From the Economist:
"Over a century ago Knut Wicksell, a Swedish economist, drew the distinction between the financial rate of interest that borrowers actually pay and the natural rate of interest that was determined by the return on capital. If the financial rate is below the natural rate, businesses can reap unlimited profits by borrowing as much as they can and ploughing it into high-returning projects. Eventually, though, all that additional spending pushes up prices, money and credit, and eventually, financial interest rates.
Wicksell saw financial rates as those set by banks competing to make loans. That job is now performed by central banks. They still think in Wicksellian terms: the natural rate prevails when the economy is at full employment. Set the policy rate above the natural rate and the economy tips into depression. Set it below, and inflation results—or, some worry, speculative credit booms.
The natural interest rate is often assumed to be constant. The Taylor rule, a popular monetary-policy formula, tends to incorporates a real rate of 2%. But, according to Wicksell, the natural rate is “never high or low in itself, but only in relation to the profit which people can make with the money in their hands, and this, of course, varies. In good times, when trade is brisk, the rate of profit is high, and, what is of great consequence, is generally expected to remain high; in periods of depression it is low, and expected to remain low.'"
Juxtapose the above explanation of the Wicksellian natural rate with the following from Michael Roberts Blog:
Economic expansion
In an economy characterized by slack, the output gap closes as the economy begins to produce closer to full potential due to a greater degree of private investment spending. Unemployment declines and idle resources are put to use to increase productive capacity and eventually output.
Financial amplifiers
Households and businesses that desire to save via the accumulation of financial securities are able to do so as firms issue securities or spend retained earnings to fund their planned investments. In other words, households via financial intermediaries are able to find and accumulate enough bonds and other financial assets to balance their portfolios in the way they desire.
Asset prices and collateral values are likely to climb as investors sentiment improves in anticipation of the upturn in the economic cycle. Household balance sheets are repaired or enhanced as wealth effects kick in. Rising collateral values enable households and firms to increase their debt issuance in order to fund a greater degree of spending.
As private investment slows, the economy begins to produce below full potential resulting in an output gap. Employment slackens and unemployment rises as labor along with other resources go underutilized.
Financial issues - debt overhang
Aggregate income paid to labor begins to stagnate or decline. Labor income dependent households witness their balance sheets deteriorate as they maintain their spending by drawing down their prior savings (the financial assets they accumulated) or issuing debt if they are able to. That is of course until households cut spending which reinforces the negative momentum. These tendencies transmit to households who may not yet be suffering from a drop in income but fear future potential unemployment as a result of the economic downturn.
Corporations and small businesses react similarly. As unwanted inventory levels begin to build, the pace of new orders diminishes. Firms try to maintain profitability by cutting costs. Hiring halts or layoffs occur as labor is deemed to be in excess of what is required to meet expected demand. The least profitable existing projects are abandoned.
Corporate and household default rates rise as credit worthiness withers. In anticipation of this as well as the general economic slowdown, astute asset managers proactively reduce the riskiness of their portfolios by cutting back on leverage, and stocking up on safe short-term liquid financial securities. This move to safe haven securities is exacerbated when private securities once rated AAA start to turn sour. The perception of safety was illusionary.
As a result, credit conditions tighten where in the boom phase lending standards were purposely eased. Credit spreads widen and debt issuance dries up. In the worst instances, financial intermediaries are unwilling or unable to absorb the greater inventory of existing financial securities that are being offloaded into the capital markets. As a result liquidity evaporates and prices fall until value conscious investors step in as providers of liquidity.
*As has been discussed in prior posts, a greater balance towards the use of fiscal relative to monetary policy may be fundamental in how policymakers deal with future recessions and recoveries. This will be expounded upon in a later blog entry.
**During each phase there is a degree of self-fulfillment where expectations lead to actions that work to confirm the prevailing attitude and assumptions. Firms, households, financial intermediaries all act in a way that at least temporarily leads to the realization of their expectations. That is of course until actual outcomes, reality, begin to diverge drastically from general perception. General perception shifts, new expectations are formed, and a disruption in the prior order occurs.
By extension market prices do not merely reflect the present or forecast the future, but play a major role in producing the very outcomes which market participants attempt to anticipate. This is why the stories we tell ourselves are important.
"Over a century ago Knut Wicksell, a Swedish economist, drew the distinction between the financial rate of interest that borrowers actually pay and the natural rate of interest that was determined by the return on capital. If the financial rate is below the natural rate, businesses can reap unlimited profits by borrowing as much as they can and ploughing it into high-returning projects. Eventually, though, all that additional spending pushes up prices, money and credit, and eventually, financial interest rates.
Wicksell saw financial rates as those set by banks competing to make loans. That job is now performed by central banks. They still think in Wicksellian terms: the natural rate prevails when the economy is at full employment. Set the policy rate above the natural rate and the economy tips into depression. Set it below, and inflation results—or, some worry, speculative credit booms.
The natural interest rate is often assumed to be constant. The Taylor rule, a popular monetary-policy formula, tends to incorporates a real rate of 2%. But, according to Wicksell, the natural rate is “never high or low in itself, but only in relation to the profit which people can make with the money in their hands, and this, of course, varies. In good times, when trade is brisk, the rate of profit is high, and, what is of great consequence, is generally expected to remain high; in periods of depression it is low, and expected to remain low.'"
Juxtapose the above explanation of the Wicksellian natural rate with the following from Michael Roberts Blog:
As mentioned quite a few times in this blog, it's understandable to perceive today's level of policy interest rates as being "low" or abnormal if one compares them to historical levels. What follows is the belief that the Fed has "artificially" manipulated overnight rates and therefore the yield curve in a way that has distorted our economic reality. The policy conclusion is that the Fed must "normalize" rates as soon as possible by raising them to levels found in the recent past.
We can use the above profit cycle graph to understand why these assumptions are flawed.
We can use the above profit cycle graph to understand why these assumptions are flawed.
If firms in aggregate are optimistic that their expected rate of profit will be high going forward (return to capital) when adjusted for risks and borrowing costs or that risk adjusted returns on new opportunities are favorable, then planned investment is undertaken. As this happens the following occurs:
In an economy characterized by slack, the output gap closes as the economy begins to produce closer to full potential due to a greater degree of private investment spending. Unemployment declines and idle resources are put to use to increase productive capacity and eventually output.
Financial amplifiers
Households and businesses that desire to save via the accumulation of financial securities are able to do so as firms issue securities or spend retained earnings to fund their planned investments. In other words, households via financial intermediaries are able to find and accumulate enough bonds and other financial assets to balance their portfolios in the way they desire.
Asset prices and collateral values are likely to climb as investors sentiment improves in anticipation of the upturn in the economic cycle. Household balance sheets are repaired or enhanced as wealth effects kick in. Rising collateral values enable households and firms to increase their debt issuance in order to fund a greater degree of spending.
On the other side, creditors are willing to lend as financial assets are expected to outperform. Investment managers and other global financial intermediaries demand favored financial assets which boosts the drive to originate and distribute them. To allow for this profitable expansion of credit, credit standards are relaxed at the expense of credit quality.
Moreover, the need to outperform peers incentivizes asset managers to participate in the uptrend or face career risk. Risk controls are relaxed especially as leverage positions are taken on. Momentum and trend following strategies help to fuel the asset price trends.
Moreover, the need to outperform peers incentivizes asset managers to participate in the uptrend or face career risk. Risk controls are relaxed especially as leverage positions are taken on. Momentum and trend following strategies help to fuel the asset price trends.
At the very least all this reinforces, if not amplifies, the prevailing economic expansion.
Policy response
As the above trends occur, the natural rate of interest, policy rates, and the financial interest rates offered to firms and households rise. The central bank's monetary policy only remains accommodative when they target or are expected to target an overnight rate that enables financial interest rates to remain below the natural rate. As the economy begins to produce closer to potential where labor costs rise, the central bank may not be politically able to refrain from raising policy rates.
As the above trends occur, the natural rate of interest, policy rates, and the financial interest rates offered to firms and households rise. The central bank's monetary policy only remains accommodative when they target or are expected to target an overnight rate that enables financial interest rates to remain below the natural rate. As the economy begins to produce closer to potential where labor costs rise, the central bank may not be politically able to refrain from raising policy rates.
More importantly as firms compete to exploit profit opportunities, eventually financial interest rates increase and/or the realized rate of profit declines due to rising costs. Excess capacity and production may also begin to cap and put downward pressure on the rate of profit.
If these forces are great enough, this is the point in the cycle when the economy is at risk of suffering a drop-off or worse a contraction due to a reduction in the pace of private investment. The profit rate may begin to decelerate then fall to the point where the following begins to be seen:
Economic slowdown
Economic slowdown
As private investment slows, the economy begins to produce below full potential resulting in an output gap. Employment slackens and unemployment rises as labor along with other resources go underutilized.
Financial issues - debt overhang
Aggregate income paid to labor begins to stagnate or decline. Labor income dependent households witness their balance sheets deteriorate as they maintain their spending by drawing down their prior savings (the financial assets they accumulated) or issuing debt if they are able to. That is of course until households cut spending which reinforces the negative momentum. These tendencies transmit to households who may not yet be suffering from a drop in income but fear future potential unemployment as a result of the economic downturn.
Corporations and small businesses react similarly. As unwanted inventory levels begin to build, the pace of new orders diminishes. Firms try to maintain profitability by cutting costs. Hiring halts or layoffs occur as labor is deemed to be in excess of what is required to meet expected demand. The least profitable existing projects are abandoned.
Corporate and household default rates rise as credit worthiness withers. In anticipation of this as well as the general economic slowdown, astute asset managers proactively reduce the riskiness of their portfolios by cutting back on leverage, and stocking up on safe short-term liquid financial securities. This move to safe haven securities is exacerbated when private securities once rated AAA start to turn sour. The perception of safety was illusionary.
As a result, credit conditions tighten where in the boom phase lending standards were purposely eased. Credit spreads widen and debt issuance dries up. In the worst instances, financial intermediaries are unwilling or unable to absorb the greater inventory of existing financial securities that are being offloaded into the capital markets. As a result liquidity evaporates and prices fall until value conscious investors step in as providers of liquidity.
Policy response
The natural rate of interest declines. Market participants begin to price securities in anticipation of monetary policy easing. If the panic is bad enough, participants may expect or demand that the Fed act as a lender or dealer of last resort.
However until excess supply is absorbed by greater aggregate demand, the profit lead investment cycle will not necessarily restart itself. Perceptions of profitability with respect to risk needs to be restored. This necessitates that current productive capacity be fully utilized before new investments are undertaken beyond replacements or upgrades. Financial borrowing costs are not the sole or major determinant of such economic decisions. Although monetary policy easing is necessary under these circumstances, it may not be able to sufficiently offset this drag stemming from weak private investment.* It can fail to gain the traction which observers once might have expected.
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To conclude, today's historically depressed policy and long term rates are normal and what one should expect from an economy that is still suffering from deficient investment and aggregate demand. If anything, a case can be made that since 2008 the Fed's main policy rate has been too high given a Wicksellian rate that has been persistently below zero up until recently. The global ramifications of how the Fed handled the zero lower bound constraint are explored in the next post.
*As has been discussed in prior posts, a greater balance towards the use of fiscal relative to monetary policy may be fundamental in how policymakers deal with future recessions and recoveries. This will be expounded upon in a later blog entry.
**During each phase there is a degree of self-fulfillment where expectations lead to actions that work to confirm the prevailing attitude and assumptions. Firms, households, financial intermediaries all act in a way that at least temporarily leads to the realization of their expectations. That is of course until actual outcomes, reality, begin to diverge drastically from general perception. General perception shifts, new expectations are formed, and a disruption in the prior order occurs.
By extension market prices do not merely reflect the present or forecast the future, but play a major role in producing the very outcomes which market participants attempt to anticipate. This is why the stories we tell ourselves are important.
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