Natural rates of interest and sustainable growth.

• Author: Garrison, Roger W.
• Position: Essay

The evolution of macroeconomic theory and monetary policy has brought us to a state that calls for critical reflection. It is undoubtedly true that no newcomer to the field can even begin to understand the current state of macroeconomics and policy formulation without understanding just how, dating from the pre-Keynesian era, the profession has arrived at this state. High theory today takes the form of stochastic dynamic general equilibrium analysis, while policy discussion, which concerns itself with economy-wide disequilibrium, centers on the effectiveness (or ineffectiveness) of old-style fiscal and monetary stimulants. The market is a process and so too is the theorizing about it. The history of macroeconomic thought reasserts its relevance at times of economic crises and almost inevitably leads us to the question "How far back do we have to go to start all over?"

A plausible answer is that we have to go back to 1912 and the publication of Ludwig von Mises's Theory of Money and Credit (Mises [1912] 1953). The year itself has significance as the immediate predawn of the Federal Reserve System, while Mises's title focuses attention on that critical relationship (between money and credit) through which a centrally controlled monetary system threatens the stability of an otherwise decentralized economy. Unfortunately, the Keynesian Revolution shifted attention away from the underlying causes of business cycles and toward their most salient symptoms. In the modern era of interest-rate targeting (dating from the early 1980s), the Federal Reserve's concern about the misallocation of credit has been largely overshadowed by its near-exclusive attention to unemployment and inflation.

Lip service to the goal of a long-run sustainable growth rate has been just that. If interest rates are manipulated with an eye to their short- and medium-run impact on the unemployment rate and their long-run effect on the rate of inflation, they cannot at the same time steer the economy along a sustainable growth path. The sustainability that the Federal Reserve has actually achieved is strictly (and perversely) an intercrises sustainability. For all too long, the Fed has acted to extend its own policy-driven booms, forestalling market corrections and hence making the eventual (and ultimately unavoidable) crisis more pronounced than it would otherwise have been. Maintaining a sustainable growth rate in the more worthy sense of avoiding those periodic crises would require the fullest recognition of interest rates in their fundamental role of allocating credit and hence allocating resources in ways that are consistent with people's willingness to save. If long-run macroeconomic stability is our goal, then due attention to the time element that characterizes both saving propensities and investment decisions is a strict prerequisite to assessing alternative policies and recommending reforms.

In an earlier article (Garrison 2009), I argued that the Federal Reserve's implicit observance of the Taylor Rule, according to which policymakers split the difference in various proportions between reducing cyclical unemployment and constraining inflation to some target rate (customarily 2 percent), was an ill-fated exercise in learning-by-doing. The problem is that the "doing'" occurred about every six weeks, when the Fed's policy committee met to set interest rates, but the genuine "learning" occurred only about once every decade, when the cumulative discord between set rates and market realities precipitated still another economic crisis.

During the last half of 2003 and the first half of 2004, the Fed deviated from the Taylor Rule in the downward direction, setting a 1 percent target for the Fed funds rate. This move can be seen, in large part, as an attempt to maintain sustainability in the short-run sense of forestalling an inevitable downturn. The perceived need for exceedingly low interest rates on the heels of the Federal Reserve's extended conformity with the Taylor Rule suggests that the rule itself is not conducive to sustainability in the longer-run sense of avoiding those periodic crises.

Natural Rates of Unemployment and Interest

Hardwired into our macroeconomic thinking, particularly about policy issues, is the notion of a natural rate of unemployment. Though initially introduced as the wage rate or pattern of wage rates "that would be ground out by the Walrasian system of general equilibrium equations" (Friedman 1968: 7), the natural rate soon took on a more worldly meaning by its being associated broadly with real (as opposed to monetary) forces in the economy. In his 1976 Nobel Lecture, Friedman (1977) included among these real forces (in addition to the fundamentals of tastes, resource availabilities, and technology) legislative considerations affecting employment opportunities. Hence, minimum wage legislation, unemployment insurance, investment tax credits, and Social Security's minimum retirement age all have their separate macroeconomic effects, but they do not give rise to cyclical variation in macroeconomic magnitudes. The point, of course, is to identify, given any particular constellation of real forces, an ongoing, stable (i.e., cycle-free) rate of unemployment, a rate that is then christened the "natural rate." For some time now, macroeconomists have taken the natural rate to be in the neighborhood of 5-6 percent.

Though subject to change and not easily definable, the natural rate of unemployment is a benchmark for identifying rates above or below that rate--with deviation from the natural rate representing the unemployment rate's cyclical component. By contrast, structural unemployment, whatever its source, is seen as a separate category. Except for economists of the Austrian school, the structural component of unemployment, which is rooted in mismatches between workers' qualifications and employment opportunities, is not thought to be systematically related to the cyclical component.

The very term "natural rate of unemployment" was coined by Milton Friedman in explicit recognition of its being a close cousin to Swedish economist Knut Wicksell's "natural rate of interest" (Friedman 1977). By melding these concepts from Chicago and from Stockholm, we see that a healthy economy is one in which the unemployment rate and the interest rate are both at their natural levels. In this happy circumstance, the economy's labor markets would be fully adjusted to the labor-leisure tradeoffs that characterize the working-age population and credit markets would be allocating resources in accordance with saving propensities. With both rates at their natural levels, there would be no call, at least on these counts, for any proactive policy adjustments.

Thinking in terms of these complementary natural-rate concepts reveals a fundamental tradeoff in Federal Reserve policymaking, a seemingly obvious tradeoff in the light of the Fed's operating procedure of interest-rate targeting. Given this procedure and consistent with the Taylor Rule in circumstances of low inflation, an unemployment rate above the natural rate (e.g., 9 percent) calls for monetary ease (i.e., for lowering interest rates), whereas an unemployment rate below the natural rate (e.g., 4...