Sunday, August 6, 2017

Is a Natural Rate of Interest No Longer Relevant?

Perhaps the concept of a natural interest rate, is a less important consideration than it once was. After all, much has changed since Wicksell made this contribution to monetary theory. For instance: In a recent interview with David Beckworth, Scott Sumner mused whether the new economy - services dominated as it is - might also affect variations in what appeared as though a natural rate. At Econlog, he writes:
Economists define the natural rate of interest as the interest rate that is expected to deliver a level of aggregate demand which is conducive to macroeconomic stability. Wicksell thought of macro stability in terms of price stability. So he defined the natural rate as the interest rate likely to lead to price stability. But there are as many natural rates as there are theories of macroeconomic stability.
Of Wicksell's interest theory, Henry William Spiegel ("The Growth of Economic Thought") explains:
In his explanation of changes in the price level Wicksell fell back on the rate of interest, in itself not a startling idea since there was a tradition of long standing, extending from Ricardo to Marshall, which recognized, besides the direct influence of the quantity of money on prices, an indirect one which operated via the rate of interest. If the quantity of money increased, so this argument ran, low interest rates would be accompanied by an expansion of credit, and borrowers would bid up prices when putting their new financial resources to use. High and low rates are relative terms, however, and the argument did not provide a standard that could serve as a criterion whether the interest rate was high or low. Such a criterion Wicksell made available by distinguishing between the "natural" rate of interest and the loan rate. The natural rate was the expected rate of return from newly constructed capital, whereas the loan rate was that which borrowers were charged by the banks. As the two rates diverged, for example, if the natural rate exceeded the loan rate, a "cumulative" process ensued in which prospective investors, eager to maximize profit, bid up the prices of productive resources, causing in turn money incomes and the prices of consumer goods to rise. In the case of an excess of the loan rate over the natural rate, the cumulative process would move in the opposite direction.
Note especially the "expected rate of return from newly constructed capital" in the above quote. This approximation of economic activity held important clues for optimal business investment, hence served as a precursor to today's marketplace expectations.

Nevertheless, much of the earlier contribution of bank loans to aggregate output gains, has diminished. Today's banking plays a smaller role in wealth creation (via traditional manufacture in particular) than before. Consumer based loans - much like the present organizational capacity of time based services - have instead become part of the institutional apparatus which makes further demands on already existing income. While banking activity remains an important part of monetary flows, loan formation is less likely to contribute to the most dynamic sectors of the economy. Consequently, the financial role of banks in investment decisions, aggregate output potential, and long term growth, tends to be overemphasized.

How might the relative dominance of service sectors (since the twentieth century), also affect this scenario? While some non tradable sectors use automation to reduce the costs of - hence "need" for - time based product, this approach doesn't necessarily increase total output. In other words, despite what can appear as though productivity gains because of firm profits, automation for time based services will in some instances play a role in diminished aggregate output levels. Again, like consumer loans, time based services as a secondary market, is institutionalized demand for already existing income - rather than additional output - in a general equilibrium construct.

Another way to reflect on the importance of these structural shifts: remember the importance which Keynes attributed to the role of investment in connection with interest rates, in his arguments for "The General Theory". Today's investment is less driven by a commonly understood interest rate environment for capitalists, than was previously the case. In any instance, lending interest rates have always been the cost of credit, not of money. Why else would individual rates vary so widely, according to perceived consumer risk?

There are other problems with the rationale of Keyne's time, as well. It has gradually become more difficult - especially due to the crowding effects of non tradable sector requirements on demand - for fiscal policy to contribute to economic dynamism. Further, these consumption demands have created a greater "propensity to spend" across most levels of income. While these circumstance hold multiple implications, they also suggest why a level nominal target is more likely to contribute to economic stability, than the interest and inflation based indicators of the present past.

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