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.

Say's Law Keynesians

In the 1990s Fernando Henrique Cardoso, the one time sociologist and dependency theory author, turned politician and president of Brazil said that people should forget about what he had written in the past (on dependency theory). Something similar could be said about the economists at Catholic University in Rio de Janeiro, who were the main economic advisors to Cardoso during his presidency.* They seem to have forgotten what they wrote in the past.

An interesting case of the switcheroo from heterodox to mainstream is Edward Amadeo (Labor Minister during the Cardoso administration, even though he had connections to the Worker's Party up to the early 1990s), author of a very good book on Keynes (Keynes' Principle of Effective Demand), based on his dissertation at Harvard supervised by Murray Milgate and co-supervised by Lance Taylor (who was at MIT at that time), with a preface by Vicky Chick. The book is still the best interpretation of Keynes' General Theory, and its relation with the Treatise on Money.

Among other things Amadeo shows that the conventional view which assumes that Keynes moved from an interpretation of the system with flexible prices and fixed quantities in the Treatise to one of fixed prices and flexible quantities in The General Theory (GT), as interpreted by Leijonhufvud for example (see his classic On Keynesian Economics and the Economics of Keynes), is incompatible with a careful reading of chapter 19 of the GT (Amadeo, 1989, p. 4).

Further, Amadeo correctly points out that the transition from the Treatise to the GT involves a change from a dynamic theory of the trade cycle in historical time to an equilibrium theory of the level of output, one in which the flexibility of prices does not guarantee full employment. And obviously the level of activity is determined by demand. Amadeo also wrote a few papers on what we would now call the Kaleckian models of growth (see here; subscription required).

That is why is interesting to read a recent paper by Amadeo (in Portuguese here; originally published in O Globo). He says that Cardoso's agenda, which would have been carried by Serra (defeated presidential candidate in 2002), would have:

"redoubled the emphasis on education, promoted savings, done the labor reform, flattened the tax structure, promoted global integration, invested in infrastructure and modernized the public administration."

Note that the emphasis is on supply-side policies (with the exception of investment in infrastructure, which was actually accelerated during the Lula administration so-called PAC). And yes he suggests that savings would have lead presumably to investment and growth in a typical Solow model result, meaning Say's Law.

One could go on and discuss the other incompatibilities with almost all his previous work (not sure if he wrote something theoretical in a neoclassical perspective), for example the defense of labor reform (meaning lower wages) to promote growth and employment (the opposite of what the GT says). Or the silliness of suggesting at this point that more liberalization (global integration) along the lines of the Washington Consensus would really work. Or the fact, that he seems to believe that fiscal adjustment is necessary now in Brazil and that this would be compatible with higher growth (contractionary expansions).

But the remarkable thing is at the end of the day the complete 180 degree change in theoretical perspective, with no justification of what made him change his mind. I assume that in his case we can paraphrase Keynes and suggest that when proven correct, he changes his mind.

* Other economists close to Cardoso, like Serra from the more radical Unicamp, also moved to the right, favoring privatization and fiscal adjustment, but arguably abandoned academic economics long ago, being like Cardoso politicians. Finally, some economists from the Fundação Getúlio Vargas from São Paulo, like Bresser Pereira, remained more heterodox, and defend now something called New Developmenatlism. I'll leave comments on that for another post.