More on the natural rate of interest

Since my recent post on Wicksell, a number of famous economists have also blogged on the Wicksellian ‘natural’ rate of interest.

Tyler Cowen asked ‘what’s the natural rate of interest?’ and has a few interesting points. Paul Krugman responds to Cowen by making the usual mistake (albeit shared by most mainstream academics) of defining the natural Wicksellian rate as the “the rate of interest at which the economy would be more or less at full employment, which in turn implies that inflation will be more or less stable.” He adds that there is no reasonable case that interest rates are kept artificially low. Meanwhile, on Econlog, Scott Sumner added that there was “nothing natural about the natural rate of interest” and added some comments and charts on his own blog, declaring that the natural rate is surely negative.

Cowen in turn responded to Krugman, highlighting that risk was not a good reason to justify low risk-free natural rates. He elaborates on a few points, but one in particular was, I believe, spot on: what he calls “growing legal and institutional requirements for T-Bills as collateral”. While he believes that this hypothesis still has to be demonstrated empirically, he linked to a 2-year old post of his I had missed in which he discusses this theory in more detail.

Here are his first few points:

1. Imagine that financial institutions and traders have to hold large quantities of T-Bills (and similar assets) to participate in financial markets. That may be to satisfy collateral requirements, to meet government regulations, to be credible in private market transactions, and so on.

2. The demand for these assets is now so high and so persistent that the assets have persistently low nominal returns and often negative real returns.

3. The holders of these assets do not however receive negative returns on their portfolio as a whole, when deciding to hold these T-Bills. Holding the T-Bills is like paying an entry fee into financial markets. And once they are in financial markets of the right kind, these market players can earn high returns by possessing special trading technologies (the technology may vary across market participants, but think HFT, hedge funds, prop trading, employing quants, and so on).

4. Let’s say you are not a major financial institution. Then you really will earn negative returns on your safe saving. You might try holding equities, but a) you are not wealthy and thus you are fairly risk averse, and b) as a small player you do not have access to these special trading technologies and indeed you must trade against those who do. You thus will often earn negative or low returns on your portfolio no matter what.

5. The implied prediction is that differential rates of wealth accumulation will be a driver of inequality over time. This seems to be the case.

It is sad that Cowen is not an expert in banking and financial regulation, because he had a remarkable insight there.

US Treasury yields (as well as most government-issued securities and a number of highly-rated corporate ones) do not reflect the ‘natural’ supply and demand of the market. Instead, demand is artificially raised by financial regulation, as I have explained in a number of posts (see this previous blog post on the BIS, which explained how its recent financial reforms will impact a number of reference rates, and also this post for instance). This is where Krugman is wrong when he says that interest rates are not kept artificially low. While we can argue whether or not the Fed and other central banks manipulate rates downward, there is no argument here: regulation does push a number of reference interest rates down.

This was also the case (to a lesser extent) in the post-war era, making Scott Sumner’s reasoning inaccurate, as pointed out by one his commenters. Remarkably, Scott seemed to agree that this might indeed be a good point. Over the past three decades, regulation has fundamentally influenced the demand for a number of assets, modifying their market prices/yields in the process. Any comprehensive analysis, from the causes of the crisis to secular stagnation, should take those microeconomic changes into account. I have read countless academic papers over the past few years, and almost none did. They seemed to consider that banking behaviour and incentives were (mostly) constant over time. They weren’t.

So a number of economists might be slowly waking up to the fact that financial market prices are not freely determined, which seriously constrains our ability to reach conclusions based on market trends. There are many other underlying drivers (the ‘microeconomics of banking’ that I keep mentioning) that are at play.

PS: Marcus Nunes has an interesting post on determining (or not) the natural rate of interest. I agree that there is no point trying to determine the rate to target it.