The Economist struggles with Wicksell
Looks like Wicksell is back in fashion. After years (decades?) with barely any mention of this distinguished Swedish economist outside of work from some heterodox economic schools academics (like the Austrians), he is now everywhere and has unleashed a great debate among academics and financial practitioners. This is the outcome of both the financial crisis (preceded by interest rates that were below their ‘natural’ level according to Wicksellian-based theories) and the current unconventional policies undertaken by central banks all over the world (that risk repeating the same mistakes according to those same theories).
This week’s Economist’s column Free Exchange tries to identify whether or not current interest rates are too low based on a Wicksellian framework (A natural long-term rate). The article is complemented by a Free Exchange blog post on the newspaper’s website.
I won’t get back to the definitions of Wicksell’s money and natural rates of interest as I’ve done it in two recent posts (here and here). I only wish today to comment on The Economist’s interpretation (and misconceptions) of the Wicksellian rate.
A few of things shocked me in this week’s column. First, the assertions that “the natural rate prevails when the economy is at full employment” and that “the natural interest rate is often assumed to be constant.” I’m sorry…what? Putting aside the fact that ‘full employment’ is hard to define, there can be full employment with interest rates below or above their natural level, and interest rates can be at their natural level with the economy not at full employment. Many other ‘real’ factors have effects on ‘full employment’. Using full employment as a basis for spotting the equilibrium rate is dangerous.
Second, where did they get that the natural interest rate was constant? This doesn’t make sense. The natural interest rate rises and decreases following a few variables (various economic schools of thought will have differing opinions) such as time preference (i.e. whether or not people prefer to use income for immediate or future consumption), marginal product of capital (demand for loanable funds by entrepreneurs would increase as long as they can make a profit on the marginal increase in capital stock, driving up the interest rate in the process), liquidity preference (i.e. whether or not people desire to hold money as cash rather than some other less liquid form of wealth – pretty much the only important factor driving the interest rate for Keynesians –)… As you can imagine, all those factors vary constantly, impacting the demand for money and the demand for credit and in turn the rate of interest. It clearly does not remain constant…
The Economist also dismisses the possibility that real interest rates are too low by the fact that sovereign bonds’ yields are low, not only in the US (where the Fed is engaged in massive bonds purchases), but also in other economies whose central banks are less active in purchasing sovereign debt. But it overlooks the fact that natural rates aren’t uniform and may well be lower in other countries (for example, the natural rate was probably lower in Germany than in Spain and Ireland before the crisis, despite having a common central bank). It also overlooks that ‘risk-free’ rates used as a basis of most financial calculations internationally are US Treasuries, not sovereign bonds of other countries.
Finally, in support of its point, the column argues that expected future low rates could also reflect investors’ expectations of sluggish future growth and that “despite profit margins near record levels and rock-bottom interest rates, business investment has been sluggish, recently peaking at just above 12% of GDP; it topped 14% in the late 1990s.” Once again, this is misinterpreting the natural rate: the level of the natural rate of interest does not necessarily depend on expected future economic growth as I described above. Sluggish business investments also are more likely to reflect current regulatory ‘regime uncertainty’ than entrepreneurs’ doubts about the future state of the economy. On top of that, using the dotcom bubble as a reference for business investment is intellectually dishonest. Moreover, the article contradicts itself starting with “central banks ignore this century-old observation at their peril” only to conclude that “all this suggests that policy rates, low as they seem, are not out of line with their natural level.” Hhhmmm, ok.
The Free Exchange blog post by Greg Ip is a little better but still overall quite confused and confusing. Interestingly, it cites a paper by Bill White (http://dallasfed.org/assets/documents/institute/wpapers/2012/0126.pdf) who argues that the sort of yield-chasing that we can witness in financial markets today is a symptom of nominal rates being lower than natural rates. Doesn’t this remind you of anything? That’s right; it was exactly my point in this post. But it then cites Brad de Long, who can be added to the list of people who don’t understand what regulatory uncertainty is, and who tries as a result to convince us that the natural rate is below zero. Theoretically, a below zero natural rate if possible in period of deflation. But it does not make much sense to have a natural rate below zero when inflation is above zero.
It is definitely a hard task to identify the natural rate of interest. Nonetheless, a few rules of thumb are sometimes better than overly-complex reasoning. Investors would be perfectly happy with negative nominal yields if cost of life was declining even faster. This is obviously not the case at the moment.
I fail to see significant differences between the economist article and this one, except that this article believes “regulatory uncertainty” is driving natural rates down, while de Long, the Economist and many others argue it is liquidity preference (or debt overhang, which in the aggregate has the same impact as higher liqudity preference).
Some statements also misrepresent the Economist, such as “the natural rate is constant” – the Economist does not make this claim but disputes it, as the author does himself.
Henry, The Economist argues that interest rates currently are at or even higher than their natural level, whereas I argue that they may be lower in some countries at least (much clearer in my previous posts).
I’m not saying that regime uncertainty lowers the interest rate but that it has a negative impact on both investment and employment, independently of the rate.
Regarding the the claim that natural rates are constant, it is not very clear what the stance of The Economist is. It looks like they originally want to refute it, but then kind of change their minds. But the blog post is more nuanced than the article from the print edition, that’s for sure.