Wednesday, November 5, 2014

Rothbard on the Natural Rate

A succinct statement here, even though Rothbard does not use the expression “natural rate”:
“The willingness of the firm’s owners to pay a fixed-interest return to lenders is, of course, a function of their anticipated profit in selling the product to the consumers. Willingness to pay interest will always be less than or equal to the anticipated profit rate; and in the long-run general-equilibrium world of changeless certainty—a world that has never and can never come into existence—the rate of return would be equal throughout the market economy. In that world, the rate of profit in every firm would be equal to the rate of interest on loans.” (Rothbard 2011: 451).
This is very much a version of the Wicksellian monetary equilibrium approach, where the “rate of return” in long-run general-equilibrium is equal to one version of Wicksell’s natural rate, and in turn the rate of return on capital is equal to the rate of interest.

Rothbard notes that only in “long-run general-equilibrium” can the rate of return be uniform: consequently it follows from this that only in such an equilibrium can there be a single natural rate.

Yet, despite this, Rothbard just blathers on about the single “natural rate” when he discusses the Austrian business cycle theory (ABCT) (Rothbard 2009: 794, 1003–1004), and sees no contradiction when he bases the whole ABCT on the idea of central banks and credit expansion driving the money rate below the single natural rate. If nothing else, this proves how incoherent and intellectually incompetent Rothbard’s version of the ABCT was, just as the earlier versions of Hayek and Mises.

At one point Rothbard (2009: 1003, 112) even claims his version of the “natural rate” is different from Wicksell’s, but he seems ignorant of the fact that Wicksell had two definitions of the “natural rate,” and Wicksell did sometimes define it as the “expected yield on the newly created capital” (Wicksell 1935: 192–193) or the long-run “profit on capital” (Wicksell 1907: 214).

Further Reading
“Another Example of Wicksell’s Second Definition of the Natural Rate of Interest,” October 8, 2014.

“How did Wicksell, the early Austrians and Keynes define the Natural Rate of Interest?,” October 4, 2014.

Rothbard, M. N. 2009. Man, Economy, and State with Power and Market: The Scholar’s Edition (2nd edn.). Ludwig von Mises Institute, Auburn, Ala.

Rothbard, M. N. 2011. Economic Controversies. Ludwig von Mises Institute, Auburn, Ala.

Wicksell, K. 1907. “The Influence of the Rate of Interest on Prices,” The Economic Journal 17.66: 213–220.

Wicksell, K. 1935. Lectures on Political Economy. Volume 2: Money (trans. E. Classen). Routledge & Kegan Paul, London.


  1. You suggest that the ABCT is incorrect because there is no single natural rate of interest. This argument is flawed. The ABCT does not depend on a single natural rate of interest.

    Consider the Capital Asset Pricing Model. According to CAPM, the discount rate (k) for an investment is:

    k = r + B(m-r)

    r is the risk-free rate
    B is Beta of the investment
    m is the market risk premium

    Now imagine that intervention in the market reduces the risk-free rate (r). The artificially low risk-free rate will reduce the discount rate of every investment.

    In the CAPM framework, every investment will have a different discount rate. Still, an artificially low risk-free rate will artificially reduce the discount rate on every investment.

    Austrians will probably reject using CAPM to explain ABCT. Still, this illustrates that the ABCT does not depend on a single natural rate of interest.

    1. Your drivel doesn't in the least show that the "ABCT does not depend on a single natural rate of interest."

    2. Furthermore, if the "ABCT does not depend on a single natural rate of interest" show me one formal exposition of it that does not explicitly use the natural rate.

    3. A quick correction on the CAPM. If "m is the market risk premium" then you don't need the (m-r) term. If m is the market rate of return then you do. I'm not nitpicking at an error (I'm sure you knew this and it was just an honest mistake); there's actually an important difference here.

      So would the Austrian suppose that market rate of return is the "natural rate" or is there a "natural risk premium" and the natural rate is derived from that? This question may seem trivial until you think about it...

      I'll use your (standard) CAPM example but most of this will apply to any Capital Asset Pricing Model (CAPM) and not just the nonsense one taught in the textbooks (which as you note, most Austrians would object to).

      A few questions to keep in the back of your mind:

      (1) Do Austrians believe in a risk-free rate?

      (2) Do Austrians believe that all investors have identical risk preferences?

      (3) Are risk preferences constant across time or do they vary?

      (4) Do Austrians believe there is a "correct" relationship between risk and return?


      Let's suppose in your world CAPM applies. I'll call big M the "market rate of return" and the little m the "market risk premium". So the CAPM formula will look like one of these:

      k = r + B(M-r)
      k = r + Bm

      Let's suppose at time t the risk-free "natural rate" is 2%. Let's suppose the risk premium is 4%. So k=6%.

      Now suppose that at time t+1 the government "artificially" lowers the risk-free rate to 0%.

      Now suppose that we have an asset whose beta is B=1.

      What's k in this world? Consider 2 scenarios:

      Scenario 1: k=6% (as it was before)

      In this case we have two possible interpretations:

      6% = 0% + 1(M-0%) ===> M=6%
      6% = 0% + 1(m) ===> m=6%

      Scenario 2: k=4%

      The two interpretations:

      4% = 0% + 1(M-0%) === M=4%
      4% = 0% + 1(m) ===> m=4%

      Two questions:

      (1) Do Austrians predict Scenario 1 or Scenario 2 will actually occur in the real world? (Or do Austrians withhold judgement allowing that either may occur depending on how market participants respond?)
      (1a) Side question: Do Austrians believe that market participants ought to follow Scenario 1 or Scenario 2? (Or do Austrians withhold judgement on that as well?)

      (2) Is 6% the "natural rate of return" for this asset or is 4% the "natural risk premium" for this asset?

    4. For a presentation of the ABCT in the CAPM framework, see:

    5. Thanks for showing how flawed and harebrained are the Austrians, Anonymous -- including the author of the paper you cite.

      He says:

      " What is the source of the widespread
      “cluster of entrepreneurial errors” (Rothbard
      [1962] 1970, 746; [1963] 1975, 18-21) that typifies the boom-bust sequence ? It is that
      market rates of interest are driven below the “natural rate” as result of credit expansion by the central bank. Market rates are the result of the supply of and demand for credit (or loanable funds), while the natural rate is an expression of individuals’ time preferences, ..."
      p. 3.
      Just another Austrian who never properly understood Sraffa's critique of Hayek.

    6. LK,spot on!Austrians don´t understand Piero Sraffa one bit!And it seem they grasp slow or are unabel to grasp even things explained directly adressed to them in their own work! Gunnar Myrdal, a student of Wicksell and one that understood all this tried to explain the weakness of natural rate concept already in 1932 to Hayek in Hayek´s own editoral book "Bieträge zur Geldtheori" in his article 'Der Gleichgewichtsbegriff als Instrument der Geldtheoretischen Analyse'. And neverless Hayek,continued to both misunderstand and misinterpret both Wicksell and stick to a closeminded natural rate as nothing had happened.If not even the most reputable of Austrian schoolers don´t understand, it´s no dawn wonder their loud internet epigones don´t get it right either i guess.

    7. LK,i find a little bit amusing that the Austrian at least those ones i read stick to the natural rate and the quantity theory of money as well as Say´s Law, that even in a very narrowminded interpretation of Wicksellian cumulative process with a natural rate of interest is a obvouis contradiction.It do not go together, a fact that even Wicksell noticed,although as a prisoner of his time and neoclassical dogma had very hard to melt.But Austrians seem not aware of the conclusions the tools they play with lead to!So if you wonder why those persons can´t deal with a Sraffian critque of natural rate, i fear that is fare beyond their cognitive capabilities!

    8. Samuel,

      Thanks for your reply. Also, you're right about the market return vs. the market risk premium. Sorry for this error.

      Your two scenarios are interesting. There is no standard 'Austrian' answer to your questions because Austrians (like the Post Keynesians) reject CAPM. As you suggest, Austrians withhold judgement.

      You're right. My original post does assume that, ALL ELSE EQUAL, an artificially low risk-free rate will reduce every investments' discount rate.

      Advocates of CAPM would argue scenario 2 is correct. Advocates of CAPM do not argue that reductions in the risk-free rate must be offset by changes in the market return. Advocates of CAPM also use the 'all else equal' assumption.

      Moreover, if changes in the risk-free rate were always offset by changes in the market return, then monetary policy would be useless. Artificially low interest rates would be incapable of increasing the amount of investment, and hence GDP.

    9. anon,

      what do you mean by 'artificially low' ?

    10. Anonymous,

      I think Philippe's question is probably relevant here and that's part of what I was getting at with the different interpretations.

      It seems to me one could argue one of two things is artificially "low".

      The first is the market rate of return. If you insist that the market rate of return ought to be 6% (why?) then a decrease in the risk-free rate (assuming it lowers the market rate. . . Scenario 2) would result in an "artificially low" market rate of return.

      But if instead you insist that it's the market risk premium that is either too low or too high, then it's too high in scenario 1 (perhaps... or perhaps risk has gone up?) but just right in scenario 2.

      So which is it?

      I suspect the tie in comes down to return on new investment since, presumably, the return on investment exceeds the unlevered cost of capital.

  2. "Rothbard notes that only in “long-run general-equilibrium” can the rate of return be uniform: consequently it follows from this that only in such an equilibrium can there be a single natural rate."

    His claim is actually more restricted than this since he invokes a "world of changeless certainty".

    Each capital asset would have known, certain cash flows. There would be no need for risk premiums in this fantasy since all cash flows are certain; there is no risk. (Would there be other reasons to prefer assets over others such as liquidity?)

  3. I think the original post misses the point of Rothbard's "long-run general-equilibrium", or Evenly Rotating Economy.

    Rothbard uses the Evenly Rotating Economy (ERE) to distinguish between interest and profit.

    There is no uncertainty in the ERE. Investors' cash flow forecasts are certain. Since there is no uncertainty, there are no profits or losses. In other words, every investment's net present value (NPV) is equal to zero in the ERE.

    However, there is still interest in the ERE. The time value of money still exists in the ERE. Investors still discount cash flows in the ERE. Investors still make NPV calculations in the ERE, and investors discount cash flows at the interest rate.

    The main purpose of the ERE is to separate interest and profit. Rothbard uses the ERE to distinguish between profit (an investment's NPV) and the interest rate (the investment's discount rate).

    1. I understand these points perfectly well, thank you.

      That is why I said "in long-run general-equilibrium ... the rate of return on capital is equal to the rate of interest."

    2. And what you describe is not that much different to the neoclassical view of profits in long run equilibrium:

    3. LK,

      Do you believe that there is a tendency for all rates of return to equalize?

      In other words, do you accept or reject the law of abnormal returns?

    4. "Do you believe that there is a tendency for all rates of return to equalize?"


      It is an absurd idea derived from an absurd underlying general equilibrium theory.

      The real world departs too far from anything like perfect competition. The fact that (1) most firms set their prices as cost-based, mark-up prices both in the short and long run and (2) the widespread use of excess capacity and inventories create severe market barriers to entry is enough to render the "tendency for all rates of return to equalize" ridiculous.

      For example, the profit markup across sectors in the real world will always differ because competition is not efficient enough to drive profits to zero or some uniform mark-up.

    5. LK,

      Imagine that the rate of return in industry X is higher than the rate of return in industry Y.

      Investors will pull resources out of industry Y and invest those resources in industry X. As these resources are invested in industry X, the rate of return in industry X will fall. Conversely, the rate of return in industry Y will rise. This process creates a tendency for the rate of return in industry X and industry Y to equalize.

      You reject this?

    6. I won't speak for LK but here's my take. . .

      1) As we've discussed earlier, if Industry Y is riskier than Industry X, I might prefer to invest in Industry X.

      2) The empirical evidence doesn't support this:

      See for example McKinsey's Thinking About ROIC and Growth (powerpoint)

      Slide 4 shows ROIC by industry.

      Slide 6 shows that there is some mean reversion (as your theory would predict) but (as the slide puts it), "ROIC does not fully regress to the aggregate median of 9 percent".

      Slide 7 looks at the consumer staples industry and shows an even slower regression.

      3) Competitive Advantage

      Some of this has to do with various competitive advantages. Here are a list (I reproduced) from McKinsey:

      Competetive Advantage Types

      4) Excess Capacity

      I suspect LK's point above regarding excess capacity may be relevant here as well.

      Many companies can increase output at a lower cost-per-unit with existing capital.

  4. "Imagine that the rate of return in industry X is higher than the rate of return in industry Y."

    As with many such examples, the issue is the framework built into the question. The question poses implicitly a world in which its possible to know the rate of return in industries X and Y. So the world of this question contains no uncertainty and is totally un-realistic. The question poses a world in which business is similar to playing roulette, but in the real world business is not constrained by such well defined probabilities. Without being able to know the rate of return in X and Y before hand, or only being able to estimate it from previous returns, will take us away from general equilibrium and any ideas that the economy is heading towards equilibrium.

    @Samuel Goti, I believe that the rate of return in X and Y in the question is posed as taking the risk into account.

  5. Lord Keynes,

    I really don't understand your obsession with the natural rate of interest.

    Suppose an economist wants to analyze the effects of a price ceiling in the milk market. He draws a supply and demand diagram. He shows that, if the price ceiling is below the equilibrium (natural) price of milk, then there will be a shortage.

    The economist knows that every carton of milk in the store is not homogeneous. Regardless, he can still use a single milk price to illustrate the point that a price ceiling on milk will causes shortages.

    Using a single interest rate to analyze interference in the loanable funds market is no different than using a single milk price to analyze interference in the milk market.

    Do you reject all supply and demand analysis, or just supply and demand analysis applied to the loanable funds market?

    Why don't you criticize neoclassical economists and monetarists for using the loanable funds theory? Why do you single out Austrians?

    1. Anonymous,

      You clearly haven't read much of my blog, nor do you really understand Post Keynesian economics. If you did, you won't be asking these questions.

      There are any number of posts here criticising neoclassical economics; neoclassical economists are just as wrong and flawed when they use loanable funds theory.

      Regarding the natural rate, it is fundamental idea running through neoclassical economics and Austrianism, but as Colin Rogers has said, the "concept of the natural rate of interest is not merely non-operational: it is an abstract special case of no general theoretical significance. It cannot, therefore, provide the theoretical foundations for an operational loanable funds theory of the rate of interest" (Rogers, C. 1989. Money, Interest and Capital: A Study in the Foundations of Monetary Theory, Cambridge University Press, Cambridge. p. 546). If the natural rate and loanable funds theory fall, then so do many aspects of neoclassical and Austrian economics.

      If think that is outcome is insignificant, there's little point in any debate here.

    2. Do you believe that the law of supply and demand is incorrect?

      For example, suppose Colin Rogers had said:

      the "concept of [equilibrium price] is not merely non-operational: it is an abstract special case of no general theoretical significance."

      Would you agree with Rogers in this case?

      I'm just trying to figure out if you reject supply and demand analysis in general, or whether you just reject the application of supply and demand analysis to the interest rate.

    3. Supply and demand analysis is appropriate only if the relevant markets have goods with flexible prices, demand curves are well behaved and the real world supply curve also behaves as marginalist theory predicts.

      Unfortunately, the vast majority of newly produced goods markets do not fulfil these conditions, since most prices are mark-up prices, and they tend to be inflexible with respect to demand changes.

      There are also serious epistemological problems with the law of demand.

      The law of demand cannot be proven except for purely hypothetical conditions where there is only one commodity and only one consumer:

  6. I have been reading through multiple articles that are in opposition to Austrian Economics.

    One of the biggest fallacies in your method of argumentation is the way you position the "facts" different from their context or complete misunderstanding of the Austrian position.

    Take the above article.

    1. Start off with a comment from Rothbard where he specifically doesn't mention the phenomenon you are attempting to refute.
    2. immediately connect the above statement by Rothbard to Wicksell argument/definitions. There is no way that Rothbard or any Austrian would except this definition of natural rate: "one version of Wicksell’s natural rate, and in turn the rate of return on capital is equal to the rate of interest."
    3. Use the above fact that no Austrian would agree to to attempt to poke holes in Rothbard's discourse on the subject.
    4.Then at the end admits Rothbard maintained his did not agree with Wicksell: "At one point Rothbard (2009: 1003, 112) even claims his version of the “natural rate” is different from Wicksell’s". By doing this you are already presupposing that Rothbard and Wicksell positions were the same.
    5. Claim that Rothbard is ignorant of Wicksell's position, when he thoroughly read and analyzed Wicksell's position and praised his contributions to certain areas of economics but also ensure that when his position differed he would make a footnote explaining as such. And what do you see on page 1003 in Man Economy, State, with Power & Market?

    "Since Knut Wicksell is one of the fathers of this business-cycle approach, it is important to stress that our usage of “natural rate” differs from his. Wicksell’s “natural rate” was akin to our “free-market rate”; our “natural rate” is the rate of return earned by businesses on the existing market without considering loan interest. It corresponds to what has been misleadingly called the “normal profit rate,” but is actually the basic rate of interest. See chapter 6 above."

    One again go back and actually understand his chapter on: "PRODUCTION: THE RATE OF INTEREST AND ITS DETERMINATION".

    This "refutation" method or shall I say "backward refutation" method you use throughout your writings is the prime reason that I cannot take your site seriously. If someone isn't well read ie Read at least Human Action and Man, Economy, State with Power & Markets, they are led by you to conclude the incorrectness or "absurdity" in Austrian Economics. This leading is done on strictly misrepresented and/or misunderstood statements you put forth.

    I honestly believe you are a very talented and well educated person to put together a site on so many topics. Unfortunately, many of the arguments are fundamentally flawed such as what has been mentioned above.

    I wish you the best and hope you will actually dig deeper into topics / authors / Worldviews that you clearly lack understanding.

    1. Let's start with your point 2:

      " There is no way that Rothbard or any Austrian would except this definition of natural rate: "one version of Wicksell’s natural rate, and in turn the rate of return on capital is equal to the rate of interest."

      Given this is exactly how Rothbard defines the natural rate in the quotation I gave above, it makes me think you have no proper understanding of the issue here, or just misunderstood my statement.