THE NATURAL RATE OF INTEREST IS ZERO
Warren Mosler, Cambridge University, and Mathew Forstater,
of “natural” (or “normal”) values and magnitudes is a recurring theme in the
history of economics. It was central to the Classical Political Economy of Adam
Smith and David Ricardo, and survived the transition to neoclassical economics
in the work of authors such as Wicksell and Marshall. In modern economics, it
has its most familiar usage in the notion of a natural rate of unemployment, but
has been applied also to the analysis of economic growth rates and interest
rates, among others. And while many economists reject the very notion of
“natural” itself, this paper argues that in general there are significant
instances in which natural magnitudes do apply to the economic system, and,
specifically, that the natural, nominal, risk free rate of interest is zero
under relevant contemporary institutional arrangements.
The next begins with a
brief history of the notion of natural magnitudes, and examples are cited from
the history of economic thought. This is followed by a discussion of modern
monetary systems and their operation, concluding that the natural rate of
interest is zero.
NATURAL OR NORMAL VALUES AND
We use the word
‘natural,’ mimicking the sense that mainstream economists have at times
attempted to use it regarding such issues as employment, growth, and interest
rates. However, as Pack reminds us, “Natural and nature are complex words,
fraught with ambiguity and contradiction” (1995, p. 31). The sense in which we
wish to employ the term natural here does not imply a ‘law of nature’,
which may be why “Marshall replaced the evocative label ‘natural’ with the more
prosaic ‘normal’” (Eatwell, 1987, p. 598). The notion of natural or normal
values and magnitudes in political economy refers primarily to conditions that
hold in the ‘general case’ rather than under ‘specific circumstances.’ (ibid.):
(although in conversation ‘natural’ may be substituted for ‘equilibrium’ as a
thinly disguised hyperbole). Terms such as ‘permanent’, ‘fundamental’, and
‘intrinsic’ were used in Pre-Smithian classical political economy by authors
such as Petty, Cantillon, and Quesnay to indicate a similar meaning (Vaggi,
1987, pp. 606-607). Of course, the term natural has also been used to indicate
‘real’ as opposed to ‘monetary’ forces, magnitudes “ground out by the Walrasian
system of general equilibrium equations” (Friedman, 1968, p. 8), or to indicate
‘equilibrium’ magnitudes (e.g., by Wicksell, 1898), and we do not wish to attach
these meanings to our use of the term. Neither do we wish to invoke a
“long-period” methodology, as in Garegnani (1976), despite the family
resemblances between his use of the term and our own. Marshall may have
clarified it the best when he wrote that “normal results are those which may be
expected as the outcome of those tendencies which the context suggests”
(1920 , p. 28, emphasis added). In this case, it is of the utmost
importance to first clarify the context, to which we now turn.
STATE ISSUED CURRENCY
The primary, defining
institutional arrangement characterizing the relevant context is that of a ‘tax
driven’ state currency and flexible exchange rates. By state currency we mean
to indicate there is a government that taxes and has a monopoly of issue. A
flexible exchange rate is commonly referred to as a ‘fiat’ currency, in other
words a state-issued currency convertible only into itself (Keynes, 1930), as
opposed to a fixed exchange rate policy such as a gold standard or other
convertibility to any other commodity or currency (no currency boards, pegged
currencies, or monetary unions) fixed by the state of issue. Examples of such
monetary systems currently include the United States, Japan, and most of the
world’s industrial economies, including the Eurozone, although the individual
nations are no longer issuers of their currency.
There is a long
tradition of analysis of state currency or “state money,” referred to by London
School of Economics Professor of Banking and Finance and Bank of England
monetary economist Charles A. E. Goodhart as the “Cartalist” (or Chartalist)
school of monetary thought, and which he contrasts with the “metallist” (Mengerian,
monetarist) tradition (Goodhart, 1998). While authors such as Schumpeter (1954)
passed down a view of chartalism with a misplaced emphasis on “legal tender”
laws, resulting in something of “legal” or “contractual” version of chartalism,
Goodhart makes clear that the fundamental insight is that the power of the
state to impose a tax liability payable in its own currency is sufficient to
create a demand for the currency and give it value. Recent research into
the history of economic thought has revealed substantial evidence pf past
support for this thesis regarding tax-driven money: we now know that, throughout
history, many more economists understood the workings of tax-driven money, and
many of not most currencies in history were in fact tax-driven, contrary to what
was previously thought to be the case (see, e.g., Wray, 1998, 2004; Bell and
Nell, 2003; Forstater, 2005).
The idea of a
tax-driven currency was once common knowledge. The 1946 Encyclopedia
Britannica entry on “Money” stated it very clearly:
If the government announces its
readiness to accept a certain means of payment in settlement of taxes, taxpayers
will be willing to accept this means of payment because they can use it to pay
taxes. Everyone else will then be willing to accept it because they can use it
to buy things from the taxpayers, or to pay debts to them, or to make payments
to others who have to make payments to the taxpayers, and so on. (Lerner, 1946,
Neither was this a “new” idea, as
it can be found in the writings of economists and others going back to Adam
Smith and beyond. Smith, in his famous treatise An Inquiry into the Nature
and Causes of the Wealth of Nations wrote:
who should enact that a certain proportion of his taxes should be paid in a
paper money of a certain kind, might thereby give a certain value to this paper
money. (Smith, 1776, p. 312)
The Father of Economics
well-understood that taxation is the key to understanding the value of state
money (in fact he used the example of Massachusetts’ 1692 issue of paper money
as an example). So did a diverse array of economists that came after him,
including John Stuart Mill, William Stanley Jevons, Phillip H. Wicksteed, and
John Maynard Keynes, among many others (see Forstater, 2005).
A key distinction
is that between the government as issuer of a currency and the
non-government agents and sectors as users of a currency. Households,
firms, state and local governments, and member nations of a monetary union, are
all currency users. A State with its own national currency is a currency
issuer. The issuer of a national currency operates from a different
perspective than a currency user. Operationally, government spending consists
of crediting a member’s bank account at the government’s central bank, or paying
with actual cash. Therefore, unlike currency users, and counter to popular
conception, the issuer of a currency is not revenue-constrained when it spends.
The only constraints are self-imposed (these include no overdraft provisions,
debt ceiling limitations, etc.). Note that if one pays taxes or buys government
securities with actual cash, the government shreds it, clearly indicating
operationally government has no use for revenue per se.
When the U.S.
Government makes payment by check in exchange for goods and services (including
labor), or for any other purpose, the check is deposited in a bank account.
When the check ‘clears,’ the Fed (i.e., Government) credits the bank’s account
for the amount of the check. Operationally, ‘revenue’ from taxing or borrowing
is not involved in this process, nor does the government ‘lose’ any ability to
make future payments per se by this process. Conversely, when the U.S.
government receives a check in payment for taxes, for example, it debits the
taxpayer’s account to the amount of the check. While this reduces the
taxpayer’s ability to make additional payments, it does not enhance the
government’s ability to make payment, which is in any case operationally
infinite. In the case of direct deposit or payment by electronic funds
transfer, the government simply credits or debits the bank account directly and,
again, without operational constraint. The government of issue in such
circumstances may be thought of as a “scorekeeper.” As in most games, there is
no reason for concern that the scorekeeper will run out of points. On the other
hand, non-government agents can only spend when in possession of sufficient
funds from current or past income, or from borrowing. They are indeed revenue
constrained—their checks will ‘bounce’ if there are not sufficient funds
Given that a
government of issue is not revenue constrained, taxation and bond sales
obviously must have other purposes (see Bell, 2000). As we have already seen,
taxation (and the declaration of what suffices to settle the tax obligation)
serves to create a notional demand for the government’s (otherwise worthless)
currency. The process can be viewed in three stages:
- THE GOVERNMENT IMPOSES A TAX
LIABILITY PAYABLE IN ITS CURRENCY OF ISSUE.
- FACED WITH THIS NEED FOR
UNITS OF THE GOVERNMENT’S CURRENCY, TAXPAYERS OFFER GOODS AND SERVICES FOR
SALE, ASKING IN EXCHANGE UNITS OF THE CURRENCY.
- THE GOVERNMENT ‘ISSUES’ ITS
CURRENCY—SPENDS—IN EXCHANGE FOR THE GOODS AND SERVICES IT DESIRES.
The non-government sector will be
willing to sell sufficient goods and services to the government to obtain the
funds needed to pay tax liabilities and satisfy any desire to net save
(financial assets) in that unit of account. Note that, from inception, and as a
point of logic, in order to actually collect taxes, the government, as the
monopoly issuer of the currency, must, logically, spend (or lend) first. Note
that it would be logically impossible for the government to collect more than it
spends (or run a budget surplus), unless it had already previously spent more
than it collected (past budget deficits). Thus the normal budgetary stance to
be expected under these institutional arrangements is a budget deficit.
budget deficit is also “normal” in the sense that it is the mirror image of the
non-Government surplus in the basic macroeconomic accounting identity:
Government deficit =
where non-Government surplus
includes both the domestic (or resident) private sector and the foreign
(non-resident) sector, which includes foreign firms, households, and
governments. It is therefore equivalent to the well-known identity:
(G – T)
= (S – I) + (M – X)
Government budget deficit =
domestic private sector surplus + foreign sector surplus
where the foreign sector surplus
is another way of expressing the trade deficit. The government budget deficit
permits both the domestic private sector and the foreign sector to ‘net save’ in
the government’s unit of account. Only a domestic government budget deficit
permits the domestic private sector and foreign sector to actualize their
combined desired net saving.
We are now in a
position to demonstrate our proposition: the natural rate of interest is zero.
First, to reiterate the argument thus far: Under a state money system with
flexible exchange rates, the monetary system is tax-driven. The federal
government, as issuer of the currency, is not revenue-constrained. Taxes do not
finance spending, but taxation serves to create a notional demand for state
money. Spending logically precedes tax collection, and total spending will
normally exceed tax revenues. The government budget, from inception, will
therefore normally be in deficit, which also allows the non-government sector to
‘net save’ state money (this in fact has been observed in all state currencies).
THE NATURAL RATE OF INTEREST IS
If spending is not
revenue constrained, why does the government (conceived here as a consolidated
Treasury and Central Bank) borrow (sell securities)? As spending logically
precedes tax collection, the government must likewise spend sufficiently before
it can borrow. Thus, government spending must also, as a point of logic,
precede security sales. To site a ‘real world’ example, market participants
recognize that when Treasury securities are paid for, increasing treasury
balances at the Fed, the Fed does ‘repos’ on the same day; the Fed must ‘add’ so
the Treasury can get paid.
currency issuer does not need to borrow its own money to spend, security sales,
like taxes, must have some other purpose. That purpose in a typical state money
system is to manage aggregate bank reserves and control short-term interest
rates (overnight inter-bank lending rate, or Fed Funds rate in the U.S.).
In the contemporary economy, government ‘money’ includes currency and central
bank accounts known as member bank reserves. Government spending and lending
adds reserves to the banking system. Government taxing and security sales drain
(subtract) reserves from the banking system. When the government realizes a
budget deficit, there is a net reserve add to the banking system. That is,
Government deficit spending results in net credits to member bank reserves
accounts. If these net credits lead to excess reserve positions, overnight
interest rates will be bid down by the member banks with excess reserves to the
interest rate paid on reserves by the central bank (0% in the case of the US and
Japan, for example). If the central bank has a positive target for the
overnight lending rate, either the central bank must pay interest on reserves or
otherwise provide an interest bearing alternative to non interest bearing
reserve accounts. This is typically done by offering securities for sale in the
open market to drain the excess reserves. Central bank officials and traders
recognize this as “offsetting operating factors,” since the sales are intended
to offset the impact of the likes of fiscal policy, float, etc. on reserves that
would cause the fed funds rate to move away from the Fed’s target rate.
Our main point is, in nations that include the US, Japan, and others where
interest is not paid on central bank reserves, the ‘penalty’ for deficit
spending and not issuing securities is not (apart from various self imposed
constraints) ‘bounced’ government checks, but a 0% interbank rate, as in Japan
The overnight lending rate is the most important benchmark interest rate for
many other important rates, including
banks’ prime rates, mortgage
rates, and consumer loan rates, and therefore the fed funds rate serves
as the ‘base rate’ of interest in the economy. In a state money system with
flexible exchange rates running a budget deficit—in other words, under the
‘normal’ conditions or operations of the specified institutional context—without
government intervention either to pay interest on reserves to offer securities
to drain excess reserves to actively support a non-zero, positive interest rate,
the natural or normal rate of interest of such a system is zero.
This analysis is supported by both recent research and experience. Japan’s
experience in the 1990s shows clearly that large government budget deficits as a
proportion of GDP (in the neighborhood of 7%) and a debt/GDP ratio of 140% do
not drive up interest rates, as conventional wisdom would have it. In fact, the
overnight rate has stayed at near 0% for nearly a decade. In addition,
Fullwiler (2004) demonstrates that concerns about technological change in
financial markets and other recent developments such as financial deregulation
disrupting the interest rate channel of monetary policy are misplaced. On the
contrary, since the 1990s, market rates have become even more closely linked to
the fed funds rate (ibid.):
that banks are obligated to use reserve balances to settle their customers’ tax
liabilities ensures that a non-trivial demand for reserve balances will exist,
which itself ensures that the federal funds rate target will remain ‘coupled’ to
other interest rates. (ibid.)
natural rate of interest is zero is also supported by recent experimental
evidence. Wray (2001) reports on a community service program run in the
Economics Department at the University of Missouri—Kansas City. Students are
‘taxed’ in the Department’s own currency and must perform community service to
obtain units of that currency. The Department’s ‘Treasury’ could offer
interest-earning ‘bonds’, purchased by students with excess
(non-interest-bearing) units of the school’s currency, but the rate of interest
offered is entirely up to the discretion of the Departmental Treasury. If the
Treasury did not offer interest-earning bonds, the base rate on the currency
would be zero:
“natural base interest rate” is zero on … hoards created through deficit
spending…[U]nless the Treasury chooses to intervene to maintain a positive base
rate (for example, by offering interest on bonds), deficits necessarily imply a
zero base rate. (Wray, 2001, p. 50)
deficits with the department’s currency are “natural” in the sense that they
result from the student demand to net save units of that currency.
The central bank
clearly controls short-term interest rates in a state currency with flexible
exchange rates, and there are a number of good reasons for setting the overnight
rate at its natural or normal rate of 0%, and allowing markets to factor in risk
to determine subsequent credit spreads (see Mosler, 2004). The Japanese
experience has already demonstrated that this does not cause inflation or
currency depreciation. If anything, lower rates support investment,
productivity, and growth. While changing rates can have important
distributional or micro effects (and that can spur employment and output growth,
such as shifting income from ‘savers’ to working people), the net income or
macro effect is zero since for every dollar borrowed from the banking system
there is a dollar saved, as the Fed clearly recognizes in its literature.
Additionally, it can be argued that asset pricing under a 0 interest rate policy
is the ‘base case’ and that any move away from a 0 rate policy constitutes a
(politically implemented) shift from this ‘base case.’
INTEREST RATES UNDER A FIXED
EXCHANGE RATE REGIME
While this paper
focuses on a floating exchange rate regime, a brief summary of interest rate
determination in a fixed exchange rate regime offers context as well as contrast
to the prior discussion.
Inherent in a
fixed exchange rate is the risk of government not honoring its legally binding
conversion features. Historical examples of this type of default in fixed
exchange rate regimes abound, and recent examples include Argentina and Russia
failing to honor conversion of their currencies into $US at their central
banks. History is also filled with examples of default under various gold
standards, with the U.S. itself technically defaulting in 1934 when it both
devalued the $US versus gold and permanently suspended domestic convertibility.
Bondholders were subject to this default as well since the $US they received at
maturity were subject to the new terms and conditions.
translate this default risk into a term structure of interest rates. Default
risk is a function of maturity and credit worthiness, with the ‘risk free’ rate
being the return on holding the object of conversion itself. So in contrast to
a floating exchange rate regime, where the term structure of interest rates is
necessarily a political decision generally reserved for the central bank, with a
fixed exchange rate regime the term structure of rates is a function of market
In the case of a
gold standard, the risk free rate is negative, as it is the storage charge of
holding physical gold. In fact, for all practical purposes, there is no such
thing as ‘risk free’, as physical gold can be stolen or otherwise lost even with
the most expensive guarding techniques. In the case of conversion into another
government’s currency, such as the $US, the ‘risk free’ rate is the risk free
rate of $US deposits, which is the rate on US Treasury securities or deposits at
US Government-insured institutions. This is the case today in Hong Kong, for
example, where the risk free rate is that of the risk free rate of the $US.
With a fixed
exchange rate, governments that spend by issuing currency and not borrowing risk
having those outstanding units of currency converted to the reserve currency (or
gold, as the case may be) at the central bank. Therefore government borrowing
functions to protect central bank reserves and keep the government from
defaulting on its legal conversion requirements. Since holders of the currency
have the option of conversion to the reserve currency at the central bank, govt.
securities can be thought of as ‘competing’ with the conversion option, with
market forces determining the indifference levels. This explains the very high
interest rates paid by governments with perceived default risk in fixed exchange
rate regimes, in contrast to the ease a nation such as Japan has in keeping
rates at 0 in a floating exchange rate regime, despite deficits that would
undermine a fixed exchange rate regime.
history, today’s central bank systems with floating exchange rate policies have
followed fixed exchange rate (mostly gold standard) regimes. We suggest that
policy makers used interest rate data collected under these fixed exchange rate
regimes as well as their experience of using interest rates for reserve
management and macroeconomic policy under fixed exchange rate regimes to guide
them after shifting to floating exchange rates. The various correlations
between interest rates and economic variables were assumed to continue under the
new floating exchange rate regime, including the current notion of ‘real rates’
versus ‘inflation,’ etc.
analysis of the U.S. ‘twin deficits’ is but one example of being ‘out of
paradigm’ with respect to exchange rate policy. One reads daily of the U.S.
facing a day of reckoning due to ‘borrowing from abroad’ to fund its imports.
While this may have had much validity under fixed exchange rate arrangements,
with floating exchange rates a current account deficit is instead the result of
nonresidents realizing savings desires of $US financial assets. There is no
‘funding risk’ for the U.S. nor are U.S. interest rates per se a function of the
The notion of
natural or normal magnitudes and values in economics refers to the results
expected as the outcome of a specified institutional context. The relevant
institutional context specified herein is a monetary system with a state (or
tax-driven) currency and a floating exchange rate policy. There is significant
historical and theoretical support for such a system’s relevance. It has been
shown that in this context, the government budget will normally be in deficit,
corresponding to net savings of financial assets in the non-government sectors.
Deficit spending will result in net central bank reserve credits in the
aggregate banking system, which will drive the short-term overnight inter-bank
lending rate to zero. While government security sales may be used to drain the
excess reserves to maintain some positive overnight rate, or the central bank
may pay interest on reserve balances, absent such government intervention the
base rate of interest is zero. In other words, the natural rate of interest is
zero. As many other key rates of interest in the economy continue to follow the
fed funds rate very closely, this will serve as the base rate in the economy,
with markets determining the credit spreads through risk assessment.
Furthermore, there are a number of reasons why allowing the rate of interest to
settle at its natural rate of zero makes good economic sense.
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