There's nothing natural about the natural rate of interest
By Scott Sumner
It’s not clear what a term like ‘natural’ actually means. What are “natural foods” for instance? Are they foods free of natural pesticides? Free of artificial pesticides? Are they free of both natural and artificial pesticides? And what if the artificial pesticide is chemically identical to a natural pesticide? Does that matter?
Or consider climate change. What is the “natural” level of CO2? Is it the CO2 level assuming humans did not exist? Why not if bison did not exist, burping lots of methane? (Yes, I know, methane isn’t CO2. But still . . . ) And if (let’s assume, counterfactually) Native Americans had decimated bison herds 10,000 years ago, and affected methane levels, would that be artificial or natural? Are hunter-gatherer societies artificial or natural?
How about the price of oil; is there a “natural” price of oil? Would that be a price not distorted by government polices like price controls? How about taxes? And suppose the global oil market was highly competitive, with lots of private firms and no price controls and no taxes. Is that a natural price? Now add one state-owned oil company, say in Norway. Otherwise laissez-faire. Is the resulting oil price the “natural” free market global price, or is it set by the Norwegian government, which has the discretion to adjust oil output, and thus oil prices (but only a little bit, or by a lot but for a short time)?
And how about central banks, which have the discretion to adjust the monetary base, and hence short term interest rates (but only a little bit, or by a lot but for a short time)?
I see ‘natural’ as a term that does more to confuse than enlighten, and in that sense I agree with a recent post by Tyler Cowen (but not in every particular).
Wicksell regarded the natural rate as the one that led to price stability. Why price stability? Presumably because he thought price stability was the proper way of thinking about “macroeconomic stability” more broadly. Here’s Tyler:
As Scott Sumner has pointed out, the older natural rate of interest used to truly be about price stability. Nowadays that has morphed into “two percent inflation a year.” Yes a definition can be changed, but still I find that intellectual maneuver strange and it implicitly suggests there may be multiple natural rates of interest; neither “zero” nor “two” is a special number. There is also a blurring between the rate of inflation, the increase in the rate of inflation, the expected rate of price inflation, and so on.
Part of Tyler’s objection can be addressed by switching to the natural real rate of interest, which may be unaffected by a shift from zero to 2% trend inflation (although perhaps not precisely.) But that doesn’t address all of his objections. And it’s even worse, as there is no particular reason to assume that either stable prices or stable inflation is consistent with macroeconomic stability. You need a model. And we don’t have a model that everyone agrees upon. I prefer using the benchmark of stable NGDP growth, although even that can undoubtedly be improved upon. And I’d prefer stabilizing expected NGDP growth. Thus for me the most useful definition of the “natural rate of interest” is the path of actual interest rates if we assume that NGDP futures prices are stable along a path rising at 4% or 5% per year.
You don’t have to agree with me, but I’d encourage Austrian readers not to make the same mistake as those dreamy-eyed environmentalists or health food nuts, who equate ‘natural’ and “untainted by human actions.” That is, don’t assume that a natural rate of interest is the rate in a society free of government interference. Wage and price stickiness is a thorny problem, and it doesn’t magically go away in an idyllic libertarian utopia. Getting to a path of nominal spending that leads to reasonable macroeconomic equilibrium is a hard problem, or else we would have solved it long ago.
Here’s Brad DeLong:
More important, however, in thinking about our present concern with the natural (“neutral”) (“equilibrium”) real rate of interest is knowledge of the historical path by which we arrived at our current intellectual situation. Alan Greenspan did it. On July 20, 1994, Alan Greenspan announced that the Federal Reserve was not a “Keynesian” institution, focused on getting the volume of the categories of aggregate demand-C, I, G, NX-right. He announced that the Federal Reserve was not a “Friedmanite” institution, focused on getting the quantity of money right. He announced that the Federal Reserve was now a “Wicksellian” institution, focused on getting the configuration of asset prices right:
. . .
Greenspan thus shifted the focus of America’s macroeconomic discussion away from the level of spending and the quantity of money to the configuration of asset prices. In some ways this is no big deal: “Keynesian”, “Friedmanite”, and “Wicksellian” frameworks are all perfectly-fine ways to think about macroeconomic policy. They are different-some ideas and some factors are much easier to express and focus on and are much more intuitive in one of the frameworks than in the others. But they are not untranslateable-I have not found any point that you can express in one framework that cannot be more-or-less adequately translated into the others.
The point, after all, is to find a macroeconomic policy that will make Say’s Law, false in theory, true enough in practice for government work. You can start this task by focusing your analysis first on either spending, or liquidity, or the slope of the intertemporal price structure.
This seems like a kind of strange way of thinking about things. I’ve always thought of interest rates and money supply targeting as two means to an end, two tools to achieve stable growth in total spending. But even if it is strange, it’s actually pretty close to how I’d like the profession to think about things. That is, the Fed could target M, or it could target i, or it could target NGDP futures prices. I prefer the latter, which is the expected growth in total spending.
I tend to think Say’s Law is either true or false, depending on how you think about it. (I.e., what you are holding constant.) But I much prefer DeLong’s way of thinking about it, and I wish more Austrians would think about it this way. Maybe DeLong’s aphorism is not literally true, but it brilliantly expresses a sort of poetic truth, as when Borges said:
India is larger than the world
HT: Marcus Nunes, TravisV.