Fair Rates of Interest

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Fair Rates of Interest

• In Post-Keynesian Political Economy

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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

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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.

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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.

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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)

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The natural rate of interest in growth theory --
Solow models

• In Solows 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.

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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.

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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.

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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.

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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)

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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).

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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).

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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

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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.

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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.

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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).

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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).

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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.

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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

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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.

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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.

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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.

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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.