Saturday, November 15, 2014

The Natural Rate and New Consensus Macroeconomics

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

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

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

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

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

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

As Philip Pilkington points out,
“the Taylor Rule, when integrated into new consensus macro models, implicitly assumes that there exists a natural rate of interest which the central bank can target in order to generate both full employment and relative price stability. This natural rate is assumed to be the rate below which there will be a substantial trade-off between inflation and real output (i.e., if real output accelerates so too will inflation). This, of course, is familiar to many as the natural rate of interest, as sketched out by Knut Wicksell (Wicksell, 1898), and this is the reason why the natural rate has received renewed interest at central banks.” (Pilkington 2014: 4).
As a matter of historical interest, Wicksell defined the “natural rate” in at least two ways (and if one wants to be pedantic Arthur W. Marget actually argued that there are no less than eight ways in which Wicksell defined the “natural rate”! [Marget 1966: 201–204]).

At any rate, the relevant Wicksellian definition is found in Lectures on Political Economy. Volume 2: Money (1935):
The rate of interest at which the demand for loan capital and the supply of savings exactly agree, and which more or less corresponds to the expected yield on the newly created capital, will then be the normal or natural real rate. It is essentially variable.” (Wicksell 1935: 192–193).
A similar definition also appears in Wicksell’s article “The Influence of the Rate of Interest on Prices” (1907):
“According to the general opinion among economists, the interest on money is regulated in the long run by the profit on capital, which in its turn is determined by the productivity and relative abundance of real capital, or, in the terms of modern political economy, by its marginal productivity. (Wicksell 1907: 214).
In modern New Consensus Macroeconomics, the natural rate (which is also sometimes called the “neutral rate”) is seen as the interest rate that
(1) equates saving and investment at full employment, and

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

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

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

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

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

So how can the advocates of the New Consensus Macroeconomics defend their monetary policy? Again, as argued by Philip Pilkington,
“For Wicksell’s theory to be coherent when the notion of risk is taken into account, every specific interest rate in the economy must be set in a rational manner in line with the level of objective risk that must be given to each investment project. There must thus be a different natural rate of interest for each investment project, which reflects its true underlying risk relative to its return. Even if the central bank can set the money rate in line with something resembling a natural rate of interest—perhaps they might set it in line with the lowest risk investment projects’ natural rate—the capital markets will still have to line up all the other rates of interest on various heterogeneous projects with their specific natural rates. So, in order for Wicksell’s theory to hold, each interest rate must be set in line with the central bank money rate of interest plus a markup premium that takes full account of the objective risk of the capital project underlying this specific rate of interest relative to its objective return. This view of the capital markets can be summarized as that of the [efficient markets hypothesis] … . Investors/savers have access to perfectly clear knowledge of potential investments. Thus, they view potential investments as a series of given objective probabilities and they assign these probabilities a price—a required yield or rate of interest—that is inversely proportional to the risk of the investment not paying off.” (Pilkington 2014: 9).
Under such a condition,
“At equilibrium, we can assume that all information is being reflected in financial market prices and thus that all interest rates are aligned with their particular natural rate. The equilibrium point ..., if applied to the market as a whole, can be thought of as a whole series of natural rates of interest that will balance the economy at the optimum level of full employment output. This series of interest rates, if arrived at by the capital markets, will generate a stable equilibrium growth path with no inflation or deflation.” (Pilkington 2014: 10).
But this is completely and utterly unrealistic: it requires perfect information, no fundamental uncertainty and the untenable efficient markets hypothesis to be remotely credible. In reality, interest rates are set under uncertainty by liquidity preference and “set in line with that asset’s perceived riskiness and the level of risk aversion that the investment community holds at any given moment in time” (Pilkington 2014: 11).

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

Anderson, Richard G. 2005. “Wicksell’s Natural Rate,” Federal Reserve Bank of St. Louis

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

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

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

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

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


  1. This post mixes some things up in a rather confusing way. I see two unrelated issues:

    1) the concept of natural rate

    Here we must distinguish between long-run and short-run horizon. In NK models, long-run is understood as the "steady state" - an allocation to which the economy would converge if there were no exogenous shocks (and around which it fluctuates if there are). Assuming zero-inflation in steady state, nominal rate of interest will be equal to real rate determined by time preference and marginal productivity of capital (it's a simultaneous relationship, so it doesn't make sense to argue which causes what). In practice, all this means is just that a Taylor rule must be consistent *on average* with these steady state relationships - if long-run real rate is 2%, yet Taylor rule implies average nominal interest rate 4%, then there must be on average 2% inflation. This is hardly controversial.

    From a short-run view, one can define natural rate as the real rate that would hold in an alternate version of the economy without nominal frictions (but with all other state variables otherwise the same). In simpler versions of NK model, an optimal policy would be to set nominal interest rate in each period to this hypothetical natural rate, which would stabilize inflation at zero. In practice, presence of cost-push shocks would prevent perfect inflation stabilization, and short-run natural rate is unobservable anyway. Many NK models thus simply assume that the central bank follows a Taylor rule depending on observables only, and short-run natural rate plays no practical role in monetary policy.

    2) transmission of short-run rate set by CB to the rest of the economy

    Here, all the claims that NK models rely in crucial way on EMH are, frankly, nonsense. Yes, it's true that models often assume that all asset prices are set by rational, risk-adjusted expectations because it's *analytically convenient* - but even if they weren't, there's clearly a great deal of comovement between various interest rates, both empirically and theoretically due to no-arbitrage restrictions (and in modern financial markets, any arbitrage opportunities won't last long).

    So let's assume for example that agents in the economy have biased expectations about future riskiness of capital, which will affect their investment decisions. Does this make NK model incoherent? No - central bank actions will still impact the rest of the economy, and the overall logic of Taylor rule (i.e. increase interest rate if inflation is higher than usual) will most likely stay the same. Sure, maybe the transmission mechanism will be quantitatively different, and maybe the optimal monetary policy should take the bias into account - but all such features can be incorporated into the model (and I would be surprised if somebody hasn't done so already).

    1. The first point has nothing to do with my paper.

      The second point is equivalent to stating "Pilkington may be right in theory, but in practice this shouldn't make a difference". If this were true then we could find no empirical instance when the divergence of one interest rate in the economy from the central bank rate contributed to overinvestment. Of course, anyone familiar with the data would be able to think of one straight away:

      Indeed, it would be difficult to say that many interest rates prior to 2008 were at their natural rates. Rather they seemed to be determined by the unusually lax liquidity preference stance (i.e. the reckless Bullishness) of the capital markets. To simply handwave this away seems to me an act of intellectual repression.

      But the issue is deeper than this (unfortunately LK has left it out in this post but it is key). In the paper I also argued that the rate of investment is not simply determined by the rate of interest in a given market but rather by the marginal efficiency of capital. This means that even if the interest rates all line up in some approximation of the EMH there is still no guarantee that investment will behave in a linear manner.

      Now, ivansml will say "oh yes, but again we are dealing with an approximation, we know that generally speaking investment rises as interest rates fall". Actually there is little if any evidence for this and many New Keynesians today argue that the channel through which interest rates effect economic activity. See:

      Now, how far are we away from the Wicksell theory? We have made so many approximations at this stage. Does the theory really have any legs at all? A reasonable person would respond in the negative. But let's give the theory the benefit of the doubt: how did it perform since it has been implemented?

      Answer: terribly. Interest rate targeting has been disastrous. During the 1990s New Keynesian economists were all convinced that the natural rate of unemployment (a key component of the Taylor Rule approach) was much, much higher than it actually was. Greenspan let unemployment fall. No inflation resulted. The profession then rejigged their models post factum to excuse themselves for their collective incompetence. More intellectual repression.

      And what about the 2000s? Need it even be said? Need it be pointed out that the haphazard policies implemented were partially responsible for the mess we are in? Low interest rates were used, not to generate real capital investment, but to bump up a stock market and then a housing market bubbles. The whole Taylor Rule schlock was just ideology covering over the fact that central banks were engaged in trying to steer a bubble economy. Because that is what New Keynesian theory is: ideology that helps economists ignore what is actually going one. Simple as.

    2. "But the issue is deeper than this (unfortunately LK has left it out in this post but it is key). In the paper I also argued that the rate of investment is not simply determined by the rate of interest in a given market but rather by the marginal efficiency of capital. "

      Yes, an unfortunate omission by me. Also, I should have said that the quantity theory of money is false and this undermines the whole New consensus macro since they must assume it is true.

    3. Well, I think that they have -- like Wicksell -- replaced the quantity theory with the idea of a natural rate. Actually these two theories are basically synonymous but to show that I would need a bit more space than this comment section allows for. Ultimately both theories are trying to neutralise the effects of (a) money and (b) intervention in what is thought to be a self-regulating economy.

    4. Philip,

      1) you still seem to think that all various interest rates must move in lockstep with CB rate for NK model to work. That's just wrong. It's perfectly possible that there are other things going on in the economy which affect term premia, risk premia, default premia etc. AND at the same time CB policy also affects the economy.

      2) by the way, plotting Fed Funds rate with 30-year rate on mortgages is comparing apples and oranges. Plot mortgage rate with long-term yields on Treasury bonds instead and you'll get almost parallel curves ( ). That long-term rates don't react one-to-one to changes in short-rate is a standard result, implied e.g. by the simple expectation hypothesis of the term structure.

      3) if "marginal efficiency" of capital means its expected productivity, then that's already accounted for in New Keynesian models with capital (the model would have two rates of return - return on bonds and on capital, and two equations linking them to other variables). But because saving through bonds and investing into productive capital both mean (from individual's point of view) shifting consumption from today to the future, the two rates must be related in equilibrium.

      4) yes, there's some evidence questioning the textbook interest rate channel of monetary policy transmission. Focus on that, drop all the nonsense about EMH and you might get a reasonable paper.

      5) I don't really care about Wicksell. The goal of economic theory is not to provide the most faithful representation of old masters, but to study causal mechanisms underlying the economy. If that requires "many approximations", so be it.

      6) inflation targeting also delivered few decades of Great Moderation, which wasn't so bad. Regarding whether and to what extent it caused the housing bubble, [citation needed], as they say. Otherwise, you are starting to sound a lot like deranged internet austrians.

    5. On point (6), regarding central banks, one must add the crucial factor of financial deregulation that occurred in the 1980s and 1990s; this has a lot to do with the re-emergence of large and destabilising asset bubbles in this period.

      If you don't believe that, then you must explain why in the 1940s-early 1970s, these sorts of problems either disappeared or were minimal, even though central banks also had an easy money policies and low interest rates.

  2. Good post. My own calculations of a variety of natural rates of interest (weighted own rates of interest) highlights the significant differences with money rates and that a constant state of disequilibrium mostly exists. This provides empirical evidence that assumptions on perfect information, competition and rational expectations do not have much in common with reality. My interpretation of chapter 17 of the GT is that Keynes remained rather classical when it came to the investment function.