Lesson Three: Low Neutral Interest Rates

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This post is the third installment of the GEM critique of lessons of the Great Recession according to  Olivier Blanchard and Lawrence Summers, editors of Evolution or Revolution? (2019). Their third lesson is the challenge presented by chronically low neutral interest rates. I am skeptical about calling a shift in trend rates a lesson of the 2008-09 extreme instability, but it is nonetheless instructive to look at their argument.

The Lesson

From B&S: “Low interest rates, especially interest rates lower than growth rates, have essential implications, not only for monetary policy but also for fiscal and financial policies. [The] focus has been on the implications for monetary policy and the effective lower bound. While central banks have explored and used other tools, there is little question that the binding lower bound on short-term nominal interest rates (zero or slightly negative) limited the scope of monetary policy to sustain demand during the recovery….

“The limits of monetary policy imply, other things equal, a larger role for other policies, in particular fiscal policy. And low interest rates raise many questions about the design of fiscal policy in such a context. If the interest rate is below the growth rate, could this be a signal that the economy is dynamically inefficient, in which case larger public debt is actually not only feasible but also desirable…. Finally, low interest rates also have implications for financial regulation and macroprudential policy, although these are less obvious. The main issue is the relation between low interest rates and risk taking. It has been argued that a combination of human nature, leading to reach for yield, and of agency issues leads to more risk taking when interest rates are low.”

GEM Contribution

The GEM Project’s microfounding of meaningful wage rigidity (MWR) greatly enhances investigations of the implications of low interest rates. It most helps us understand the importance of rates in investment and consumption spending, especially in episodes of extreme-instability that concern the authors of Evolution or Revolution? It turns out that the effect of rate changes is greatly exaggerated in consensus thinking. Maybe that is, indeed, a lesson of the Great Recession.

Pure profit and investment outlays. Start with the GEM model’s rejection of the general-market-equilibrium banishment of pure profit. The Project uses WMR (defined by its capacity to rationally suppress wage recontracting) to construct optimizing residual-rent income distribution that is recognized as having roots in Jensen (2000):



such that Έ is the measure of labor input that is in 1:1 correspondence with output, Έj(t)=Źj(t)Hj(t), and Ƙj(t)≤ƘjP(t)=ƒ(Ҡj(t)), while Wn denotes the efficiency wage that embodies meaningful wage rigidity, řm is the market interest rate, R is pure profit, and Ҡr is the capital stock net of its sunk component (Ҡr=ҠҠS), making the term (řm(t)Ҡr(t)) the market opportunity cost of the firm’s capital stock. Generalized-exchange modeling establishes that, given large-scale production and its information-challenged workplaces, neither labor hours nor capital services can be efficiently priced in the marketplace. (For elaboration, see the website’s e-book, chapter 3.)

R  is the residual claim by owners of sunk capital on revenue net of production-related outlays. It can be greater than, less than, or equal to zero, providing guidance for the cyclical and trend management of production capacity. It is featured in the Project’s rational-behavior continuous-equilibrium model of macro instability that was summarized last week. In a result that surprises no practitioner, pure profit is the key determinant in that model’s investment spending:

Į(t)=ƒ(Ƈ(t)(ИJ(t),Ƈ(t)řm(t),(1- Ƈ(t))₡(t)), such that ΔĮ/ΔИJ>0, ΔĮ/Δřm<0, ΔĮ/Δ₡>0,

where И is pure-profit expectations rooted in economic fundamentals, ₡ denotes investor/lender (I/L) confidence, and Ƈ is a heuristic index of I/L perceptions of the credibility of stabilization authorities’ trend full-employment objective, scaled from zero to one. (For elaboration, see the website’s e-book, chapter 6.) Generalized-exchange analysis of the demand for investment goods and services must pay attention to Ƈ; by contrast, mainstream dynamic general-market-equilibrium modeling has no need for Ƈ. In market-centric thinking, interest rates are the default determinant investment spending.

By contrast, once rational exchange is no longer restricted to the marketplace, continuous-equilibrium wages and prices are substantially restricted in their response to changing market conditions. The mainstream investment narrative breaks down, making capital spending especially volatile. Expectations for future pure profit (И) and the credibility of authorities’ effective management of aggregate demand (Ƈ) replace interest rates as the central determinants of investment. Investors/lenders confront a more complex, more recognizable profit-seeking decision set than their market-centric counterparts. Moreover, as demonstrated last week, the already diminished interest-rate influence collapses to insignificance in conditions of extreme instability.

The lower effective bound for the central bank’s target interest rate that so concerns B&S was in fact irrelevant in 2008-09. Careful consideration of the evidence implies paying more attention when practitioners tell us that the most important, by far, driver of outlays on equipment, structures, and software is their expectations of pure profit.

Keynesian consumption. In the most important contribution to the fixed-wage general-equilibrium literature that received a great deal of attention in the 1970s, Robert Barro and Herschel Grossman (1971, 1976) posited nominal wage rigidity to anchor their careful investigation of the relationship between aggregate demand and involuntary job loss rooted in the interdependence of rationing in the labor and goods markets. The GEM Project microfounds B&G’s crucial assumption, reviving the stabilization-relevance of the FWGE school.

B&G’s objective was to support Clower’s interpretation of the Keynesian consumption function. They showed that the strong relation between income and consumer spending, unmistakable in the data,  is a rational manifestation of wage-related disequilibrium in the labor market. Worker income, now representing the constrained effective demand for current output resulting from the excess market-supply of labor, centrally determines rational household spending. Interest rates, dominant in neoclassical analysis of consumption, play a relatively tiny role.


There are two interrelated problems with the B&S interest-rate analysis. The first, i.e., the greatly exaggerated capacity of lower rates to increase spending, has been the focus of this essay. The second is more subtle but also important. B&S limit their analysis of deficit spending to its capacity to increase total demand and, therefore, output and employment, which is only part of the story. It is especially irresponsible to ignore the consequences of using a chronic full-employment reserve-currency deficit to engineer a huge shift of consumption to the present from the future. The Greek credit crisis is a relevant example of such damaging intertemporal policy inconsistency. If B&S intend to excuse current trillion-dollar deficits in the United States, they are peddling badly misreading policy advice. Why aren’t mainstream macro theorists more worried about this time bomb?

Blog Type: New Keynesians Chicago, Illinois

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