Natural Rate of Interest

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I am of the mind that the natural interest rate is one of the least understood and appreciated concepts in economics.  In our standard pedagogy we talk about economic vs. accounting profits and try to separate the interest rate into two parts.  We talk a lot about what drives the interest rate derived from inflation, but very little about the natural interest rate.  I’d like to investigate this concept a little further.

 

If we can imagine a world with a constant money supply, where the dollars now in play are the only dollars that will be in play, we can eliminate inflation and get a head start.  The dollars each consumer now holds will all be worth more tomorrow if productivity is increasing.  By this I mean that if there is a certain quantity of consumer goods available today, and the amount of consumer goods is greater tomorrow, then each dollar chases more goods, and can buy more.  The prices of goods will go down.  This makes each of us less hungry to invest our money in speculative endeavors and more likely to hold on to cash.  In fact, every day our cash becomes more and more valuable.  We can achieve a certain interest rate on savings held in cash by just comparing the relative prices of goods from one period to another.  Prices can change under the following set of circumstances:

1. An increase or decrease in productivity.  If a factory discovers a method for making pencils which requires more available resources which are in lower demand they can make more pencils for the same money.  Or if they find a way to improve a process, they can make more pencils using less energy, time, or resources.  These improvements in productivity often accompany a change in technology.  We very seldom see decreases in productivity.

2.  A change in tastes.  When people change their tastes in products those products which increase in popularity will become more scarce, and their prices will be bid up.  Likewise people can change their overall level of consumption.  As people consume more, the price of goods will increase.

3.  Shocks.  This amounts to a combination of the first two.  When there is a war, people often change their consumption patterns, and things are broken and people are moved away from productive labor.  Prices can become very unstable under these circumstances.  But at any given time the market process can be counted on to be moving adjusting rates toward the right price for each good.

 

Under a constant money supply certain activities of the government are likely to be easier to notice.  For example: wealth transfers will have direct, one-to-one, dollar-for-dollar correlations.  It can be easier to identify a particular dollar which was taxed away from one individual to be handed to another individual.  Whether we approve or disapprove of such behavior by the government ought not to be affected by this distinction, but my hunch is that it will.  The peculiar ability of the state to rob Peter to pay Paul without Peter or Paul having to know about each other is crucial.  I am much more likely to be blamed for favoritism if I take a candy belonging to one of my daughters and hand it to the other in full sight of both of them than if I take a candy from one under the pretense of punishment, and then give it to the other independently at some other time.  The knowledge of where the money came from and how affects the relationships.

 

Under a constant money supply some people will still be attracted to investment opportunities.  These will be individuals who believe they know about an opportunity where productivity can be improved or where they can better satisfy consumers’ tastes than current goods.  They will be willing to risk their money, which would otherwise be increasing in value every day, on opportunities which may or may capture these productivity or market rents.

If they are successful at improving productivity, they will be able to sell more of their product, and money will flow to them.  Everyone else will have had their money become more valuable to them as well, but they will have a bit less of it, since there has been a shift in distribution.  Importantly, the purchasing power of that lesser quantity of money will be greater than the former quantity of money under lower productivity circumstances.  The consumer will be wealthier.  The investor will be wealthier, too.  They will hold more of the money, and the money will be more valuable.  This is his reward for risking the money he held earlier on the investment opportunity. 

If he had failed, then he would have less money than others, and resources would have been wasted on a failed experiment, so there would be fewer resources to go around, and everyone else’s supply of money would have increased.  More money for fewer goods would cause the prices of goods to go up.  People will have more money, but less stuff to spend that money on, so they will be worse off overall.  People don’t consume money, they consume the stuff money can buy.

Naturally, prices should be decreasing.  If they are increasing, we have to ask which is true: is productivity decreasing, so that there are fewer goods being chased by the same number of dollars, or in the state printing more money, so that there are more dollars chasing the same number of goods?  When the state inflates the money supply in order to stabilize prices it does so arbitrarily.  That is because there are more than two goods in the world in which we live.  We don’t just have money on one hand and stuff on the other.  Instead, we have money, cows, TV’s, cars, pencils, tin, blackboards, and a myriad of other things, all of which are constantly changing in demand relative to one another.  For the state to stabilize prices, they would have to know the elasticity of demand for every good in existence relative to every other good at every point in time from now until forever.  Instead they pick a few goods which they believe to be representative of entire categories of goods and try to stabilize their prices by increasing or decreasing the amount of money in the market.  This doesn’t work, because they sometimes leave whole categories out of the equation, and often there are large shifts in relative demand within categories of goods.  The selection process is ultimately arbitrary, even if informed by good historically based educated guesses.

What happens then is that people realize holding on to cash is a loosing prospect.  So, they look for somewhere else to invest their resources.  Many people buy stocks.  Others buy houses, or bonds, or put their money into a savings account.  The smartest invest in businesses and capital which will be successful in the next period.  Many people realize that they are better off being in debt if the value of money is decreasing.  If the interest rate on a loan is lower than the interest rate in a savings account, it might be better to buy a bunch of stuff on credit and enjoy life now, since it is impossible to know what the future might hold.

The future is uncertain enough.  We might guess that things will continue to get better and that productivity will continue to expand.  We might notice that 2/3 of the world has yet to realize the returns to scale developed nations have over the last 100 years, and once those a realized there will be vast amounts of goods available.  I’m optimistic.  But unless an individual know about a good investment opportunity and can take advantage of it on their own, unwitting savers will continue to be shuffled into speculative markets.

This exacerbates the principle-agent problem already negatively affecting firms, because it becomes hard to find investors with talents at monitoring firms.  The volatility increases across the board.

All of this is occurring now, underneath the blanket of inflation.  But that blanket makes it very difficult to do economic calculation.  Especially since the changes in money supply and where that supply is being injected are very difficult to know or understand.  Complete exposure of these actions might improve overall calculus, though they will remain as extra variables to be considered.  Calculation becomes constantly more expensive.

What is worse is that most graduating economics majors do not have a grasp of these issues.  They do not know anything about how a natural interest rate would operate independent of inflation.  Most of them would wrongfully assume that it is increasing.  This confusion leads to thoughtless head-nodding and acceptance of the models that they are taught without understanding.  They turn their intuition off, because it stops working somewhere along the line, and all they have left is an internal calculator which performs according to a prescribed order of operations.  And then, one day, the most efficient market in the world notices that it has wrongfully evaluated the value of billions and billions of dollars in assets.  The calculator is exposed as broken, but is not thrown away, because without it all we have is logic, which we are trained not to trust.

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