I think they miss something...

Browsing the Billy Blog, a title catches my eye: The natural rate of interest is zero! But reading it, as often happens, I am distracted long before I get to Billy's main point.

Billy writes of the "rather insidious notion that mainstream economists continually refer to which is termed the 'neutral rate of interest'". Not being familiar with this technical term -- Oh, I've heard of it, but I don't remember the definition -- it catches my interest. Billy quotes from the Melbourne Age:

It’s generally considered that a cash rate around 5 per cent is now neutral for the Australian economy – that is, it neither stimulates the economy nor holds it back... A cash rate at 3 per cent then is highly stimulatory.

Right away I'm off on a tangent. Let's consider the idea: An interest rate of 5%, say, that neither stimulates nor holds back the economy.

What's missing from the picture? It's obvious to me. Consider two Australias, identical in every way but one. In the first, ten percent of all spending requires the use of credit at that 5% interest rate. In the second Australia, 90% of all spending requires the use of credit, at the same interest rate.

In the one Australia, the reliance on credit is low; in the other it is high.

In the one Australia, the total cost of interest is low, relative to total spending; in the other it is high.

In the one Australia, the total cost of interest is low, relative to wages and profits and rent; in the other it is high.

In the one Australia, the cost of interest does not significantly affect prices; in the other, it does.

In the one Australia, there is no monetary imbalance; in the other, there is.

Five percent may be the "neutral" rate of interest^[1] , but the effect on the economy of that or any other interest rate will depend heavily upon the level of the reliance on credit. Will Billy point this out?


In the same post, Bilbo Billy quotes Knut Wicksell:

There is a certain rate of interest on loans which is neutral in respect to commodity prices, and tend neither to raise nor to lower them.

I have the same objection again. As long as the reliance on credit remains low in the economy, the cost of interest remains a small part of total cost, and competes neither with wages nor profits. But should the reliance on credit become excessively high, the cost of interest becomes a significant part of total cost, and necessarily reduces both profits and wages.

The cost of interest, in our time, and since the time of President Nixon at least, has been the primary cost-push force in our economy: squeezing profits, undermining growth, and driving prices upward. Even at low interest rates, an excessive reliance on credit will have results that look like stagflation: Not only is it not "neutral" in respect to prices, but also negative in respect to growth. Billy does not point this out.


Again in the same post, Billy quotes Federal Reserve Chairman Alan Greenspan speaking to Congress in 1993:

In assessing real rates, the central issue is their relationship to an equilibrium interest rate, specifically the real rate level that, if maintained, would keep the economy at its production potential over time.

Greenspan's "equilibrium" rate here is the same as Wicksell's "neutral" rate of interest. Greenspan, like the others quoted above, keeps two eyes on the rate of interest and no eye on the level of the reliance on credit in the economy. So there is some risk that the reliance on credit could, accidentally perhaps, rise too high.

Or if the Federal Reserve overlooks the significance of the reliance on credit, it might drive reliance to too high a level on purpose, without understanding the trouble that would arise as a result of this change.

And if they combined this naivete with

1. the mistaken notion that "too much money" can cause inflation but "too much credit-use" cannot; and

2. incomplete, open-ended rules based on a flawed understanding of the economy,

there is every chance that even a carefully-engineered, Taylor-made interest rate would lead us straight to financial disaster.

Billy does not point this out.



NOTES:

1. My bet is that the neutral rate of interest (assuming there is such a thing) will tend to vary over the course of the Cycle of Civilization. And as Sidney Homer has shown, the pattern of variation will tend to be the same for different civilizations. [Return]