The “Natural” Interest Rate and Secular Stagnation: Loanable Funds Macro Models Don't Fit Today’s Institutions or Data

By Lance Taylor

Can America recover ideal rates of growth through interest-rate policies? This important analysis suggests that most economists misunderstand the issue. Updating Keynes, the analysis suggests that fiscal stimulus, labor union bargaining power, and more progressive income taxes are needed to support growth. (The article includes some algebra, which some readers may choose to skip.)

The main points of this paper are that loanable-funds macroeconomic models with their “natural” interest rate do not fit with modern institutions and data. Before getting into the numbers, it makes sense to describe the models and how to think about macroeconomics in the first place.

Today’s “New Keynesian” orthodoxy says that short- to medium-run performance is determined by interest-sensitive “loanable funds.” Unimpeded interest-rate adjustment should support robust macroeconomic equilibrium. Examples of this thinking include the (visibly nonexisting) “zero lower bound” on rates, which allegedly holds down saving and contributes to secular stagnation, the global “savings glut” keeping market rates near zero, and the “dynamic stochastic general equilibrium” (DSGE) models beloved by freshwater economists and central banks in which investment is determined by saving as a function of financial return.

Loanable-funds doctrine dates back to the early nineteenth century and was forcefully restated by the Swedish economist Knut Wicksell around the turn of the twentieth (with implications for inflation not pursued here). It was repudiated in 1936 by John Maynard Keynes in his General Theory. Before that he was merely a leading post-Wicksellian rather than the greatest economist of his and later times.

Macroeconomic models are built around assumptions about behavior imposed upon accounting relationships such as value of output (or demand) equals cost of output (which generates income), and value of assets in a balance sheet equals value of liabilities plus net worth. Keynes said that changes in income dominate in making sure that the first accounting balance is satisfied. He switched Wicksell’s assumptions about macro causality—or, in the jargon, the “closure” of the model—to fit his understanding of the system. New Keynesian economists reswitch the closure back to Wicksell.

Institutions have evolved since Wicksell and Keynes were writing—the welfare state materialized and international trade expanded. Both thought, correctly for their times, that most saving comes from households and that most investment is done by business. Unlike Keynes, Wicksell argued that “the” interest rate as opposed to the level of output adjusts to ensure macro balance. If potential investment falls short of saving, then, maybe with some help from inflation and the central bank, the rate will decrease. Households will save less (and possibly also run up debt to buy into a financial bubble as prior to 2007), and firms seek to invest more. The supply of loanable funds will go down and demand up, until the two flows equalize with the interest rate at its “natural” level.

In New Keynesian thinking, demand for investment can be so weak and the desire to save so strong that the natural rate lies below zero. The “distortion” imposed by the zero lower bound short-circuits the adjustment process, leading to calls for central banks to raise their inflation targets to reduce the “real” interest rate (nominal rate minus inflation). More straightforward interventions—such as restoring American labor’s bargaining power so that rising wages can push up prices from the side of costs, expansionary fiscal policy, or redistributing from the top 1 percent to households in the bottom half of the income size distribution whose saving rates are negative—are apparently impossible for “political” reasons.

Read the rest here.

Lance Taylor on Loanable Funds and the Natural Rate

New paper on INET. Here is from Lance's conclusion:

... writing in the General Theory after leaving his Wicksellian phase, Keynes said that “... I had not then understood that, in certain conditions, the system could be in equilibrium with less than full employment….I am now no longer of the opinion that the concept of a ‘natural’ rate of interest, which previously seemed to me a most promising idea, has anything very useful or significant to contribute to our analysis (pp. 242-43).” Today’s New “Keynesians” have tremendous intellectual firepower. The puzzle is why they revert to Wicksell on loanable funds and the natural rate while ignoring Keynes’s innovations. Maybe, as he said in the preface to the General Theory, “The difficulty lies, not in the new ideas, but in escaping from the old ones… (p. viii).”

His point is that while there are good reasons to believe in the forces of stagnation, the reasons are not the Wicksellian ones given in New Keynesian models. Worth reading.

Giancarlo Bertocco on Keynes’s criticism of the Loanable Funds Theory

Recently, Lars P. Syll posted a critique of the loanable funds theory (see here), and Matias Vernengo provides his take here. Below is a paper by Giancarlo Bertocco, in which he provides an analysis of Keynes' criticism of LFT.

From the abstract:

Contemporary monetary theory, by accepting the theses of the Loanable funds theory, distances itself from Keynes, who considered the rate of interest as an exclusively monetary phenomenon, and overlooks the arguments Keynes used, following publication of the General Theory, to respond to the criticism of supporters of the Loanable funds theory such as Ohlin and Robertson. This paper aims to assert that the explicit consideration of the role of banks in financing firms‘ investments connected with the specification of the finance motive does not imply acceptance of the LFT, which holds that the interest rate is a real phenomenon determined by saving decisions, but makes it possible to elaborate a theory of credit alternative to the LFT and a sounder theory of the non neutrality of money than the one based on the liquidity preference theory. 

Read rest here and here.

Lars P. Syll on how wrong Krugman & Mankiw are on loanable funds

By Lars P. Syll

Earlier this autumn yours truly was invited to participate in the New York Rethinking Economics conference. A busy schedule didn’t allow me to “go over there.” Fortunately some of the debates and presentations have been made available on the web, as for example here. Listening a couple of minutes into that video one can hear Paul Krugman strongly defending the loanable funds theory. Unfortunately this is not an exception among “New Keynesian” economists. Neglecting anything resembling a real-world finance system, Greg Mankiw — in the 8th edition of his intermediate textbook Macroeconomics — has appended a new chapter to the other nineteen chapters where finance more or less is equated to the neoclassical thought-construction of a “market for loanable funds."

Read rest here.

For an explication and presentation of the extent to which LFT is derivative of modern neo-Wicksellian macroeconomics, see here.

More on Murphy, and Rowe on the Natural Rate of Interest

My post on Robert Murphy's critique of Piketty generated a few comments, and a good debate (see the comments section here). But there are a few things worth clarifying, and also Robert pointed out a post by Nick Rowe, which is also worth discussing in more detail.

As I noted before there seems to be a confusion among Austrians, which think that their notion of the rate of interest is purely based on intertemporal consumption (savings) preferences, and is not open to the problems of the capital debates (this is as old as Austrian economics, by the way; for more below). It would not be, in their view, equivalent to the natural rate of interest of Wicksell and the Loanable Funds Theory of the rate of interest.

First, let me get back to Robert Murphy's original post, which led to my previous post. Just to remind you his argument was that the non-Austrian mainstream (and Piketty, as a result) confused financial or monetary measures of capital with purely physical ones. It's worth quoting extensively from his post. He says:

"If a firm hires a specific capital good for a unit of time, the payment is the rental price of the capital good. For example, suppose that a warehouse pays $100,000 per year to an independent company that maintains fleets of forklifts. These annual payments are clearly due to the "marginal product" of the forklifts; the warehouse can sell more of its own services to its customers when it has use of the forklifts. 

However, these technological facts tell us nothing about the rate of interest enjoyed by the owners of the forklifts. In order to determine that, we would have to know the market price of the forklifts. For example, if the forklifts that the independent company rents out to the warehouse could be sold on the open market for $1 million, then their owners would enjoy a 10-percent return each year on their invested capital. But if the forklifts could be sold for $2 million, then the $100,000 payments—due to the "marginal product" of the forklifts—would correspond to only a 5-percent interest rate. As this simple example illustrates, knowledge of the marginal product of capital, per se, does not allow us to pin down the rate of interest."

Note that this is a triviality, and by no means contradictory with the conventional neoclassical analysis. It only says that the rate of interest specific to a particular capital good (forklifts) and its price are inversely related. That per se, certainly does NOT mean that "the relationship between the productivity of capital and the interest rate is not [direct]." The point is that, in marginalist economics, the entrepreneur would 'hire' more capital to the point were the additional (marginal) cost would equalize the additional (marginal) revenue that can be obtained from using one more unit of capital, and the latter would depend on how much more output the additional capital (forklift in this case) unit would bring. So according to changes in prices of the capital good, and, as a result, of its rate of return, the capital good would be used if it provides a gain over the interest rate. If there is an advantage in using the capital good (forklift), then more will be used, pushing its price up, and bringing its remuneration down into equilibrium with the rate of interest (the natural one).

The point of the capital debates (go here) is that there is no reason to believe that a certain technology (forklifts) would be more profitable at low rates of interest, while at higher rates of interest firms would switch to manually powered hoists (more labor intensive, arguably), for example, to lift the cargo. It would be even impossible to define clearly that one technology (forklifts) is more capital intensive than another (manual hoists). The point is that there is no relation between intensity (relative scarcity) of the use of a capital good and its remuneration.

For example, in the conventional story if the price of the forklift goes down, more capitalists would be willing to buy it, supposedly substituting other technologies (which are now relatively more expensive for the cheaper one). Yet, the fall in the price of the forklift might reduce the remuneration of the producer of forklifts, even if demand increased, since the increase in the quantity sold might very well be trumped by the effect of a lower price. Also, and more importantly for us, the decrease in the price of forklifts might lead to a reduction in the demand for forklifts. This could be the case, for instance, if the decrease in the price of forklifts and lower remuneration reduces the forklift producers' demand for other goods, which are produced, in turn, using forklifts, leading to a lower demand for forklifts. The changes in the price of the forklift, and its remuneration, are not directly correlated to its relative use (how many forklifts are bought and used in production).

Note that the fact that forklifts are produced by means of forklifts, is central to this perverse effect (the absence of any discussion of re-switching in Robert's discussion of the capital debates is telling). Here it is also worth understanding why Sraffa used the old classical and Marxist terminology of means of production rather than factors of production. A means of production is produced (like the forklift) by using means of production (including forklifts). Robert is actually utilizing the notion of a factor of production, even though he uses emptily the same terminology as Sraffians (means of production), which means that the impact of the production on capital goods (forklifts) on the production of capital goods is actually ignored.

Further, Robert does NOT deny that supply and demand determine prices and by substitution lead to allocation of resources (which makes him, and all Austrians, marginalist).* He seems just to be suggesting that a monetary rate of interest might be at some point different than the rate of remuneration of forklifts.** And it sure can. However, there must be some reason, for an agent not to invest in forklifts if the remuneration is higher than the monetary rate of interest. With free entry, and using Robert's conventional (Austrian) supply and demand logic, the entry should bring prices down, univocally lead to more demand for forklifts and equalize the marginal productivity of the forklifts and remuneration to the natural rate of interest.

Note that this opens up the question of the time preference, the other leg in Loanable Funds Theory of the rate of interest. Assume that you start from a situation in which the rate of return on forklifts is the same as the monetary rate of interest. Now assume that for some reason (Robert would say a change in intertemporal consumer preferences) the monetary rate of interest changed. Then, all of a sudden the demand for forklifts should increase, and the prices of forklifts go up, reducing its remuneration to the new equilibrium. This is when Nick's post comes in handy (again, link here).

Nick shows a very conventional story of the Loanable Funds Theory. On the one hand, we have the conventional Production Possibilities Frontier (PPF, in red), which shows how much more consumption in the future can be obtained by using less resources to produce consumption goods in the present. That is basically the marginal productivity story, in this case with the traditional neoclassical assumption of marginal diminishing returns, since the technology only allows for more consumption tomorrow at a decreasing rate (graph from Nick's post).

On the other hand, you have the indifference curve (in blue) and its slope represents the marginal intertemporal rate of substitution, which gives you how much economic agents are willing to part with consumption today in order to obtain more consumption tomorrow. When the two curves are tangential, and the marginal productivity of capital equals the marginal rate of substitution you are in equilibrium. Two things are important to note here. The intertemporal notion used in this discussion, is not exactly the same as the intertemporal notion of equilibrium used in General Equilibrium models. Not only the notion of capital above is aggregative, but more relevantly, the individual capital goods, when they are considered, would have to obtain a long-term uniform rate of profit. In fact, Bhöm-Bawerk used this notion, which was then lifted by Wicksell and Fisher (cited by Nick).***

In addition, Nick suggests that the marginal productivity of capital is NOT necessary to determine the rate of interest, but the marginal rate of transformation at which we transform less consumption goods today into more tomorrow does. Actually this is an empty distinction, since the rate at which one investment good allows you to produce (transform) more consumption goods in the future is, essentially, its marginal productivity.

This is an old and well-known confusion by Bhöm-Böhm-Bawerk, who wanted to suggest that interest rates were not the remuneration of marginal productivity of capital. His solution revolved about the notion of roundaboutness of productive process, and it does not scape the notion that marginal productivity is still relevant in the Austrian framework, and Wicksell, as well as Fisher (and if I recall correctly even J.B. Clark was too) seemed to be aware of the limitations of Böhm-Bawerk's analysis (a full explanation would require another post).

In sum, this is another case of a mainstream author that does think that markets (supply and demand) determine prices efficiently, producing the correct allocation of resources (in this case capital) confused with his own theory (for a similar lack of understanding of his own neoclassical theory by Noah Smith go here). There is the added perversity of trying to use a critique of his own theory (the capital debates) to show that the theoretically challenged but politically progressive Piketty is wrong (he is, but that idea of wealth taxes is NOT the problem).

The lack of understanding of neoclassical economics by neoclassical economists is, not surprisingly, a result of their defeat in the capital debates, and the fragmentation of teaching thereafter, something that I referred to as the return of vulgar economics. It could be said that the mainstream graduate programs are now basically the production of confused economists by means of confused economists.

* Actually his argument against Piketty's tax is that it would distort prices, and hence the incentives for entrepreneurs to invest, being detrimental to growth. So there is a lot of faith in the powers of supply and demand to allocate resources efficiently.

** One wonders if Robert read the Hayek-Sraffa debate on own rates of interest, in which Hayek committed a similar mistake.

*** Again here there is a terrible confusion in Robert's understanding of the meaning of the intertemporal models, since the latter presume, inconsistently, that the notion of a uniform rate of profit can be abandoned. That's why the intertemporal General Equilibrium models remain short-term models. By the way, as shown in the graph above the determination of the rate of interest (1+r), which is the slope at the tangential point of the PPF and the indifference curve, is the natural rate and is open to the capital debates critique.

Say's Law of Markets: Classical and Neoclassical versions

Teaching macroeconomics, and having to deal, as always with the confusion generated by all manuals (to a great extent Keynes' fault for using the term classical for everybody that came before him) between the old classical political economy tradition and the marginalist (or neoclassical, other misnomer, this one Veblen's fault) school.

Not all classical authors accepted Say's Law, to which Keynes' Principle of Effective Demand (PED) was contrasted, but all neoclassical authors do accept it (last week the Societies for the History of Economics, aka SHOE, had a very confusing discussion on Say's Law, in which this simple fact got completely lost by a few debaters). Marx certainly was critical of Say's Law.

Ricardo in chapter XXI of his Principles famously says:

"M. Say has, however, most satisfactorily shewn, that there is no amount of capital which may not be employed in a country, because demand is only limited by production. No man produces, but with a view to consume or sell, and he never sells, but with an intention to purchase some other commodity, which may be immediately useful to him, or which may contribute to future production. By producing, then, he necessarily becomes either the consumer of his own goods, or the purchaser and consumer of the goods of some other person. It is not to be supposed that he should, for any length of time, be ill-informed of the commodities which he can most advantageously produce, to attain the object which he has in view, namely, the possession of other goods; and, therefore, it is not probable that he will continually produce a commodity for which there is no demand."

The Ricardian notion is relatively simple. It suggests that the objective of production is consumption (what Marx would call later the "simplest form of the circulation of commodities," or simple exchange, where commodities are produced for exchange for commodities, with money being just an intermediary, C-M-C'). Further, Ricardo suggests that nobody would continue to produce something for which there is no demand over the long run. Yes there might be mistakes and excess production, but over time producers learn from their mistakes. In this simple story if a capitalist saves, it is by definition because he intends to invest and be able to produce more in the future. Think of the corn model; the corn not consumed, for wages (for the reproduction of the system), goes by definition into expanded reproduction.

The Ricardian model has no adjusting mechanism between investment and savings, which are by definition one and the same. Also, there is no guarantee that the system fully utilizes labor resources, or that the system would be at full employment. The rate of interest was regulated by the rate of profit, and adjusted to its level in the long run, but it did not adjust savings and investment.

This is, in fact, the main difference between the old classical version of Say's Law when compared to the marginalist or neoclassical one. In the neoclassical version the rate of interest (the natural rate of interest indeed) becomes the adjusting mechanism in what is often referred to as the Loanable Funds Theory (LFT) of the Rate of Interest (for a simple discussion of Wicksell's version of the LFT go here). Now an excess supply of funds (savings) for investment would be eliminated by the tendency of the monetary rate of interest to equilibrate with the natural rate, guaranteeing that investment is at the level of full employment savings. Investment can deviate from the equilibrium level of savings only in the short run, and neoclassical theory (including Wicksell of course; a few in the SHOE discussion seemed confused about this) would accept Say's Law in this new version in the long run. Note that in order for a rate of interest to lead to increasing investment demand, it must be the case that labor is fully utilized, and firms decide to substitute labor for capital. In the marginalist version Say's Law implies full employment in the labor market.

Keynes' Principle of Effective Demand, by suggesting that savings were simply a residual (income not spent), famously argued that, instead of supply creating its own demand, it was autonomous spending decisions (which Keynes associated with investment) generated income and, hence, made the supply effective. It was the variations of the level of income that made the adjustment of savings to investment possible, and there was no guarantee that autonomous spending would provide for the full utilization of resources.

For a thorough analysis of Keynes' PED, this book remains in my view one of the best around.

Lars Syll on Loanable Funds Theory

By Lars Syll

The classical theory of the rate of interest [the loanable funds theory] seems to suppose that, if the demand curve for capital shifts or if the curve relating the rate of interest to the amounts saved out of a given income shifts or if both these curves shift, the new rate of interest will be given by the point of intersection of the new positions of the two curves. But this is a nonsense theory. For the assumption that income is constant is inconsistent with the assumption that these two curves can shift independently of one another. If either of them shift, then, in general, income will change; with the result that the whole schematism based on the assumption of a given income breaks down … In truth, the classical theory has not been alive to the relevance of changes in the level of income or to the possibility of the level of income being actually a function of the rate of the investment.

There are always (at least) two parts in an economic transaction. Savers and investors have different liquidity preferences and face different choices — and their interactions usually only take place intermediated by financial institutions. This, importantly, also means that there is no “direct and immediate” automatic interest mechanism at work in modern monetary economies. What this ultimately boils done to is — iter — that what happens at the microeconomic level — both in and out of equilibrium — is not always compatible with the macroeconomic outcome. The fallacy of composition has many faces — loanable funds is one of them.

Read the rest here.

Liquidity preference and effective demand

Reading The Battle of Bretton Woods, by Benn Steil, an interesting book with some problems associated to its conventional economics analysis, I was struck by the following phrase: "Keynes had struggled for years ... to induce a compelling theoretical cause for his burning belief that investment could, even under flexible prices, fail to harmonize savings in a way that would maximize aggregate income. ... It was the concept of ´liquidity preference,' or the idea that people might choose to hoard inert cash rather than consume or invest the fruits of their labor."

It is improtant to remember how Keynes himself suggested he developed Liquidity Preference, to put Steil's argument in perspective. Keynes says in his "Alternative Theories of the Rate of Interest" (1937, p. 250; subscription required) that:

"the initial novelty [in his General Theory] lies in my maintaining that it is not the rate of interest, but the level of incomes which ensures equality between saving and investment. The arguments which lead up to this initial conclusion are independent of my subsequent theory of the rate of interest, and in fact I reached it before I had reached the latter theory."

In other words, the central idea of the GT is effective demand (investment determines savings through the multiplier) and liquidity preference is more or less an afterthought, developed to deal with the fact that by eliminating the Loanable Funds Theory he had left "the rate of interest in the air" (ibid.). Further, note that the situation in which "people might hoard cash," corresponds to the so-called Liquidity Trap.

In other words, when everybody expects that in the future the rate of interest will increase, and prices of bonds will collapse, and hence there would be windfall losses, there might be an absolute demand for liquidity [in spite of Krugman, not the case now]. What did Keynes have to say about the liquidity trap? In chapter 15 Keynes tells us ‘after the rate of interest has fallen to a certain level, liquidity preference may become virtually absolute … [b]ut … I know of no example of it hitherto’ (Keynes, 1936, p. 207). In other words, a downward rigidity of the rate of interest, while possible in theory, was not in practice the cause of unemployment for him, and certainly it was not the "compelling theoretical cause for his burning belief that investment could fail to harmonize savings in a way that would maximize aggregate income."

There are several other issues with the book, which I'll discuss in other posts.