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Natural Nonsense – Why The Natural Rate of Interest is a Distraction

The “natural rate of interest” is a theoretical concept in economics that describes the interest rate at which the economy operates at full employment with stable inflation. If this price actually exists and economists can calculate it then that would be a pretty important number to know when implementing policy.  Of course, it’s a totally vague concept to begin with because there isn’t just one interest rate in the economy and we can’t even reliably calculate what the natural rate of interest would be.

There’s been a lot of chatter about this in recent days. Tyler Cowen is thinking out loud about it.  Brad Delong is thinking out loud about it. And Paul Krugman seems a little annoyed about it.  But I don’t even know why we’re having this discussion.  Don’t we already know that we don’t know what that price is and that monetary policy isn’t going to get us there any time soon?  How long does the economy have to flail for us to realize this?  Here’s my broader view:

  • Despite being largely theoretical this idea of a natural rate is central to mainstream economic models.  Paul Krugman’s model of the economy over the last 7  years has been largely based on this idea that the natural rate is too low.  The whole idea of a “liquidity trap” is central to this idea.  It’s the idea that we’re trapped with a low natural rate and we can’t stimulate the economy because overnight interest rates have been pushed to 0%.
  • Frankly, I don’t care that much about the theory here.  I personally don’t find much value in the idea of a natural rate of interest and I agree with Roger Farmer’s thinking that the economy actually operates in multiple inefficient equilibria and this means there isn’t some single “price” that will get us to optimal employment. So, we should spend a lot less time focusing on monetary policy and interest rate changes than we do.
  • Unfortunately, what we’re seeing in mainstream economics is just more of the same old Monetarist styled thinking though. Instead of focusing on interest rates we’re now focused on things like QE and other policies that Central Banks can implement to get the economy going again.  And because of this we’ve paid far less attention to fiscal policy than we should be.  In other words, our poor economic policy outcomes can be largely blamed on our poor economic discourse which has focused excessively on Central Banks and their powers.
  • If there’s one thing we should have all learned by now it’s that low interest rates aren’t nearly as stimulative as we used to think.  And that’s not a post-crisis phenomenon.  Alan Greenspan dealt with this “conundrum” for much of his career before there was ever a mythical “liquidity trap”.  But what’s worse is that we’ve pivoted from focusing on interest rate changes to other policies like QE which now look equally ineffective.  So, when will the discourse change from spending so much wasted time on monetary policy to fiscal policy?  Or are we just destined to see our economic policies forever be a function of our failed theoretical economic ideas?

Seems to me like a lot of wasted breath and economic output thanks to theoretical ideas that have been tested in reality for 7 years and have already failed.