Saturday, 10 August 2013

What Natural Interest Rate?

Most of the times, the articles that inspire me to write leave a positive impression on me. Other times, I just feel that a subject needs to be clarified or that an issue has not been addressed properly. There times though, like this one, where articles I read do not seem to understand that the issues they address are so theoretical and so convoluted that they have very little use (if any) to either consumers or firms. Although I like theory and believe that especially in macroeconomics many more (useful) conclusions may be reached from theory than empirical work (although not dismissing the latter), I share a strong resentment towards theory which cannot really focus on reality and presents the world on how it could potentially be or how its author believes it should be. Without further ado will let you know that the article which sparked this response is Miles Kimball's Natural Interest Rates: Clearing Away the Confusion

Perhaps, in some way, Kimball has cleared away the confusion on what he feels is the natural rate of interest. Although he mentions that low output levels lower the short-run interest rate (which is true) and the deeper the recession the lower interest rates should be to counter it (which is partially true), it appears that Monetarism got the best of him. Nobody would argue that interest rates play an important role in recessions, yet they are not a panacea: they can be employed to assist but they cannot do all the work on their own. For example, he states that monetary policy supposedly determines the equilibrium interest rates in the market. Yet, this not only does not really hold as Central Banks are most of the times retroactive in their responses; it is not until commercial bank rates rise that Central Banks raise theirs, meaning that unless we are to employ the previous period's policy rates in our calculations, we wouldn't factor the effect of monetary policy in estimating the short-run interest rate.

In addition, what is my greatest disagreement with not only Kimball but many economists is what is presented as the "natural" interest rate. This, is nothing but a number which might (or might not since we cannot see it) be true if we had no wage stickiness, price-stickiness or, in general, if them people (and yes I do mean all of us) did not distort the idea world economists are trying to build. (Ironically, economists do not act like the ideal people of the ideal world...)

The essence of the disagreement is that he believes (as many other economists do to be fair) that we could have both a medium-run and a short-run interest rate. What most economists fail to see is that we cannot distinguish one from the other even if they exist. In fact, they are so convoluted that we can only see the result of this interaction, without being able to see the original inputs. According to his definitions, we have an ultra short run, a short run and a medium run which would appear like this:
(Click to Enlarge)
As anyone may observe, in the medium run we would be experiencing the results of 4 distinct short run periods and 16 (!) ultra short run periods. This means that when we are about to measure the medium-run interest rate of an economy we have to take into account the short run as well, as it defines it. Suppose that we were at #1 and now we are almost at #16. According to the calculations made at #1, we would be witnessing the results of the medium-run interest rate which, according those calculations would be, say 2%. Now suppose that a recession or a boom occurs at #15, meaning that the interest rate would either be at 1% or at 3%. These effects are not due to neither fiscal policy nor technology shocks which Kimball understands as affecting the rate. They are, in fact, outcomes of the whole business cycle, models which lie behind the sticky-price, sticky-wage models.

The claim is that this medium-run "natural" interest rate is not a constant. If it was, then debunking their thinking would be too easy. Nevertheless, even saying that the medium run interest rate is not a constant actually indicates that we have some knowledge about what it would look like and we can re-calculate it with every new piece of information we get.

The reader may inquire why I am bothered with this. Yes, the medium-run interest rate is never what we calculate it to be, not just because of stickiness but because such a medium run does not exist. Still, this is just the tip of the iceberg. Kimball's argument is that investment, as he understands it, occurs when the benefit relative to amount spent is more than the real interest rate plus the depreciation rate and the obsolescence rate. What Kimball is trying to say (I think) is that basically the return on the investment made should be higher than the cost. Yet, this does not really depend on just the real rate, or to be specific the firm does not really care about the real rate. It does care about its return though. As long as the estimated return from the project is higher than the estimated rate it has to pay then the project is valuable. The firm cannot really know about the interest rate, more so about inflation, even at the Ultra Short-Run. It can only estimate them. Now, these estimates may actually affect both the rate as well as inflation, yet they are neither constant nor precise. They are mere estimates, which, considering Kimball's arguments should affect the medium run. Yet, there can be no medium-run estimate and neither can there be a long-run one. The reason is that they both require the economy to remain stable and stability is something the economy has never done.

It's not just that the economy needs to be stable to have the medium-run interest rate come out like we estimate it. It's that we have to magically transport ourselves from 2013 to 2025, with the state of the economy being exactly as it were 12 years ago, the same short run interest rate and have the exact same conditions. But... oh wait, if we had that, then we wouldn't experience the medium-run interest rate but the short-run one. This, makes the medium run a state which we cannot ever experience, even in theory.

Another issue with regards to the interest rate ups and downs is why the interest rate is lower in recessions and higher in booms. The reason that rates are lower in recessions is not because the real rate is not high enough or that depreciation rates are higher than in other periods (in fact depreciation should be the same in recessions and in booms). The reason is that the expected return in a recession is lower than the one in a boom. These are based on scenarios given the state of the economy at the time. When a wide enough problem has occurred in the economy which keeps demand down, it makes sense to lower estimates about perspective demand (whether firms are correct in estimating that is another question which is beyond the scope of this article). This means that the expected return of the project will be lower. Thus, the firms will say no to high interest rates and will continue to say no until these rates are lowered. The same logic can also be applied to consumers. If rates remain high because of Central Bank inaction, it could seriously harm investment expenditure in the country (or region).

Obviously corporate finance experts take the possible duration of a recession into consideration when they make their scenarios, but as usual when times are bad, people tend to err to the side of caution. In Kimball's words, the firms choose whether to "rent" capital (i.e. rent buildings, etc) and treats buying capital distinctly (separating it into two companies). Yet, renting capital would be the same as buying it if one considers that buying the capital means that they have to pay a depreciation expense which those who rent it do not incur. This is not really mentioned in the article, and at a point I just get the feeling that we employ perplexity for the sake of perplexity.

In addition, he mentions that people who work in corporate finance are more eager to buy when business is good than when business is bad. In all fairness, this all depends on how good or how bad things are. If sales are down 5% because of a recession, then we would be more willing to buy capital at a cheaper price than when sales are up 5% because of a boom and capital costs more. More so, he mentions that since capital does not change fast increases in wages and total worker hours push the rental rate up. This is true but it's not the whole story: the rate does go up but it is only because demand has already gone up and the firm is better off producing more than it did. Why? Well because the firm, seeing its products have more demand wishes to produce more in order to have more profits. Yet, this means that their estimates concerning new projects has been re-evaluated upwards, making them more eager to get money at just a bit higher rates than the current ones.

Thus, the workers who actually see this from the inside and understand that since their firm is expanding, money is more plentiful now and the outlook is going to be better in the future (in addition to seeing their employers earn much more than before) they demand higher nominal wages. This, in addition to the already higher demand, makes the interest rate rise. Now, from what we have already learned, this means that demand will be further encouraged with rates increasing even further.

Yet, in this analysis we have left out the role of the banks: when banks have more liquidity that they want, they are more willing to give out that money as loans. Thus, even though the demand for funds is increased during booms which makes the interest rate rise, the bank's willingness to supply funds is also increased (this means lowering the interest rates). The first is much more powerful than the latter though, for the simple reason that those who want to get money are usually more than the amount of money the bank is willing to lend, thus, the interest rate does not skyrocket unless in extreme situations (too much inflation for example). Another reason the rate does not skyrocket is that investment projects do not really skyrocket themselves. Although firms would have enjoyed it, they cannot earn a 35% annual return on a project (unless in very extreme and unsustainable cases) putting an upper limit to the rates; no firm would borrow at 15% when the most it can make is 12%.

Concluding, the main topic to be extracted from the article is that the defining powers of interest rates are firms, consumers and banks. The lower limit in a recession is imposed by the Central Bank (in the sense that it will not allow for the rate to fall below some point, i.e. not become negative) and in booms by the expected return on investments. There is no such thing as a "natural" rate of interest since it would necessarily mean that there are "unnatural" ones. There is only the prevailing interest rate of the economy. In addition, there is no "medium-run" interest rate, nor is there any way of actually experiencing such a rate; even if we lived in an ideal world filled with "homo economicuses".

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