Yield curves and recessions

Let me get back to my discussion of the neo-Wicksellian macro model. One important feature of the model, is that it suggests that the central bank controls the rate of interest, and it should try to flatten the yield curve. That is, the bank rate (short run) should adjust to the natural rate (long run). In many respects this is the general rule behind all conventional stories about central banking. The Taylor Rule or the New Keynesian ideas behind Clarida, Galí and Gertler are basically a variation of Wicksell's story.

One thing that is also important about Wicksell's rule is that if the yield curve is negatively sloped (the bank rate is higher than the natural rate) then a recession (deflationary forces) are to be expected. The graph below uses the Fed Funds for the bank rate and the 10 year Treasury bond rate for the natural rate. In between the gray lines the official NBER recessions are shown.

As it can be seen, after the red line (Fed Funds) moves above the blue line (Treasury bonds rate) a recession always follows. There are many problems with the Wicksellian model, not the least the assumption of a natural rate of interest, that was severely criticized by Keynes in the General Theory. But the empirical notion that an inverted yield curve forecasts a recession seems to survive any possible theoretical critique. More on the critique will be left for other posts.

Neo-Wicksellian macroeconomics

Modern macro has more to do with Wicksell's Interest and Prices than with Keynes' General Theory. For one, the idea of a natural rate of unemployment derives directly from Wicksell's natural rate of interest, as Friedman noted. So here is a brief explanation of Wicksell's main argument in that book.

Wicksell distinguished between the natural rate of interest (R*) and the monetary or bank rate of interest (R). The former was determined by the marginal productivity of capital (I) and the intertemporal decisions of consumption (leading to savings S), along the lines of what became known as the loanable funds theory. The monetary rate was determined by bank decisions. That is, banks supplied credit (Ms) at the chosen rate of interest (R), according to money demand (Md). Monetary equilibrium occurred when the two rates coincided (see figure below). The natural rate is the gravitational center around which the bank rate fluctuates. Real and monetary shocks could cause deviations of the bank rate from equilibrium.

Wicksell assumes that a positive productivity shock raises the natural rate of interest, and that banks maintain the initial monetary rate. Thus, with a low bank rate, investment exceeds savings and once the system reaches full employment prices would go up. However, continuous lending would reduce bank reserves, and as a result banks would be forced to increase the monetary bank until a new equilibrium was reached. Inflation resulted from a bank rate that was too low, as much as deflation (and temporary unemployment) from a bank rate that was too high.

The low bank rate implies overinvestment, and the need for additional savings. The inflationary process by reducing the ability of consumers to spend provides the additional 'forced savings.' Inflation acts as a tax that provides the additional resources needed to finance investment. The business cycle can be explained by exogenous shocks to productivity (the I curve), changes in consumers preferences (shocks to S), or by the misconduct of the banking sector (shocks to Ms). Wicksell, as much as the modern Real Business Cycle (RBC) School, favored the former.

Dr. Krugman and the natural rate of interest



So I have said a few times here that, while Krugman has been extremely useful for Keynesians in recent policy debates, as a New Keynesian (neo-Wicksellian would be a better term for this school of thought), he is not properly a real Keynesian.  In a recent post he shows exactly my point.  He says:

"There is still a sufficiently low real interest rate that would produce recovery, but it’s a rate that’s hard to achieve."

In other words, there is a rate of interest that would increase investment and bring about the full employment level of savings.  In this post he surprisingly seems to say that liquidity traps or lower zero bound limits (rigidities) for nominal rates do not matter.

The reason seems to be connected to the fact that creditors must have a positive effect on their net wealth in a deflationary balance sheet recession, and their spending should go up.  Hence, creditors should spend more with a slightly lower interest rate.  Wealth effects have been the traditional neoclassical argument for a self-equilibrating economy since Pigou.  If this were true no fiscal policy would be actually necessary.

It's hard to believe that Wall Street bankers would spend sufficiently more for a recovery to follow.  And I doubt that Krugman believes that this effect is sufficiently strong in the real world.  But he does believe in some sort of natural rate, like Wicksell did, which is compatible with Friedman's natural rate of unemployment.

Keynes, on the other hand, thought that the very concept of a natural rate should be discarded.  In chapter 17 of the General Theory Keynes states that:

"In my Treatise on Money I defined what purported to be a unique rate of interest, which I called the natural rate of interest — namely, the rate of interest which, in the terminology of my Treatise, preserved equality between the rate of saving (as there defined) and the rate of investment. I believed this to be a development and clarification of Wicksell’s “natural rate of interest”, which was, according to him, the rate which would preserve the stability if some, not quite clearly specified, price-level. ... I had not then understood that, in certain conditions, the system could be in equilibrium with less than full employment.
I am now no longer of the opinion that the concept of a “natural” rate of interest, which previously seemed to me a most promising idea, has anything very useful or significant to contribute to our analysis."

So, in fact, there might be the case that NO long term rate of interest, a highly conventional one according to Keynes, would be compatible with full employment.  The socialization of investment, in Keynes' terms, then would be necessary.  In other words, effective demand matters in the long run, not just the short run, because there is no tendency for self-adjustment.

Since Friedman's infamous Presidential address to the American Economic Association the neo-Wicksellian approach has dominated macroeconomics.  In this view, the central bank pins the short run policy rate to the long run natural rate, and the economy (save for rigidities and imperfections) moves automatically to full employment.  No fiscal policy is necessary, again with the exception of short run imperfections.  That's why long term considerations about deficits and debt are important. 

My question is: should we be surprised that with this theoretical model as the dominant one, we are in a situation in which the administration is unable to understand and unwilling to promote the fiscal expansion necessary to get us to full employment (or at least lower levels of unemployment)?

PS: Keynes developed the ideas in chapter 17 on the basis of Sraff'a's critique of Hayek's theory of capital in 1932 (here; subscription required).  Note that while Keynes understood that the idea of a natural rate of interest that equalized investment to full employment savings had to be discarded, he did not get that his negatively sloped marginal efficiency of capital actually provided the basis for such a rate.