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James Montier Rightly Dismisses the Natural Rate of Interest

Warning – This post is extremely nerdy and could result in extreme sleepiness.  Do not try to read this post while operating heavy machinery. The consumption of alcohol before, after or during a reading of this is not ill-advised. 

James Montier has an excellent new quarterly letter dismissing the idea of the Natural Rate of Interest. None of it will sound new to regular readers given that I’ve regularly expressed the same sentiments that James does. James and I are both market practitioners who tend to veer towards a Post-Keynesian view on economics so our views tend to overlap quite a bit.

James makes two big points in the new paper: 1) The idea of the Natural Rate of Interest is bunk; 2) Monetary Policy doesn’t matter. In my view, James is perhaps a bit too hard on monetary policy. After all, monetary policy works best when it’s basically fiscal policy. That is, from an accounting perspective, if the Central Bank were to actually spend dollars into the economy (let’s say, for instance, by purchasing worthless bags of dirt from consumers) then it would essentially be operating through a fiscal channel. The difference between the Treasury spending new T-Bonds into the economy and the Federal Reserve spending new cash into the economy is, from an accounting perspective, the same basic thing. It adds net financial assets to the private sector which adds to the financial net worth of the private sector. We can quibble over the differences in bonds and cash, but at the end of the day this is like arguing that there’s a great big difference between opening a checking account and a savings account.  So monetary policy can matter quite a bit, but James is right that monetary policy, as we currently know it, is not nearly as impactful as some people might think.

The first point is much more interesting in my view given that it’s the cornerstone of so much of New Keynesian thinking. New Keynesian thinking has really dominated so much of the crisis commentary with the never ending discussion about “liquidity traps” and the “zero lower bound”. The New Keynesian thinking exposes a few interesting things about the current mainstream econ dialogue:

  • New Keynesian economics is highly influenced by Wicksellian and Monetarist thinking which means that it’s actually not so much Keynesian as it is Monetarist.
  • This leads economists to focus first on Monetary Policy and only second on Fiscal Policy.
  • The crisis should have exposed the reality that Monetary Policy is far less impactful than most economists think, but instead has been described as some sort of temporary environment referred to as the “liquidity trap” even though JM Keynes, who coined the term, would have never called this a liquidity trap.

If you’re not familiar with this debate then it’s really quite simple. In essence, economists argue that there’s a “natural” rate of interest, or the price of money, at which the market will always clear. If nominal interest rates are at 0% and there’s still substantial slack in the economy then we’ve hit a nominal lower bound which means that REAL interest rates must be much lower in order for the market to clear. This is important from a policy perspective because it just means that the Central Bank needs to reduce the real interest rate by adjusting market expectations. So, in the economist’s model you don’t need fiscal policy. You just need the Fed to implement some alternative policy like QE or something else that will get the real rate that much lower. If all else fails then maybe we try some fiscal policy in addition. But the problem with this model is, as James notes, that the natural rate idea is purely theoretical. There is no actual evidence showing that there’s a “natural” rate at which the economy will actually achieve some magical equilibrium. And yet the policy discussion is driven almost entirely by this theoretical narrative.

Paul Krugman, predictably, doesn’t like the Montier post. But his response doesn’t say anything meaningful at all. Which is unfortunate because I think the economy could be operating at a much higher level if we had more REAL Keynesian economists who were willing to throw out these pseudo Monetarist models and emphasize the fact that the Fed isn’t just weak in this environment, but is probably a lot less impactful even in “normal” times than we tend to think. Instead, we have models constructed by pseudo Monetarists and so the debate always starts and ends with the influence of the Fed. And thanks to these pie in the sky models the economy is operating at a historically weak level when there are very real things we can and should be doing to get things going.