I Was Writing About the Natural Rate of Interest Before It Was Cool
As Free Advice readers know, I have had my differences with Scott Sumner. But in a recent exchange he told me: “I’d encourage you to brush up on the Wicksellian theory of interest rates, it might help you to better understand my argument.”
More generally, it seems that all the cool bloggers are talking about natural interest rates now. Here’s a good summary post from Tyler Cowen (HT2 von Pepe).
Some responses:
==> I am actually somewhat familiar with this concept. For example, check out this paper I prepared for a Liberty Fund conference a few years ago, which drew heavily on work from my (2003) dissertation. You see “natural rate” jumps out quite a bit, including the very first sentence of the paper.
==> The reason for that, of course, is that Mises-Hayek business cycle theory is founded upon the market interest rate being pushed below the natural rate. And any well-read Austrian can go further, and say that that term comes from Knut Wicksell. From my recent book Choice:
…Mises drew on Bohm-Bawerkian capital theory, the interest theory of Swedish economist Knut Wicksell (1851-1926), and the earlier work of the British Currency School on the role of banks in economic crises, in order to advance what Mises called the circulation credit theory of the trade cycle. This is nowadays known as Austrian business cycle theory, the teaching of which is a major objective of the present book. (Murphy, Choice, p. 8)
==> As Scott himself acknowledges, the original Wicksellian approach said the natural rate would keep prices stable. So since prices have been rising since 2009, we can only conclude that actual interest rates have been… (I’ll let you guys fill in the blank.)
I will return to Scott’s thermostat analogy at some point soon, because if that’s the analogy he wants to use, he’s dead in the water. Any normal human being would reject Scott’s approach to monetary policy as crazy in the house-heating analogy that Scott himself picked.
In the meantime, in case Scott sees this post and thinks I’m wrong, all I can say is: Brush up on your Robert Lucas, and then I’m sure you’ll see how I’ve been right all along.
P.S. That last line is a joke, for those of you who are wit-challenged. I’m saying that Scott telling me to go read Wicksell is like me telling him to go read Lucas.
Prices were stable in the 1920s! Sumner was and is right!
“The reason for that, of course, is that Mises-Hayek business cycle theory is founded upon the market interest rate being pushed below the natural rate.”
Hmmm… but curiously you still seem to defend the same orthodox ABCT in your apologetic work on Austrian economics, even though you know that Sraffa won the natural rate debate against Hayek. Cognitive dissonance anyone?
But, anyway, if you are interested some history of the concept here:
http://socialdemocracy21stcentury.blogspot.com/2014/10/how-did-wicksell-early-austrians-and.html
http://socialdemocracy21stcentury.blogspot.com/p/a-list-of-my-posts-on-natural-rate-of.html
Curiously you seem to ignore the reconciliation I offer in the very paper I cite in this blog post.
And that would indeed be a fair answer, IF you also stated cheerfully in your apologetic work on Austrian economics (e.g., here) that the orthodox ABCT is badly flawed by its reliance on the natural rate and that you propose a new, revised and reformed version of it. But you don’t do this. You leave libertarians with the impression it is all 100% valid.
LK I don’t regret a single sentence of that article. That is 100% compatible with my views on interest rates and the capital structure.
I can say, “If the Fed pushes down interest rates by inflating the money stock it will cause problems” without committing myself to the view that, “In a barter economy we can identify the natural rate of interest and that’s the rate that a neutral central bank should target.”
Gosh, it’s almost like having one thing (and nothing else) defined as “money” which all parties are forced to use, might somehow create an intrinsic change in the nature of an economic system.
Multidimensional economic calculation, vs single dimensional economic calculation… I wonder if they always give the same answer?
This sounds convincing to me. I can believe eating salt raises my blood pressure without committing to any theory of what my bp should be. So if my bp is high I can sensibly reduce my salt consumption.
I.e., if you want to complain about Scott Sumner not understanding that you are well aware of the technical details of the natural rate, then maybe you should start showing you do in your defence of Austrian economics on Austrian blogs and public forums instead of just preaching to the choir.
Do you talk to your mother with that mouth?
So this is not an Austrian blog AND a public forum? LOL.
The whole idea of a “thermostat” is right there in the name, “thermo” => temperature, “stat” => constant… hence constant temperature.
If you enjoy some particular temperature, then you should set your thermostat to that particular temperature you prefer, and then leave it there because the whole purpose of the thermostat is that it can do the work. If you find yourself constantly twiddling with it, then either your thermostat is broken and you are attempting to compensate (generally won’t work but be my guest with your own property) or you are just fooling yourself. Many people seem confused by feedback control systems, sad to see Sumner is one.
Now that said, I generally turn my thermostat (on my Daikin air-conditioner) up in summer and down in winter, and there’s two logical reasons for that. First reason is that in summer I don’t want it too cold relative to the outside temperature. I only use the air-conditioner at night, and don’t want too much of a shock because the human body does acclimatise to the seasons, somewhat. Second reason is that in summer I use the cooling cycle, and in winter I use the warming cycle which operates slightly differently. For whatever reason, the cooling cycle tends to be slightly cooler than the set-point, and the warming cycle tends to be slightly warmer than the set-point. There’s no particular good reason for this, it’s just what I have discovered from living with this particular device. Other than that minor imperfection it’s worked pretty well (and of course, always clean the filters).
Sumner even got that wrong, because Krugman has been banging on about natural interest rates recently. Now I don’t always agree with Tyler Cowen, but I would be very hesitant and careful before disagreeing with him in public, especially when all he has done is provide a survey of various points of view (along with references on each). For Krugman to just dismiss the entire survey for being too complex does make you wonder who he is aiming his criticism at (ans why).
http://krugman.blogs.nytimes.com/2015/11/01/natural-confusion/
Oh yes, so Wicksell was using the Keynesian definition of “full employment” was he? What exactly is that again? I keep forgetting because the Keynesians keep changing their minds about what it means, oh well, whatever the Keynesians are talking about today… now that’s exactly what fits with the Wicksellian theory.
Krugman says it, so you know it must be true.
Bob, can you make up a story (like you did with the “Sushi economy”) to explain what it means for the natural interest rate to be zero (or below zero)? I.e. a simple economy where, for some reason, if you give you consumption today, you cannot consume more tomorrow. Can we even conceive such a situation? How would that island look like? How would the islanders end up in such a situation?
Sorry, I meant “where, if you give UP consumption today, you cannot consume more tomorrow”.
I still maintain that Hayek said it best in 1975. The “equilibrium structure” or the “natural rate” or “rates” are nothing other than the prices that would obtain in the absence of violent intervention and/or fraud. To the extent that there is violent intervention and/or fraud, there is no way to discover what they would have been (because they do not exist. The only way to discover them is to “give the market free play”. And “by definition, therefore, the divergence of actual prices from the equilibrium structure is something that can never be statistically measured” [because they do not exist]. LK and the Keynesians simply cannot allow this simple analysis to be clearly stated and understood.
These discrepancies of demand and supply in different industries, discrepancies between the distribution of demand and the allocation of the factors of production, are in the last analysis due to some distortion in the price system that has directed resources to false uses. It can be corrected only by making sure, first, that prices achieve what, SOMEWHAT MISLEADINGLY, we call an equilibrium structure, and second, that labor is reallocated according to these new prices. ****
The primary cause of the appearance of extensive unemployment, however, is a deviation of the actual structure of prices and wages from its equilibrium structure. Remember, please: that is the crucial concept. The point I want to make is that this equilibrium structure of prices is something which we cannot know beforehand because the only way to discover it is to give the market free play; by definition, therefore, the divergence of actual prices from the equilibrium structure is something that can never be statistically measured. ****
In contrast, the modern fashion demands that a theoretical assertion which cannot be statistically tested must not be taken seriously and has to be discarded. As a result of this belief, a theory which, in my opinion, is the true explanation has been discarded as not adequately confirmed, and a false theory has been generally accepted merely because it happens to be the only one for which statistical evidence, even though very inadequate evidence, is available.”
https://www.flickr.com/photos/bob_roddis/7534880182/in/album-72157630494776170/lightbox/
Hayek’s definition appears to be one definition of natural rate (or rates) of interest not mentioned in Tyler Cowan’s list… what you get if you just let the economy do it’s thing. Logically you also have a companion definition of “full employment” which is whatever employment you get in the absence of violent intervention or fraud… but you won’t find a Keynesian content with that idea.
Krugman would then be arguing that the Fed is setting interest rates to what they would be in the absence of the Fed (how can he know that?) but if that was the case, might as well get rid of the Fed because it isn’t serving a purpose.
i think this is exactly the reason why Austrians and Sumner, the others will never understand each other.
Everyone but austrian thinks NAtural = MArket => stable prices
only austrians doesnt till austrians doesnt conviced the others this debates are meaningless
Or am i incorect?
however what makes me wonder its the fact that Sumner in one of his blog wrote something of the kind that economy which is growing is deflanatory… so in this case im confused…
Well I do commonly request people to define their terms, and get told I’m annoying and nitpicking… yet what I find is that so many people argue without even thinking carefully for themselves about what these things mean.
Something I like about Tyler Cowan is he spends a whole lot of time reviewing these concepts… he takes a genuinely thoughtful approach. I have a lot of respect for that.
For example, here’s another of these questioning definitions type articles:
http://marginalrevolution.com/marginalrevolution/2012/05/what-is-austerity.html
Krugman rarely defines anything, and will happily use multiple different definitions of the same thing… in the case of austerity, sometimes not even measured in the same units (but Krugman also regularly ignores units).
Coupla things:
1 – Is Sumner just trolling? I mean, everyone knows that turning a heater on warms your house, right? Who in their right mind would ever say, when attempting to explain the relationship between heaters and termperatures, “Well, the heater is on, so the house must be cold.” ? I’m not saying he’s wrong, I’m just saying that it sounds deliberately inflammatory to make it sound like the relationship between interest rates and money expansion is the opposite of what it is. I get it, it’s quirky, etc., but…
2 – Didn’t Scott Sumner always used to complain on his blog about those crazy Austrians who were always using their own private definition of “inflation,” and therefore disqualifying themselves from the discussion? Isn’t Sumner effectively doing this with the interest rate discussion?
So yeah, I don’t disagree with him per se I just think it’s sort of like trolling. I’ve trolled the internet enough times to have a good feel for these things. 😛
RPLong right, I’m going to beat the horse some more, but if you actually expand on Sumner’s thermostat analogy, you would end up doing “cookoo” hand motions if anyone took the analog of Sumner’s monetary views with respect to home heating.
He didn’t say “turn the heater on” he said “turning up the thermostat” which implies a change in preference.
Thermostats already maintain constant temperature, to within a degree or so.
Bob,
I had a quick look at The Liberty Fund paper you link to. I plan to read it in more detail but had some initial questions.
First off, it seems obvious obvious that you do reject the concept of a single natural rate, as you say: ‘If a Misesian boom-bust cycle ensues, the reason is not that the banks charged a money right below “the” natural rate, because there is no such thing.’. Is that correct ?
Towards the end of the paper you give an example of a dynamic equilibrium (table 3). This has the money rate of interest at 10% (11 future dollars for 10 present dollars). While the own rate of interest may differ for different commodities (in your example the own rate for wheat is 0%) , would it be reasonable to call the money rate of 10% “the” natural rate in that equilibrium ? if not why, not ?
You then have the banking system creating lots of new money (table 4), which causes relative prices and interest rates to get messed up which leads to a mis-allocations of resources from future goods to the present goods.
In theory though, if everyone had perfect foresight and matching expectations, would there not be a similar set of own-rates (including a money rate) that would ensure equilibrium just as in table 3 ? For example: Suppose the banks trebled the money supply. If nothing else changed then you could redo table 3 and just increase all money values by 300%. The money rate of interest would be 310% rather than 10% in period 1. Why wouldn’t 310% be the new equilibrating rate in period 1 ? Why wouldn’t this be the natural rate ?
To generalize my questions:
– When you say there is no natural rate do you mean there are actually multiple money rates, or just that there are own rates for multiple commodities and these multiple own-rates count as multiple natural rates ?
– I can see that when you try and derive an “inflation-adjusted” natural rate that excludes changes in the value of money itself then it is impossible for the reason given by Straffa. Is that your view also, or do go further and say that there is not even a natural rate of interest that correctly factors in inflation expectations and would equilibrate the economy ?
Transformer, a lot of people in the Austrian tradition defined the natural rate to mean something like “the rate of interest on goods in a barter economy” or “the rate of interest if there were no monetary disturbances.” I don’t think you can define such a thing outside of a stationary economy.
However, I still think it is correct to say that when new money is created “out of thin air” and enters the economy through the credit market, pushing interest rates lower than they otherwise would have been, that this sets up an unsustainable boom.
Your other questions are good but sorry I’m just swamped right now.
‘a lot of people in the Austrian tradition defined the natural rate to mean something like “the rate of interest on goods in a barter economy” or “the rate of interest if there were no monetary disturbances.”’.
It seems logically consistent to believe that there is indeed an underlying (marginal?) rate of time preference in the economy, and that all actual money and own-rates of interest will be adjusted by risk, expected future relative prices , liquidity preference etc in relation to this underlying rate. Isn’t that what Rothbard thought ?
I think this is pretty much what Lachman was saying too – that arbitrage will lead to all the various own-rates in the economy being equilibrated – so it not clear to me why you reject his views.
But, anyway – look forward to your response to Sumner on the thermostat thing.
Transformer wrote:
“I think this is pretty much what Lachman was saying too – that arbitrage will lead to all the various own-rates in the economy being equilibrated – so it not clear to me why you reject his views.”
Because that statement is not correct.
Why is it not correct ?
You say: “What is “the” rate of interest in the world economy? Perhaps
the rate of interest measured in U.S. dollars is 4 percent, while the rate of interest
measured in Japanese yen is 3 percent. So what is the natural or real, underlying rate?
Only by arbitrarily specifying a commodity basket can we give an answer. Lachmann’s
arguments, though correct, do not help the Austrians on this point.”
Does it matter that we can only quote the natural rate for a particular currency (or in a commodity-specific own-rate) ? As long as we understand the process by which the own-rates get set and how the different own-rates get equilibrated via arbitrage haven’t we nailed the concept of “natural rate” ?
Lachmann describes this process and agrees that “the” natural rate will be reflected in many different own-rates. I’m just not seeing what in this you disagree with.
I don’t get this. If I lend milk and get repaid in milk I need to worry about spoilage. If I lend in rocks and get repaid in rocks I don’t. I might want different rates.
But … Scott_Sumner *should* read Lucas, since his entire advocacy basically screams, “I haven’t considered how people can game NGDP numbers or how that metric would ever deviate from the thing we really want to optimize.”
Yeah, this.
Ha ha good one Silas. I actually had in mind something like, “Lucas knew it was really important to consider ‘real’ factors in the business cycle, and thought people could adjust to monetary values quickly enough…” but yours works too.
Bear with me, this is an observation from a regular reader and a casual, armchair economist.
It seems trivially obvious to me that there is not a single natural rate of interest. It also seems trivially obvious to me that this is completely irrelevant to ABCT. It seems both the critics, and the Austrians who agree with their criticisms, are guilty of excessive aggregation and losing track of a simple truism: only individuals act and value.
It seems trivially obvious that all individuals have individual “natural” interest rates for all potential commodity to commodity ratios upon which a given individual places value.
It seems, at least from my perspective, that methodological individualism has been lost in the obsession over monetary issues. The fundamental point upon which ABCT hinges is the qualitative properties of the investments made under conditions of depressed interest rates. The lower the bank interest rate (which is a mere price signal today not reflective of time preference), the higher the probability that an individual project will fall prey to corrupted calculation, and therefore the higher the probability it will fail. The lower the bank interest rate, the more instances of loans will there tend to be (the more actors will purchase them), and the more instances of loans there are, the more chances there are to fail. Combine higher probability of failure with higher numbers of instances of potential failures, and the cycle follows thereafter.
The logic here is not fully sussed out, I am aware. This is intended to be a general comment, and not a formal rebuttal.
What am I missing here? Interest rates need not be so aggregated. Only discrepancies between the advertised loan prices and each individual’s expected rates of interest seem to matter to the analysis. I admit that this leaves open the possibility that the cycle is not fully caused by actions of central banks or states, they could possibily be caused by errors made by banks making loans (misjudged pricing, specifically), but I am not particularly troubled by this.
I am positive I am completely missing something since I am not a professionally trained economist, I just don’t know what that might be.
Cheesy Mac I think you’re on the right track, for sure. That’s actually similar to what I tried to do in my paper.
But, like I told someone else, Hayek for example said that the central bank should set the interest rate equal to the natural rate. So if there are multiple natural rates, that’s tough to do…
“But, like I told someone else, Hayek for example said that the central bank should set the interest rate equal to the natural rate. So if there are multiple natural rates, that’s tough to do…”
Yes, precisely.
It seemed to me that Hayek was attempting to respond to a question on its own terms, rather than conceding that there was a single natural rate.
The question he seemed to be answering, “If the Fed is setting the wrong rate, then what’s the right one”, presupposes that there’s one rate – the market rate – that the Fed should be targeting, instead.
I think this was an honest linguistic slip, though.
There is no single market rate, which is why the Fed shouldn’t target any rate – except for maybe the rate that they think would be most profitable for themselves, and do it without government protections.
The market would then look for mediums of exchange that people would more likely find valuable over longer periods of time.
Thanks, Bob! Looking forward to reading your new book. Just need to make the time.
Too bad it’s not in audio, I prefer to do my “reading” during my commute. I’ll figure it out though!
“It seems trivially obvious that all individuals have individual “natural” interest rates for all potential commodity to commodity ratios upon which a given individual places value.”
Hell, yeah!
“The lower the bank interest rate (which is a mere price signal today not reflective of time preference), the higher the probability that an individual project will fall prey to corrupted calculation, and therefore the higher the probability it will fail.”
Thank you! That’s gold.
“Interest rates need not be so aggregated. Only discrepancies between the advertised loan prices and each individual’s expected rates of interest seem to matter to the analysis.”
Except that even the advertised loan price isn’t an aggregate, either – it’s the individual owner’s rate, given his assessment of demand.
“I admit that this leaves open the possibility that the cycle is not fully caused by actions of central banks or states, they could possibily be caused by errors made by banks making loans (misjudged pricing, specifically), but I am not particularly troubled by this.”
The business cycle is simply business errors that continue for a long time.
The Austrian position is that system-wide artificial booms are impossible in a free market because the price signals of failure would not be obscured to such a degree that business errors could continue for significant lengths of time.
“Except that the advertised loan price isn’t an aggregate either,”
Well, I don’t think that I said it was?
“The business cycle is simply business errors that continue for a long time.”
Somewhat. The business cycle is consequent of the clustered identification of error. The length of time seems arbitrary, though I’m not necessarily in disagreement with this statement on an empirical level.
I’m not convinced that the “Austrian position” is necessarily anything on this topic. I view Austrian economics as a particular methodology based on particular set of propositions, but commits itself to nothing beyond those methodological premises.
I think that it might be an acceptable Austrian position to claim that it is conceivable that a system-wide boom can occur (I’m not sure what “artificial” boom means to you) but that its magnitude, both to the upside and downside, are comparatively limited absent monetary credit expansion.
My reasons for this are tied to the tendency of all sellers to migrate their prices toward uniformity. However, I’ve not yet worked out all the details, and I don’t necessarily feel like making a formal proof on Bob’s blog.
“(I’m not sure what “artificial” boom means to you)”
OK, so economic activity begins with individuals pursuing some ends using some means.
That’s the consumer, which is, at the very least, what we all are. We’re not all producers, for example, but we’re all consumers.
If I see some consumer using some resource, I deduce that the resource is valuable to him. And if I can provide that to him for an opportunity cost that is less than my second-ranked preference, then I’ll make a profit by trading with him.
And if there is significant demand from him or multiple people, I might hire workers to help me get an economy of scale.
Now, if I engage in production processes (investing in capital, hiring workers, etc.) that haven’t been justified by sufficient consumer demand (which entails them trading real resources with me, even if that’s indirectly so, through sound money), then I made a malinvestment. I may think there’s enough demand, but in this case there’s not.
So that’s malinvestment.
If I make a malinvestment due to my own sloppy thinking, or not enough research, or I misread people’s intentions in the economic actions they took, then that’s my mistake.
It’s just a normal business error. My malinvestments were the result of me using means to attempt to satisfy a preference of mine. It’s not artificial at all.
If I am mislead into making bad investments – say someone lies to me (and is not simply mistaken, themselves) – then at that point any profitability that the people I paid, and the equipment I now have that enables me to produce more widgets (or maybe it’s new workers I’m paying), I would technically include in my definition of an “artificial” boom.
My productive capacity has expanded (“boomed”), but there doesn’t actually exist the consumer demand to have justified it.
This is not a systemic artificial boom, though, and it’s not what we would normally call the business cycle. But I think it’s important to understand the essence of the business cycle.
I, personally, will have to unwind my own malinvestments. The rest of the economy is doing fine, in my scenario, so I can still engage in economic calculation, and can know what to do to reallocate my resources into more economically productive processes.
Now, if multiple businesses in multiple industries get decieved into increasing their productive capacity beyond that which has been justified by consumer demand, then we have many instances of artificial booms, and this phenomenon is what I call an “artificial boom”.
And the reason multiple businesses in multiple industries get decieved all at once is that they do, in fact, have something in common: their use of credit that has been artificially expanded by their common central bank.
Even though these people may not know each other, money and credit affects all industries.
Oh I do understand the theory already. Thanks for the explanation though, especially the clarification of what you mean by artificial.
I am still not convinced that this phenomenon would be eliminated. I am convinced that the relative magnitudes would be decreased, both in time and severity of impact.
I was convinced of it at one time, but not so much any longer. I would agree that in a hypothetical construct of an optimal free market with pareto optimality this analysis would obtain.
But we don’t live in that universe, either. The purpose of hypothetical constructs is to allow us to identify factors in the real world which have causal effects.
“… especially the clarification of what you mean by artificial.”
It looked like you understood the theory well.
I just thought you would have a better understanding of my own definition of “artificial boom” if you could see the train of thought that lead up to it.
“I am convinced that the relative magnitudes would be decreased, both in time and severity of impact.”
Right. We agree, here, too. Just maybe not about *how much* the magnitudes would decrease, absent a centrally planned monetary system.
Although, it looks as if maybe you’re just saying that we’ll never get to live in such a universe, and that’s possibly the only reason you think the magnitudes would be larger than do I.
Good points all around, at any rate.
Thank you for helping explain the “multiple interest rates” issue.
I came late into this post and have just sifted through the comments.
And I would just like to add that the commenter who goes by the alias “Lord Keynes” often has insightful comments on economics and raises some good criticisms on austrian economics in particular. But regarding his criticisms, past and present, on ABCT and it’s use of the natural rate or interest, he is nothing but a troll!
He is well aware that the absence of a ‘natural rate of interest’ does nothing to hinder ABCT. (review his blog and check the comments section)
So whenever LK makes a comment on ABCT and the natural rate of interest. He is trolling!
Glad I got that off my chest haha