A Unique Natural Rate Of Interest?

by
Robert Vienneau
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In explaining the policy implications of the Austrian Business Cycle Theory, Hayek argued that the central bank should try to keep the money rate of interest rate equal to the natural rate. Sraffa famously criticized Hayek by describing a model with multiple interest rates, not necessarily all equal. In reply, Hayek asserted that all the interest rates in Sraffa's example would be equilibrium rates. Sraffa had a rejoinder:

"The only meaning (if it be a meaning) I can attach to this is that his maxim of policy now requires that the money rate should be equal to all these divergent natural rates."

This interchange was part of the downfall of the Austrian theory of the business cycle. I thought I would try to shortly explain what is and is not compatible with a unique natural interest rate.

When one talks about the interest rate or the rate of profits, one may be abstracting from all sorts of complications. And these complications may be consistent with multiple interest rates, in some sense. Yet these multiple interest rates were not in dispute between Hayek and Sraffa.

Suppose at the start of the year, one can obtain a one-year loan of money for an interest rate of 10%. At the same time, one can obtain a two-year loan for 21%. Implicit in these different rates is a prediction that a one-year loan will be available at the start of next year for an unchanged interest rate of 10%. This implication follows from some trivial arithmetic:

1 + 21/100 = (1 + 10/100)(1 + 10/100)

The yield curve generalizes these observations. A certain shape, with the interest rate increasing for longer loans is consistent with the interest rate being expected to be unchanged, for loans of a standard length, over time.

One might also find interest rates being higher for loans deemed riskier, independently of the time period for which the loan is made. This variation is consistent talk of the interest rate. Often, in finance, one sees something called the risk-free rate of interest defined and used for discounting income streams. In practice, the rate on a United States T-bill is taken as the risk-free rate.

One can also distinguish between finance and business income. One might refer to the interest rate for the former, and the rate of profits for the latter. Kaldor and others, in a dispute over a Cambridge non-marginal theory of the distribution of income, have described a steady state in which the interest rate is lower than the rate of profits. Households lend out finance to businesses and obtain the interest rate. Such a steady state is compatible with the existence of two classes of households. Capitalist households receive income only from their ownership of firms.

Steady states are also compatible with the rate of profits varying among industries, as long as relative profit rates are stable. Perhaps some industries require work in more uncomfortable circumstances. Or perhaps firms are able to maintain barriers to entry.

I have shown above how money interest rates for loans of different lengths embody expectations of the future course of money interest rates. Interest rates need not be calculated in terms of money. They can be calculated for any numeraire. And the ratio of real interest rates embody expectations of how relative prices are expected to change.

• p_{W, t}: The spot price of a bushel wheat for immediate delivery.
• p_{S, t}: The spot price of a ton steel for immediate delivery.
• p_{W, t + 1}: The spot price of a bushel wheat for delivery at the end of a year.
• p_{S, t + 1}: The spot price of a ton steel for delivery at the end of a year.

The wheat-rate of interest is defined by:

(1 + r_W) = p_{W, t}/p_{W, t + 1}

I always like to check such equations by looking at dimensions. The units of the numerator on the right-hand side are dollars per spot bushels. The denominator is in terms of dollars per bushel a year hence. Dollars cancel out in taking the quotient. The wheat interest rate is quoted in terms of bushels a year hence per immediate bushels.

Suppose all real interest rates are equal. So one can form an equation like:

p_{W, t}/p_{W, t + 1} = p_{S, t}/p_{S, t + 1}

Or:

p_{W, t}/p_{S, t} = p_{W, t + 1}/p_{S, t + 1}

If spot prices a year hence were expected not to be in the ratio of current forward prices, one would expect to be able to make a pure economic profit by purchasing some goods now for future delivery. Hence, a no-arbitage condition allows one to calculated expected relative prices from quoted prices on complete spot and forward markets.

Anyways, a steady state requires constant ratios of spot prices and, thus, real interest rates to be independent of the numeraire. This is the condition Hayek imposed in his exposition of Austrian business cycle theory in Prices and Production. And this is the condition that he dropped in his argument with Sraffa, leaving his macroeconomics a confused mess.

I might as well note that a steady state is consistent with constant inflation. If all prices go up at, say, ten percent, relative spot prices do not vary. On the other hand, relative spot prices differ with the interest rate in comparisons across steady states.

Perhaps Hayek was willing to get himself into a muddle about the natural rate because he had already investigated another equilibrium concept in previous work.

Suppose above that real interest rates vary among commodities. Then forward prices show expected movements in spot prices. One might go further and assume a complete set of forward markets do not exist. Markets clear when each agent believes they can carry out their plans, consistent with their expectations, including of future spot prices. Should one call such market-clearing an equilbrium, even if agents plans and expectations are not mutually consistent.

Concepts of temporary, intertemporal, and sequential equilibrium were to become more important in mainstream economics after Hayek quit economics, more or less. John Hicks was a major developer of these ideas, under Hayek's influence at the London School of Economics. He eventually came to accept that the mainstream notions could not be set in historical time and were, at best, of limited help in understanding actual economies.

The above has outlined multiple ways in which multiple interest rates and multiple rates of profits are compatible with steady states. Nevertheless, such circumstances are often described by models in which one might talk about the rate of interest.

I have also described an equilibrium in which one cannot talk about the interest rate, whether natural or not. Advocates of Austrian business cycle theory have never clarified how it can be set in a temporary equilibrium. One can sometimes find Austrian fanboys asserting that critics do not appreciate distinctions between:

• Sources of exogenous shocks in central banks and supposed determinants (inter temporal preferences, technology) of the natural rate
• Money rates of interest and real rates
• Subjectivism and objectivism
• Interest rates and relative prices.

But assertions do not constitute an argument. One would have to do some work to show that these distinctions can serve to rehabilitate Austrian business cycle theory. No matter how much you send somebody chasing through the literature by Kirzner, Lachmann, Jesus Huerta de Solo, and Garrison, they will find the work has yet to be done. (Robert Murphy probably knows this.)

• Hahn, Frank. 1982. The neo-Ricardians. Cambridge Journal of Economics 6: 353-374.
• Hayek, F. A. 1932. Money and Capital: A Reply. Economic Journal 42: 237-249.
• Kaldor, Nicholas. 1966. Marginal Productivity and the Macro-Economic Theories of Distribution: Comment on Samuelson and Modigliani. Review of Economic Studies 33(4): 309-319.
• Sraffa, Piero. 1932. Dr. Hayek on Money and Capital. Economic Journal 42: 42-53.
• Sraffa, Piero. 1932. A Rejoinder. Economic Journal 42: 249-251.