How did Wicksell, the early Austrians and Keynes define the Natural Rate of Interest?

There appears to be two ways in which Wicksell defined the natural rate of interest, as pointed out by Klausinger (2003: 73). In what follows, I will look at the following points:

(1) how Wicksell defined the “natural rate of interest”;

(2) how it was defined by Mises and Hayek in their early trade cycle theory, and

(3) how Keynes defined it in his pre-General Theory work.

First, how did Wicksell define the “natural rate of interest”? The first definition is given in Geldzins und Güterpreise (Wicksell 1898). We can quote from the English translation of this called Interest and Prices (trans. R. F. Kahn; 1936).

In the context of a discussion about excessive money supply and inflation, Wicksell has this to say about the interest rate:

“The rate of interest charged for loans can clearly never be either high or low in itself, but only in relation to the return which can, or is expected to, be obtained by the man who has possession of money. It is not a high or low rate of interest in the absolute sense which must be regarded as influencing the demand for raw materials, labour, and land or other productive resources, and so indirectly as determining the movement of prices. The causative factor is the current rate of interest on loans as compared with what I shall be calling the natural rate of interest on capital. This natural rate is roughly the same thing as the real interest of actual business. A more accurate, though rather abstract, criterion is obtained by thinking of it as the rate which would be determined by supply and demand if real capital were lent in kind without the intervention of money.” (Wicksell 1936: xxiv–xxv).

Later in the book Wicksell elaborates on this:

“There is a certain rate of interest on loans which is neutral in respect to commodity prices, and tends 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. (Wicksell 1936: 102).

In Wicksell’s later work Vorlesungen über Nationalökonomie. Band 2: Geld und Kredit (1922) there is another definition. In the English translation of this work called Lectures on Political Economy. Volume 2: Money (trans. E. Classen; 1935) we have this:

“But of what does this capital consist? In this connection it is usual to think of the stocks of goods in the warehouses of merchants and manufacturers’ stocks of articles ready for consumption, or of raw materials, or semi-manufactured goods. But this is not correct. The magnitude of stocks of goods is of little importance to the real phenomenon of capital, although in certain circumstances it may become so (cf. p. 251). On the contrary, on a first approximation we may completely ignore the existence of stocks and assume that all products, consumption goods, raw materials, and machinery find a market as soon as they are ready either for consumption or for further processes of production. Under such circumstances free capital will not really have any material form at all—quite naturally, as it only exists for the moment. The accumulation of capital consists in the resolve of those who save to abstain from the consumption of a part of their income in the immediate future. Owing to their diminished demand, or cessation of demand, for consumption goods, the labour and land which would otherwise have been required in their production is set free for the creation of fixed capital for future production and consumption and is employed by entrepreneurs for that purpose with the help of the money placed at their disposal by savings. Of course, this process presupposes an adaptability and a degree of foresight in the reorganization of production which is far from existing in reality, though this is as a rule of secondary importance in comparison with the main phenomenon.

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. It is essentially variable. If the prospects of the employment of capital become more promising, demand will increase and will at first exceed supply; interest rates will then rise and stimulate further saving at the same time as the demand from entrepreneurs contracts until a new equilibrium is reached at a slightly higher rate of interest. And 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 will remain unchanged. The sum of money incomes will then usually exceed the money value of the consumption goods annually produced, but the excess of income—i.e. what is annually saved and invested in production—will not produce any demand for present goods but only for labour and land for future production.” (Wicksell 1935: 192–193).

So what is the difference here? Erturk (2006: 454–455) defines the natural rate (apparently in the sense as given by Wicksell here) as the rate that is equal to the “return on new capital.” So Wicksell in Vorlesungen über Nationalökonomie. Band 2: Geld und Kredit (1922) seems to abandon the definition of the “natural rate” in terms of the barter rate on real capital goods that clears those real markets. By 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” does Wicksell mean the monetary rate on loanable funds (or the exogenous money supply “saved” and loaned out by banks)? But if this in turn causes clearing of real markets for capital goods, it seems to come to same thing as the earlier definition.

The early Austrians Mises and Hayek took over the natural rate and the Wicksellian loanable funds theory in their Austrian business cycle theory (ABCT).

We can see this in Mises’ statements in The Theory of Money and Credit (2009 [1953], original German edition 1912) and his “Monetary Stabilization and Cyclical Policy” (1928):

“Wicksell distinguishes between the natural rate of interest (natürliche Kapitalzins), or the rate of interest that would be determined by supply and demand if actual capital goods were lent without the mediation of money, and the money rate of interest (Geldzins), or the rate of interest that is demanded and paid for loans in money or money substitutes. The money rate of interest and the natural rate of interest need not necessarily coincide, since it is possible for the banks to extend the amount of their issues of fiduciary media as they wish and thus to exert a pressure on the money rate of interest that might bring it down to the minimum set by their costs. Nevertheless, it is certain that the money rate of interest must sooner or later come to the level of the natural rate of interest, and the problem is to say in what way this ultimate coincidence is brought about. Up to this point Wicksell commands assent; … .” (Mises 2009 [1953]: 355).

“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. Through continued expansion of fiduciary media, it is possible for the banks to force the money rate down to the actual cost of the banking operations, practically speaking that is almost to zero. As a result, several authors have concluded that interest could be completely abolished in this way. Whole schools of reformers have wanted to use banking policy to make credit gratuitous and thus to solve the ‘social question.’ No reasoning person today, however, believes that interest can ever be abolished, nor doubts but what, if the ‘money interest rate’ is depressed by the expansion of fiduciary media, it must sooner or later revert once again to the ‘natural interest rate.’ The question is only how this inevitable adjustment takes place. The answer to this will explain at the same time the fluctuations of the business cycle.” (Mises 2006 [1978]: 107–108).

This is the “natural rate” as in Wicksell’s Geldzins und Güterpreise (Wicksell 1898).

We can see too that in Hayek’s Prices and Production (2nd edn.; 1935; the 1st edition was published in 1931), Hayek takes over the “natural rate” from Wicksell as defined in the latter’s Geldzins und Güterpreise (1898):

“Put concisely, Wicksell’s theory is as follows: If it were not for monetary disturbances, the rate of interest would be determined so as to equalize the demand for and the supply of savings. This equilibrium rate, as I prefer to call it, he christens the natural rate of interest. In a money economy, the actual or money rate of interest (“Geldzins”) 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.

Now, so long as the money rate of interest coincides with the equilibrium rate, the rate of interest remains “neutral” in its effects on the prices of goods, tending neither to raise nor to lower them. When the banks, however, lower the money rate of interest below the equilibrium rate, which they can do by lending more than has been entrusted to them, i.e., by adding to the circulation, this must tend to raise prices; …” (Hayek 2008 [1935]: 215).

It very strange indeed, then, to see that in Hayek’s earlier work Geldtheorie und Konjunkturtheorie (1929) – translated into English in 1933 as Monetary Theory and the Trade Cycle – he endorses the alternative definition of the natural rate in Wicksell’s Vorlesungen über Nationalökonomie. Band 2: Geld und Kredit (1922), and as in the later English translation Lectures on Political Economy. Volume 2: Money (1935):

“As regards the relationship of the natural or equilibrium rate of interest to the actual rate, it should be noted, in the first place, that even the existence of this distinction is questioned. The objections, however, mainly arise from a misunderstanding which occurred because K. Wicksell, who originated the distinction, made use in his later works of the term ‘real rate’ (which to my mind is less suitable than ‘natural rate’) and this expression became more widespread than that which we have used. The expression ‘real rate of interest’ is also unsuitable, since it coincides with Professor Fisher’s ‘real interest’, which, as is well known, denotes the actual rate plus the rate of appreciation or minus the rate of depreciation of money, and is thus in accordance with common usage, which employs the term ‘real wages’ or ‘real income’ in the same sense. Unfortunately Wicksell’s change in terminology is also linked up with a certain ambiguity in his definition of the ‘natural rate’. Having correctly defined it once as ‘that rate at which the demand for loan capital just equals the supply of savings’ he redefines it, on another occasion, as that rate which would rule ‘if there were no money transactions and real capital were lent in natura’. If this last definition were correct, Dr. G. Halm would be right in raising, against the conception of a ‘natural rate’, the objection that a uniform rate of interest could develop only in a money economy, so that the whole analysis is irrelevant. If Dr. Halm, instead of clinging to this unfortunate formula, had based his reasoning on the correct definition which is also to be found in Wicksell, he would have reached the same conclusion as Professor Adolf Weber—the distinguished head of the school of which he is a member; that is, that the natural rate is a conception ‘which is evolved automatically from any clear study of economic interconnections’. In accordance with this view, Wicksell’s conception must be credited with fundamental significance in the study of monetary influences on the economic system; especially if one realizes the practical importance of a money rate of interest depressed below the natural rate by a constantly increasing volume of circulating media. Unfortunately, although Wicksell’s solution cannot be regarded as adequate at all points, the attention which it has received since he propounded it has borne no relation to its importance. Apart from the works of Professor Mises, mentioned above, the theory has made no progress at all, although many questions concerning it still await solution. This may be due to the fact (on which we have touched already) that the problem had become entangled with that of fluctuations in the general price level. We have already stated our views on this point, (p. 196) and indicated what is necessary for the further development of the theory. Here, we shall try to restate the problem in its correct form, freed from any reference to movements in the price level.” (Hayek 1933: 209–212).

Again, is Hayek trying to define the natural rate merely as a monetary rate that clears that market for loanable funds, and that is equal to the return on capital? But at the same time that rate must cause equilibrium in the markets for real capital goods, so it is unclear why Wicksell’s earlier definition is problematic.

Now we come to Keynes. I am unsure whether Keynes’ uses the natural rate in A Tract on Monetary Reform (1923), but in Keynes’ A Treatise on Money (1930), he also uses a concept called the natural rate, which he connects with Wicksell:

“It is now evident in what manner changes in the Bank-rate, or—more strictly—changes in the rate of interest, are capable of influencing the purchasing power of money.

The attractiveness of investment depends on the prospective income which the entrepreneur anticipates from current investment relatively to the rate of interest which he has to pay in order to be able to finance its production;—or, putting it the other way round, the value of capital-goods depends on the rate of interest at which the prospective income from them is capitalised. That is to say, the higher (e.g.) the rate of interest, the lower, other things being equal, will be the value of capital-goods. Therefore, if the rate of interest rises, P´ will tend to fall, which will lower the rate of profit on the production of capital-goods, which will be deterrent to new investment. Thus a high rate of interest will tend to diminish both P´ and C, which stand respectively for the price-level and the volume of output of capital-goods. The rate of saving, on the other hand, is stimulated by a high rate of interest and discouraged by a low rate. It follows that an increase in the rate of interest tends— other things being equal—to make the rate of investment (whether measured by its value or by its cost) to decline relatively to the rate of saving, i.e. to move the second term of both Fundamental Equations in the negative direction, so that the price-levels tend to fall.

Following Wicksell, it will be convenient to call the rate of interest which would cause the second term of our second Fundamental Equation to be zero the natural-rate of interest, and the rate which actually prevails the market-rate of interest. Thus the natural-rate of interest is the rate at which saving and the value of investment are exactly balanced, so that the price-level of output as a whole (Π) exactly corresponds to the money-rate of the efficiency-earnings of the Factors of Production. Every departure of the market-rate from the natural-rate tends, on the other hand, to set up a disturbance of the price-level by causing the second term of the second Fundamental Equation to depart from zero.” (Keynes 1930a: 154–155).

Later in A Treatise on Money Keynes has an extended discussion of the natural rate:

“Whilst Marshall, unless I have misunderstood him, regarded the influence of Bank-rate on investment as the means by which an increase of purchasing power got out into the world, and Mr. Hawtrey has limited its influence to one particular kind of investment, namely investment by dealers in stocks of liquid goods, Wicksell—though here also there are obscurities to overcome—was closer to the fundamental conception of Bank-rate as affecting the relationship between investment and saving. I say that there are obscurities to overcome, because Wicksell’s theory in the form in which it has been taken over from him by Professor Cassel seems to me to be reduced to practically the same thing as the first strand of thought mentioned above, namely that the level of Bank-rate determines the volume of bank-money and hence the price-level. But I think that there was more than this in Wicksell’s own thought, though obscurely presented in his book.

Wicksell conceives of the existence of a ‘natural rate of interest’ which he defines as being the rate which is ‘neutral’ in its effect on the prices of goods, tending neither to raise nor to lower them, and adds that this must be the same rate as would obtain if in a non-monetary economy all lending was in the form of actual materials. It follows that if the actual rate of interest is lower than this prices will have a rising tendency, and conversely if the actual rate is higher. It follows, further, that so long as the money-rate of interest is kept below the natural-rate of interest, prices will continue to rise—and without limit. It is not necessary for this result, namely the cumulative rise of prices, that the money-rate should fall short of the natural-rate by an ever-increasing difference; it is enough that it should be, and remain, below it.

Whilst Wicksell’s expressions cannot be justified as they stand and must seem unconvincing (as they have to Professor Cassel) without further development, they can be interpreted in close accordance with the Fundamental Equation of this Treatise. For if we define Wicksell’s natural-rate of interest as the rate at which Saving and the value of Investment are in equilibrium (measured in accordance with the definitions of Chapter 10 above), then it is true that, so long as the money-rate of interest is held at such a level that the value of Investment exceeds Saving, there will be a rise in the price-level of output as a whole above its cost of production, which in turn will stimulate entrepreneurs to bid up the rates of earnings above their previous level, and this upward tendency will continue indefinitely so long as the supply of money continues to be such as to enable the money-rate to be held below the natural-rate as thus defined. This means, in general, that the market-rate of interest cannot be continually held even a little below the natural-rate unless the volume of bank-money is being continually increased; but this does not affect the formal correctness of Wicksell’s argument. Professor Cassel’s belief, that Wicksell was making a very odd mistake in arguing in this way, may be justified by the incompleteness of Wicksell’s expression, but it probably indicates that, whilst Wicksell was thinking along the same lines as those followed in this Treatise, Cassel is not,—in spite of the fact that Cassel expresses himself elsewhere in practically the same terms as Wicksell, namely that the true rate of interest is that at which the value of money is unchanged.

At any rate, whether or not I have exaggerated the depth to which Wicksell’s thought penetrated, he was the first writer to make it clear that the influence of the rate of interest on the price-level operates by its effect on the rate of Investment, and that Investment in this context means Investment and not speculation. On this point Wicksell was very explicit, pointing out that the rate of investment is capable of being affected by small changes in the rate of interest, e.g. … [one and a quarter] per cent., which could not be supposed to affect the mind of the speculator; that this increased investment causes an increased demand for actual goods for use and not for ‘speculative’ purposes, and that it is this increased actual demand which sends up prices.

More recently a school of thought has been developing in Germany and Austria under the influence of these ideas, which one might call the neo-Wicksell school, whose theory of bank-rate in relation to the equilibrium of Savings and Investment, and the importance of the latter to the Credit Cycle, is fairly close to the theory of this Treatise. I would mention particularly Ludwig Mises’s Geldwertstabilisierung und Konjunkturpolitik (1928), Hans Neisser, Der Tauschwert des Geldes (1928), and Friedrich Hayek, Geldtheorie und Konjunkturtheorie (1929). (Keynes 1930a: 196–199).

So Keynes here defines the natural rate as:

(1) “… the rate at which saving and the value of investment are exactly balanced, so that the price-level of output as a whole (Π) exactly corresponds to the money-rate of the efficiency-earnings of the Factors of Production.”

(2) “… the rate at which Saving and the value of Investment are in equilibrium … .”

This seems to be developed from Wicksell’s definition in Vorlesungen über Nationalökonomie. Band 2: Geld und Kredit (1922).

The final point (astonishing as it may seem) is that Keynes’ period as a quasi- or proto-monetarist before his work on the General Theory saw him developing a theory of inflation, the natural rate and investment which he saw as “fairly close to” the Austrian theory of Mises and Hayek. Though Keynes did not accept Austrian capital theory or the notion of the unsustainable lengthening of the structure of production, there seems to be some truth in this. Later of course when Hayek came to England and published Prices and Production on the basis of the lectures he had given at the LSE and Keynes knew the theory in greater detail, Keynes was not supportive.

BIBLIOGRAPHY
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