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.

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.

BIBLIOGRAPHY
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.

Alfred Marshall’s Interest Rate Theory

We can start with Alfred Marshall’s statement on 19 December 1887 to the British “Royal Commission on the Value of Gold and Silver” (edited for clarity):

[sc. Question:]“9651. The evidence that has been put by some witnesses before us has been intended to show that so far from any connexion being traceable between plentiful money and a low rate of discount and a plentiful supply of the precious metals, the evidence was just the other way?

[sc. Marshall’s answer:] Oh yes, that is certainly true as regards permanent results; the supply of gold exercises no permanent influence over the rate of discount. The average rate of discount permanently is determined by the profitableness of business. All that the influx of gold does is to make a sort of ripple on the surface of the water. The average rate of discount is determined by the average level of interest in my opinion, and that is determined exclusively by the profitableness of business, gold and silver merely acting as counters with regard to it.”
(Final Report of the Royal Commission Appointed to Inquire into the Recent Changes in the Relative Values of the Precious Metals; With Minutes of Evidence and Appendixes. Eyre and Spottiswoode, London, 1888. p. 4).

The “rate of discount” is Marshall’s expression for the money rate of interest. But, for Marshall, in the long-run the money rate of interest is determined by the “real” rate of interest, which is in turn determined by the demand and supply of real capital goods (Bridel 1987: 38): the “real” rate concept is analogous to Wicksell’s natural rate of interest.

But of course, for Marshall, variations in supply of gold can cause short-run changes in the money rate of interest.

In fact, Marshall saw four factors that could influence the money rate of interest, as follows:

(1) changes in the supply and demand for real capital;

(2) changes in the supply of commodity money;

(3) changes in the supply of money available for lending in the banking system, and

(4) the influence of speculators on financial asset markets (Bridel 1987: 38).

If the supply of gold increases, for example, then this will induce excessive demand for real capital goods and price inflation, according to Marshall (Bridel 1987: 41), and if there is an expectation of further prices rises there might be a cumulative process of inflation as further investment occurs (Bridel 1987: 41–42). This process is a short-run phenomenon. Eventually banks will raise money rates of interest and a new equilibrium will be reached as money rates rise to equal the long-run “real” rate (the functional equivalent of the natural rate) (Bridel 1987: 42).

Bridel (1987: 43) argues that Marshall missed the idea of “forced saving” and the latter insights of Keynes in the Treatise on Money (1930), that a contraction of consumption induced by forced saving lowers the marginal productivity of capital and hence lowers the natural rate of interest.

Nevertheless, Marshall’s interest theory is clearly a precursor to the loanable funds theory (Bridel 1987: 44).

BIBLIOGRAPHY
Bridel, Pascal. 1987. Cambridge Monetary Thought: The Development of Saving-Investment Analysis from Marshall to Keynes. Macmillan, Basingstoke.

Final Report of the Royal Commission Appointed to Inquire into the Recent Changes in the Relative Values of the Precious Metals; With Minutes of Evidence and Appendixes. Eyre and Spottiswoode, London, 1888.

Wicksell’s Natural Rate and Homogenous Capital

Colin Rogers points out an interesting assumption of Wicksell’s natural rate.

The concept of capital can be divided into two ideas:

(1) real capital, or the physical goods themselves, e.g., machines, tools, or raw materials, or
(2) capital defined in terms of a sum of exchange value (or in monetary terms). (Rogers 1989: 27).

Real capital in sense (1) can be measured in technical units, but that would mean that there would be as many technical units as there are types of capital goods (Rogers 1989: 28).

But in order to calculate the rate of interest (the return on capital), capital has to be measured in monetary terms.

Rogers continues:

“Apart from pointing out the technical necessity of defining capital in value terms, Wicksell also suggests that it is necessary for theoretical reasons; namely, that in equilibrium the rate of interest must be the same on all capital. This condition is, of course, the classical condition of long-period equilibrium defined in terms of a uniform rate of return on all assets. It is the notion of equilibrium employed by Wicksell to define the natural rate of interest. To define such an equilibrium, however, capital must be treated as a mobile homogeneous entity so that it may move between sectors to equalize the rate of interest/profit. Capital defined as value capital (financial capital) can fulfil this role but capital defined in technical or quantity terms cannot.” (Rogers 1989: 28).

It well known that Wicksell’s unique “natural rate of interest” was taken over by Mises and Hayek in their early formulations of the Austrian business cycle theory. In essence, the classic Austrian business cycle theory borrowed the “real” natural rate idea from Wicksell that required an assumption of homogeneous capital: something that modern Austrians are at pains to deny, since they accept (as Post Keynesians do) that capital is heterogeneous.

This is serious problem for Austrians. Austrians use a concept – the Wicksellian natural rate of interest – that is incompatible with their heterogeneous capital theory.

BIBLIOGRAPHY
Rogers, C. 1989. Money, Interest and Capital: A Study in the Foundations of Monetary Theory. Cambridge University Press, Cambridge.

Matias Vernengo on the Natural Rate (Part II)

Matias Vernengo follows up his earlier post here:

Matias Vernengo, “The Natural Rate in Pure Exchange, Intertemporal Models,” Naked Keynesianism, August 11.

Keynes’s Marginal Efficiency of Capital: A Mistake?

It is very interesting to note what Joan Robinson thought of Keynes’s notion of the marginal efficiency of capital:

“[sc. Keynes] made a fatal mistake in offering a quasi-long-period definition of the inducement to invest as the ‘marginal efficiency of capital’, that is, the profit that will be realised on the increment to the stock of capital that results from current investment and, still worse, identified the profitability of capital with its social utility. This was an element in the old doctrine from which he failed to escape. He had an alternative concept of the inducement to invest as the expected future return on sums of finance to be devoted to investment. Minsky (1976) points out that he did not seem to recognise the difference between the two formulations. If he had stuck to his short-period brief, he would have used only the second.” (Robinson 1979: 179–180).

I have seen other criticisms of the marginal efficiency of capital idea, on the grounds that Keynes, in developing it, failed to free himself from the neoclassical marginal productivity of capital (King 2002: 209). Keynes was also influenced by Sraffa’s own rates of interest concept (Barens and Caspari 1997: 294). In fact, Knut Wicksell’s natural interest rate concept, by one of his definitions, appears rather similar to the marginal efficiency of capital:

“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). But Keynes’s marginal efficiency of capital is arguably not a “real” concept: the marginal efficiency of capital is a rate expressed in terms of money.

BIBLIOGRAPHY

Barens, I. and V. Caspari, 1997. “Own-Rates of Interest and Their Relevance for the Existence of Underemployment Equilibrium Positions,” in G. C. Harcourt and P. A. Riach (eds.), A “Second Edition” of The General Theory (Vol. 1), Routledge, London. 283–303.

Harcourt, G. C. and P. A. Riach. 1997. A “Second Edition” of The General Theory (Vol. 1), Routledge, London.

King, J. E. 2002. A History of Post Keynesian Economics since 1936, Edward Elgar Publishing, Cheltenham, UK and Northampton, MA.

Lawlow, M. S. 1994. “The Own-Rates Framework as an Interpretation of the General Theory: A Suggestion for Complication the Keynesian Theory of Money,” in J. B. Davis (ed.). The State of Interpretation of Keynes, Kluwer Academic, Boston and London. 39–90.

Robinson, J. 1979. “Garegnani on Effective Demand,” Cambridge Journal of Economics 3: 179–180.

Uhr, C. G. 1994. “Knut Wicksell – A Centennial Evaluation,” in J. Cunningham (ed.), Knut Wicksell: Critical Assessments (vol. 3), Routledge, London. 72–103.

Wicksell, K. 1934. Lectures on Political Economy (trans. E. Classen), Routledge & Kegan Paul, London.