(A year ago, I mentioned that Arjun Jayadev were writing a book about money. The project was then almost immediately derailed by covid, but we’ve recently picked it up again. I’ve decided to post some of what we’re writing here. Plucked from its context, it may be a bit unclear both where this piece is coming from and where it is going.)
The problem of interest rates is one of the key fissures between the vision of the economy in terms of the exchange of real stuff and and the reality of a web of money payments. Like a flat map laid over a globe, a rigid ideological vision can be made to lie reasonably smoothly over reality in some places only at the cost of ripping or crumpling elsewhere; the interest rate is one of the places that rips in the smooth fabric of economics most often occur. As such, it’s been a central problem since the emergence of economics as a distinct body of thought. How does the “real” rate determined by saving and investment demand get translated into the terms set for the exchange of IOUs between the bank and its customer?
One straightforward resolution to the problem is simply to deny that money plays a role in the determination of the interest rate. David Hume’s central argument in his essay “On Interest” (one of the first discussions within the genealogy of modern economics) was that changes in the supply of money do not affect the interest rate.1
High interest arises from three circumstances: A great demand for borrowing; little riches to supply that demand; and great profits arising from commerce: And these circumstances are a clear proof of the small advance of commerce and industry, not of the scarcity of gold and silver… Those who have asserted, that the plenty of money was the cause of low interest, seem to have taken a collateral effect for a cause…. though both these effects, plenty of money and low interest, naturally arise from commerce and industry, they are altogether independent of each other.
“Riches” here means real, material wealth, so this is an early statement of what we would today call the loanable-funds view of interest rates. Similar strong claims have been taken up by some of today’s more doctrinaire classical economists, in the form of what is known as neo-Fisherism. If the “real” rate, in the sense of the interest rate adjusted for inflation, is set by the fundamentals of preferences and technology, then central bank actions must change only the nominal rate. This implies that when the central bank raises the nominal interest rate, that must cause inflation to rise — not to fall, as almost everyone (including the central bankers!) believes. Or as Minneapolis Federal Reserve president Narayana Kocherlakota put it, if we believe that money is neutral, then “over the long run, a low fed funds rate must lead to … deflation.”2 This view is, not surprisingly, also popular among libertarians.
The idea that monetary influences on the interest rate are canceled out by changes in inflation had a superficial logic to it when those influences were imagined as a literal change in the quantity of money — of the relative “scarcity of gold and silver,” as Hume put it. If we imagine expansionary monetary policy as an increase in the fixed stock of money, then it might initially make money more available via loans, but over time as that money was spent, it would lead to a general rise in prices, leaving the real stock of money back where it started.
But in a world where the central bank, or the private banking system, is setting an interest rate rather than a stock of money, this mechanism no longer works. More money, plus higher prices, leaves the real stock of money unchanged. But low nominal rates, plus a higher rate of inflation, leaves the real interest rate even lower. In a world where there is a fixed, central bank-determined money stock, the inflation caused by over-loose policy will cancel out that policy. But when the central bank is setting an interest rate, the inflation caused by over-loose policy implies an even lower real rate, making the error even worse. For the real rate to be ultimately unaffected by monetary policy, low interest rates must somehow lead to lower inflation. But it’s never explained how this is supposed to come about.
Most modern economists are unwilling to outright deny that central banks or the financial system can affect the rate of interest.3 Among other things, the privileged role of the central bank as macroeconomic manager is a key prop of policy orthodoxy, essential to stave off the possibility of other more intrusive forms of intervention. Instead, the disjuncture between the monetary interest rate observable in credit markets and the intertemporal interest rate of theory is papered over by the notion of the “natural” interest rate.
This idea, first formulated around the turn of the 20th century by Swedish economist Knut Wicksell, is that while banks can set any interest rate they want, there is only one interest rate consistent with stable prices and, more broadly, appropriate use of society’s resources. It is this rate, and not necessarily the interest rate that obtains at any given moment, that is set by the nonmonetary fundamentals of the economy, and that corresponds to the intertemporal exchange rate of theory. In the classic formulation of Milton Friedman, the natural rate of interest, with its close cousin the natural rate of unemployment, correspond to the rates that would be “ground out by the Walrasian system of general equilibrium equations, provided there is imbedded in them the actual structural characteristics of the labor and commodity markets, including market imperfections, stochastic variability in demands and supplies, the cost of gathering information about job vacancies and labor availabilities, the costs of mobility, and so on.”
The natural rate of interest is exactly the rate that you would calculate from a model of a rational individual trading off present against future — provided that the model was actually a completely different one.
Despite its incoherence, Friedman’s concept of the natural rate has had a decisive influence on economic thinking about interest in the 50 years since. His 1968 Presidential Address to the American Economics Association introducing the concept (from which the quote above comes) has been called “very likely the most influential article ever published in an economics journal” (James Tobin); “the most influential article written in macroeconomics in the past two decades” (Robert Gordon); “one of the decisive intellectual achievements of postwar economics” (Paul Krugman); “easily the most influential paper on macroeconomics published in the post-war era” (Mark Blaug and Robert Skidelsky). 4 The appeal of the concept is clear: It provides a bridge between the nonmonetary world of intertemporal exchange of economic theory, and the monetary world of credit contracts in which we actually live. In so doing, it turns the intertemporal story from a descriptive one to a prescriptive one — from an account of how interest rates are determined, to a story about how central banks should conduct monetary policy.
To understand the ideological function of R*, it’s useful to look at a couple of typical examples of how it’s used in mediating between the needs of managing a monetary economy and the real-exchange vision through which that economy is imagined.
A 2018 speech by Fed Chair Jerome Powell is a nice example of how monetary policy practitioners think of the natural rate. He introduces the idea of R* with the statement that “In conventional models of the economy, major economic quantities such as inflation, unemployment, and the growth rate of gross domestic product (GDP) fluctuate around values that are considered ‘normal,’ or ‘natural,’ or ‘desired.’” The slippage between the three last quoted terms is a ubiquitous and essential feature of discussions of R*. Like the controlled slipping between the two disks of a clutch in a car, it allows systems moving in quite different ways to be joined up without either fracturing from the stress. The ambiguity between these meanings is itself normal, natural and desired.
In a monetary policy context, Powell continues, these values are operationalized as “views on the longer-run normal values for the growth rate of GDP, the unemployment rate, and the federal funds rate.” Powell immediately glosses this as “fundamental structural features of the economy … such as the ‘natural rate of unemployment’.” Here again, we see a move from something that is expected to be true on average, to something that is a “fundamental structural feature” presumably linked to things like technology and demographics, and then to the term “natural”, which implies that these fundamental structures are produced by some quite different process than the network of money payments managed by the Fed. The term “natural” of course also implies beyond human control, and indeed, Powell says that these values “are not … chosen by anyone”. In the conventions of modeling, such natural, neutral, long-run, unchosen values are denoted with stars, so along with R* there is U* and a bevy of starred Greek letters.
Powell, to be fair, goes on to talk about how difficult it is to navigate by these stars in practice, and criticizes his predecessors who were too quick to raise interest rates based on hazy, imprecise ideas of the natural rate of unemployment. But there’s a difference between saying the stars are hard to see, and that they are not there at all. He has not (or, plausibly, assumes his audience has not) escaped the scholastic and tautological habit of interpreting any failure of interest rate changes to deliver the expected result as a sign that the natural rate was different than expected.
It is, of course true, that if there is any stable relationship between the policy rate controlled by the Fed and a target like GDP or unemployment, then at any particular moment there is presumably some interest rate which would move that target to its desired level. But the fact that an action can produce a desired result doesn’t make it “natural” in any sense, or an unchanging structural feature of the world.
Powell, a non-economist, doesn’t make any particular effort to associate his normal or natural values with any particular theoretical model. But the normal and natural next step is to identify “fundamental structural features” of the world with the parameters of a non monetary model of real exchange among rational agents. Indeed, in the world of macroeconomics theory, that is what “deep structural parameters” mean. In the usage of Robert Lucas and his followers, which has come to dominate academic macroeconomics, structural parameters are those that describe the rational choices of agents based only on their preferences and the given, objective production function describing the economy. There’s no reason to think Powell has this narrower meaning in mind, but it’s precisely the possibility of mapping these meanings onto each other that allows the “natural rate” and its cousins to perform their ideological role.
For an example of that next step, let’s turn to a recent report from the Centre for Economic Policy Research, which assembles work by leading European macroeconomists. As with Powell’s speech, the ideological understanding of the natural rate is especially striking here because much of the substantive policy argument being made is so reasonable — fiscal policy is important, raising interest rates makes public debt problems worse, the turn to austerity after great financial crisis was a mistake.
The CEPR economists begin with the key catechism of the real-exchange view of interest: “At its most basic level, the interest rate is the ‘price of time’ — the remuneration for postponing spending into the future.” R*, in other words, is a rate of interest determined by purely non monetary factors — it should be unaffected by developments in the financial system. This non monetary rate,
while unobservable … provides a useful guidepost for monetary policy as it captures the level of the interest rate at which monetary policy can be considered neutral … when the economy runs below potential, pushing actual real policy rates sufficiently below R* makes policy expansionary.
The notion of an unobservable guidepost doesn’t seem to have given the CEPR authors any pause, but it perfectly distills the contradiction embodied in the idea of R*. Yes, we can write down a model in which everyone has a known income over all future time, and with no liquidity constraints can freely trade future against present income without the need for specialized intermediaries. And we can then ask, given various parameters, what the going rate would be when trading goods at some future date for the same goods today. But given that we live in a world where the future is uncertain, where liquidity constraints are ubiquitous, and where a huge specialized financial system exists to overcome them, how do we pick one such model and say that it somehow corresponds to the real world?
And even if we somehow picked one, why would the intertemporal exchange rate in that world be informative for the appropriate level of interest rates in our own, given that the model abstracts away from the features that make monetary policy necessary and possible in the first place? In the world of the natural rate, there is no possibility for the economy to ever “run below potential” (or above it). Nor would there be any way for a single institution like a central bank to simultaneously change the terms of all those myriad private exchanges of present for future goods.
Michael Woodford, whose widely-used graduate textbook Interest and Prices is perhaps the most influential statement of this way of thinking about monetary policy is, unusually, at least conscious of this problem. He notes that most accounts of monetary policy treat it as if the central bank is simply able to fix the price of all loan transactions, but it’s not clear how it does this or where it gets the power to do so. His answers to this question are not very satisfactory. But at least he sees the problem; the vast majority of people using this framework breeze right past it.
The CEPR writers, for instance, arrive at a definition of the natural rate as
the real rate of interest that, averaged over the business cycle, balances the supply and demand of loanable funds, while keeping aggregate demand in line with potential output to prevent undue inflationary or deflationary pressure.
This definition simply jams together the intertemporal “interest rate” of the imagined non monetary world, with the interest rate target for monetary policy, without establishing any actual link between them. (Here again we see the natural rate as the clutch between theory and policy.) “Loanable funds” are supposed to be the real goods that their owners don’t currently want, which they agree to let someone else use. The “while” conjunction suggests that clearing the loanable-funds market and price stability are two different criteria — that there could in principle be an interest rate that keep output at potential and inflation on target, but failed to clear the market for loanable funds. But what could this mean? Are there any observable facts about the world that would lead a central bank to conclude “the policy rate we have chosen seems to be consistent with price stability, but the supply and demand for loanable funds are not balanced”? Where would this imbalance show up? The operational meaning of the natural rate is that any rate associated with the macroeconomic outcomes sought by the central bank is, by definition, the “natural” one. And as Keynes long ago pointed out — it is a key argument of The General Theory — the market for loanable funds always clears. There is no need for a market price balancing investment and saving, because any change in investment mechanically produces an exactly equal change in saving.
In practice, the natural rate means just this: We, the central bank, have set the interest rate under our control at a level that we hope will lead to our preferred outcomes for GDP, inflation, the unemployment rate, etc. Also, we can imagine a world in which rational agents trade present goods for future goods. Since in some such world the exchange rate between present and future goods would be the same as the policy rate we have chosen, our choice must be the optimal one.