Reckless – Chapter 3: The Natural Rate

Chapter 3 of the book Reckless: The Story Of Cryptocurrency Interest Rates is published below. The full book is available on Amazon. The book was written before the bankruptcy of FTX and therefore does not include coverage of this event. However, the book does provide useful commentary in the run up to the failure of FTX, which provides context for the eventual calamity.

There is a concept in economics called the natural rate of interest, which is sometimes called the equilibrium rate. This rate is considered the most appropriate rate, some kind of fair equilibrium interest rate, which maximises the utilisation of available resources in the economy. This rate can therefore be considered as an optimal rate. One may argue that even talking about the natural rate is not appropriate, because there is no one rate in the economy. Instead, the economy consists of different loans to different borrowers, each with unique risks and therefore different rates. However, for convenience, in this book we will talk about the natural rate. Many other commentators discuss total inflation and aggregate prices, while of course prices of different goods and services move differently. Therefore, it is probably also ok to talk about overall natural interest rates.

The natural rate of interest is somewhat of a similar concept to the risk free rate of interest. This is the rate of return that carries zero risk, or more specifically, zero counterparty risk. This can be obtained by lending money directly to the government, purchasing government bonds. In theory, the risk of the government defaulting is zero in countries where the government can both print its own currency and has a legal obligation to repay the debt. Therefore, all other interest rates in the currency should be above this floor interest rate, as other interest rates have some risks, which require compensation. This risk free rate therefore often drives all other rates in the economy.

There has never been widespread agreement on what the ideal natural rate of interest is for any given period or economy, or how to calculate it. Nor is there widespread agreement as to whether authorities should seek to set or cap interest rates or leave it up to the market to determine rates. Part of the difficulty is that there is no universal agreement on what natural interest rates fundamentally are or which factors and dynamics they should be linked to. Below we briefly discuss four alternative views.

  1. Returns on assets and growth – As was mentioned in chapter one, this growth framework was probably how interest rates were originally determined. Loans can be provided to invest in assets which produce goods and services or yield a return. It therefore seems only fair that a lender should receive a share of this growth. The natural rate of interest can therefore be contrasted to the overall growth rate in the economy: GDP growth. The natural rate should be less than the GDP growth rate, but not too far behind it, or it may cause overinvestment, asset price bubbles and then inflation. Of course, some people borrow money for consumption, rather than investment. For consumption driven loans, this growth framework may not be appropriate.
  2. Time preference – Another framework by which to evaluate interest rates is time. Interest rates can be thought of as the price of time. People are thought to prefer instant gratification rather than delays. Interest rates represent the price of locking up capital, such that one can enjoy the benefits of their labour at some point later on in time. The natural rate of interest therefore represents society’s collective impatience. This theory seems more applicable to loans related to consumption, although it can also apply to investment related loans.
  3. Supply and demand for credit – Interest rates can also be thought of as not only the price of time, but the price of money. In an economy there is a level of demand for credit and a level of supply (savings). The interest rate is the equilibrium rate at which the market clears and supply and demand are in balance. The equilibrium rate will therefore encourage the correct amount of saving and investment. Interpreting the natural rate in this framework depends on the nature of money. In a gold system, a new discovery of gold can increase the money supply and therefore reduce the natural interest rate. In a debt based monetary system, the system we have today, where banks create money by issuing loans, this framework may be somewhat circular in reasoning as a tool to determine the natural rate. In the current climate, the willingness and ability of banks to lend may not be entirely dependent on market forces, but instead banking regulations such as reserve requirements, capital ratios and central bank liquidity provisioning. Therefore, this framework may not be appropriate.
  4. Monetary phenomenon – The natural interest rate could also be a purely monetary phenomenon, driven by central bank policies and commercial banks expanding credit. One can argue that this means the natural interest rate is manipulated and not really linked to the real world. Today, central banks typically target a 2% inflation rate and officially alter the base interest rate to achieve this objective. There was also often an objective to keep unemployment low. Therefore, interest rates can be determined indirectly by consumer price levels. However, according to Goodhart’s law: “Any observed statistical regularity will tend to collapse once pressure is placed upon it for control purposes”. In other words, when inflation becomes a target, it becomes a poor measure for the natural interest rate. Therefore, again, using the interest rate as a control stick to determine inflation may be somewhat circular in logic. Therefore, when interest rates are used as a monetary tool, we may not achieve a reasonable natural or equilibrium rate.

One can therefore argue that the natural interest rate can be determined by some complex combination of the above competing theories. However, this is probably quite difficult given the complexities involved here. The natural interest rate is often determined by an unclear and weak methodology and interpreting the rate and trying to assign meaning to it can be quite challenging. However, the fourth system listed above, the monetary phenomenon, however flawed, arbitrary and circular its logic is, seems to be the main driver of the natural interest rate in the modern economy.

When looking for correlations, history doesn’t strongly support any of the above factors as the main driver of interest rates. Instead, typically natural interest rates appear to be driven by the peculiarities of the time, circumstance, or they are just manipulated. Interest rates seem mostly path-dependent, rather than being linked to any particular characteristics of the real world or economies. And while this looks to be the case through history, the same also appears true today.

Value Of Time

Perhaps the most philosophically perplexing paradigm in which to evaluate interest rates is time. Time preference is the idea that people prefer instant gratification, rather than delayed gratification. The interest rate can therefore be thought of as the price of time, the price for delaying gratification.

There is a rational argument for supporting the thesis that humans prefer instant gratification. Afterall life is inherently uncertain, anyone could die tomorrow. Therefore, bringing forward consumption reduces risk and uncertainty. There is also the logic of necessity. Perhaps some people have no choice but to bring forward consumption immediately, in order to survive. Only if they have accumulated sufficient savings can they afford the luxury of delayed gratification.

The 1972 Stanford marshmallow experiment, conducted by psychologist Walter Mischel, is often considered a key study in delayed gratification. Nursery school aged children were offered one marshmallow immediately, or two after a delay of 15 minutes. An annualised interest rate of over 3.5 million percent. More recently, the experiment has become a meme online, with parents performing the test on their kids, filming the result and posting it on social media. The experiment showed that a majority of children ate the marshmallow before the 15 minutes was up. Whilst perhaps the experiment was more about temptation than interest rates, it does illustrate that there is a cost of delayed gratification, perhaps more than just the uncertainty.

The extent to which delayed gratification is really less desirable than instant gratification now can be considered somewhat of a philosophical question or even a paradox. One cannot always delay consumption indefinitely, if one is always accumulating wealth and never spending, one will never enjoy the fruits of their labour. This was humorously explored in Lewis Carroll’s 1871 book “Through the Looking-Glass”:

“It’s very good jam,” said the Queen.

“Well, I don’t want any today, at any rate.”

“You couldn’t have it if you did want it,” the Queen said. “The rule is, jam tomorrow and jam yesterday – but never jam today.”

“It must come sometimes to ‘jam today’,” Alice objected.

“No, it can’t,” said the Queen. “It’s jam every other day: today isn’t any other day, you know.”

With regards to the natural interest rate, if it is society’s collective price of impatience, we can make some assumptions. Perhaps an older, wealthier, healthier, more educated, harmonious society will experience lower interest rates. The improvement in technology and structure of society could therefore explain why interest rates have been declining for hundreds of years. Perhaps this could also explain why interest rates are especially low in Japan and partly explain the recent low rates in the West, but perhaps not the extremes seen post 2009. The zero or even negative rates we have witnessed recently cannot be explained within this time framework. The price of time explanation is hopeless at explaining negative rates. Only some kind of time machine or property of relativistic time dilation perhaps, could explain negative interest rates.