Wicksellian natural interest rate vs Keynesian neutral rate (and the need to know History of eco thought..)

I guess this blog could just be dedicated to the cause of knowing history and history of economic thought and be a history…:-)

With each passing day and article, one is beginning to realise how important concepts sketched out much earlier are impacting us and we have no clue.

In this post, Joseph Salerno says it is fashionable to say central banks’ policy rates should be in line with Wicksellian interest rate (How many macro people even know of Wicksell for instance?). It adds that historical dimension and prestige to it. However, this usage is more  Keynesian than Wicksellian as Wicksell would have last wanted the rates to be set by policymakers:

These contemporary statements of the natural rate generally cite only a very small fragment of Wicksell’s discussion of the concept in which he refers to the natural rate as “a certain rate of interest on loans which is neutral in respect to commodity prices, and tends neither to raise nor to lower them.” (See, for example, hereand here). But if we look closely at the definition of the natural rate by Bernanke, Krugman et al., we find that it is really drawn from Keynes’s work and not from Wicksell’s. For it is simply the interest rate that is consistent with full employment of resources at a zero, or non-accelerating, inflation rate.  Indeed in The General Theory of Employment, Interest, and Money (pp. 242–43), Keynes explicitly rejected the Wicksellian natural rate as not being analytically “very useful or significant.” He went on to suggest that the natural rate be replaced by the concept of what he called the “neutral” or “optimum” rate of interest, which is the interest rate “which prevails in equilibrium where output and employment are such that the elasticity of employment as a whole is zero” — which is a clumsy and pretentious way of describing the state of full employment or what is in today’s jargon called “potential GDP.” So for Keynes and his contemporary disciples the natural or neutral rate of interest is determined wholly in financial markets and is one of the main determinants of the level of investment spending and the real rate of return on investment.

This conception is the polar opposite of the natural rate of interest as conceived by Wicksell. According toWicksell (p. 205) who was a follower of Böhm-Bawerk and an Austrian capital theorist through and through, “the natural rate of interest [is] the real yield of capital in production.” The natural rate is thus an “intertemporal” price, or the ratio of prices between present consumption and future consumption (as embodied in capital goods), and it is wholly and directly determined by capital investment in the real sector of the economy. The loan rate of interest is therefore a mere shadow of the natural rate. As Wicksell (p. 192) put it: “That loan rate that is a direct expression of the real rate, we call the normal rate.” This “normal” or “natural” loan rate derives from the natural rate of return on investment throughout the economy’s capital structure and moves in near lock-step with it: “The rate of interest at which the demand for loan capital and the supply of savings exactly agree … more or less corresponds to the expected yield on the newly created capital.” 

For Wicksell, then, in sharp contrast to Keynes, the natural rate is a real price spontaneously determined by market forces, to which the loan rate normally and automatically tends to adjust. In his view, one of the main reasons why the two rates might substantially diverge from one another is because fractional-reserve banks have the power to expand credit by lending deposited gold or, more likely, creating and lending out bank notes and what he called “fictitious deposits.” The expansion of credit by the banks drives down the loan rate below its “normal” equivalence to the natural rate. The divergence between the two rates induces entrepreneurs to eagerly borrow the additional funds at the loan rate and invest them in production processes yielding the higher natural rate of return. The result is an increase in the demand for labor, raw materials, commodities and machinery and a bidding up of wages rates and other factor prices and rents. The additional money payments to laborers and other resource owners eventually cause a rise in the demand and prices of consumer goods. The result is what Wicksell called a “cumulative process” of general price increases that lasts as long as banks suppress the loan rate below the natural rate. The inflationary cumulative process comes to an end only if and when credit expansion ceases and market forces are permitted to establish equality between the loan and natural rates.

Hmmm.. This will read like a new language for even most macro majors. For most of natural is same as neutral/optimum.

Why can’t we spot these differences? Of course as there is no history of thought:

In the current era, serious engagement with the history of economic thought is actively discouraged in PhD programs in economics. Contemporary macroeconomists therefore fail to grasp the difference between Wicksell’s and Keynes’s definitions of the equilibrium interest rate and confuse the provenance and meaning of what they call “the natural rate.” Their view is that the natural rate is an elusive, non-market “policy goal” subject to sudden and inexplicable fluctuations, which must be laboriously extracted from the data using statistical methods. In order to maintain economic stability, the Fed must continually manipulate the fed funds target rate to roughly approximate the natural rate. But, as we have seen, because Fed policymakers deny that the true natural rate can ever be known with certainty, they argue that the Fed must use its own judgment and discretion in conducting monetary policy.

Wicksell and modern Austrian economists — who are Wicksell’s true heirs — hold a conflicting view of the natural rate. They argue that the natural rate is a real and observable market phenomenon that is ultimately determined by the consumption/saving preferences of households and effected by entrepreneurial decisions about the allocation of resources among consumer goods’ and capital goods’ industries based on anticipations of these preferences. The decisions of entrepreneurs tend to bring the rate of return on capital investment into equilibrium across all production processes and business firms in the economy. This rate is reflected in the interest rate on the loanable funds market, which is merely a component of the overall capital or intertemporal market. The latter market includes all funds used to purchase factors of production whether the funds are borrowed or directly invested by shareholders, partners, and proprietors into their own corporations and privately-held firms. 


As much as we think and want to be modern macroeconomists looking into future, it is these crucial concepts which have evolved historically which matter so much to our policy. How will history get primacy it truly deserves in economics teaching?

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