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.Let us set out the analysis in the following points:
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 : 215).
(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).FURTHER READING
(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.
“The Natural Rate of Interest: A Wicksellian Fable,” June 6, 2011.BIBLIOGRAPHY
“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.
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“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
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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.