Thursday, April 19, 2012

Natural rate brain twisters

Mike Sankowski has a good primer over at MMR on the fallacies about the 'natural rate'. His main points:
  1. The NRoI doesn’t exist
  2. If the NRoI does exist, it’s not stable
  3. Then, even if it does exist and is stable, it’s power is so weak it’s not useful to consider it in policy.
  4. Then, even if it does have a powerful impact on our economy, we have such a problem measuring it and observing it and knowing it in real time, we shouldn’t consider using it as any sort of guide for policy.
  5. Then, even if we can observe and measure it and consider using it as a policy guide, the NRoI is focusing on the wrong goal and should not be used as a policy guide
I'll just add that it boggles me how economists purport to be able to calculate the ‘natural rate’ or the ‘equilibrium rate of interest’ in the ‘absence of the capital markets’. Since everything is linked to the capital market, how are they able to compute for the natural rate without it, and how do they at all know it is the ‘equilibrium’? Furthermore, what is the conceptual significance of a rate of interest in the absence of a capital market? 

The natural rate means something different for everyone, even for economists, so there can never be one objective measure for it. Personally, I have my own personal ‘natural rate of interest’, but that is personal to me. I’m sure the ‘natural’ rate would be different for you, and different for the next person. Furthermore, the ‘natural’ rate would be different for me tomorrow, and different again next week. It depends on a lot of personal factors that affect how I value whether or not to take out that next loan or make the next investment. Kind of like the risk premium, it’s going to be a different value for everyone, and its value would change as their personal circumstances change. 

There’s no economy-wide risk premium, and there’s no economy-wide natural rate.  Averaging out everyone’s natural rates to get at one overall natural rate to target still ends up with people with higher than average personal natural rates who still end up misallocating funds (and ending up affecting everybody else’s natural rate). I tend to equate the natural rate with risk premium. Having said that, even economists who argue about the merits of calculating a natural rate will calculate the risk premium as exogenous to the interest rate set by the central bank. So how can something calculated exogenously to the natural rate also be endogenous to it?

Are you still with me? Maybe not. That's how convoluted it gets when you start thinking of an economy's so-called natural rate. Mike is right - to calculate it is to focus on the wrong goal and it should not be used as a policy guide.


Michael Sankowski said...

I have to add this critique in there. I think it would be shoved between 2 and 3, because this isn't exactly the same as what I was saying.

I was saying there wasn't one rate. I think you are saying, if there is one rate, then it causes huge distortions because everyone has their own personal natural rate and well, that means some people are foolishly investing and others are foolishly not investing.

ha! :) I'll do an update!

Rogue Economist said...

Mike, Krugman today adds Wicksell's definition, which might add even more layers of issues to your natural rate project - "Roughly, the natural rate of interest is the rate that would lead to stable inflation at more or less full employment."

Does this mean the natural rate can only calculated at full employment?
And what does it mean to have stable inflation at full employment? To have an economy that doesn't grow anymore? No more business cycles? No more new business creation or destruction?

With the natural rate, any definition just brings forth more questions.