The Natural Rate and New Consensus Macroeconomics

There is a curious tendency in economics to define “interest” as what is commonly called “profit”: the return to capital used in production.

In neoclassical theory, the long-run equilibrium, uniform rate of profit, usually understood as the marginal productivity of capital or the “natural rate,” is seen as the anchor of the system and the variable that governs and determines the money rate of interest in the long run (Pivetti 2012: 475), even if in the short run the money rate of interest can deviate from the natural rate. The “natural rate” is usually thought to be the rate that ensures price stability as well, as in the New Consensus Macroeconomics and its “Taylor Rule” (Pivetti 2012: 475–476).

The trouble with this of course is that you can’t have a long-run, uniform rate of profit in disequilibrium: it is only in a long-run equilibrium that such a thing could exist. In the real world of disequilibrium, there are many changing rates of return in thousands of industries, and in a world of uncertainty, severe barriers to entry in many markets and imperfect competition, there is no reason to think they will converge to a uniform rate even in the long run.

So how on earth can New Consensus Macroeconomics monetary policy be justified?

It is at this point that a reading of Philip Pilkington’s excellent paper “Endogenous Money and the Natural Rate of Interest” elucidates matters considerably.

To its credit, the New Consensus Macroeconomics now recognises that money supply is endogenous (Pilkington 2014: 3). It also recognises that the central bank sets the money rate of interest, while the actual money supply “floats” (Pilkington 2014: 3). It is now accepted that it is the monetary interest rate that is the relevant “real policy target of the central banks” (Pilkington 2014: 4).

As Philip Pilkington points out,

“the Taylor Rule, when integrated into new consensus macro models, implicitly assumes that there exists a natural rate of interest which the central bank can target in order to generate both full employment and relative price stability. This natural rate is assumed to be the rate below which there will be a substantial trade-off between inflation and real output (i.e., if real output accelerates so too will inflation). This, of course, is familiar to many as the natural rate of interest, as sketched out by Knut Wicksell (Wicksell, 1898), and this is the reason why the natural rate has received renewed interest at central banks.” (Pilkington 2014: 4).

As a matter of historical interest, Wicksell defined the “natural rate” in at least two ways (and if one wants to be pedantic Arthur W. Marget actually argued that there are no less than eight ways in which Wicksell defined the “natural rate”! [Marget 1966: 201–204]).

At any rate, the relevant Wicksellian definition is found in Lectures on Political Economy. Volume 2: Money (1935):

“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.” (Wicksell 1935: 192–193).

A similar definition also appears in Wicksell’s article “The Influence of the Rate of Interest on Prices” (1907):

“According to the general opinion among economists, the interest on money is regulated in the long run by the profit on capital, which in its turn is determined by the productivity and relative abundance of real capital, or, in the terms of modern political economy, by its marginal productivity. (Wicksell 1907: 214).

In modern New Consensus Macroeconomics, the natural rate (which is also sometimes called the “neutral rate”) is seen as the interest rate that

(1) equates saving and investment at full employment, and

(2) also ensures prices stability.

New Consensus Macroeconomics monetary policy – through the Taylor Rule – requires that there exists such a natural rate, which the central bank can target, and which is a reliable tool for achieving full employment and price stability.

As we have seen, this “natural rate” is clearly the modern descendent of the Wicksellian “natural rate” and Wicksell’s attempt to reformulate the quantity theory to be consistent with endogenous money (Pilkington 2014: 5).

Keynes, however, rejected “the natural rate” concept as the long-run determinant of monetary interest rates, and developed his liquidity preference theory of interest; Keynes also argued that the “level of employment is ultimately determined by the level of investment” (Pilkington 2014: 5–6).

Keynes’ insights have been rejected, and modern neoclassical economics has returned to the Wicksellian loanable funds theory.

However, we live in a world of disequilibrium. Given the non-existence of a present long-run, uniform rate of profit that is the “natural rate” anchor for the central bank, how can New Consensus Macroeconomics monetary policy be coherent? Even if a market economy had a real long-run tendency to a uniform rate of profit that is the “natural rate,” how could a central bank possibly know that rate? Of course, if there is no convincing reason to think that real-world market economies converge towards a long-run general equilibrium state, the whole notion that there is some hypothetical natural rate that might be a central bank target is untenable.

So how can the advocates of the New Consensus Macroeconomics defend their monetary policy? Again, as argued by Philip Pilkington,

“For Wicksell’s theory to be coherent when the notion of risk is taken into account, every specific interest rate in the economy must be set in a rational manner in line with the level of objective risk that must be given to each investment project. There must thus be a different natural rate of interest for each investment project, which reflects its true underlying risk relative to its return. Even if the central bank can set the money rate in line with something resembling a natural rate of interest—perhaps they might set it in line with the lowest risk investment projects’ natural rate—the capital markets will still have to line up all the other rates of interest on various heterogeneous projects with their specific natural rates. So, in order for Wicksell’s theory to hold, each interest rate must be set in line with the central bank money rate of interest plus a markup premium that takes full account of the objective risk of the capital project underlying this specific rate of interest relative to its objective return. This view of the capital markets can be summarized as that of the [efficient markets hypothesis] … . Investors/savers have access to perfectly clear knowledge of potential investments. Thus, they view potential investments as a series of given objective probabilities and they assign these probabilities a price—a required yield or rate of interest—that is inversely proportional to the risk of the investment not paying off.” (Pilkington 2014: 9).

Under such a condition,

“At equilibrium, we can assume that all information is being reflected in financial market prices and thus that all interest rates are aligned with their particular natural rate. The equilibrium point ..., if applied to the market as a whole, can be thought of as a whole series of natural rates of interest that will balance the economy at the optimum level of full employment output. This series of interest rates, if arrived at by the capital markets, will generate a stable equilibrium growth path with no inflation or deflation.” (Pilkington 2014: 10).

But this is completely and utterly unrealistic: it requires perfect information, no fundamental uncertainty and the untenable efficient markets hypothesis to be remotely credible. In reality, interest rates are set under uncertainty by liquidity preference and “set in line with that asset’s perceived riskiness and the level of risk aversion that the investment community holds at any given moment in time” (Pilkington 2014: 11).

In conclusion, we can see how New Consensus Macroeconomics monetary policy requires rational expectations, perfect foresight, perfect knowledge and the efficient markets hypothesis. None of these things is remotely realistic and New Consensus monetary policy, with its emphasis on a modern version of the natural rate, cannot be taken seriously.

BIBLIOGRAPHY
Anderson, Richard G. 2005. “Wicksell’s Natural Rate,” Federal Reserve Bank of St. Louis
https://research.stlouisfed.org/publications/mt/20050301/cover.pdf

Marget, Arthur W. 1966. The Theory of Prices: A Re-examination of the Central Problems of Monetary Theory (2 vols.). Augustus M. Kelley, New York.

Pilkington, Philip. 2014. “Endogenous Money and the Natural Rate of Interest,” Levy Institute Working Paper No. 817, September.

Pivetti, Massimo. 2012. “Rate of Interest,” in J. E. King, (ed.). The Elgar Companion to Post Keynesian Economics (2nd edn.). Edward Elgar, Cheltenham. 474–478.

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.