The Economic Consequences of the Overthrow of the Natural Rate of Interest

Fixing the Economists Article of the Week

by Philip Pilkington

For quite a few months I have, on this blog, been alluding to a paper that I had written which showed that the natural rate of interest is implicitly dependent on the EMH in its strong-form in order to be coherent. I have finally published this paper (in working paper form) with the Levy Institute and it can be read here:

Endogenous Money and the Natural Rate of Interest: The Reemergence of Liquidity Preference and Animal Spirits in the Post-Keynesian Theory of Capital Markets

Some notes on the paper.

The motivation for the paper was that when reading up on endogenous money during my degree I found that mainstream economists had largely integrated it in their more recent models. This integration, as the paper notes, usually took the form of a Taylor Rule. I should be clear that although this had become standard practice at some levels of the discipline most mainstream economists remained ignorant or confused (the famous Krugman debates were highly illustrative of this). Nevertheless, I found that the mainstream had conceded to endogenous money and yet, for some reason, they were not in agreement with Post-Keynesians on the implications for this in theory nor were they in agreement on important policy issues.

What I found was that they were able to avoid the important implications of endogenous money theory by resurrecting the loanable funds theory in a different way. They did this by effectively becoming neo-Wicksellian and replacing the exogenous money proclamations with the idea of a ‘natural rate of interest’. This device allowed them to keep the rest of marginalist monetary theory intact and served as a justification for the dangerous idea that the economy could be steered to full employment and prosperity through vigilant manipulation of the central bank’s overnight interest rate (I deal with the track record of that dubious policy here).

In my paper I show that such ideas implicitly rely on a strong-form EMH view of capital markets. Think of it this way: the central bank set a single rate of interest. Piled on top of this rate of interest are countless other rates of interest — the interest rate on mortgages, student loans, junk bonds, and so on. This ‘stack’ of interest rate will be affected by the central bank rate of interest but, and this is crucial, the spread between the central bank rate and these other interest rates are set by the market. The assumption of mainstream monetary theory is that the market will line each of these rates of interest up with their particular natural rate. So there the natural rate on each type of loan will be automatically hit by the market.

It is clear that what is being assumed here is that the market will price in all relevant information objectively. That, of course, is the EMH view of capital markets and it is one that has been completely refuted and dismissed by all relevant economists since the 2008 financial crisis. But once this falls apart mainstream monetary theory goes out the window with it. What we end up with is Keynes’ own monetary theory; one in which liquidity preference determines interest rates across the markets and animal spirits drive the rate of investment in the economy. These two key economic variables are now subject to the vagaries of human psychology.

I have since had the opportunity to try the argument out on a few very senior economic policymakers and former economic policymakers. The results have been very encouraging. They seem to see instantly the logic of the approach and how much damage it does to the mainstream theoretical underpinnings. They also see that this has massive implications for policy: it completely changes how we should understand central banks to operate and how economic policy should be managed.

No longer should we use the interest rate to steer economic activity. This will not work. In the last boom we saw the interest rates on mortgages remain low even as the overnight rate was rising and we saw animal spirits in the housing market cause overly high rates of unsustainable investment in this market. This is what the theory would predict: using interest rates to steer the economy will only result in speculative excesses and destructive boom-bust cycles.

While I do not outline the policy conclusions in the paper they should be familiar to Post-Keynesians. First, the interest rate should be ‘parked’ at some permanent low-level; somewhere between 0% and 2%. Secondly, central banks should have their role changed to (a) providing easy credit policies and (b) regulating excesses in potentially speculative asset and investment markets — I favour Tom Palley’s ABRR proposal here. Thirdly, the currency should be flexible but can be managed should needs require through central bank intervention in the foreign exchange markets. Fourthly, shortfalls and excesses in effective demand should be managed by government expenditure and taxation.

This, of course, outlines an entirely different regime to the present inflation-targeting environment. It is somewhat similar to the post-war arrangements but would probably be more aggressive if implemented with full force.