According to Wicksell, there are two interest rates, one visible and the other almost totally invisible. The visible rate is the number found in every central bank publication. It is prominently displayed in every trading bank and is generally recognised as the price of credit. If you want to borrow, this rate, the market rate of interest, is the amount you pay.
Then there is the invisible ‘natural’ rate. This is the rate that brings the demand for savings into equilibrium with the supply of savings. It is the price of real capital – not money and credit but actual productive resources – available for use by the private sector.
The rate manipulated by central banks is the nominal rate. And the question is whether the natural rate is higher than, the same as, or lower than the nominal rate.
The problem facing a central bank is that if the nominal rate is lower than the natural rate, the outcome is excess demand for the available savings of an economy. The consequences then are all of the kinds of things a central bank is supposed to protect an economy from.
Excess demand for real savings leads to asset bubbles, underperforming investments, inflation and slower growth. The banking system allocates savings towards less risky borrowers since lower rates attract far more demand than the available supply.
We also find the more adventurous and potentially more productive forms of investment are ignored by lenders as they choose the safest borrowers to place savings with, even though these more adventurous investments are the kinds that, over time, lead to the fastest growth and the largest increases in living standards.
It comes down to this. The more governments use up our savings, the fewer savings are available for private sector use. The more savings are directed by governments, the higher the natural rate becomes.
The insights of Wicksell may now be influencing monetary policy in Australia, where in contrast to most of the rest of the world, the central bank has been raising rates. Just how different policy in Australia is can be gleaned from the published text of a speech given by the Governor of the Reserve Bank, Glenn Stevens, at the University of Sydney on 15 May 2008. Amongst the footnotes to this speech was the following:
‘For what it is worth, I think that the Wicksellian notion of the natural rate of return on capital, the market interest rate and the dynamics set in train by the differences between those two rates is one of the more useful analytical devices for understanding the modern economy with a private credit system.’
If Wicksell is indeed its basis, Australian monetary policy has become about as good as it gets anywhere in the world. The Reserve Bank of Australia may be raising rates to reflect the lower volume of real savings available to business.
Rising interest rates are part of what has kept the Australian economy on an upward trend since the global financial crisis began, in the same way that artificially lower rates may have caused, and with QE2 will continue to cause, ongoing damage to any economy where policymakers try to keep rates lower than the available supply of savings will permit.