The Economic Consequences of the Overthrow of the Natural Rate of Interest


For quite a few months I have, on this blog, been alluding to a paper that I had written which showed that the natural rate of interest is implicitly dependent on the EMH in its strong-form in order to be coherent. I have finally published this paper (in working paper form) with the Levy Institute and it can be read here:

Endogenous Money and the Natural Rate of Interest: The Reemergence of Liquidity Preference and Animal Spirits in the Post-Keynesian Theory of Capital Markets

Some notes on the paper.

The motivation for the paper was that when reading up on endogenous money during my degree I found that mainstream economists had largely integrated it in their more recent models. This integration, as the paper notes, usually took the form of a Taylor Rule. I should be clear that although this had become standard practice at some levels of the discipline most mainstream economists remained ignorant or confused (the famous Krugman debates were highly illustrative of this). Nevertheless, I found that the mainstream had conceded to endogenous money and yet, for some reason, they were not in agreement with Post-Keynesians on the implications for this in theory nor were they in agreement on important policy issues.

What I found was that they were able to avoid the important implications of endogenous money theory by resurrecting the loanable funds theory in a different way. They did this by effectively becoming neo-Wicksellian and replacing the exogenous money proclamations with the idea of a ‘natural rate of interest’. This device allowed them to keep the rest of marginalist monetary theory intact and served as a justification for the dangerous idea that the economy could be steered to full employment and prosperity through vigilant manipulation of the central bank’s overnight interest rate (I deal with the track record of that dubious policy here).

In my paper I show that such ideas implicitly rely on a strong-form EMH view of capital markets. Think of it this way: the central bank set a single rate of interest. Piled on top of this rate of interest are countless other rates of interest — the interest rate on mortgages, student loans, junk bonds, and so on. This ‘stack’ of interest rate will be affected by the central bank rate of interest but, and this is crucial, the spread between the central bank rate and these other interest rates are set by the market. The assumption of mainstream monetary theory is that the market will line each of these rates of interest up with their particular natural rate. So there the natural rate on each type of loan will be automatically hit by the market.

It is clear that what is being assumed here is that the market will price in all relevant information objectively. That, of course, is the EMH view of capital markets and it is one that has been completely refuted and dismissed by all relevant economists since the 2008 financial crisis. But once this falls apart mainstream monetary theory goes out the window with it. What we end up with is Keynes’ own monetary theory; one in which liquidity preference determines interest rates across the markets and animal spirits drive the rate of investment in the economy. These two key economic variables are now subject to the vagaries of human psychology.

I have since had the opportunity to try the argument out on a few very senior economic policymakers and former economic policymakers. The results have been very encouraging. They seem to see instantly the logic of the approach and how much damage it does to the mainstream theoretical underpinnings. They also see that this has massive implications for policy: it completely changes how we should understand central banks to operate and how economic policy should be managed.

No longer should we use the interest rate to steer economic activity. This will not work. In the last boom we saw the interest rates on mortgages remain low even as the overnight rate was rising and we saw animal spirits in the housing market cause overly high rates of unsustainable investment in this market. This is what the theory would predict: using interest rates to steer the economy will only result in speculative excesses and destructive boom-bust cycles.

While I do not outline the policy conclusions in the paper they should be familiar to Post-Keynesians. First, the interest rate should be ‘parked’ at some permanent low-level; somewhere between 0% and 2%. Secondly, central banks should have their role changed to (a) providing easy credit policies and (b) regulating excesses in potentially speculative asset and investment markets — I favour Tom Palley’s ABRR proposal here. Thirdly, the currency should be flexible but can be managed should needs require through central bank intervention in the foreign exchange markets. Fourthly, shortfalls and excesses in effective demand should be managed by government expenditure and taxation.

This, of course, outlines an entirely different regime to the present inflation-targeting environment. It is somewhat similar to the post-war arrangements but would probably be more aggressive if implemented with full force.


About pilkingtonphil

Philip Pilkington is a macroeconomist and investment professional. Writing about all things macro and investment. Views my own.You can follow him on Twitter at @philippilk.
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24 Responses to The Economic Consequences of the Overthrow of the Natural Rate of Interest

  1. GermanAngst says:

    Very nice paper.
    A question to your post:
    “First, the interest rate should be ‘parked’ at some permanent low-level; somewhere between 0% and 2%.”
    How do we make this decision? What would be the rationale behind 0%, 2% or 4%? If you can get the agreement that it should be permanent, you still have to come up with a number that is left untouched.

    • Hmm… It is a tough question. The MMT people favour ZIRP. The rationale is that people have access to free money. I tend to think that there should be some low baseline rate of return on money.

      The intuition is that when investment is being undertaken there should be a small risk penalty. My feeling is that this would set a sort of psychological baseline for borrowing and make people act a tad more responsibly. It would also allow for reasonable rates on savings.

      If I were to give a number I would say, at full employment and high growth the central bank should maintain a rate of interest between 1% and 1.5%. So, 1.25% would seem ideal to me.

      • GermanAngst says:

        I favour your intuition.
        I don’t know much about Sraffa but I took at least one rationale from him: That prices should be set so that a system can reproduce itself. That presupposes for society as a whole that the conflict between benefits and risks/costs of the financial system have to be discussed. Theory should also inform along these lines.

      • NeilW says:

        ZIRP is just from central bank to regulated commercial banks. It means the commercial banks can operate entirely on an overdraft from the central bank without having all the ridiculous and pointless messing around with deposit funding and insurance that just has to be undone as soon as a crisis hits.

        MMT make the commercial banks operate ‘in the bank’ – effectively they become franchises of the CB.

        The cost to commercial banks is then the cost of raising capital, and the risk cost of advancing loans – which under Minsky proposals cannot be protected by hypothecated collateral.

        So borrowing always has a cost in the real economy – as determined by the bank underwriting systems, and by national policy as to what can be funded.

        Removing collateral protection and the restrictions on lending reduce the number of ‘creditworthy borrowers’ able to access new money from regulated banks.

        You can have National Savings operate accounts that pay savers interest – if that is state policy. Otherwise to get a return from banks people have to buy bank capital, or invest in something less boring instead.

      • GermanAngst says:

        would you also recommend the ABRR proposal? how would you regulate excesses in speculative asset and investment markets?

      • You raise the ABRR ratio in that particular market.

  2. LK says:

    Great paper. Just finished reading it.

    There are so many issues in there to think about, but two questions:

    (1) if the bank rate goes below the natural rate, it is because the economy is engaged in too great a level of capital investment in excess of real capital goods, driving their prices upwards, right?

    Basically, it is like the ABCT but without the assumption of the “lengthened structure of production,” without the hostility to fractional reserve banking, and with the assumption that flexible wages and prices will take care of problems by the tendency to market clearing?

    (2) is there a good discussion you can recommend from some of the Post Keynesian literature on the Cambridge capital controversies against the natural rate of interest? I normally look to Sraffa’s articles, but presumably there is a better discussion now.

    • Could you restate question (1), I cannot get my head around it? Thanks.

      (2) It’s not really something that I find terribly interesting. It is far too “as if”. The idea is to buy into the crappy marginalist models and then show that they don’t work due to internal contradiction. The above approach — Keynes’, Minsky’s, mine — is to look at the real world and show that the assumptions for the natural rate to function are not remotely realistic. Indeed, since much of the mainstream buys into “behavioral” theories of capital markets even they concede that their own theories don’t measure up to the real world!

      • LK says:

        On (1), when the bank rate is reduced below the natural rate, then the primary driver of inflation is that there is too much investment, which drives up factor prices and through higher wages, consumption prices?

        It just strikes me how this is similar to the Austrian story, but stripped of their more dogmatic aspects (e.g., unsustainable lengthening of structure of production, etc.).

      • Yes. But this is just Wicksell. I am just adding the fact that capital markets can engage in overinvestment even if the central bank gets the “right” rate (although properly understood the idea of the CB targeting a “right” rate no longer makes any sense…).

      • LK says:

        A mistake:
        “consumption prices” = consumer goods prices

  3. Auburn Parks says:

    Hey Phil,

    Its my view that interest rate manipulation is undertaken mainly to protect investors from inflation, and to prevent huge anomalies in the market, not to combat inflation itself. For example, lets assume that everyone has come around on the interest rate fine tuning hoax, so that psychology is no longer operative, we have a more or less permanent 2% FFR.

    Now say, we enter a supply side induced lengthy high inflation period, with rates around 6%. What would the effects be on the level of bank deposits with a real return of negative 4%? Or conversely, what would happen to investment in real plant and equipment if you the FFR was 10% and inflation 6%, so people were getting a guaranteed 4% real return by doing nothing?

    While I do prefer the low interest rate environment generally, I am skeptical about the ZIRP effects when we had normal growth.

    In other words, we dont raise interest rates to fight inflation, but rather to maintain some particular level real risk free returns.

    • But why on earth do we want risk-free returns? Surely if investors/savers want to earn money they should be investing the money productively.

      Imagine you had a risk-free rate at 1.25%. Now, say inflation was 3%-4% and there was full employment (this would be the post-war norm). In such an environment the stock market would be rising maybe 15%-20% year-on-year. An investor/saver just has to park their money in an index fund and they would be getting 11%-17% real returns. And since the central bank would be guarding the market against speculative excess this would be a pretty safe investment.

      This is basically what we see in the post-war era, minus the CB guarding against speculative excess. It does work. I’m about to start working as a professional investor next week and if I could earn 11%-17% every year I would be pretty content with that.

      • Auburn Parks says:

        “But why on earth do we want risk-free returns? Surely if investors/savers want to earn money they should be investing the money productively.”

        Have to go to work, but this one I can answer quickly. So people like my parents, who distrust financial advisers and the stock market in general, can beat inflation. My parents (68 & 66) have never owned stock and would never own stock. I dont think that forcing my parents to give money to the financial community through fees etc, is proper.

        A real negative return of ~1% is not killing them because they are pretty well off, but if the real rate on CD, savings accounts etc was negative 8%, the situation would be worse for them.

      • Set up a government guaranteed index funds that only accepts small quantities from individual investors. It can be insured against any substantial losses that occur on the stock exchange (which should be stable anyway because it is being managed by the CB).

  4. Nick Edmonds says:

    You write: “For Keynes, this means that there is in fact a natural rate of interest for every level of employment.”

    Isn’t this the very point that the New Consensus position is based on? If there is a (natural) rate of interest for every level of employment, then there must be one for full employment. They would then say that the role of the central bank is to hit this rate. It’s just that when they talk about the natural rate they mean only the one that applies to full employment. If it applies to a lower level of employment, they would not consider it to be the natural rate.

    The question then is whether there is in fact any rate of interest which equate savings and investment at full employment. If there is no such rate, then the fact that savings and investments must be equal by identity means that full employment is not possible without further intervention. I see no reason to assume that there should be such a rate, but neither do I think we can conclude that there isn’t. In any event, even if there is sometimes such a rate, I would expect it to move around a lot (including not existing at all for periods of time), so having a central bank policy of chasing it around is not going to very efficient.

    I’m not sure how this fits with what you are saying.

    • Very perceptive! You are correct. Keynes got it wrong.

      If we accept liquidity preference then there can be no natural rate tout court.

      I think this should be clear insofar as the central bank does not have control over all interest rates due to liquidity preference. And even if it did have control over all these rates it would still not be able to force investor expectations (marginal efficiency of capital) to all accept this rate and invest how they “should”.

      Thus, even if each rate were perfectly calibrated to its particular natural rate, if investors get scared for any reason whatsoever full employment will not result. This, of course, undermines the very idea of a natural rate!

  5. Its the prinicple says:

    The natural rate of interest implies one interest rate constant in time, one natural rate.

    In reality, there is no one rate of interest is there?

  6. Jan says:

    Very interesting Phil!As I argued like a more or less parrot over and over, i can´t understand why they still use the “Natural rate” at all ,since allready Knut Wicksell used it so many different way that it had allready lost it´s meaning during his own lifetime. Wicksell presented his Interest and Prices 1898, as “a study of the causes regulating the value of money”. His core idea was to reformulate the quantity theory of money in terms of an interest-rate mechanism that explains changes in the price level as effects of changes in investors’ demand for loans.At pages 70-76 he described the “pure credit system” as an economy in which all payments are made by transfers between bank accounts, and in which all deposits earn interest. Loans make deposits whose volume is not limited by any cash constraint. On pp.110-1 he writes that the supply of money in the banking system is completely endogenous: “No matter what amount of money may be demanded from the banks, that is the amount which they are in a position to lend… The ‘supply of money’ is thus furnished by the demand itself.” 110-1.In some passages, Wicksell referred to the multi-bank Giro systems of his time,in other parts he used it “for the sake of simplicity” as analysis of pure credit systems to the description of a single institution,a sort of “Ideal Bank”” with several branches where gold is no longer used as means of payment but remains the standard of value of the economy.there long-run value of money is, th determined by the demand for gold as a commodity and its marginal cost of production at pp 71-76. So allready in Interest and Prices he at least used the Natural Rate concept of the pure credit in two different versions.In one version as a risk consolidation and economizing on cash and another one there it fictitious centralization of credit to simplify the analysis of monetary policy and cumulative price changes.There lies the danger in the concept of Natural rate.You could simply read in what ever you want to such losely terms.I don´t want to confuse even more by take up the later works of Wicksell there he uses other alternative take on “Natural” or “Normal” and “Real” rates with lot different meanings that make it even more mezzy. It obvoius that the Natural rate for Wicksell was more of tool of thought,since he don´t use it more than very rarely the few times he had some sort of influence on public policy. But just to mention the two versions in Interest and Prices is enough. It´s two very different versions ,It explains why so different persons as austrians like Hayey, the early Keynes and Stockholm Schoolars to modern New Keynsians like Woodfoord etc make so different use of the work.. Modern planners of Stockholm school like Wicksell own close student Knut Lindahl used and developed a version of the Wicksellian framework in Interest Prices as argument for an completely centralized banking system on the other hand people like Hayek used Interest and Prices as argument for more or less free banking and a multi currency regime.People like “neo-Wicksellian” Woodford in his 2003: Interest and Prices make the interpretation of the same work that “markets are perfectly competitive, prices adjust continuously to clear markets, and there exist markets in which state-contingent securities of any kind may be traded” .There are also i guess 2000 or more “Wicksellians” makes their own story of 1898 book Interest and Prices! Of course there is something wrong when you could reach such contradictonary uses of the Natural Rate concept.

    • Yes, the key reason why it is so incoherent is because he never spelled it out properly at a “micro” level. If he had he would have become aware of the errors presented above.

      • Jan says:

        Yes absolutly right Phil, he didn´t. But notice at the time Wicksell lived an economist had a total different status.At least in Sweden. Wicksell had no influence what so ever until maybee at his last years in life,and he had to write popular articles to survive.It was not seen as an respectable job to be an economist at his time,Economics was at his time under department of Law at Universities and it was often failed law clercs that went in to economics.Even what an relativly famous economist like Wicksell wrote ,was not taken really serouisly at the time,They was not even relied to deal with money.You had to be accountant to be trusted with such. Economists was more in the storytelling buisness or speculative philosophy branch.When Wicksell wrote about losely concepts like natural rate he was aware that almost no one would care what he wrote.I don´t think he could dream that lot of people at Harvard or Federal Reserve should play with a Natural Rate as a divine rule of god! I sometimes wonder if this thing called progresse was such good idea after all 🙂 ? At least not in all cases !

  7. Michael Robinson says:

    “Fourthly, shortfalls and excesses in effective demand should be managed by government expenditure and taxation.”

    Of course, you know there is a reason why “central bank independence” has been valued so highly in principle and practice.

    An economically correct counter-cyclical fiscal policy, no matter how desirable in theory, is essentially undemocratic, in that voters have a strongly expressed and nearly universal preference that tax rates not increase as part of a deliberate strategy to dampen economic expansions.

    Therefore, if excesses in effective demand “should be managed by government…taxation”, you’re going to need a new form of (undemocratic) government to do it.

    • I must say, I rarely have the opportunity to deal with outright regurgitated propaganda on this blog…

      (1) If you think that is the reason we have independent CBs you have more than a little reading to do. Start with the literature emerging around the Swedish Bank Prize (Google that if you don’t know what it is…).

      (2) If you think that you need government officials to tick the box on fiscal stimulus or tax increases Google ‘automatic stabilizers’ and then apply a bit of the imagination-juice that I hope you have on tap to come up with alternatives to Fascism. Lol!

      For everyone else: remember this comment. It is an echo of propagandistic arguments that were spread in the 1960s by the nascent neoliberal movement. Not to say that you’re conscious of the source or error in what you’re saying, Mr. Robinson, but then neither is your average Tea Party advocate spewing garbage about fiscal deficits.

      A key propaganda tactic for educated elites is to spread a sense of hopelessness about real change to gain credence for a politics that they know to be undesirable. Propaganda 101.

  8. philippe101 says:


    Interesting stuff.

    In your paper you quote Leijonhufvud:

    “When nominal income is rising, investment exceeds saving by the net addition to loanable funds injected by banks. ”

    I don’t really get this idea of investment exceeding saving. What does he mean?

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