Fair Rates of Interest

2. Fair Rates of Interest In Post-Keynesian Political Economy

3. Fair rates versus natural rates • Discussing fair rates usually makes no sense because most economists believe in the relevance of the natural rate of interest

4. The natural rate of interest • The natural rate of interest plays a role similar to that of the natural rate of unemployment. • When Milton Friedman presents the natural rate of unemployment in his 1968 AEA address, he makes the analogy.

5. Friedman and the natural rate • “Thanks to Wicksell we are acquainted with the concept of the natural rate of interest….The preceding analysis [NAIRU] can be translated fairly directly into Wicksellian terms. The monetary authorities can make the market rate less than the natural rate only by inflation.”

6. The natural rate of interest • The natural rate of interest is said to depend upon the forces of productivity and thrift. • It is the rate of interest that would exist if the demand for and the supply of savings could be expressed in real terms (a loanable funds theory, based on real capital) • (See in particular Robertson)

7. The natural rate of interest in growth theory -- Solow models • In Solow’s model, the rate of interest is an endogenous variable, which depends on the rate of growth of population, the propensity to save, and technology. • This rate of interest is identical to the rate of profit. This endogenous rate of interest is subject to the Cambridge capital critique.

8. The rate of interest in “New” growth theory • In the so-called new growth theory, the rate of interest is determined by technology alone. This rate of interest, with a given propensity to save, yields the endogenous rate of growth. • The rate of interest so determined is also subject to the Cambridge capital controversies.

9. The necessity of the natural rate of interest • The market rate of interest cannot be any different from the natural rate of interest. If it were lower than the natural rate, this would induce accelerating inflation. Therefore central banks have no choice in setting short-term nominal rates of interest.

10. Long-term vs short-term rates • Long term rates (on bonds) reflect the forces of productivity and thrift (those of supply and demand). Fluctuations of long-term rates are a good approximation of the fluctuations of the natural rate of interest. • Short-term rates, as influenced by the actions of the central bank, must thus be made to follow the views of the Market.

11. Causality • The mainstream view: long-term rates cause short-term rates (the natural rate causes market rates) • The non-orthodox view: short-term rates, as set by the central bank, eventually modify the views of the Market as to what is the right convention, through arbitrage (there is no natural rate)

12. The post-Keynesian view • “In the absence of a natural rate of interest, it can be argued that the central bank control over short real rates will ultimately influence the entire structure of interest rates in the economy, including long rates”.(Smithin 1996).

13. Short rates vs long rates (bis) • “…Liquidity preference may well periodically insert a wedge between those rates of interest which are more or less directly under the central bank control and rates elsewhere”. (Smithin 1996).

14. Various rates of return • Rates of interest • Rates of return on financial assets (dividend or coupon plus capital gain) • Normal rate of profit (the target rate of return) • Realized rate of profit (which depends on the rate of capacity utilization) • The fair rate of interest

15. The normal rate of profit • It depends, according to Sraffians, on the trend rate of interest (the interest rate regime) plus a normal entrepreneurial premium. • The normal rate of profit is thus the fair rate of return on real assets, for a given interest rate regime.

16. The fair rate of interest -- History • In Antiquity and in the Middle Ages, the fair rate of interest was considered to be equal to zero.

17. The fair rate of interest-- Pasinetti (1) • “The fair rate of interest stems from the principle that all individual, when they engage in debt/credit relations, should obtain, at any time, an amount of purchasing power that is constant in terms of labour” (Pasinetti 1981).

18. The fair rate of interest - Pasinetti (2) • “The [fair] rate of interest is that rate of interest which realizes through time a distribution of income among the participants to the production process, which is proportional to the physical quantities of labour they have contributed” (Pasinetti 1993).

19. The fair rate of interest (3) • The fair rate of interest maintains the purchasing power, in terms of command over labour hours, of funds that are borrowed or lent. • It preserves the intertemporal distribution of income between borrowers and lenders.

20. The fair rate of interest - practical definition (1) • The fair rate of interest in real terms should be equal to the rate of increase in the productivity of the total amount of labour that is required, directly or indirectly, to produce consumption goods and to increase productive capacity

21. The fair rate of interest -practical definition (2) • Should equal the correctly measured multifactor productivity growth rate. • In the special case where the profit rate is constant through time, it should exactly equal the growth rate of real wages.

22. Fair rates, the Church and the Coran • In Antiquity, and in the Middle Ages, although economies experienced some swings in activity, it may well be that observers felt that they were in some sort of a stationary state. • With no inflation and no technical progress, the fair nominal rate of interest was zero.

23. Simple example • Wage at the start of the year is $10.00/hour. • There is a $10,000 loan • This is like 1000 hours of labour time. • Real wages grow by 2%. Inflation is 5%. • Nominal wages at the end of the year: $10.70 • If the rate of interest charged is 7%, then the borrower will have to reimburse $10,700. • This is also equivalent to 1000 hours of labor.

24. What should real rates of interest be now? • Smithin (1996) argues that central banks should target after-tax real rates of interest at positive levels of 1% or 2% (before tax levels of 2 to 3 per cent ?) • Over the last ten years, in Canada, multi-factor productivity growth has been 0.6% a year. This is what real rates ought to be for rates to be fair.