Thursday, November 7, 2013

On the natural rate of interest one more time

After one of my last posts Warren Mosler sent me a link to his paper with Mathew Forstater on the natural rate of interest (here). In the paper they suggest that the natural rate is zero. Note that Warren and Mat actually are talking about a normal (rather than natural) rate of interest, that would be set in a particular institutional framework (they emphasize State money, i.e. Chartalism, and flexible exchange rates).

The conventional argument about the natural rate of interest is mainly associated with neoclassical economics, and with the work of Knut Wicksell. Axel Leijonhufvud, in the New Palgrave entry on "Natural and Market rate of Interest"  (subscription required) says that:
"the ‘natural rate’ ... divulges Wicksell's engagement in the ancient quest for a ‘neutral’ monetary system, that is, a system neutral in the original sense that all relative prices develop as they would in a hypothetical world without paper money. Wicksell asserted three equilibrium conditions that the interest rate should satisfy; the first of these was that the market rate should equal the rate that would prevail if capital goods were lent and borrowed in kind (in natura). This criterion was later shown by Myrdal, Sraffa and others not to have an unambiguous meaning outside the single input–single output world of Wicksell's example. The further development of Wicksellian theory, therefore, centered around the two remaining criteria: saving–investment coordination and price level stability."
In all fairness the last two arguments fall with the first too. If there is no unambiguous relation between capital intensity and the rate of interest, then there is no way of finding a rate of interest that would equalize investment to the full employment savings and as a result no reason to believe that there is a rate that by guaranteeing the equilibrium with full utilization of resources it will be associated with price stability (no excess demand). The reasons for that were discussed several times here and are associated to the capital debates.

The point that Warren and Mat make is quite different. The basis of their arguments relies on the following notions:
"Under a state money system with flexible exchange rates, the monetary system is tax driven. The federal government, as issuer of the currency, is not revenue constrained. Taxes do not finance spending, but taxation  serves to create a notional demand for state money. Spending logically precedes tax collection, and total spending will normally exceed tax revenues. The government budget, from inception, will therefore normally be in deficit, which also allows the non government sector to “net save” state money (this in fact has been observed in all state currencies)."
I tend to agree with the main thrust of their idea, but it is important to add a caveat. Flexible rates exchange rates might not be sufficient to eliminate current account deficits (and capital flows might not be attracted even by very high rates of interest) in peripheral countries, which might imply that a foreign constraint imposes a limit to the fiscal space for the state. But assuming we are talking about the United States or other countries unconstrained by the external accounts, then we can proceed with their argument.

Their point quite correctly is that, again quoting directly:
"Since the currency issuer [the State] does not need to borrow its own money to spend, security sales, like taxes, must have some other purpose. That purpose in a typical state money system is to manage aggregate bank reserves and control short-term interest rates (overnight interbank lending rate, or Fed funds rate in the United States)."
Finally, they note that if the central bank has a positive short-term interest rate target, then it must either: "pay interest on reserves or otherwise provide an interest-bearing alternative to non-interest-bearing reserve accounts ... by offering securities for sale in the open market." Hence, their conclusion:
"In a state money system with flexible exchange rates running a budget deficit—in other words, under the 'normal' conditions or operations of the specified institutional context—without government intervention either to pay interest on reserves or to offer securities to drain excess reserves to actively support a nonzero, positive interest rate, the natural or normal rate of interest of such a system is zero."
Again, with the caveat that peripheral countries might need to maintain a positive (and high) rate of interest to attract capital or at least avoid capital flight, the argument is not incorrect. But it is strange, to say the least, to assume that there is something normal about a zero rate. In fact, the point of State money is that the State does provide an asset free of risk (government bonds) that allows financial accumulation to take place.

In the long transition to the capitalist system, one of the initial steps in the transformation of feudal societies was the resurgence of public debt (in Northern Italian City States), well before the consolidation of National States and national currencies. Normal interest rates were always relatively high until recently [Sidney Homer's classic book A History of Interest Rates provides the evidence].

In reality, without a risk-free asset financial markets cannot develop [a problem for developing countries that need to import capital and intermediary goods in foreign currency, and are, hence, always subjected to foreign exchange and sovereign risk] and this might hinder the process of capital accumulation. The normal rate can actually be any rate that the social conditions and the pressures imposed on the monetary authorities would permit. That was the point made by Sraffa when he suggested that the money rate of interest set by the monetary authority was exogenous and determined the normal rate of profit.


  1. "Again, with the caveat that peripheral countries might need to maintain a positive (and high) rate of interest to attract capital or at least avoid capital flight"

    There is no capital flight in a sovereign currency - not in any real sense. To get your money out you have to exchange it with somebody coming in *or you can't do it*.

    The issue for developing nations is getting the real capital in the first place - since they have little of value to exchange.

    What seems to happen with developed countries running a current account deficit is that export led countries come to depend upon that trade and use 'liquidity actions' (swaps mostly) to ensure that enough of the exporter's currency is available to allow the import transactions to complete. That means that export-led nations are essentially forced to hoover up other nations financial assets. Since they are forced anyway by their own export-led policy (and the one world constraint), there is no good policy reason to pay them.

    Smaller countries are less important to export led nations and therefore cannot rely on anything other than a one for one real swap with their goods/services for export. Since these are low value initially it is difficult to get started.

    Therefore we have a role for the IMF - which is to act as a 'liquidity swap' of last resort - purchasing enough of the target currency with foreign currency to allow the capital import to proceed.

    Floating rate changes the nature of the way the currency areas interact. Exchange is different from conversion, and I don't think we have a full handle on that difference yet.

    As John T Harvey is fond of saying - "it's complicated".

  2. @Matías

    "But it is strange, to say the least, to assume that there is something normal about a zero rate. In fact, the point of State money is that the State does provide an asset free of risk (government bonds) that allows financial accumulation to take place."

    One thought. Financial assets accumulation is, like you said, made possible by the issuance of ** risk-free ** government bonds: as the bond is risk-free, bond-holders can put their money in bonds and know they will be able to get it back later, presumably with the same purchasing power.

    No additional justification or incentive is required. In particular, to require a positive real interest rate would imply, it seems to me, an additional justification is needed (on top of the safety) to convince would-be bond-holders.

    For neoclassicals/Austrians this is not a problem: they can explain positive interest rates as the reward for abstinence.

    But I thought this view wasn't shared by heterodox economists.


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