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The “Natural” Interest Rate and Secular Stagnation: Loanable Funds Macro Models Don’t Fit the Data

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The point of this paper is that loanable funds macroeconomic models with their “natural” interest rate don’t fit the data. Before getting into the numbers, it makes sense to describe the models and how to think about macroeconomics in the first place.

New Keynesian macroeconomic orthodoxy in 2016 says that short- to medium-run performance is determined by “loanable funds.” Unimpeded interest rate adjustment should support robust macroeconomic equilibrium. Examples include the (visibly non-existent) “zero lower bound” on rates which is allegedly holding down investment and contributing to secular stagnation, the global “savings glut” keeping market rates near zero, and the “dynamic stochastic general equilibrium” (DSGE) models beloved by freshwater economists and central banks in which investment is determined by saving as a function of financial return.

Loanable funds doctrine dates back to the early nineteenth century and was forcefully restated by the Swedish economist Knut Wicksell around the turn of the twentieth (with implications for inflation not pursued here). It was repudiated in 1936 by John Maynard Keynes in his General Theory. Before that he was merely a leading post-Wicksellian rather than the greatest economist of his and later times.

Like Keynes, Wicksell recognized that saving and investment have different determining factors, and also thought that households provide most saving. Unlike Keynes, he argued that “the” interest rate as opposed to the level of output can adjust to assure macro balance. If potential investment falls short of saving, then the rate will, maybe with some help from inflation and the central bank, decrease. Households will save less and firms seek to invest more. The supply of loanable funds will go down and demand up, until the two flows equalize with the interest rate at its “natural” level.

In New Keynesian thinking, demand for investment can be so weak and the desire to save so strong that the natural rate lies below zero. The “distortion” imposed by the zero lower bound short-circuits the adjustment process, leading to calls for central banks to raise their inflation targets to reduce the “real” interest rate (nominal rate minus inflation). More straightforward interventions such as restoring labor’s bargaining power so that rising wages can push up prices from the side of costs, expansionary fiscal policy, or redistributing from the top one percent to households in the bottom half of the income size distribution whose saving rates are negative are apparently impossible for “political” reasons.

Mostly because saving is a residual quantity in ways to be discussed, loanable funds theory is not consistent with data on the composition of gross domestic product (GDP). To begin to see why, we can look at simplified numbers for 2014 from the Bureau of Economic Analysis national accounts for income and outlays of US households and business. The estimates below are expressed in trillions of current dollars. They are presented with one digit after the decimal point (one hundred billion dollars) and minor items are left out, so they don’t quite add up.

The sectors receive incomes “from production” (wages, profits, etc.), transfers (pensions, health insurance, etc.) from government at all levels, and from and to the rest of the world (or RoW). The American economy is heavily financialized, with large flows of interest and dividend payments across all sectors. Details about sector-to-sector payments are not presented. Rather, each sector is treated as making transfers into a fictional accounting sector which then pays all the money back out. Overall, some sectors gain and others lose but you can’t see the counter-parties.

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