My Posts on the Natural Rate of Interest

A list of my posts on the natural rate of interest, its history, the various ways it has been defined, and why it is rejected in Post Keynesian economics.

“The Natural Rate of Interest: A Wicksellian Fable,” June 6, 2011.

“Robert P. Murphy on the Sraffa-Hayek Debate,” July 19, 2011.

“Bibliography on the Sraffa-Hayek Debate,” July 20, 2011.

“ABCT without a Unique Natural Rate of Interest?,” September 22, 2011.

“Hayek’s Natural Rate on Capital Goods, Sraffa and ABCT,” December 27, 2011.

“The Natural Rate of Interest in the ABCT: A Definition and Analysis,” February 26, 2013.

“Wicksell’s Natural Rate and Homogenous Capital,” September 25, 2013.

“Colin Rogers’ Money, Interest and Capital, Chapter 2,” June 12, 2014.

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

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

“Ralph Hawtrey on the Natural Rate of Interest,” October 10, 2014.

“Axel Leijonhufvud’s ‘The Wicksell Connection’: A Review,” October 11, 2014.

“Alfred Marshall on the Natural Rate of Interest,” October 13, 2014.

“Thomas Joplin on the Natural Rate of Interest,” October 16, 2014.

“The Proto-Natural Rate of Interest and Henry Thornton,” October 17, 2014.

“David Ricardo on the Natural Rate of Interest,” October 18, 2014.

“Alfred Marshall’s Interest Rate Theory,” November 3, 2014.

“Rothbard on the Natural Rate,” November 5, 2014.

“The Natural Rate and New Consensus Macroeconomics,” November 15, 2014.

David Ricardo on the Natural Rate of Interest

Both Blaug (1992: 126) and King (2013: 123) point out that a market rate of interest and some kind of “natural” rate of interest can be found in David Ricardo’s On the Principles of Political Economy and Taxation.

I quote from the 3rd edition of 1821:

“The rate of interest, though ultimately and permanently governed by the rate of profit, is however subject to temporary variations from other causes. With every fluctuation in the quantity and value of money, the prices of commodities naturally vary. They vary also, as we have already shewn, from the alteration in the proportion of supply to demand, although there should not be either greater facility or difficulty of production. When the market prices of goods fall from an abundant supply, from a diminished demand, or from a rise in the value of money, a manufacturer naturally accumulates an unusual quantity of finished goods, being unwilling to sell them at very depressed prices. To meet his ordinary payments, for which he used to depend on the sale of his goods, he now endeavours to borrow on credit, and is often obliged to give an increased rate of interest. This, however, is but of temporary duration; for either the manufacturer's expectations were well grounded, and the market price of his commodities rises, or he discovers that there is a permanently diminished demand, and he no longer resists the course of affairs: prices fall, and money and interest regain their real value. If by the discovery of a new mine, by the abuses of banking, or by any other cause, the quantity of money be greatly increased, its ultimate effect is to raise the prices of commodities in proportion to the increased quantity of money; but there is probably always an interval, during which some effect is produced on the rate of interest.” (Ricardo 1821: 349–350).

So though affected by other factors, the money rate of interest is ultimately determined “by the rate of profit.”

Ricardo is adamant that the rate of profit is what fundamentally determines the money interest rate:

“M. Say allows, that the rate of interest depends on the rate of profits; but it does not therefore follow, that the rate of profits depends on the rate of interest. One is the cause, the other the effect, and it is impossible for any circumstances to make them change places.” (Ricardo 1821: 353, n.).

In Ricardo’s The High Price of Bullion (1810), an earlier work, he had already given a similar statement of what determines the money rate of interest:

“It is contended, that the rate of interest, and not the price of gold or silver bullion, is the criterion by which, we may always judge of the abundance of paper-money; that if it were too abundant, interest would fall, and if not sufficiently so, interest would rise. It can, I think, be made manifest, that the rate of interest is not regulated by the abundance or scarcity of money, but by the abundance or scarcity of that part of capital, not consisting of money.” (Ricardo 1810: 43).

So Ricardo though that the money rate of interest was determined by a real factor: the rate of profit on capital (King 2013: 123).

Ricardo even speaks of the money interest rate being driven below its “natural” level by excessive money supply increases:

“I do not dispute, that if the Bank were to bring a large additional sum of notes into the market, and offer them on loan, but that they would for a time affect the rate of interest. The same effects would follow from the discovery of a hidden treasure of gold or silver coin. If the amount were large, the Bank, or the owner of the treasure, might not be able to lend the notes or the money at four, nor perhaps, above three per cent.; but having done so, neither the notes, nor the money, would be retained unemployed by the borrowers; they would be sent into every market, and would every where raise the prices of commodities, till they were absorbed in the general circulation. It is only during the interval of the issues of the Bank, and their effect on prices, that we should be sensible of an abundance of money; interest would, during that interval, be under its natural level; but as soon as the additional sum of notes or of money became absorbed in the general circulation, the rate of interest would be as high, and new loans would be demanded with as much eagerness as before the additional issues.” (Ricardo 1810: 46–47).

There also appear to be two letters where Ricardo discusses the “natural” rate of interest in relation to the money rate, but I have not yet been able to read them:

(1) a letter to Pascoe Grenfell on the 27 August 1817, and

(2) a letter to Thomas Malthus on the 21 October, 1817.

BIBLIOGRAPHY
Blaug, Mark. 1992. The Methodology of Economics, or, How Economists Explain (2nd edn.). Cambridge University Press, Cambridge, UK.

King, John Edward. 2013. David Ricardo. Palgrave Macmillan, Basingstoke, UK.

Ricardo, David. 1810. The High Price of Bullion: A Proof of the Depreciation of Bank Notes (2nd edn.). John Murray, London.

Ricardo, David. 1821. On the Principles of Political Economy and Taxation (3rd edn.). John Murray, London.

Smithin, John N. 2003. Controversies in Monetary Economics (rev. edn.). Edward Elgar, Cheltenham, UK and Northhampton, MA.

Thomas Joplin on the Natural Rate of Interest

The “Economicreflections” blog has a fascinating post on the early-19th-century maverick economist Thomas Joplin (c. 1790–1847) and his version of the natural rate of interest:

“Early 19th century origins of the Natural Rate of Interest,” Economicreflections, 15 October, 2014.

This discussion of the “natural rate” comes in one of Joplin’s letters (which was later noted by Jacob Viner 1955: 191 over a hundred years later):

“The circulation of each district must bear a certain proportion with that of the rest of the kingdom, in order that its internal trade may balance, and if the general circulation be ever so deficient, the Banks of no district can increase their issues, unless the others do so; nor yet, in the regular course of banking reduce them, be it ever so redundant, unless the reduction be general. If the prices of any district were either above or below their due proportion with the rest, an exportation or importation of corn and cattle, as we explained in our last letter, would bring them in, probably, a few weeks to their level. Any internal cause, therefore, by which a general extension or contraction of the currency is produced must be common to all.

We also pointed out, in our former letters, that money had two values,—its value as currency, and its value as income, or capital; and that the issues of our banks are founded upon a demand for the latter, governed evidently by principles that ought to have no connexion whatever with the currency. There was no want of currency when the banks first issued notes; but by forcing the original metallic money out of circulation, they have created a want, and this want, is a sum of paper, precisely equal to the amount of metallic money, which would have been in circulation if there had not been any paper money at all.

The interest demand for money, or capital is also subject to great fluctuations. During war, when Government borrows largely, it is infinitely greater than during peace, when it does not borrow any. In the former period, the natural market-rate of interest has often been seven or eight per cent, and is generally above five; in the latter it has often been at two per cent, and is generally under four.

The natural rate of interest, however, can never be properly known with our system of currency. It depends, as we have stated, upon the quantity of income saved, proportioned to the demand for capital. But, with the power possessed by our banks of cancelling money which has been saved, or manufacturing it when it has not, this supply and demand can never be ascertained. Consequently, the banks have an arbitrary charge, some of four, but most of five per cent., from which they do not vary; but which, being neither the natural war-rate nor the peace-rate, is as little likely to be the true rate as any other between these two extremes they could have pitched upon.

The natural rate of interest is pretty uniform throughout the kingdom; and when money is scarce or plentiful it operates upon all the banks at the same time. When, therefore, during the war, it was above five per cent, there was a constant tendency in the banks to increase their issues; since the war, except for a short interval, it has been considerably under that rate, and a great reduction of their issues has taken place.” (Letter IX. To the Editor of the Courier, in Joplin 1825: 37–38).

This appears to be a monetary “natural rate” that clears the market for loanable funds, when the money supply is limited strictly to a given supply of commodity money (for Joplin’s other works, see Joplin 1823 and 1832).

According to Glasner (1997: 56), Thomas Joplin had the clearest expression of the idea of a “natural rate” before Wicksell, although Henry Thornton (1760–1815) was also another early theorist with a proto-natural rate concept.

I am not quite sure what relationship Joplin had to the Currency School, but their ideas seem similar, and Hayek even considered Joplin the “inventor of the currency [sc. school] doctrine” (Hayek 1935: 15). The Currency School’s ideas were seen by the early Austrians like Mises and Hayek as the precursor to their Austrian business cycle theory (Mises 2006 [1978]: 101–103; Garrison 1997: 23).

Addendum
Another point that strikes me (as brought out in the Economicreflections blog post) is that there was a great deal of intense discussion of economic issues in the early 19th century, but now largely forgotten.

In addition to the development of writings in Classical Political Economy following Adam Smith, there was the following:

(1) the last phase of the bullionist controversies from 1800 to 1819 (Glasner 1997);

(2) the debates after 1819 between the Banking School, the Currency School, and Free Banking School over what caused the business cycle and other monetary issues (White 1997).

(3) the emerging anti-laissez faire, protectionist writings of Friedrich List (1789–1846), Henry Clay (1777–1852), and the early German Historical School.

(4) the writings of the proto-Keynesian “Birmingham School” of economists (Checkland 1948), including the following economists:

Birmingham School
Thomas Attwood
George Frederick Muntz
Matthias Attwood
Arthur Young
Patrick Colquhoun
Sir John Sinclair
Robert Montgomery Martin.

BIBLIOGRAPHY
Checkland, S. G. 1948. “The Birmingham Economists, 1815–1850,” The Economic History Review n.s. 1.1: 1–19.

Garrison, R. W. 1997. “Austrian Theory of Business Cycles,” in D. Glasner and T. F. Cooley (eds.), Business Cycles and Depressions: An Encyclopedia. Garland Pub., New York. 23–27.

Glasner. D. 1997. “Bullionist Controversies,” in D. Glasner and T. F. Cooley (eds). Business Cycles and Depressions: An Encyclopedia. Garland Pub., New York. 56–58.

Hayek, F. A. von. 1935. Prices and Production (2nd edn). Routledge and Kegan Paul.

Joplin, Thomas. 1823. Outlines of a System of Political Economy: written with a View to Prove to Government and the Country, that the Cause of the Present Agricultural Distress is Entirely Artificial: and to suggest a Plan for the Management of the Currency. Baldwin, Cradock, and Joy, London.

Joplin, T. 1825. An Illustration of Mr. Joplin’s Views on Currency, and Plan for Its Improvement; together with Observations applicable to the Present State of the Money; in a series of Letters. Baldwin, Cradock, and Joy, London.

Joplin, Thomas. 1832. An Analysis and History of the Currency Question: Together with an Account of the Origin and Growth of Joint Stock Banking in England: Comprised in a Brief Memoir of the Writer’s Connexion with these Subjects. James Ridgway, London.

Mises, L. von. 2006 [1978]. The Causes of the Economic Crisis and Other Essays Before and After the Great Depression. Ludwig von Mises Institute, Auburn, Ala.

O’Brien, D. P. 1997. “Joplin, Thomas (c. 1790–1847),” in D. Glasner and T. F. Cooley (eds). Business Cycles and Depressions: An Encyclopedia. Garland Pub., New York. 344–345.

Viner, Jacob. 1955. Studies in the Theory of International Trade. Allen & Unwin, London.

White, Lawrence H. 1997. “Banking School, Currency School, and Free Banking School,” in D. Glasner and T. F. Cooley (eds). Business Cycles and Depressions: An Encyclopedia. Garland Pub., New York. 47–49.

Alfred Marshall on the Natural Rate of Interest

Joan Robinson (1969: 397) noted that Alfred Marshall had developed something analogous to the concept of a “natural rate of interest,” though this appears to have been independently of Wicksell.

On 19 December 1887, Alfred Marshall gave evidence before a British “Royal Commission on the Value of Gold and Silver,” which was instituted in 1887 to investigate the question of changes in the value of gold and silver and the effects of this on trade and production.

The relevant quotation is as follows:

“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 notion that the level of interest is determined “exclusively by the profitableness of business” appears quite similar to the way in which Wicksell defined the natural rate in “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. This remaining the same, as, indeed, by our supposition it is meant to do, would it be at all possible for the banks to keep the rate of interest either higher or lower than its normal level, prescribed by the simultaneous state of the average profit on capital?” (Wicksell 1907: 214).

BIBLIOGRAPHY
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.

Robinson, Joan. 1969. The Accumulation of Capital (3rd edn.). Macmillan, London.

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

Ralph Hawtrey on the Natural Rate of Interest

That is, Ralph Hawtrey’s own peculiar definition of this concept from his book Good and Bad Trade (1913), with his two other interest rates:

“In the absence of a banking system we found that two distinct elements had to be taken into consideration in calculating the rate of interest. First, there was the rate which represented the actual labour-saving value of capital at the level of capitalisation reached by industry. This ratio of labour saved per annum to labour expended on first cost is a physical property of the capital actually in use, and under perfectly stable monetary conditions is equal to the market rate of interest. It may be conveniently termed the ‘natural rate.’ But, secondly, where monetary conditions are not stable, the market rate diverges from the natural rate according to the tendency of prices. When prices are rising the market rate is higher, and when falling lower, than the natural rate, and this divergence is due to the fact that the actual profits of business show under those conditions corresponding movements.

And now, thirdly, we find that where a banking system is in operation the market rate does not even coincide with this second rate of interest, which, as it represents the true profits of business prevailing for the time being, may be called the ‘profit rate.’ The market rate is in fact the bankers’ rate, and is greater or less than the profit rate, according as the bankers wish to discourage or encourage borrowing.” (Hawtrey 1913: 65–66).

This seems to be a rather different formulation of the concept from Wicksell’s own definitions.

Deutscher (1997: 300) defines Hawtrey’s concept of the “natural rate” as the real rate of interest in an equilibrium state with no inflation.

Hawtrey’s third rate corresponds to the conventional “bank rate.”

BIBLIOGRAPHY
Deutscher, P. 1997. “Hawtrey, Ralph George (1879–1975),” in D. Glasner and T. F. Cooley (eds). Business Cycles and Depressions: An Encyclopedia. Garland Publishing, New York. 300–302.

Hawtrey, Ralph George. 1913. Good and Bad Trade: An Inquiry into the Causes of Trade Fluctuations. Constable, London.

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
Erturk, K.A. 2006. “Speculation, Liquidity Preference and Monetary Circulation,” in P. Arestis and M. Sawyer (eds), A Handbook of Alternative Monetary Economics. Edward Elgar, Cheltenham, UK and Northampton, MA. 454–470.

Hayek, F. A. von. 1929. Geldtheorie und Konjunkturtheorie. Hölder-Pichler-Tempsky, Vienna.

Hayek, F. A. von. 1933. Monetary Theory and the Trade Cycle (trans. N. Kaldor and H. M. Croome). J. Cape, London.

Hayek, F. A. von. 2008. Prices and Production and Other Works: F. A. Hayek on Money, the Business Cycle, and the Gold Standard. Ludwig von Mises Institute, Auburn, Ala.

Hayek, F. A. von. 2008a [1933] “Monetary Theory and the Trade Cycle,” in F. A. von Hayek, Prices and Production and Other Works: F. A. Hayek on Money, the Business Cycle, and the Gold Standard. Ludwig von Mises Institute, Auburn, Ala. 1–130.

Keynes, John Maynard. 1923. A Tract on Monetary Reform. Macmillan, London.

Keynes, John Maynard. 1930. A Treatise on Money. Volume 1. The Pure Theory of Money. Macmillan, London.

Keynes, John Maynard. 1930a. A Treatise on Money. Volume 2. The Applied Theory of Money. Macmillan, London.

Klausinger, Hansjoerg. 2003. “Hayek Translated: Some Words of Caution,” History of Economics Review 37: 71–83.

Mises, L. von. 1912. Theorie des Geldes und der Umlaufsmittel. Duncker & Humblot, Munich and Leipzig.

Mises, L. von. 2006 [1978]. The Causes of the Economic Crisis and Other Essays Before and After the Great Depression. Ludwig von Mises Institute, Auburn, Ala.

Mises, L. von. 2009 [1953]. The Theory of Money and Credit (enlarged, new edn). Ludwig von Mises Institute, Auburn, Ala.

Wicksell, K. 1898. Geldzins und Güterpreise. Fischer, Jena.

Wicksell, K. 1922. Vorlesungen über Nationalökonomie. Band 2: Geld und Kredit. Fischer, Jena.

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

Wicksell, K. 1936. Interest and Prices (trans. R. F. Kahn). Macmillan, London.

Philip Pilkington on the Natural Rate of Interest

In a great Levy Institute working paper here:

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

More background here.

The paper looks at endogenous money theory and the deficient and flawed way this was been incorporated into the “New Consensus Macroeconomics” (mainstream neoclassical theory), through the use of the natural rate of interest.

Matias Vernengo on the Natural Rate of Interest

Matias Vernengo has a great post here on Austrians and the natural rate of interest:

Matias Vernengo, “On Austrians and the Natural Rate of Interest,” Naked Keynesianism, August 9.

The highlight is Vernengo’s observation that Juan Ramón Rallo’s re-interpretation of the Austrian business cycle theory, in which there is a mismatch between real savings and investment, requires an equilibrium natural rate, despite Rallo’s protestations to the contrary.

The Natural Rate of Interest in the ABCT: A Definition and Analysis

This seems appropriate in light of this post at Robert Murphy’s blog.

It is 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 (ABCT).

Consider this passage from Hayek’s Prices and Production (2nd edn.; 1935):

“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).

Let us set out the analysis in the following points:

(1) The “natural rate of interest” is a non-monetary theory of the interest rate, and is independent of money and credit (Rogers 1989: 27). It is supposedly the centre of gravity towards which the monetary rate converges (Rogers 1989: 27).

(2) The condition where loans are made in natura is a barter state (or, more correctly, a credit/debt transaction where real goods are lent out, and then repayed with interest in terms of other goods later). What would a rate of interest be when loans are made in goods?

The “natural rate of interest” would be the rate on loans of a physical commodity or commodities (Sraffa 1932: 49–51). In a world of heterogeneous capital goods which is out of general equilibrium, there could be as many natural rates on each commodity considered as a capital good as there as such commodities (Barens and Caspari 1997: 288).

(3) The significant thing is that the “natural rate” is an “equilibrium rate” for Hayek: it is the rate that clears the various loan markets for real goods lent out as capital goods (whether durable or non-durable capital). These capital loan markets in natura – the markets in real capital goods lent out without money – will have market clearing with a natural rate.

This point is brought out by Lachmann in his observations on the Hayek–Sraffa debate:

“One thing is clear: when Hayek and Sraffa use the word ‘equilibrium’ they use it to denote quite different things. For Hayek it means market-clearing demand-and-supply equilibrium, for Sraffa long-run cost-of-production equilibrium.” (Lachmann 1994: 153).

(4) Therefore real savings and investment are equated: no intertemporal discoordination (or future lack of capital goods in relation to current plans) will result.

But the natural rate of interest can only be a single rate inside general equilibrium (or in some other equilibrium state such as Mises’s “final state of rest” or the ERE). Outside of general equilibrium, there can be as many natural rates as there are capital goods commodities lent out.

(5) therefore (by the internal logic of Hayek’s theory) no monetary system where capital goods investments are made by means of money can hit the right equilibrium natural interest rate on each in natura loan of various capital goods, because there is no such thing as a unique “natural rate.”

(6) therefore (by the internal logic of Hayek’s theory) no monetary system where capital goods investments are made by means of money can hit the right multiple natural interest rates either on each in natura loan of various capital goods, because the banks’ monetary interest rates – even in a free banking system – converge in a spread, yet there could be vast differences between the spread of banks rates and many individual commodity natural rates.

(7) According to the logic of Hayek’s theory, it follows that there is therefore no way in principle for a monetary system of lending for capital goods purposes to achieve ideal or consistent intertemporal coordination.

The only way is: to abolish money and return to a barter system (but even then there is no reason why “own commodity equilibrium rates” must exist on each type of capital good available for investment).

(8) Furthermore, the whole theory is dependent on unrealistic assumptions about real world tendencies to general equilibrium. There is no reason to think that there are equilibrium interest rates that will clear all loan markets just waiting to be discovered by entrepreneurial activity.

A possible and likely mismatch between planned investment and available real future savings is perfectly possible in a world of uncertainty, subjective expectations, entrepreneurial error, and even investment financed via retained earnings.

But question is: do these possible intertemporal discoordination problems really cause severe economic problems in real world market economies, and do they produce the type of trade cycle imagined in the Austrian business cycle theory?

The Austrian business cycle theory requires that booms develop with full employment and a lack of resources, but ignores the fact that virtually all modern economies are open to international trade and even at full employment still have idle capacity in many sectors (which overcome scarcity problems for many investments made in the past).

The theory requires a full use of resources (modelled in a closed economy) that only really occurs in fictitious states of general equilibrium.

The theory also requires a real world tendency to general equilibrium that does not exist in modern market economies.

FURTHER READING

“The Natural Rate of Interest: A Wicksellian Fable,” June 6, 2011.

“Austrian Business Cycle Theory (ABCT) and the Natural Rate of Interest,” June 18, 2011.

“Austrian Business Cycle Theory: The Various Versions and a Critique,” June 21, 2011.

“Hayek on the Flaws and Irrelevance of his Trade Cycle Theory,” June 29, 2011.

“Robert P. Murphy on the Sraffa-Hayek Debate,” July 19, 2011.

“Bibliography on the Sraffa-Hayek Debate,” July 20, 2011.

“Robert P. Murphy on the Pure Time Preference Theory of the Interest Rate,” July 13, 2011.

“Lachmann on Trade Cycle Models,” August 27, 2011.

“ABCT without a Unique Natural Rate of Interest?,” September 22, 2011.

“ABCT and the Flow of Credit,” October 6, 2011.

“Hayek’s Natural Rate on Capital Goods, Sraffa and ABCT,” December 27, 2011.

“Hayek’s Trade Cycle Theory, Equilibrium, Knowledge and Expectations,” January 4, 2012

“Equilibrium Amongst the Austrians,” January 28, 2012.

“Hülsmann on Mises’s Business Cycle Theory,” February 11, 2012.

“Why Isn’t the Boom of 1946-1948 a Problem for Austrians?,” June 2, 2012.

“Bruce Caldwell on the Flaw in Hayek’s Early Business Cycle Theory,” July 8, 2012.

“Repapis on Hayek’s Business Cycle Theory,” October 10, 2012.

“Hayek on his Simplified Capital Theory Assumptions in Prices and Production,” October 15, 2012.

“Critics of the Classic Hayekian Business Cycle Theory,” December 13, 2012.

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.

Hayek, F. A. von, 2008. Prices and Production and Other Works: F. A. Hayek on Money, the Business Cycle, and the Gold Standard. Ludwig von Mises Institute, Auburn, Ala.

Lachmann, L. M. 1994. Expectations and the Meaning of Institutions: Essays in Economics (ed. by D. Lavoie), Routledge, London. 141–158.

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

Rogers, C. 2001. “Interest Rate: Natural,” in P. Anthony O’Hara (ed.), Encyclopedia of Political Economy. Volume 1. A–K. Routledge, London and New York. 545–547.

Sraffa, P. 1932. “Dr. Hayek on Money and Capital,” Economic Journal 42: 42–53.

The Natural Rate of Interest and the Austrian Business Cycle Theory: A Reply

One Guillermo Sanchez has a post here defending the Austrian business cycle theory (ABCT):

“Sraffallacies: A Misesian Defense of ABCT (II),” Econo-Mia [y Tuya], January 29, 2013.

If I am not mistaken, Guillermo Sanchez already acknowledges that Sraffa’s critique of Hayek on the non-existence of the Wicksellian natural rate of interest is sound.

Sanchez states:

“Robert P. Murphy’s great paper “Multiple Interest Rates and Austrian Business Cycle Theory” (2010) takes the subject directly as Lachmann did. The enormous merit of this paper is that even if Sraffa was right, his critique does not refute ABCT. In other words he was able (after criticizes Lachmann’s solution) to ensure the validity of ABCT in Sraffa’s own terms (a multiple rates environment). ABCT is still valid even in the circumstances in which Sraffa said it would not be valid. He managed to do it using a Dynamic Equilibrium simple model. Maybe the best refutation is not to demonstrate that Sraffa was wrong, but to demonstrate that even if he was right, the theory still holds logically”

What Sanchez is trying to argue here is that ABCT can be reformulated by purging it of its use of the natural rate of interest, and that such a reformulated ABCT can be defended against Sraffa’s critique on the basis of the mythical natural rate.

That is perfectly true, of course, and I have never denied this. The problem is that such a theory is not a Hayekian theory, it requires real world tendency to a general equilibrium state, and it is still subject to a host of other problems, such as subjective expectations, uncertainty, capital theory, unrealistic assumptions about use of resources, and so on.

But let me turn to the specific criticisms Sanchez has of my arguments:

(1) First, Sanchez points out a red herring:

“Lord Keynes” does not mention the fact that Mises was not the only one whose theory relied on the [W]icksellian natural interest rate concept. Keynes himself confessed that he also relied on it on the same time (early 30s) that Sraffa accused Hayek of using that unique rate concept …. As everybody knows, in the early 30s (and before that) Keynes was a [W]icksellian and a quantitative [= “quantity” – LK] theorist.

Yes, before the General Theory Keynes was indeed a quantity theorist and used the natural rate. But so what? Keynes was wrong.

Let me repeat that: Keynes was as wrong and misguided as any neoclassical in these years in his use of these concepts.

But, in the end, Keynes abandoned the natural rate idea between the Treatise on Money and his writing of the General Theory. Keynes came to see that the “natural rate” does not equate investment with savings, that savings can be much higher than investment, and that subjective expectations can shatter business confidence.

(2) Next, Sanchez asks me this:

“Why did ‘Lord Keynes’ accuse Mises (or Hayek) of using Wicksell’s natural rate and did not say anything about Keynes who was using it too two years after Mises and at the same time that Sraffa was accusing Hayek of using that [W]icksellian concept? Has he the guts to refute his ‘master’’s Treatise and his previous books because he was using the [W]icksellian natural rate concept? Can LK write ‘Keynes’s early theory is a complete nonsense because he relied on [W]icksellian theory of natural rate of interest’ or ‘All Keynes’s pre-GT writings on monetary and interest theory are worthless because he relied on [W]icksellian natural rate’? I doubt it. But let’s assume LK admits it and says “yes, all what Keynes wrote before GT is garbage because he relied on Wicksell natural rate. But obviously later on he did not used that faulty concept.”, however he himself has confessed that Mises in his later treatments abandoned that concept too. So in order to be intellectually honest he must say that Mises-ABCT is as immune to Sraffa’s criticism as it is the monetary and interest theory of Keynes in GT.”

The answer is “yes.” A great deal of what Keynes wrote before the General Theory is wrong, because of his use of neoclassical theory. (Although not all of it is wrong, for Keynes was, for example, receptive to the Chartalist theory of money and wrote some quite insightful though things about the history and nature of money).

In fact, I am surprised that any knowledgeable Austrian really thinks he has scored any points here. And, as I have admitted above, yes, a version of the ABCT purged of the Wicksellian natural rate of interest can be defended against Sraffa.

(3) The third issue is that Mises’s originary interest rate is still a flawed, real theory of interest. Interest is a monetary phenomenon, not explained by time preference.

If Mises’s originary interest rate is false, it follows that his later version of the ABCT (without the natural rate) still has a severe flaw.

(4) The objection that an economy where factor inputs are relatively abundant still poses a serious problem to the Austrian business cycle theory, despite what Sanchez says.

Instead of dealing with this issue, he merely distorts the issue, by attributing a straw man to his opponents. Keynesians and even Marxists do not deny that insufficient resources are often a problem in the real world.

The word “scarce” can have two meanings: (1) finite, and (2) insufficient quantities available in relation to demand. When I say that something is “relatively abundant,” I mean that it is available in a quantity that exceeds the demand for it.

But relative scarcity and relative abundance in these senses exist, and an economy can have a relative abundance of certain goods in any time outside a boom. International trade also provides goods even when domestically there might be shortages.

Nor do I deny that as an economy expands and reaches a boom, inflationary pressures build up as resources become less available.

Critics of my posts on the ABCT have simply misunderstood my critique. The non-existence of the natural rate of interest is one of the reasons why Hayek’s early business cycle theory is wrong. That critique applies to all Hayekian forms of the theory that use the natural rate, and even these Austrian critics are admitting this point.

The other versions of ABCT are flawed for other reasons. One of these is the unrealistic assumption of a economy that converges to a general equilibrium state:

“Hayek’s Trade Cycle Theory, Equilibrium, Knowledge and Expectations,” January 4, 2012

An unrealistic capital theory is yet another problem, as I have shown here:

“Hayek on his Simplified Capital Theory Assumptions in Prices and Production,” October 15, 2012.

“Why Isn’t the Boom of 1946-1948 a Problem for Austrians?,” June 2, 2012.

Hayek’s Natural Rate on Capital Goods, Sraffa and ABCT

Consider this passage from Hayek’s Prices and Production (2nd edn.; 1935):

“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).

This passage illustrates a fundamental reason why Sraffa’s critique of Hayek was so important. In Sraffa’s analysis of Hayek’s theory, we see that

(1) the relevant market for the “demand for and the supply of capital” is the market for capital goods. Depending on how one defines “saving” (see Pollin 2003: 304–308) and “investment,” the demand for capital that is met results in investment (if savings is defined simply as “income not spent,” savings can exceed investment when money or even goods are held without lending for capital goods investment).

(2) By the words

“because the demand for and the supply of capital do not meet in their natural form but in the form of money,”

Hayek is referring to the idea of loans being made in natura (in real commodities), as opposed to in money terms.

(3) A state where loans are made in in natura is a barter state (or, more correctly, a credit/debt transaction where real goods are lent out and repayed with interest with some other goods later). What would a rate of interest be when loans are made in goods? The rate of interest would be the rate on loans of a physical commodity or commodities (Sraffa 1932: 49–51). In a world of heterogeneous goods as factor inputs (including capital goods) which is out of equilibrium, there could be as many natural rates on each commodity considered as a factor input (or capital good) as there as such commodities (Barens and Caspari 1997: 288).

(4) Which one of these rates would in fact be the “natural rate”? There is no unique natural rate, but multiple rates. Any monetary rate could be both above and below a number of multiple natural rates, or, as Lachmann stated, “it is evidently possible for the money rate of interest to be lower than some [sc. multitude of commodity rates] but higher than others” (Lachmann 1994: 154). In short, one should agree with Robert P. Murphy, who concludes that “canonical ABCT does need to be updated, in light of a crippling objection raised early on by Piero Sraffa (1932a, 1932b) [my emphasis]” (see “Multiple Interest Rates and Austrian Business Cycle Theory,” p. 1).

(5) It therefore makes no sense to speak of a monetary rate of interest diverging from the unique Wicksellian natural rate of interest (or what Hayek calls the equilibrium rate), because there is no such rate outside of an imaginary equilibrium position.

(6) If some average of multiple natural rates were constructed, would this get Hayek out of his conundrum? No. As Sraffa argued,

“I pointed out that only under conditions of equilibrium would there be a single rate; and that when saving was in progress there would at any one moment be many ‘natural’ rates, possibly as many as there are commodities; so that it would be not merely difficult in practice, but altogether inconceivable, that the money rate should be equal to ‘the’ natural rate. And whilst Wicksell might fall back, for the criterion of his ‘money’ rate, upon an average of the ‘natural’ rates weighted in the same way as the index number of prices which he chose to stabilise, this way of escape was not open to Dr. Hayek, for he had emphatically repudiated the use of averages. 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: 251).

Lachmann also noted that Wicksell’s natural rate could be interpreted as an average of actual own-rates in a barter economy (Lachmann 1978: 76–77), and later tried to defend the natural rate idea.

For Lachmann’s attempts to salvage the notion of a natural rate, see Lachmann (1978: 75–77) and Lachmann (1986: 225–242). See Robert P. Murphy (2003) and Murphy’s paper “Multiple Interest Rates and Austrian Business Cycle Theory” for why Lachmann’s solution does not work.

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.

Hayek, F. A. von, 1932. “Money and Capital: A Reply,” Economic Journal 42 (June): 237–249.

Hayek, F. A. von, 2008. Prices and Production and Other Works: F. A. Hayek on Money, the Business Cycle, and the Gold Standard, Ludwig von Mises Institute, Auburn, Ala.

Lachmann, L. M. 1978. Capital and its Structure, S. Andrews and McMeel, Kansas City. pp. 75–77.

Lachmann, L. M. 1986. “Austrian Economics under Fire: The Hayek-Sraffa Duel in Retrospect,” in W. Grassl and B. Smith (eds.), Austrian Economics: Historical and Philosophical Background, Croom Helm, London. 225–242. [reprinted in Lachmann 1994: 141–158.]

Lachmann, L. M. 1994. Expectations and the Meaning of Institutions: Essays in Economics (ed. by D. Lavoie), Routledge, London. 141–158.

Murphy, Robert P. 2003. Unanticipated Intertemporal Change in Theories of Interest, PhD dissert., Department of Economics, New York University.

Murphy, Robert P. “Multiple Interest Rates and Austrian Business Cycle Theory.”

Pollin, R. 2003. “Saving,” in J. E. King (ed.), The Elgar Companion to Post Keynesian Economics, Edward Elgar, Cheltenham, UK and Northhampton, MA, USA. 304–308.

Sraffa, P. 1932a. “Dr. Hayek on Money and Capital,” Economic Journal 42: 42–53.

Sraffa, P. 1932b. “A Rejoinder,” Economic Journal 42 (June): 249–251.


UPDATED BIBLIOGRAPHY ON THE HAYEK–SRAFFA DEBATE

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.

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

Burger, P. 2003. Sustainable Fiscal Policy and Economic Stability: Theory and Practice, Edward Elgar, Cheltenham, UK.

Caldwell, B. 2004. Hayek’s Challenge: An Intellectual Biography of F.A. Hayek, University of Chicago Press, Chicago and London.

Cottrell, A. 1993. “Hayek’s Early Cycle Theory Re-examined,” Cambridge Journal of Economics 18: 197–212.

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

Hayek, F. A. von, 1931. Prices and Production, G. Routledge & Sons, Ltd, London.

Hayek, F. A. von, 1932. “Money and Capital: A Reply,” Economic Journal 42 (June): 237–249.

Hayek, F. A. von, 1935. Prices and Production (2nd edn), Routledge and Kegan Paul.

Hicks, J. R. and J. C. Gilbert. 1934. Review of Beiträge zur Geldtheorie by F. A. von Hayek, Economica n.s. 1.4: 479–486.

Kurz, H. D. 2000. “Hayek-Keynes-Sraffa Controversy Reconsidered,” in H. D. Kurz (ed.), Critical Essays on Piero Sraffa’s Legacy in Economics, Cambridge University Press, Cambridge. 257-302.

Kyun, K. 1988. Equilibrium Business Cycle Theory in Historical Perspective Cambridge University Press, Cambridge. p. 36ff.

Lachmann, L. M. 1978. Capital and its Structure, S. Andrews and McMeel, Kansas City. pp. 75–77.

Lachmann, L. M. 1986. “Austrian Economics under Fire: The Hayek-Sraffa Duel in Retrospect,” in W. Grassl and B. Smith (eds.), Austrian Economics: Historical and Philosophical Background, Croom Helm, London. 225–242. [reprinted in Lachmann 1994: 141–158.]

Lachmann, L. M. 1994. Expectations and the Meaning of Institutions: Essays in Economics (ed. by D. Lavoie), Routledge, London. 141–158.

Lawlor, M. S. and Horn, B. 1992. “Notes on the Hayek–Sraffa Exchange,” Review of Political Economy 4: 317–340.

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

Milgate, M. 1979. “On the Origin of the Notion of ‘Intertemporal Equilibrium,’” Economica n.s. 46.181: 1–10.

Murphy, Robert P. 2003. Unanticipated Intertemporal Change in Theories of Interest, PhD dissert., Department of Economics, New York University.

Murphy, Robert P. “Multiple Interest Rates and Austrian Business Cycle Theory.”

Myrdal, G. 1965 [1939]. Monetary Equilibrium, Augustus M. Kelly, New York.

Sraffa, P. 1932a. “Dr. Hayek on Money and Capital,” Economic Journal 42: 42–53.

Sraffa, P. 1932b. “A Rejoinder,” Economic Journal 42 (June): 249–251.

Vaughn, K. I. 1994. Austrian Economics in America: The Migration of a Tradition, Cambridge University Press, Cambridge and New York.

Mises’s “Evenly Rotating Economy” (ERE) and ABCT

Mises’s early work on the Austrian business cycle theory (ABCT) uses the Wicksellian natural interest rate concept and Wicksell’s monetary equilibrium analysis. This can be seen here:

“[Mises] surely made use of the natural and market rate concepts, developing Wicksell's analysis of the upward price spiral caused by a too low market rate into a theory of the business cycle” (Horwitz 2000: 77).

“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; but his further argument provokes contradiction. According to Wicksell, at every time and under all possible economic conditions there is a level of the average money rate of interest at which the general level of commodity prices no longer has any tendency to move either upwards or downwards. He calls it the normal rate of interest; its level is determined by the prevailing natural rate of interest, although, for certain reasons which do not concern our present problem, the two rates need not coincide exactly. When, he says, from any cause whatever, the average rate of interest is below this normal rate, by any amount, however small, and remains at this level, a progressive and eventually enormous rise of prices must occur ‘which would naturally cause the banks sooner or later to raise their rates of interest.’ Now, so far as the rise of prices is concerned, this may be provisionally conceded. But it still remains inconceivable why a general rise in commodity prices should induce the banks to raise their rates of interest ... ” (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.” (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; from Monetary Stabilization and Cyclical Policy [1928]).

So as late as 1928 in Monetary Stabilization and Cyclical Policy (1928), Mises is still using the Wicksellian natural interest rate concept.

I have recently seen this attempt to defend Mises’ early versions of ABCT, by invoking his later concept of the “evenly rotating economy”/stationary economy concept:

“The point Mises is making in the [sc. quotes] ... is that the natural interest rate is the rate of interest that would arise in the [“evenly rotating economy”]... It is the value towards which interest rates in the real world economy tend though there are real world factors that take the interest rate away from the natural interest rate.”

But a reading of the earlier work of Mises in works cited above does not support this:

(1) There is not one reference to the concept of the “evenly rotating economy” (ERE) in The Theory of Money and Credit (trans. J. E. Batson; Mises Institute, Auburn, Ala. 2009 [1953]). On pages 349–366 where Mises sets out his trade cycle theory, he uses the Wicksellian natural interest rate concept and Wicksellian monetary equilibrium analysis.

(2) There is not one reference to the concept of the “evenly rotating economy” in Monetary Stabilization and Cyclical Policy (1928), and again Mises is still using the Wicksellian natural interest rate (p. 99ff.).

The “evenly rotating economy” just like the “originary interest rate” appears in Human Action, not in these earlier works. The concept of the “evenly rotating economy” needs clarification:

“In Human Action, Mises advanced the Austrian theory of money by delivering a shattering blow to the very concept of Walrasian general equilibrium. To arrive at that equilibrium, the basic data of the economy—values, technology, and resources—must all be frozen and understood by every participant in the market to be frozen indefinitely. Given such a magical freeze, the economy would sooner or later settle into an endless round of constant prices and production, with each firm earning a uniform rate of interest (or, in some constructions, a zero rate of interest). The idea of certainty and fixity in what Mises called “the evenly rotating economy” is absurd, but what Mises went on to show is that in such a world of fixity and certainty no one would hold cash balances. Everyone’s demand for cash balances would fall to zero. For since everyone would have perfect foresight and knowledge of his future sales and purchases, there would be no point in holding any cash balance at all.” (Rothbard 2011: 697).

“The Evenly Rotating Economy is a fictitious system in which there are no price changes whatever – i.e., there is perfect price stability. The concept is used to illustrate the function of entrepreneurship and to demonstrate meaning of profit and loss by hypothesizing a system where they are absent.”
http://wiki.mises.org/wiki/Evenly_Rotating_Economy

“… this line of argument makes it necessary to clarify the precise meaning of general equilibrium, as well as its role in economic analysis. Mises argued that general equilibrium—which he called the stationary economy (stationäre Wirtschaft)—is a purely methodological device. It is an imaginary construct (Gedankenbild) that has no counterpart in the real world. Its only purpose is for the definition of profit and loss.” (Hülsmann 2007: 773).

If Mises really believed that “the natural interest rate is the rate of interest that would arise in the ERE. It is the value towards which interest rates in the real world economy tend though there are real world factors that take the interest rate away from the natural interest rate,” then ABCT has no application to real world capitalism. Why?

In the real world, economies are growing, and there can never be an “endless round of constant prices and production.” This would require an economy without growth, frozen in time, for a single natural rate of interest to even exist. As Sraffa showed, even in a barter economy with growth, there can be as many natural rates of interest as there are commodities.

Yet ABCT requires a single natural rate of interest in the real world for the market/bank rate to coincide with, in order that we can avoid the cycle effects allegedly caused by ABCT.

BIBLIOGRAPHY

Horwitz, S. 2000. Microfoundations and Macroeconomics: An Austrian Perspective, Routledge, London and New York.

Hülsmann, J. G. 2007. Mises: The Last Knight of Liberalism, Ludwig von Mises Institute, Auburn, Ala.

Mises, L. 1998. Human Action: A Treatise on Economics, Mises Institute, Auburn, Ala.

Mises, L. von. 2006 [1978]. The Causes of the Economic Crisis and Other Essays Before and After the Great Depression, Ludwig von Mises Institute, Auburn, Ala.

Mises, L. von, 2009 [1953]. The Theory of Money and Credit (trans. J. E. Batson), Mises Institute, Auburn, Ala.

Rothbard, M. 2011. Economic Controversies, Ludwig von Mises Institute, Auburn, Ala. p. 697.

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,” Mises.org, February 8
http://mises.org/daily/1743

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.

BIBLIOGRAPHY

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.

Burger, P. 2003. Sustainable Fiscal Policy and Economic Stability: Theory and Practice, Edward Elgar, Cheltenham, UK.

Caldwell, B. 2004. Hayek’s Challenge: An Intellectual Biography of F.A. Hayek University of Chicago Press, Chicago and London.

Cowen, T. 1997. Risk and Business Cycles: New and Old Austrian Perspectives, Routledge, London.

Festré, A. 2002. “Money, Banking and Dynamics: Two Wicksellian routes from Mises to Hayek and Schumpeter,” American Journal of Economics and Sociology 61.2: 439–480.

Garrison, R. W. 1997. “Austrian Theory of Business Cycles,” in D. Glasner and T. F. Cooley (eds), Business Cycles and Depressions: An Encyclopedia, Garland Pub., New York. 23–27.

Hayek, F. A. von, 1931. Prices and Production, G. Routledge & Sons, Ltd, London.

Hayek, F. A. von, 1932. “Money and Capital: A Reply,” Economic Journal 42 (June): 237–249.

Hayek, F. A. von, 1935. Prices and Production (2nd edn), Routledge and Kegan Paul.

Hayek, F. A. von, 1939. Profits, Interest and Investment, Routledge and Kegan Paul, London.

Hayek, F. A. von, 1942. “Professor Hayek and the Concertina-Effect: A Comment,” Economica n.s. 9.36: 383–385.

Hayek, F. A. 1995. Contra Keynes and Cambridge: Essays, Correspondence (ed. B. Caldwell; Collected Works of Friedrich August Hayek, Vol. 9), Routledge, London.

Hülsmann, J. G. 2007. Mises: The Last Knight of Liberalism, Ludwig von Mises Institute, Auburn, Ala.

Kaldor, N. 1939. “Capital Intensity and the Trade Cycle,” Economica n.s. 6.21: 40–66.

Kaldor, N. 1940. “The Trade Cycle and Capital Intensity: A Reply,” Economica n.s. 7.25: 16–22.

Kaldor, N. 1942. “Professor Hayek and the Concertina-Effect,” Economica n.s. 9.36: 359–382.

Kurz, H. D. 2000. “Hayek-Keynes-Sraffa Controversy Reconsidered,” in H. D. Kurz (ed.), Critical Essays on Piero Sraffa’s Legacy in Economics, Cambridge University Press, Cambridge. 257-302.

Lachmann, L. M. 1994. Expectations and the Meaning of Institutions: Essays in Economics (ed. by D. Lavoie), Routledge, London.

Lawlor, M. S. and Horn, B. 1992. “Notes on the Hayek-Sraffa exchange,” Review of Political Economy 4: 317–340.

Maclachlan, F. 1996. “II. Macroeconomics, Inflation, Business Cycles: The Concept of the Natural Rate of Interest in Mises and Hayek,” Cultural Dynamics 8 (November): 295–308.

Mises, L. von. 2002 [1978]. On the Manipulation of Money and Credit, Ludwig von Mises Institute, Auburn, Ala. p. 129–130.

Mises, L. von. 2006 [1978]. The Causes of the Economic Crisis and Other Essays Before and After the Great Depression, Ludwig von Mises Institute, Auburn, Ala.
(this reprints Monetary Stabilization and Cyclical Policy (1928).)

Mises, L. 1998. Human Action: A Treatise on Economics, Mises Institute, Auburn, Ala.

Mises, L. von, 2009 [1953]. The Theory of Money and Credit (trans. J. E. Batson), Mises Institute, Auburn, Ala. p. 355.

Rogers, C. 2001. “Interest rate: natural,” in P. Anthony O’Hara (ed.), Encyclopedia of Political Economy. Volume 1. A–K, Routledge, London and New York. 545–546.

Selgin, G. 1999. “Hayek versus Keynes on How the Price Level Ought to Behave,” History of Political Economy 31: 699-722.

Shostak, F. 2008. “The Myth of the Neutral Interest Rate Policy,” Mises.org, February 8
http://mises.org/daily/1743

Sraffa, P. 1932a. “Dr. Hayek on Money and Capital,” Economic Journal 42: 42–53.

Sraffa, P. 1932b. “A Rejoinder,”Economic Journal 42 (June): 249–251.

Trautwein, H. M. 1996. “Money, Equilibrium, and the Business Cycle: Hayek’s Wicksellian Dichotomy,” History of Political Economy 28.1: 27–55.

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

Vaughn, K. I. 1994. Austrian Economics in America: The Migration of a Tradition, Cambridge University Press, Cambridge and New York.

Vienneau, R. L. 2007. “Hayek Versus Sraffa,” February 19
http://robertvienneau.blogspot.com/2007/02/hayek-versus-sraffa.html

Vienneau, R. L. 2006. “Some Fallacies of Austrian Economics,” September
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=921183

Vienneau, R. L. 2010. “Some Capital-Theoretic Fallacies in Garrison’s Exposition of Austrian Business Cycle Theory,” September 4
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1671886

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