Wednesday, June 29, 2011

Dr. Krugman and the natural rate of interest

So I have said a few times here that, while Krugman has been extremely useful for Keynesians in recent policy debates, as a New Keynesian (neo-Wicksellian would be a better term for this school of thought), he is not properly a real Keynesian.  In a recent post he shows exactly my point.  He says:
"There is still a sufficiently low real interest rate that would produce recovery, but it’s a rate that’s hard to achieve."
In other words, there is a rate of interest that would increase investment and bring about the full employment level of savings.  In this post he surprisingly seems to say that liquidity traps or lower zero bound limits (rigidities) for nominal rates do not matter.

The reason seems to be connected to the fact that creditors must have a positive effect on their net wealth in a deflationary balance sheet recession, and their spending should go up.  Hence, creditors should spend more with a slightly lower interest rate.  Wealth effects have been the traditional neoclassical argument for a self-equilibrating economy since Pigou.  If this were true no fiscal policy would be actually necessary.

It's hard to believe that Wall Street bankers would spend sufficiently more for a recovery to follow.  And I doubt that Krugman believes that this effect is sufficiently strong in the real world.  But he does believe in some sort of natural rate, like Wicksell did, which is compatible with Friedman's natural rate of unemployment.

Keynes, on the other hand, thought that the very concept of a natural rate should be discarded.  In chapter 17 of the General Theory Keynes states that:
"In my Treatise on Money I defined what purported to be a unique rate of interest, which I called the natural rate of interest — namely, the rate of interest which, in the terminology of my Treatise, preserved equality between the rate of saving (as there defined) and the rate of investment. I believed this to be a development and clarification of Wicksell’s “natural rate of interest”, which was, according to him, the rate which would preserve the stability if some, not quite clearly specified, price-level. ... I had not then understood that, in certain conditions, the system could be in equilibrium with less than full employment.
I am now no longer of the opinion that the concept of a “natural” rate of interest, which previously seemed to me a most promising idea, has anything very useful or significant to contribute to our analysis."
So, in fact, there might be the case that NO long term rate of interest, a highly conventional one according to Keynes, would be compatible with full employment.  The socialization of investment, in Keynes' terms, then would be necessary.  In other words, effective demand matters in the long run, not just the short run, because there is no tendency for self-adjustment.

Since Friedman's infamous Presidential address to the American Economic Association the neo-Wicksellian approach has dominated macroeconomics.  In this view, the central bank pins the short run policy rate to the long run natural rate, and the economy (save for rigidities and imperfections) moves automatically to full employment.  No fiscal policy is necessary, again with the exception of short run imperfections.  That's why long term considerations about deficits and debt are important. 

My question is: should we be surprised that with this theoretical model as the dominant one, we are in a situation in which the administration is unable to understand and unwilling to promote the fiscal expansion necessary to get us to full employment (or at least lower levels of unemployment)?

PS: Keynes developed the ideas in chapter 17 on the basis of Sraff'a's critique of Hayek's theory of capital in 1932 (here; subscription required).  Note that while Keynes understood that the idea of a natural rate of interest that equalized investment to full employment savings had to be discarded, he did not get that his negatively sloped marginal efficiency of capital actually provided the basis for such a rate.


  1. Dear Matias

    Krugman´s lack of clarity seems to have misled you. In his post I am sure he means that there is a real rate of interest that would generate enough effective demand but his point is that it is so NEGATIVE that it is difficult to get enough inflation to get there (see the remarks on the IS being steep and the IS graph in his Cambridge talk). His argument seems to go through the possible effect of a negative rate of interest in consumption and housing and not only businesss investment. Therefore it does not need an interest elastic investment function. It looks much more like Lerner, Eisner and Duesenberry for it is an argument about a negative real natural rate of interest. It has nothing to do with Wicksell natural or Keynes neutral rate that were both positive and relied on the interest elasticity of business non residential investment. It is Krugman´s fault however to have confused you because of his difficulty with basic things (like his annoying habit of calling "liquidity trap", which is a flat LM , when he is talking about "elasticity pessimism" , which is nearly vertical IS).

  2. Not sure that this is the case. Krugman tends to be ecclectic, using different arguments according to convenience, which are not necessarily coherent between them. It is true that his normal argument is based on a downward rigidty of the nominal interest rate, associated to the zero lower bound, and that the I=S rate would be negative. However, nothing in this post suggest that. He says that creditors would spend more, and even if it is consumption, through the accelerator investment would increase. The quote is quite precise, there is a rate that would produce recovery.

  3. If there is a rate that would produce recovery and it is a very negative real rate, then it is the same "normal" argument. Moreover, you admit that in his "normal argument" is talking about a negative natural real interest rate.
    Therefore "normally" his argument is more "Keynesian" than that of Keynes who believed in a positive real "neutral" rate that would bring investment into equality with full employment savings (see keynes critique of Hobson in the GT for instance).

  4. Yes, his normal argument (still imperfectionist) is the negative interest rate (and that could be said to be more Keynesian than Keynes, in the sense that Keynes did have the neutral rate). But Keynes at least was trying to get rid of his old ways. Krugman here seems to be going in the wrong direction. More Wicksellian, less Keynesian. That's why I thought this post was so strange. Mind you Krugman suffers, in my view, from the eclecticism of modern mainstream economics. He can make more than one argument in favor of his views, and they might not be coherent among them. More on that on my last post.


The End of Bretton Woods

    End of Bretton Woods with Barry Eichengreen, myself and Lilia Costabile, organized by L-P. Rochon and the Review of Political Economy.