Friday, 17 December 2010

Is the natural rate of interest really zero?

There is a widely accepted phrase amongst advocates of Monetary Theory (MMT) that the “natural rate of interest is zero”, e.g. see Mitchell here and here. Or for a more concise exposition of the zero interest rate idea, see Mosler. I support MMT, but I’m not enthusiastic about this natural rate idea.

By the way, the word “government” will be used below to refer to “government and central bank combined”.

One possible sense of the phrase “natural rate of interest” is something like “the free market rate” or “the rate that would prevail assuming no attempt by government to influence the rate”. In other words this is the rate that arises just from the relationship between those who want to be net borrowers and those who want to save up, and be net lenders.

The phrase “natural rate” is used differently in MMT: the phrase is used to help explain what happens when government creates and spends money (i.e. does not borrow or tax to fund the spending). The effect is a drop in interest rates. And the rate can, according to MMTers drop to zero. In the words of Mosler (p. 539), “Our main point is, in nations that include the USA, Japan, and others where interest is not paid on central bank reserves, the “penalty” for deficit spending and not issuing securities is not (apart from various self-imposed constraints) “bounced” government checks but a zero percent interbank rate, as in Japan today.”

I beg to differ: it could be that full employment in some countries is attained (because of the additional spending) BEFORE interest rates reach zero! Of course the above zero interest point may well be valid in Japan. But the Japanese are ultra enthusiastic savers: they are willing to lend their government very large sums at zero or near zero rates of interest. Spendthrift Anglo-Saxons and PIG countries are different.

Now that all might seem to be contradicted by events since the recent credit crunch. That is, interest rates have dropped to near zero even in Anglo-Saxon and some other countries, yet those countries certainly do not have full employment: put another way, in these countries, a zero or near zero rate of interest coexists with a feeble rate of exit from the recession.

The answer to this contradiction is that governments have not JUST being net spending: they have engaged in quantitative easing (QE). And QE is a policy which aims specifically at reducing interest rates, with additional consumer spending being very much of a side show. Another aim of QE is to boost asset prices: nice for the rich and asset owners generally, but this again is not the same as directly putting purchasing power into the hands of the average consumer / citizen.

So which is the better policy: QE or extra net spending? Well the basic purpose of the economy is to produce what consumer / citizens want. Thus the better policy is net spending because this puts more purchasing power into consumer / citizens’ pockets.

Of course additional net spending can mean extra government spending AND/OR reduced taxation. And it is arguable that extra government spending does not equal putting additional purchasing power into consumer / citizens’ pockets. On the other hand, additional purchasing power IS put in their pockets in the sense that citizens vote at election time for government to act as citizens’ agent and do some spending on behalf of citizens: e.g. spend money on schools, the police and so on. So let’s just say the phrase “put purchasing power into consumer / citizens’ pockets” is being used in a broad or “dual” sense here.

To put the latter point another way, and summarise, the distinction being made here is between two policies. The first is to increase both traditional consumer spending (e.g. on cars, houses, etc) plus traditional government spending (e.g. schools, the police, etc). The second policy, that is QE, is to drop interest rates and boost asset prices.
At the time of writing, the weaknesses of putting much of the emphasis on QE have been layed bare: we have (at least in the U.S.) record low interest rates and a feeble recovery from the recession.

So my favoured policy in a recession is to have government do more net spending, and let the market determine the interest rate – or at least have “net spend” as the main anti recessionary tool, with interest rate adjustments being a minor and supplementary tool. That was more or less what Abba Lerner advocated, except that he though bureaucrates and politicians were someow good judges of the optimum the interest rate for the purposes of optimising the total amount of investment.

Keynes also advocated the above “extra net government spending” idea, but not in such a blatant or bold manner as Lerner.

Afterthought (18th Dec). To summarise, “the natural rate of interest is zero” is a bit of a non statement, for the following reasons. Given falling unemployment and no deliberate attempt by government to influence interest rates, full employment may be attained at least in some countries before interest rates reach zero. And if demand is then raised still further, inflation ensues. In this scenario the “zero interest rate” scenario is an irrelevance: it should be avoided.

So perhaps the above quote from Warren Mosler should be rephrased and toned down, and the phrases “natural rate” and “zero” should be avoided. The above quote reads “the “penalty” for deficit spending and not issuing securities is not . . . bounced government checks but a zero percent interbank rate…” . Instead, it should simply read, “the penalty of deficit spending and not issuing securities is not bounced government checks but a reduced interest rate”.


  1. " But the Japanese are ultra enthusiastic savers: they are willing to lend their government very large sums at zero or near zero rates of interest."

    Surely it's a function of the export oriented nature of the economy. The only people who have Yen are the Japanese. Therefore they are the only people who can appear to 'save' in it. Really it is just Japanese names on the remaining stock of currency reserves.

    Import oriented countries will have more foreign people with their name on the stock of currency reserves, simply by nature of the direction of trade.

  2. Neil, Good point. But I think over and above that, there is a sort of genetic or cultural desire amongst the Japanese to save more than others.

  3. Natural risk-less interest rate is zero. Nobody said anything about risky market rate.

  4. Ralph,

    Thanks for the link to B Mitchells older blog on this. From your first link above:

    "It makes much better sense not to offer a support rate at all. In that situation, net public spending will drive the overnight interest rate to zero because the interbank competition cannot eliminate the system-wide surplus (all their transactions net to zero – no net financial assets are destroyed).

    So in pursuit of the “natural” policy goal of full employment, fiscal policy will have the side effect of driving short-term interest rates to zero. It is in that sense that modern monetary theorists conclude that a zero rate is natural.

    If the central bank wants a positive short-term interest rate for whatever reason (we do advocate against that) – then it has to either offer a return on excess reserves or drain them via bond sales.

    Our preferred position is a natural rate of zero and no bond sales. Then allow fiscal policy to make all the adjustments. It is much cleaner that way."

    So I interpret that perhaps they are saying that the natural rate should be zero for the risk free rate on overnight reserves. As excess reserves would be needed for full employment nearly in all potential real-world scenarios....


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