure Theory of Capital [1941] ..., but still the task was unfinished .... Throughout the 1930s, Hayek kept responding to his critics, making adjustments to his models along the way, and this in turn brought fresh criticism and new adjustments. According to his own assessments, however, his efforts to build a dynamic equilibrium model of a capital-using monetary economy never reached fruition. His intended second on dynamics never appeared. As he suggested, by the late 1930s Hayek had turned his attention to ‘more pressing problems’” (Caldwell 2004: 180).
By the 1940s, Hayek had turned away from dynamic equilibrium theorising and moved to writing about the social sciences, philosophy, classical liberal political theory, and social philosophy.

Appendix: Mises and the Wicksellian Natural Rate of Interest Concept?

It seems that Mises also relies on the Wicksellian “natural interest rate” concept:
“At the end of ... [The Theory of Money and Credit] (388-404), Mises combined his theory of interest and his understanding of banking practice to point to a theory of economic crises. Following on Wicksell, he identified the gap between the natural rate of interest and the money rate as the consequence of credit expansion” (Vaughn 1994: 40).
But, according to Hülsmann,
“Wicksell defined the natural rate of interest as the rate that would come into existence under the sole influence of real (non-monetary) factors) ... He also defined it as the rate at which the price level would remain constant ... Both distinctions led to great confusion among later theorists, but Mises’s business cycle theory seemed to show that it was useful to make some such distinction. In Human Action he would eventually show that the relevant distinction is between the equilibrium rate of interest and the market rate. Both rates are monetary rates and can therefore coincide” (Hülsmann 2007: 253, n. 79).
What happened is that Mises changed his mind (Maclachlan 1996), and abandoned the Wicksellian natural interest rate concept he had used in the Theory of Money and Credit and adopted a new “originary interest rate” theory:
“Originary interest is the ratio of the value assigned to want-satisfaction in the immediate future and the value assigned to want-satisfaction in remote periods of the future. It manifests itself in the market economy in the discount of future goods as against present goods. It is a ratio of commodity prices, not a price in itself. There prevails a tendency toward the equalization of this ratio for all commodities. In the imaginary construction of the evenly rotating economy the rate of originary interest is the same for all commodities” (Mises 1998: 523).
But, as late as 1928 in Monetary Stabilization and Cyclical Policy, Mises is still using the Wicksellian natural interest rate:
“In conformity with Wicksell’s terminology, we shall use ‘natural interest rate’ to describe that interest rate which would be established by supply and demand if real goods were loaned in natura [directly, as in barter] without the intermediary of money. ‘Money rate of interest’ will be used for that interest rate asked on loans made in money or money substitute.” (Mises 2006 [1978]: 107–108).

“The ‘natural interest rate’ is established at that height which tends toward equilibrium on the market. The tendency is toward a condition where no capital goods are idle, no opportunities for starting profitable enterprises remain unexploited and the only projects not undertaken are those which no longer yield a profit at the prevailing ‘natural interest rate’” (Mises 2006 [1978]: 109).
This seems to reinforce the point that the Wicksellian natural interest rate concept as used in Mises’ earlier work had to be abandoned. But it is still used in Hayekian forms of ABCT. To the extent that Mises’ presentation of ABCT in the Theory of Money and Credit and Monetary Stabilization and Cyclical Policy (1928) relies on the Wicksellian natural interest rate concept, it must be judged as worthless as Hayek’s Prices and Production.


Arestis, P. and M. Sawyer. 1991. A Biographical Dictionary of Dissenting Economists, Elgar, Aldershot.

Bellofiore, R. 1998. “Between Wicksell and Hayek: Mises’ Theory of Money and Credit Revisited,” American Journal of Economics and Sociology 57.4: 531–578.

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  1. The Cowenian critiques of ABCT have been answered.

  2. The critique above is NOT based on T. Cowen, Risk and Business Cycles: New and Old Austrian Perspectives, Routledge, London, 1997.

    So your link is a waste of time.

  3. Fascinating post. What is suggests to me is not only that the idea of a single 'natural' rate is flawed, but that a single rate is flawed. Is it possible to maintain a decentralized pluralism of rates?

  4. Is it possible to maintain a decentralized pluralism of rates?

    Interest rates are a monetary phenomenon. What would be the purpose of a "decentralized pluralism of rates"? Wouldn't competition in loans tend to equalise rates in a spread anyway?