Tuesday, August 31, 2010

Is the natural rate of interest zero?

One of tenants of Modern Monetary Theory (MMT) is that the natural rate of interest is zero. That is, the claim (if I’ve got it right) is that the inter bank rate will always tend towards zero and that this is desirable.

For the arguments behind this claim, see paper by Warren Mosler and Mathew Forstater.

One of their arguments does not stand inspection: the claim that “lower rates support investment” (p.12). The answer to that point is that while low rates certainly do “support investment”, there is an OPTIMUM AMOUNT of investment and the optimum is not necessarily that which pertains at a zero (or low) rate of interest. That is, more investment is not an end in itself.

The optimum amount of investment is attained when the marginal disutility (or marginal “pain”) of forgone consumption used to fund investments equals the marginal utility or marginal benefit of such investments (as I point out here.)

But the above “investment” argument is not the only one put by Mosler and Forstater. Does the rest of their argument stand up? I don’t think so – or rather, I think their basic point is sort of valid, but that I can argue their case better than they can. Here goes.

If a country is to avoid paradox of thrift unemployment, it must supply the private sector with the latter’s desired level of net financial assets, i.e. money (as the advocates of MMT have rightly pointed out a thousand times). However, there is absolutely no reason for those holding these assets to earn interest on these holdings. They do the country no favours whatever by holding $X in savings or checking accounts.

If anything, it’s the country doing private sector entities a favour by creating and supplying such entities a volume of “monopoly money” which makes those entities feel comfortable enough to spend, or “play the game”.

Notice that two quite different rates of interest above. First, the rate that brings an optimum amount of real investment, and second, the rate applicable to “monopoly money”.

Given these two rates, there is obvious scope for someone to make a fast buck: that is, borrow at near zero interest from the holders of monopoly money and lend to those wanting to borrow long term. And indeed, the relevant “fast buck / profit making” wheeze has been going on for centuries. The wheeze is called maturity transformation and it is carried about by banks.

This results in a misallocation of resources, because it breaks the relationship between the above two “marginal” factors.

But suppose maturity transformation were disallowed, that would destroy or reduce the ability of central banks to influence that rates of interest involved in REAL investments. Would that matter? The answer is “NO”, because fiddling with interest rates is not a good way of regulating economies for reasons I set out here.

And finally, for a bit more on maturity transformation, see here.

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