November 7, 2015

Debunking the natural rate of interest

Comment on ‘The Well-Defined, but Nearly Useless, Natural Rate of Interest’

Blog-Reference

Wicksell has always been well aware of the fact that economists are confused confusers “... when it is a matter of finding the cause of general changes in the price of commodities, and especially the influence on those of credit and the institutions regulating credit, some maintain that cheap and easy credit, in other words, a low rate of interest, will tend to increase the amount of means of payment in circulation and the demand for goods and this will tend to increase the general level of prices; while others maintain the contrary, that cheap credit means the same things as cheaper costs of production and so tends to lower the level of prices, not to raise it; and naturally ... there is no lack of more moderate opinion between the two extremes, eclectics who say that the influence of credit on prices is sometimes in one direction, sometimes in another and is sometimes nil.” (quoted in Deane, 1983, p. 8, see also 2013).

It can even be said that economic analysis consists essentially of kicking any problem around in the realm between true and false, where, as Keynes said, “... nothing is clear and everything is possible” (1973, p. 292), without ever arriving at a final true/false conclusion. Hicks is exemplary for how to deal with manifest contradictions “As far as I can make out, there are relevant and important senses in which all these statements are each of them right and each of them wrong.” (1939, p. 184)

Inconclusiveness is the very characteristic of political economics. Theoretical economics is different, it aims at clear-cut answers. This presupposes that the formal apparatus of analysis is consistent. “The highest ambition an economist can entertain who believes in the scientific character of economics would be fulfilled as soon as he succeeded in constructing a simple model displaying all the essential features of the economic process by means of a reasonably small number of equations connecting a reasonably small number of variables.” (Schumpeter, 1946, p. 3)

Standard economics never got close to this ‘simple model’. Roughly speaking, the two main approaches, the Walrasian and the Keynesian, are both defective, that is, they cannot explain how the monetary economy works (2015). The ultimate reason is that standard economics is not built upon a set of acceptable premises or axioms. Walrasianism is based on the concepts of constrained optimization and equilibrium. Both premises are methodologically unacceptable.

So, what does the correct ‘little apparatus’ look like? Generally speaking, it is based upon a set of axioms that do not contain any Walrasian or Keynesian propositions. The replacement of obsolete premises amounts to a paradigm shift.

As a matter of principle, analysis must always start with the most elementary case. This is the pure consumption economy. The theory of interest has to be developed out of the objectively given properties of the most elementary economic configuration. That is, to begin with there are two firms; one produces the consumption good and the other money/credit. This firm is also called the central bank and it stands for the banking industry as a whole. For a start, only the household sector takes up credit. There is no investment in the pure consumption economy and by consequence no investment financing.

Under the objective condition of zero profit in both firms we have Pc=Wc/Rc, the price of the consumption good is equal to unit wage costs, and Ja=Wb/Rb, ditto for the rate of interest on the asset side of the central bank's balance sheet. If wage rates are set equal for simplicity then we have Ja/Pc=Rc/Rb, that is, the real interest rate is objectively determined by the production conditions in both industries.

In the investment economy things are a bit more complex. Normally, the household sector is the lender and the business sector is the borrower. Accordingly, one has two rates of interest Ja and Jl. The interest rate on the asset side Ja denotes what business has to pay, the interest rate on the liability side Jl denotes what the household sector is paid. Under the zero profit condition there is a fix relationship between the two rates. The central bank, though, is in principle free to set any configuration of Ja and Jl. A very interesting limiting case is Jl=0.

Now, the employment equation for the investment economy reads as follows. From this equation follows inter alia:
(i) An increase of the expenditure ratio rhoE leads to higher employment.
(ii) Increasing investment expenditures I exert a positive influence on employment.
(iii) An increase of the factor cost ratio rhoF=W/PR leads to higher employment. This implies that an increase of the average wage rate W relative to price P and productivity R leads to higher employment (2015).

What remains to be done, is to establish how the expenditure ratio depends on the deposit rate rhoE=f(Jl) and how investment depends on the lending rate I=f(Ja). These two functions inserted give the general relationship between employment, prices, and the two interest rates.

Conclusion: if the functional relations f(Jl) and f(Ja) are reliable and if the price mechanism works such that rhoF is roughly constant then the central bank is in the position to establish full employment by fine-tuning the two interest rates.

Wicksell’s natural-rate mechanism implies the equalization of saving and investment (Blaug, 1998, p. 621). It has already been shown in previous posts that this equality/equilibrium never occurs, neither ex ante nor ex post. And this in turn means that the concept of the natural rate has been fallacious from the start.

Egmont Kakarot-Handtke


References
Blaug, M. (1998). Economic Theory in Retrospect. Cambridge: Cambridge University Press, 5th edition.
Deane, P. (1983). The Scope and Method of Economic Science. Economic Journal, 93(369): 1–12. URL
Hicks, J. R. (1939). Value and Capital. Oxford: Clarendon Press, 2nd edition.
Kakarot-Handtke, E. (2013). Confused Confusers: How to Stop Thinking Like an Economist and Start Thinking Like a Scientist. SSRN Working Paper Series, 2207598: 1–16. URL
Kakarot-Handtke, E. (2015). Major Defects of the Market Economy. SSRN Working Paper Series, 2624350: 1–40. URL
Keynes, J. M. (1973). The General Theory of Employment Interest and Money. The Collected Writings of John Maynard Keynes Vol. VII. London, Basingstoke: Macmillan.
Schumpeter, J. A. (1946). The Decade of the Twenties. American Economic Review, 36(2): 1–10. URL

Related 'Are economists methodological retards? and 'Down and out' and 'Humpty Dumpty is back again' and 'Accounting basics' and 'I=S: Mark of the Incompetent' and 'Interest and profit' and 'End of confusion' and 'Keynes and the logical brilliance of Bedlam'

Immediately following post 'The irreparable unreality of all ‘real’ models'