The Natural Rate of Interest Does Not Exist

by Philip Pilkington

I just want to make a quick note on the multiplier and the theory of liquidity preference that is not generally recognised. When the full implications of this argument are recognised and integrated with marginalist theories of savings and investment (including the Austrian theory) these theories basically fall apart unless some very restrictive assumptions are put in place.

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In his book The Years of High Theory, GLS Shackle sums up the problem of the multiplier nicely and succinctly as such,

The Kahn Multiplier multiplies extra income not matched by extra consumable output, and it is of no consequence to the people of one country, seeking a means to increase their own employment, whether that original extra income is generated by the extra output of tools, or of goods for export uncompensated by extra imports, or whether it is a free gift of the government or private philanthropy. Kahn chose road-building as his example, doubtless because it is unnecessary to explain that roads cannot be sold to consumers. (p186)

This gets right to the heart of the matter and Shackle highlights precisely the sentence that is most important so that I don’t have to. When investment is increased new consumer goods do not become available immediately and thus the multiplier effects generate income and consumption that must be matched by the current output capacity of the economy or else they will cause inflation.

Now, here’s the problem for marginalist theory: if the economy is operating at full capacity, as is the typical case in a marginalist model, then how does an increase in investment not lead to inflation? The answer is familiar to any undergraduate who has done his homework: the new investment must be stimulated by a rise in savings. The process here is conceptualised as one in which the causality runs, not from investment to savings, but rather from savings to investment.

Economic actors decide that they will decrease consumption and increase savings. This lowers the rate of interest and investment increases. Thus the multiplier effect that the investment produces is offset by the rise in savings that precipitated the rise in investment (in formal terms cY is offset by sY). Down the road, when the savers go to spend their savings they will find that the extra productive capacity that their invested saving has brought online will allow them to increase their consumption in real terms (i.e. without price increases)**.

Sounds pretty tidy, right? Well, it is… until you introduce Keynes’ theory of liquidity preference. Then the whole thing gets completely mucked up. In simple form the liquidity preference theory states that there exists pools or hoards of money that people hold based on their expectations of the future. When they are optimistic about the future they dump more of the hoards on the market, lowering the rate of interest; when they are pessimistic about the future they extract money from the market, raising the rate of interest.

This means that the rate of interest is no longer governed by the savings desires of economic actors. Rather it is governed by the money markets and the levels of confidence that exist therein. If this level of confidence becomes overly optimistic the rate of interest will be lowered and a boom will be produced. In this boom it is likely that many malinvestments will be made (think of the redundant real estate put in place after the housing boom in, for example, Ireland). These malinvestments will not cater to the desires on the part of savers to consume in the future and since the losses will only accrue to money that would have anyway been hoarded, consumption in the future will outstrip the productive capacity of the economy. Inflationary tendencies will result. In the opposite scenario, we will get deflationary tendencies***.

The key here is that these whims are not the result of some ‘intrusion’ by the central bank, as is the case in the Austrian Business Cycle Theory (ABCT). Rather, they are a natural result of the fact that in the money market it is expectations in the face of an uncertain future that reign supreme. This eliminates the idea of a natural rate of interest that can be arrived at through market processes. The only way of salvaging this notion is to assume some variant of the strong-form Efficient Markets Hypothesis (EMH) in the money markets so that all investors have perfect knowledge of the future and integrate this into their investment decisions.

Given that no Austrian worth their salt would accept this idea, the ABCT falls apart completely. As for the mainstream marginalists, only the New Classicals and the Chicagoites, with their highly artificial theories of the financial markets, have a coherent theory of a natural rate of interest. All the other schools accept that there are imperfections of varying degrees in the money markets. Thus all of these schools implicitly reject the natural rate of interest. But, of course, myopic as they often are, they still continue to use it in most of their models and most of their proclamations about policy. (Even Paul Krugman believes in a natural rate, as do many central bankers).

If we accept that there is no natural rate of interest what conclusion does this lead to? Well, it leads to the conclusion that a central authority should try to lean against the speculative impulses in the market. Given that these impulses are a response to the fact that expectations have to be formed in the face of an uncertain future, the central authority — that is, the central bank — should try to make this future as certain as possible by guiding interest rates. In practice, this is done by controlling the overnight rate of interest.

This is, however, a rather blunt instrument and we have seen in the past that it is not a good means to counteract speculative build-ups in specific sections of the financial architecture. If we accept the above argument then it would be far better for the central authority to intervene in different financial markets directly and give them guidance in accordance with their tendency toward speculative excess. The challenge for central banks moving into the future is to build tools that will allow them to do this. I have suggested what one such tool might be elsewhere. Another challenge will be to start producing the tools needed to try to identify speculative excesses in the markets. This, I think, is one of the biggest challenges that economics faces moving into the future.

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**Actually, the process here is far from simple. The savings must come out of the profits accrued to the new investment. Thus there are some hidden mechanics here that, if they are explored in any detail, may well undermine the argument unless very restrictive and unrealistic assumptions are made. But we will not concern ourselves with this here.

*** Note that these are highly stylised arguments. In reality the dynamics are much more complex. But I am merely taking the models on their own terms here to make the case from within, as it were.

++ I have submitted a paper laying this argument out in far more detail to a journal. If it is published I will try to make it available here in the future for those interested to read.