Krugman, Cowen, Sumner Get it Wrong on on Wicksell

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Krugman, Cowen, Sumner Get it Wrong on on Wicksell

I found this discussion online via Tyler Cowan’s excellent blog “Marginal Revolution”. I sent it to our “Davidson” since he has written the most I have seen on it to date. His response is at the end….

Krugman offers a full argument with graph, which you should read in total, but here is one bottom line summary:
When I say that the rate is too high, I mean relative to the rate that would produce full employment, which is, as Brad reminds us, Wicksell’s “natural rate”.
And here is his opening bit:

One of the baffling aspects of economic debate during this Lesser Depression, or so it seems to me, is the apparent urge of many economists to shy away from straightforward conclusions, the urge to make the simple complicated and the clear blurry.

If you’re asking what is at stake, it is whether we should be confident or even mildly confident about any predictions made through a liquidity trap model.  I’ll stick with a few points, which I will put under the fold…

1. I am persuaded by Scott Sumner that, at least these days, the interest rate channel is not very important.  Given that, one still can favor looser money, or at the very least think that tighter money would make things worse, even if the gains from looser money have by 2013 mostly come to an end.

2. I am struck by the remarks of Angus that:

Again and again I see the economy’s problem described along these lines:

“At the ZLB (zero lower bound), the real interest rate is too high to get us to the optimum. The nominal interest rate cannot fall any further by definition. So to get to the optimum the expected rate of inflation must rise.” Those are Simon Wren-Lewis’ words (they appear in a comment at the link), but Krugman and many others tell roughly the same story.

As always, I have questions.

In the IS/LM framework many (not Wren-Lewis) are using, doesn’t this mean that we are getting “growth” by firms investing in projects with a negative NPV now made profitable by an even more negative discount rate?

Second, how is that inflation expectations rise and the nominal interest rate remains unchanged?

Brad’s rather abstract talk about “lower” interest rates does not deflect me from recognizing this visceral wisdom from Cherokee Gothic.   I am sorry, but on this one I have to vote for “complicated,” not “simple.”  I will gladly admit that I do not myself have the final answers here.

3. It is not always useful to talk of “*the* interest rate” and apply that across both Treasury securities and the private sector.  Our government can borrow at some negative real rates, but are we really to think that the private sector is looking at negative rates of return in the United States?  Hardly.  Wicksell, yes, but in this case we need some Sraffa too.  Some kind of asset segmentation is going on, as David Beckworth and others have stressed, and that segmentation does matter a great deal for the transmission belt of monetary policy, at least to the extent you believe in an interest rate mechanism.

4. This is a side point, but it is Brad who doesn’t get Wicksell and Wicksell’s theory of the natural rate of interest.  Brad blogged:

The large demand for relatively safe assets like U.S. Treasury securities means that the interest rate consistent with full employment–the “natural” interest rate, in Wicksell’s terms–is lower than normal, and the natural rate is in fact less than zero.

On the natural rate of interest, what did Wicksell actually write?:

There is a certain rate of interest on loans which is neutral in respect to commodity prices, and tend neither to raise nor to lower them. This is necessarily the same as the rate of interest which would be determined by supply and demand if no use were made of money and all lending were effected in the form of real capital goods. It comes to much the same thing to describe it as the current value of the natural rate of interest on capital.

That’s from the beginning of chapter eight.  Now it’s more complicated than that, as Wicksell juggles and sometimes equates three or four different definitions of the natural rate of interest, not to mention the contrast between the natural rate of interest and the normal rate of interest.  David Laidler once referred to the “Wicksellian muddle.”  Still, DeLong is barking up a different tree.

Brad also chides me for neglecting “basic Geldzins und Guterpreis”, but speaking of basics he neglects the umlaut and also the plural on “price”, so it should be “Güterpreise“, the German-language title then being translated somewhat inexactly into “Interest and Prices.”

5. Stephen Williamson has some interesting comments on the issue.  John Cochrane hasan excellent post on this entire question, and it will not push you into thinking the matter is simple.   I also recommend these Scott Sumner remarks.
You will recall Cowen’s Third Law: “All propositions about real interest rates are wrong.”


“Davison” responds….


They all miss it. The “natural rate” is the rate of growth of one’s society, the Real GDP, added to inflation, i.e. GDP. This is not the rate which full employment occurs. Actually, full employment never occurs because there are always people switching jobs which has been estimated at ~3%, called employment friction, and there are a percentage of unemployable people ~2%, i.e. mentally unable to hold a job and etc.


The “natural rate” as Wicksell stated it is a capitalization rate about which securities and business returns are priced over the business cycle. His language implied arbitrage about this rate. Society did not seem to know this rate specifically, but seemed to be able to over time price asset returns by selling debt to buy stocks and businesses, i.e. equity and then sell equity back to debt in the search for returns. Wicksell did not have the economic data to measure the rate, but he knew it was there. Many, like Wesbury, use the 10yr Treasury rate as a proxy. The low rates today have forced Wesbury to use a 5% historical average while others have simply stuck to today’s 10yr rate as valid.


If one reads our history and I do not mean the history of market prices, but the history of human decisions across time with regards to market thinking, i.e. how key individuals have thought about market values over history, you come to understand that this has been the search of generations. If you use Wicksell’s rate in his simplest statement, then it becomes a market cap rate for pricing stocks, businesses and debt.


Because inflation varies dependent on human & govt spending behavior, one analyzes Real GDP for the society value creation trend and then adds back in current inflation. Inflation cannot be predicted so it must be followed as a best effort. Investors do not respond to inflationary trends immediately nor do they respond to good or bad economic data immediately. The Recency Effect causes us to generally view all current information in light of the past ~3yrs.  The relationship with the “natural rate” is there but it is “fuzzy”. It is most prominent at market lows because no one is overpaying for the future. This is where Buffett, Ross(Wilbur) and others can see the long term value and buy equities at market lows. When the market rises they can see that the price rise causes the long term returns to fall and they stop their buying.


The “natural rate” is the long term Real GDP trend + inflation. I use for inflation the Dallas Fed 12mo Trimmed Mean PCE. For the SP500 I use the long term mean earnings because this is what Buffett and others use in their heads to decide what to pay for assets. When they buy assets, they have these long term average returns in mind.


Krugman and others over think things and insert too much political agenda. They just don’t get it. They do not think long term enough to see the simplicity of it all. Wicksell without the data but what he could observe did get it, but then tried to discuss it thru using other aspects of society. Too bad he did not have the data we would not have been in the muddle we have been the last 115yrs.

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