Lesson 2 of 7
What sets the natural rate
Time preference is this tradition's answer. The objection, made in 1932 and repeated since, is that there may be no single natural rate to find.
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In one minute
- On this account the natural rate comes from time preference: the discount people place on a future satisfaction against the same satisfaction now.
- Mises treats that discount as a permanent feature of acting, not an institutional charge that a bank or a legislature could remove.
- The strongest objection is that there is no single such rate. Every commodity has its own rate, and there is no reason for them to agree.
Wicksell defined the natural rate without saying what fixes its level. The Austrian answer is Bohm-Bawerk's and Mises took it over: what fixes it is the value people place on getting things sooner.
Two ways to describe the same rate
Time preference, as Mises puts it
- A present good is valued above the same good later.
- The discount is a category of action, not a price of anything.
- It cannot be abolished by changing a banking rule.
- It is what a market rate of interest is a market rate of.
Wicksell's list of determinants
- The efficiency of production.
- The stock of fixed and liquid capital.
- The supply of labour and of land.
- The whole current economic position, moving continuously.
One is a proposition about choosing. The other is a description of conditions.
The Austrian answer
Bohm-Bawerk's account has a person weighing present against future provision, and coming out in favour of the present for reasons he sets out at length in The Positive Theory of Capital, published in German in 1889. Interest is the price that difference commands.
Mises carries this into Human Action, published in 1949, and states it sharply: the discount of future goods against present goods is a necessary and permanent category of human action, and cannot be abolished by bank manipulation. Against the view that interest is an institutional obstacle put in the way of production, he holds that a market rate is a market expression of something that would exist without markets.
What that buys the theory
It gives the natural rate a source that is not a market price. If the rate tracks time preference, then a bank lending below it is not correcting an error. It is charging less than the thing people actually want, and the difference has to show up somewhere. Which is the whole argument of the two lessons at the end of this course.
The objection, at strength
Keynes sets it out in the seventeenth chapter of The General Theory of Employment, Interest and Money, published in 1936, and credits it to a paper by Sraffa in the Economic Journal of March 1932.
Take wheat. The spot price and the price for forward delivery are both quoted, and the difference between them is a rate of interest expressed in wheat. Do the same with copper and the answer is different, because spot and forward prices stand in different relations for different goods. Keynes concludes that there is no reason why the rates should be equal across commodities.
If that is right, then "the natural rate" is not one number waiting to be found. It is a whole family of own rates that need not agree, and the sentence "the money rate is below the natural rate" has to be reworked before it means anything precise. This objection has never gone away, and it is taken at full length in the course on the case against this theory, later in this track.
What is left standing
Less than its defenders sometimes suppose, and more than the objection is often taken to allow. A tradition that starts from time preference can still say that a credit expansion changes the terms on which the future is bought, and the lessons that follow only need that. What it cannot do, on the strength of this objection, is speak about a single measurable natural rate as though it were an observable.
Check yourself
What does this tradition say fixes the level of the natural rate?
- The central bank's target
- Time preference: the discount people place on a future satisfaction against the same one now
- The marginal product of machinery alone
Show the answer
Answer: B.
Bohm-Bawerk argues it in 1889 and Mises restates it in 1949 as a permanent category of action rather than an institutional charge.What is the own-rate objection?
- That interest rates are set by governments
- That spot and forward prices differ commodity by commodity, so each commodity has its own rate and there is no reason for them to agree
- That time preference is always negative
Show the answer
Answer: B.
Keynes sets it out in chapter 17 of the 1936 book and credits Sraffa's 1932 Economic Journal paper with first pointing out the relationship.What does the objection cost the theory?
- Nothing at all
- The right to speak of one measurable natural rate as though it were an observable number
- The whole of the account of the cycle
Show the answer
Answer: B.
The mechanism in the later courses needs a change in the terms on which the future is bought. It does not need a single observable rate, and claiming one is where the objection bites.Sources
- Mises, Human Action, 1949, chapter XX, section 8, on the discount of future goods against present goods as a necessary category of action that bank manipulation cannot abolish.
- Bohm-Bawerk, The Positive Theory of Capital, German original 1889, English translation by Smart, book V, for the grounds on which present goods are valued above future goods.
- Keynes, The General Theory of Employment, Interest and Money, 1936, book IV, chapter 17, for own rates of interest, the wheat and copper comparison, and the statement that there is no reason for the rates of different commodities to be equal. Keynes's own footnote attributes the relationship to Sraffa, Economic Journal, March 1932.
- Wicksell, Interest and Prices, English translation 1936, chapter 8, for the list of determinants he gives.
What this leaves out
- This is a heterodox tradition. The mainstream account of the same phenomenon differs, and nothing here is a forecast or a view on any security.
- The own-rate figures in the example are round invented numbers chosen to show two rates disagreeing. No market is described.
- Sraffa's 1932 article was not read in the original for this lesson. What is stated above is Keynes's presentation of the point in his own chapter 17, with his attribution, and nothing is claimed about the rest of Sraffa's argument.