Monday, 6 March 2017

The latest bit of fashionable economics jargon: “R-Star”.

This tweet asks a pertinent question.

The so called “r-star” rate of interest, at least according to Gavyn Davies writing in the Financial Times, “is the real short term interest rate that would pertain when the economy is at equilibrium, meaning that unemployment is at the natural rate and inflation is at the 2 per cent target. This might be described as the rate the Fed should adopt under “normal” conditions..”.

So, to repeat the question put in the above tweet, what’s the value of this mysterious r-star rate? Well the quick answer is that there is no specific value or rate of interest that is compatible with full employment and acceptable inflation (NAIRU if you like). Reasons are as follows.

As MMTers have long pointed out, government debt and base money are assets as viewed by the private sector. MMTers sometimes refer to that pair of assets collectively as “Private Sector Net Financial Assets” (PSNFA). And the private sector will clearly try to spend away some of those assets if it thinks it has an excessive stock of them. Conversely, it will try to save if it thinks it has an insufficient stock: Keynes’s “paradox of thrift” unemployment being the result.

Thus if there is an excessive stock, government will either have to confiscate the excess via tax, or it will have to dissuade the private sector from spending away the excess stock by offering whatever interest on the stock induces the private sector NOT TO spend away the excess.

Thus there are an infinite number of rates of interest that are compatible with full employment and an acceptable rate of inflation. For example, we can have a highish stock of PSNFA combined with a highish rate of interest, or a lower stock combined with a lower rate of interest. So that’s dealt with the vexed “R-star” argument.

What’s the optimum stock of PSNFA?

But that of course raises an obvious question, namely what’s the optimum or GDP maximising stock of PSNFA? Well Milton Friedman and Warren Mosler’s answer is: “no government debt and as to base money, we need whatever quantity keeps the economy at capacity”.

But the latter idea assumes government should fund infrastructure and other investments out of tax rather than borrowing. Is that right? Well there certainly are arguments for that “don’t borrow even to fund infrastructure” policy. They are as follows.

1. Investment does not justify borrowing. For example if a taxi driver wants a new taxi and happens to have enough cash to hand, why borrow? There’s no point.

2. The “infrastructure investment justifies government borrowing brigade do not seem to have noticed that education is one HUGE investment. That is, money spent teaching kids to read and write this year will continue to pay dividends in 50 years’ time: much longer than some physical investments last. But no one argues the entire education budget should be funded via borrowing. That’s a clear inconsistency.

3. It could be argued that if government offers to borrow at X% and some people are willing to lend at that rate, plus others are willing to pay taxes to fund that interest, then everyone gets what they want: everyone is a winner. On the other hand that’s not quite a genuine free market arm’s length transaction is it? Each individual tax payer / interest payer does not have a clear choice as to exactly how much he or she borrows and at what rate of interest.

Moreover, potential lenders and borrowers are free to get together and strike deals even where there is no government borrowing at all. So there is no real need for the latter “lending / borrowing via government” arrangement.

So my provisional conclusion is that Friedman and Mosler are right, but I’m not 100% certain!!


  1. Mr. Musgrave,

    "or it will have to dissuade the private sector from spending away the excess stock by offering whatever interest on the stock induces the private sector NOT TO spend away the excess."

    The purpose of higher interest rates, in a credit-driven economy, is to literally tear money away from the hands of the poor as higher interest rates leave less money for consumption.

    There is no dissuading necessary.

    1. It's not just the poor who borrow: rich people also borrow e.g. to help them buy expensive houses and fund businesses. Plus corporations borrow. Thus the effect of interest rate rises are pretty widespread.


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