Home > Uncategorized > The unnatural rate of interest (ultra-wonkish)

The unnatural rate of interest (ultra-wonkish)

from Steve Keen

Paul Krugman’s latest column—“Check Out Our Low, Low (Natural) Rates” (which he didn’t flag as “Wonkish”, even though it is so in spades)—noted that the “natural real rate of interest” was falling, and that this justified the low interest rate set by the Federal Reserve.

And this made me think about Karl Marx.

Why? Because the “natural real rate of interest” is an unobservable entity—in that it’s not a rate you’ll find charged by any bank, but a rate that has to be statistically derived. But more importantly, it is a fantasy: there is no such thing. However it is required as part of a theory in which the economy returns to equilibrium after it is hit by an “exogenous shock”. So Neoclassical economists—meaning both “New Classicals” and “New Keynesians”, as the two fractious clans in this economic tribe call themselves—have to go in search of this phantom.

Marx had an equally important unobservable fantasy at the heart of his attempt to produce a mathematical version of his own economics: the “Labor Theory of Value”. This is the proposition that all value—and hence all profit—emanates solely from labor. Machinery, Marx asserted, simply passed on the value that had been transferred to it by the labor expended in making it.

It is mathematically impossible to reconcile this proposition with the Marxist belief that profit rates in different industries converge (for competitive reasons), when you acknowledge that different industries have different ratios of capital to labor. But Marxist economists have tied themselves up in logical (and illogical) knots over this fantasy for well over a century.

However Marxists have something over Neoclassicals in this regard: at least they’re aware that there is an issue. Even though they continue to cling to this belief, they don’t shy away from acknowledging the conundrum. Neoclassicals, on the other hand, don’t even realize that they might have a problem.

Some Marxists attempted to circumvent their conundrum on statistical grounds, while making the dubious assumption that the actual wage corresponded to an important concept in Marxian economics, the “value of labor power” (which strictly speaking is a subsistence wage). The great British scholar Ronald Meek rightly derided this fudge, stating that he was “unconvinced by … redefining `the value of labour-power’ so that it becomes equivalent … to any wage which the workers happen to be getting” (Meek 1956).

The real problem for Marxists was that their model of how the economy operated was simply wrong (and as I argued in my first economic papers [1,2],it also contradicted Marx’s own philosophy—but that’s another topic). Statistical work on this chimera wasn’t going to rescue them from that problem.

This is what led my mind to wander from Krugman to Marx. The statistical work Krugman reports on, about calculating the “natural real rate of interest”, is as futile as Marxist searches for their chimeras. An accurate measurement of a fantastical quantity won’t rescue a theory based on fantasies.

So back to Krugman, the Neoclassicals, and the fantasy of a “natural real rate of interest”. This is the notion that there is some rate of interest which will result in full employment. Bernanke, whom Krugman links in this article, calls it the “equilibrium interest rate”, and defines it this way:

The equilibrium interest rate is the real interest rate consistent with full employment of labor and capital resources, perhaps after some period of adjustment. (Bernanke 2015)

This portrays the interest rate as the key variable that regulates the economy: get this one right, and the economy will be blissful. This is wrong on many grounds, but the key one is that it is bundled with the belief that, while the price of debt is crucial to macroeconomics, the quantity of debt is irrelevant.

Both Krugman and Bernanke have made this false assertion on many occasions, with my favourite being when Bernanke—who is supposed to be the expert on the Great Depression—dismissed the explanation of the Great Depression developed by Irving Fisher.

The level of debt, and the fact that it was above its equilibrium value, played a crucial role in Fisher’s theory, which he dubbed “The Debt-Deflation Theory of Great Depressions”. Bernanke dismissed this with the assertion that “debt-deflation represented no more than a re­distribution from one group (debtors) to another (creditors)”, and that “Absent implau­sibly large differences in marginal spending propensities among the groups, it was suggested, pure redistributions should have no significant macro­economic effects.” (Bernanke 2000)

I won’t go into a detailed theoretical argument about why this is wrong here (I’m doing that in an academic paper coming out soon). I’ll simply point out that if this proposition was true, then I wouldn’t be able to find correlations like those between the change in private debt and the level of unemployment shown in Figure 1. The correlation of the change in private debt in the USA with the level of unemployment is minus 0.92. Not only is the magnitude of this correlation gob-smackingly high (for economic data), it is also substantially larger than the correlation of the real rate of interest with the unemployment rate (minus 0.57—see Figure 2), and the correlation of the debt servicing burden with unemployment (minus 0.53—see Figure 3)

Figure 1: Correlation coefficient for change in private debt and unemployment from 1990 till 2015 is -0.92

image002Figure 2: Correlation coefficient for the real interest rate and unemployment from 1990 till 2013 is -0.57

image004Figure 3: Correlation coefficient for the real interest rate and unemployment from 1990 till 2013 is -0.53


So the evidence is overwhelming, not only that changes in private debt have very significant macro­economic effects, but also that the importance of this factor on its own is substantially greater than either the rate of interest, or the level of debt service (the product of the two).

This alone is sufficient to reject the Neoclassical belief that the rate of interest is the significant regulating variable in the economy. The level of private debt is more important, and arguably its explosion since the mid-1990s (on top of a rising trend) is the reason that interest rates tended to fall prior to the crisis—so rising private debt could be a reason for the fall in the “natural real rate of interest”.

Figure 4: The debt level, ignored by the mainstream, matters more than the rate if interest


Why have interest rates remained low since? Because the reason economic growth is so anaemic (for what is supposed to be a recovery) is that high debt levels means reduced willingness to take on new debt, and hence a suppressed level of credit-driven demand. Even though credit growth is positive again—after being negative between 2009 and 2012—it is still a smaller percentage of GDP than at any time since 1994 (see Figure 1 again).

It’s unlikely to get much higher than that, if the experience of Japan is anything to go by. Just as with the USA and the 2008 crisis, Japan’s crisis in 1990 began with a sudden slowdown in the rate of growth of private debt—see Figure 5. Since then, credit growth has been only sporadically positive.

Figure 5: Correlation coefficient for change in private debt and unemployment in Japan from 1970 till 2015 is -0.91


America’s future won’t necessarily be as bleak as Japan’s past has been. Japan’s peak private debt level was 225% of GDP, versus 170% for the USA, and even after 25 years of deleveraging, it’s still 170%, versus 145% for the USA today. This might explain why credit growth in Japan has been so poor—never exceeding 3% of GDP since 1996—whereas the USA’s has reached 6% of GDP during this recovery (see Figure 1). But the odds of sustained credit growth from now on are very low. The positive from this is there won’t be another US bust like 2008—because that requires a high rate of growth of credit to give way to a fall in credit. But the odds of sustained stagnation are very high.

Unfortunately, the odds that mainstream economics will wake up to its errors about the role of credit in economic performance are extremely low. We’re 8 years on from the beginning of the existential crisis of 2008, and even today they refuse to consider the possibility that their model of the economy—which was completely blindsided by the crisis—might be wrong.

This wouldn’t matter if we were just talking about obscure academic scribblers—or even prominent newspaper columnists. But we’re also talking about the people who make the decisions about what to do about the still lethargic state of the economy. We will continue to sit in becalmed economic waters if they continue looking for phantoms like the “natural real rate of interest”, rather than focusing upon the real cause of our economic malaise, excessive private debt.


  1. October 29, 2015 at 3:55 pm

    “Why? Because the “natural real rate of interest” is an unobservable entity”

    It is funny. Someone who read capital informed me that Marx felt that capital would have marginal utility trending to zero, which would cause problems. Looking on line, people are claiming the opposite – that capital contains the seeds of its own destruction because the labor going into capital would increase and the value of raw labor absent assistance from capital would be marginalized.

    Which is it? Based on the Capital presentation I saw, Marx seemed to be making an argument that corresponds to the modern argument that as inequality increases, interest rates go to zero. It was not exactly clear which bad things he would have been saying would happen when you hit zero.

    It almost makes one desperate enough to go back and read the original work…

    • October 29, 2015 at 4:43 pm

      I hope jeff1089 does go back and read Capital, since the account of it that he has apparently been given is beyond caricature — “marginal utility of capital”, indeed!

  2. October 29, 2015 at 4:37 pm

    Steve writes that “It is mathematically impossible to reconcile [Marx’s value theory] with the Marxist belief that profit rates in different industries converge (for competitive reasons), when you acknowledge that different industries have different ratios of capital to labor.”

    But the impossibility only arises if you also stipulate that the system of input prices and values must be the same as the system of output prices and values – something that can only be true in a static economy, and is hence incompatible with really-existing capitalism

    As the Temporal Single System interpretation of Marx (en.wikipedia.org/wiki/Temporal_single-system_interpretation) has demonstrated, the problem with 20th-century Marxism has been its uncritical acceptance of Bortkiewicz’s objection to what he called the “successivist prejudice” of classical political economy, as opposed to the supposedly more scientific equilibrium prejudice exhibited by Walrasian marginalism.

    Given that Steve shares the TSS scorn for equilibrium thinking, it is surprising that he overlooks this. There may of course be good reasons for rejecting Marx’s value theory, but logical incoherence is not among them.

  3. October 29, 2015 at 4:40 pm

    It’s obviously an integration of capitalism and socialism…..so let’s do that integration…before the economy either collapses under the weight of its accumulated debt and/or an historically rhyming war in an age of modern weaponry. So Dr. Keen, what are your policies for that integration?

  4. October 30, 2015 at 3:55 am

    I see you continue to misrepresent Bernanke. The full quote:

    “Fisher’s idea was less influential in academic circles, though, because of the counterargument that debt-deflation represented no more than a redistribution from one group (debtors) to another (creditors). Absent implausibly large differences in marginal spending propensities among the groups, it was suggested, pure redistributions should have no significant macroeconomic effects.”

    That is, Bernanke is only reporting the position of “academic circles” at the time– not stating his own view of Fisher’s work. Bernanke even continues immediately with:

    “However, the debt-deflation idea has recently experienced a revival, which has drawn its inspiration from the burgeoning literature…”

    And he goes on to explain how more modern work steers away from this old counterargument. As for Benanke’s own views, you need only back up a few sentences:

    “In my 1983 paper I argued that nonindexation of financial contracts may have provided a mechanism through which declining money stocks and price levels could have had real effects on the U.S. economy of the 1930s. I discussed two related channels, one operating through ‘debt-deflation’… The idea of debt-deflation goes back to Irving Fisher (1933).”

    So Bernanke is supportive of Fisher, and if he is dismissive of anything it is the past “counterargument” in “academic circles.” In short, your quotes do not back up your position.

  5. October 30, 2015 at 10:20 am

    “We will continue to sit in becalmed economic waters if they continue looking for phantoms like the “natural real rate of interest”, rather than focusing upon the real cause of our economic malaise, excessive private debt”.

    An unfortunate choice of words here, since becalmed waters are at equilibrium. It seems to me that “excessive private debt” is an effect of the “real cause”, which along the lines of Steve’s conclusion here is more like not being able to see the real cause, so imagining and theoretically representing phantoms: which representations we can see, causing us to focus on these rather than the real causes.

    So we have excessive private debt. But what kind of debt: monetary or real? The phantom of bank money at interest, or the reality of private accumulation beyond need of the community’s wealth, permitted and indeed encouraged by laws which do not make the distinction but have been interpreted by the courts in the sense of monetary debt?

    My point, really – and I hope Steve will think long and hard about this – is that theory needs to be iconic rather than symbolic, a flow chart rather than a graph, if it is to get us looking in the right place. We need to be able to explain real and monetary debt with a diagram in which flows split between the 1% and the 99%, the haves and the have nots: specifically the Wheatstone Bridge, the battery of which, in its electrical form, supplies power via the motion of electrons [c.f. money] at the cost of corresponding ionic [atomic, real] transfer which – if not reversed by recharging – leads to a loss of capacity and eventually to a rather sudden loss of function.

  6. Dave Raithel
    October 30, 2015 at 12:07 pm

    Lars Syll says what about Steve Keen’s statistical models?

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