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Wednesday, April 17, 2019

Natural Rate Versus Neutral Rate: Austrian Perspective

The terms natural rate of interest and neutral rate of interest are often used interchangeably. In this article, I comment on how Richard W. Garrison distinguishes the terms, and how this fits in with the Austrian Business Cycle Theory (ABCT).

(This article is brief, and I expect to work parts of it into an overview of Austrian Business Cycle Theory that I will put into my book on recession analysis. I will mainly comment on the discussion of interest rates here, and turn to the question of the ABCT in a later article.)

Introduction

If one follows financial market commentary, one will note that there is a large population of Austrian economists -- more than their current influence in academia would suggest. (Note that the term Austrian comes from the fact the founders of the school were mainly of Austrian origin.) One issue with "popular Austrian" thinking is that the theoretical origins of their arguments is somewhat vague (which tends to be true for all market commentary).

In particular, one often runs into the concept of "free market interest rates," in Austrian commentary. For rates market participants, that is a puzzling concept: isn't determining interest rates in a market what they are doing all day? For this concept to make sense, we need to understand the Austrian notion of the natural interest rate, and the related notion of a neutral interest rate.

As a disclaimer, I am not sympathetic to Austrian policy proposals, nor a great fan of the theory. Although I read a great deal of market commentary written by Austrians, I am not an expert on the divisions of the schools of thought within the academic theory. For this article, I am relying on the article "Natural and Neutral Rates of Interest in Theory and Policy Formulation" by Richard W. Garrison.* This article matches my other readings of Austrian theory, but I would note that there are some technical differences between different camps that I am not attempting to discuss.

The Natural Rate

The starting point for Austrians is the natural rate of interest. Garrison defines it as:
In the hands of the Austrian economists, the natural rate became the rate that reflects the time preferences of market participants and allocates resources among the temporally defined stages of production. The output of one stage serves as input to the next in this logical and broadly descriptive representation of the economy’s production process. The temporal dimension of the economy’s capital structure is a key macroeconomic variable in Austrian theory. 
There is a fair amount of information that is perhaps not obvious to those who are unfamiliar with Austrian economics. Garrison discusses some of the theoretical concepts, but I will offer a summary here.

The first point to note is that the original Austrian economists were highly skeptical about the initial attempts to formalise national accounts and macro models based on those accounts. The argument is that capital is heterogeneous, and thus cannot be aggregated. Although I am also skeptical about formal models in macroeconomics, I believe that formal concepts are useful for setting out definitions, which matters in the current context.

The next point is that Austrians generally have an aversion to fractional reserve banking and anything other than 100% gold-backed money. If we transitioned to a 100% gold-backed currency, the argument is that the Federal Reserve and fractional reserve banks will not have any special powers to set interest rates, rather the holders of gold (and direct claims on gold) will be the ones setting interest rates. It should be noted that neither concept appears in the Garrison article, instead he follows the conventional line that the Federal Reserve sets the policy rate.

The possibility of commodity money brings up a theoretical quagmire -- should not each commodity have its own interest rate? This is a discussion that received a great deal of attention from Austrian and post-Keynesian economists, but given the possibility of industrial capitalism moving to 100% commodity money is so remote, I will not pursue the topic.

We now return to Garrison's arguments. He notes the "temporally defined stages of production," which is a theoretical hallmark of Austrian economics. Instead of using the time preferences of consumption as a starting point (as in the Ramsey model), the focus is on entrepreneurs. Arguing from first principles about human actions, the argument is that one can either consume now, or engage in activities that allows greater consumption in the future (e.g., building up capital). If one lengthens one's time preferences, one can use more and more complex modes of production (Garrison uses "stages," "layers" is another term.) This is related to the rate of interest, as it is the relative cost of money (or a commodity) now versus the future. As such, interest rates are meant to provide a signal to entrepreneurs as to how "roundabout" a production process is acceptable.

We could view the natural rate as being the rate of interest that brings the economy to "equilibrium." That concept is controversial, but Garrison side-steps the controversy by presenting it in terms of sustainability.
In short the natural rate of interest is the rate that avoids booms and busts. With given resources and technology, it is the rate that keeps the economy on a sustainable growth path. With increased resources or enhanced technology, it is the rate that governs the adjustment to the new growth path.

Neutral Rate of Interest

Garrison argues that the neutral rate of interest is the preoccupation of mainstream economists since the era of the Monetarist reaction to Keynes. It is the level of interest rates that leads to inflation stability. He defines it as follows (note that I have replaced symbols with text).
Like the natural rate identified by Wicksell and adopted by the Austrian economists, the neutral rate can be described with the aid of a production possibilities frontier depicting combinations of consumption and investment. The dominating concern, in the case of the neutral rate, is not with movements along the frontier or with adjustments from one frontier to another. Rather, the concern is with actually staying on a given frontier. The concern is with Q [the quantity of real production] and not with its division between [consumption goods] and [investment goods]. The economy may lapse into recession or depression, coming to rest in the frontier’s interior area. Or it may send itself into an inflationary spiral, with (nominal) movements in spending beyond the frontier. An economy prone to such inward and outward spiraling exhibits movements roughly orthogonal to the frontier. The objective of Federal Reserve policy is to undo any perverse movements away from the frontier and then, by maintaining a neutral federal funds rate, to hold in check any further such movements.
In other words, the objective of policy is to stabilise the inflation rate, not keep in check an investment boom. This is related to the often-heard complaint that "inflation is showing up in asset prices" in financial market commentary.

As Garrison notes, the neutral rate and the natural rate are likely different.
Is there any known market mechanism that causes the neutral rate to be brought into line with the natural rate? That is, is there any reason to believe that equi-worry about inflation and unemployment somehow translates into interest rates that are consistent with sustainable growth? [...]
The evidence is that the neutral rate not likely to be the natural rate, and hence the equi-worry rate itself is something to worry about. Even when financial markets are expecting neither a rate hike nor a rate cut, the economy may be growing at an unsustainable rate. There is no timely way to distinguish between robust growth and financial bubbles.

Critiques of Definitions

From a fixed income perspective, referring to "the" interest rate is problematic. Although the central bank pins down the overnight rate, interest rates form a continuum of maturities as well as quality levels. The Federal Reserve long ago gave up on setting the level of long-term risk-free rates, and its ability to influence credit spreads is limited. (The closest it came to this was during the interventions into risky credit markets during the Financial Crisis, and the purchase of mortgage-backed securities during the Quantitative Easing episodes.) This complicates matters greatly: investment booms are often associated with market participants shrinking credit spreads -- counter-acting rises in the policy rate. As such, any statements about a "natural/neutral interest rate" should actually refer to a curve. However, if we assume a steady state, the curve ought to be relatively flat and credit spreads fairly steady, so this may just be an issue for terminology.

More substantively, one of the initial issues with the Austrian notion of "stages of production" is that it is nearly impossible to operationally define this in terms of observed behaviour in industrial capitalism. Project managers will not evaluate an investment on how "roundabout" it is, rather whether it will meet a target rate of return. Although the rate of interest influences the target rate of return (perhaps more through the financing cost calculation), the investment decision is far more sensitive to the expected cash flows from the asset. Those expected cash flows depend on the knowledge of existing capacity utilisation, as well as beliefs about market share and overall growth. Commodity production is hardly the dominant form of industry in 2019; firms aim to produce differentiated goods and services, and they need to evaluate the prospects of success of their particular output.

Furthermore, given the dominance of housing finance in post-1990 cycles, the concept is hard to fit to reality. Housing represents a significant portion of modern household expenses, and is heavily debt-financed. Since the housing unit is the final good that is "consumed" (slowly), there is no real notion of "roundabout production."

The difficulty in coming up with an operational definition of the stages of production means that market commentators fall back on a vague notion of malinvestment. However, one will not find "malinvestment" showing up as a category in the national accounts, and so it ends up in practice being whatever investment that commentator feels will be non-economic. However, the only way to determine whether an investment is truly non-viable is to wait years to see whether it pays off.

The next problem is that the vagueness of "economic boom" makes the determination of the natural rate even more difficult than the neutral rate -- which at least can be inferred via comparisons to observed inflation. Garrison argues as follows.
The Austrian theory does not offer some Hayek Rule for a natural rate to be recommended over a Taylor Rule for a neutral rate. Rather, it suggests that centralizing the business of banking deprives the market of its ability to find the natural rate.
Since there are no plausible proposals for eliminating "centralizing the business of banking," this does not add a lot of value. Since there is no way of determining the natural rate, the theory is non-falsifiable. My view is that this usefulness is from the perspective of political economy: it provides a way for Austrians to blame busts on the central bank, and not errors by private sector actors.

Questioning the Separation of the Natural and Neutral Rate

Although one could argue that central banks are concerned about inflation, the belief that this ignores booms is debatable. Rate setting policy is not based solely on the current level of inflation, but also with an eye towards the sustainability of growth. If there is a fixed investment boom, the policy rate will normally be raised by both the central bank, and bond market participants will raise term interest rates.

If the economy did have a tendency to equilibrium, then it is unclear why the neutral rate would be different from the natural rate. In an equilibrium situation, inflation would presumably be stable. If stable inflation does not coincide with sustainable growth conditions (which has been the case in the post-1990 period), it calls into question the entire premise that an equilibrium exists. And if there is no equilibrium, it is unclear whether the definition of the natural rate makes sense.

Post-Keynesian Critiques

The assumption that interest rates equilibrate supply and demand of funds may be questioned.  As the Kalecki Profit Equation shows, fixed investment in aggregate is self-financing. If we are looking at floating currency sovereigns, there is no notion of a finite amount of loanable funds; interest rates are ultimately based on the risk-free rate and credit risk. Investment booms can reduce borrowing rates by narrowing credit spreads as a result of greater profit expectations.

Finally, the most important set of critiques are the post-Keynesian (particularly Modern Monetary Theory) critiques of interest rate policy. There is no reason to believe that there is a unique neutral rate of interest (never mind natural rate). The effects of interest rate policy are mixed, since interest payments from the government are a source of income.

Concluding Remarks

The Austrian argument that inflation targeting is unsatisfactory because there can be unsustainable investment processes is hard to argue against. However, in the absence of a method to calculate the natural rate, it is unclear how much guidance the concept provides.

(I would like to thank Neil Smith for providing the link to Richard Garrison's website.)

Footnote:

* "Natural and Neutral Rates of Interest in Theory and Policy Formulation," by Richard W. Garrison, Quarterly Journal of Austrian Economics, Winter 2006. URL: http://webhome.auburn.edu/~garriro/natneut.pdf


(c) Brian Romanchuk 2019

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