Why low rates of interest can cause deflation – an insight for today from Wicksell

The aim of the post is to clearly explain why in times of falling interest rates there is often deflation. Further, how does this related to today’s economy. I will explain it in terms of a simple model put forth in the economic theory of Knut Wicksell.

From the great but forgotten Stockholm school of economics

Knut Wicksell was a 19th century Swedish economist who attempted to explain the paradoxical relationship between low-interest rate environments and deflation. Geldzins und Guterpreise (Interest and Prices) contained the leading theory of business cycles and prices movement before Keynes. The theory is simple. There are actually two rates of interest.

One is the bank rate of interest or the market lending rate. That is the rate of interest entrepreneurs or must pay on loaned capital. This is clear as it is observable and measurable. The second rate of interest is the real rate of interest. The real rate of interest is the marginal productivity of capital. For simplification we can say the profit rate. The profit rate is the rate of return businesses actually get on their capital.

Here is the key point: It is the interaction between the bank rate of interest and the profit rate that determines price movements, that is inflation or deflation. This seems so obvious once your read it, but if this is so, why have so many economist tried to use complex verbose theories.

Example of Wicksell’s interest rate theory

Lets say the bank rate of interest is 10%. If the profit rate was 10% the market and prices there would be an equilibrium. However, if the profit rate was only 5% and the bank rate of interest was 10%, people would not start new ventures as there would be no economic incentive (negative economic profit). Further even if the bank rate fell, to 9% then 8% then 7% it would still not be enough to equalizes the supply and demand for money. Therefore, the economy would have deflation. This is an example of why in times of rising rates of interest there is often inflation and falling rates of interest there is often deflation.

The reason is there is only one observed interest rate, the bank rate. The real rate of interest if not directly observable. People draw conclusions based on the bank rate of interest. They say ‘gee the interest rate is so low, there has to be inflation or the economy must pick up’. This is not historically observed.

Further, once this process of price movements is initiated in one direction or another, expectations kick in and there is something called the ‘cumulative process’. That means prices have a life of their own and get out of control in the direction they are moving. This could mean a deflationary spiral.

Why is deflation and low interest rates are bad ?

Is deflation bad? No, it allows prices to adjust to their natural level in most cases. However, the reason central bankers do not like deflation is they feel it can suppress demand.

What if the bank rate of interest was zero or close to zero? This was the case in post Civil War America and the Great Depression, there is a point where no matter how far interest rates (the bank rate mind you) falls, deflation continues and the economy is not moving. During the Great Depression deflation was about 10% a year. What is wrong with deflation? The real debt becomes larger. Think about this. Why? Again the real rate of interest is below zero.

In this situation, people do not want to put their money in banks, real asset values go up, investments falls, demand is depressed etc. There are many problems. However, the real problem is this – disequilibrium in the supply and demand for money will cause disequilibrium in the real sector. That is recession or depression.

Knut Wicksell tried to explain this in theory.

An alternative to government control of the money supply

The effect could be, no matter how much the government tried to prime the pump it will not work, because the real rate of interest is stuck below zero. Or at least exacerbated businesses cycles.

What is the solution? One idea was something called free money. Even the name ‘free money’ sounds good does it not? The money supply is regulated by market forces and not government control over the money supply. Just like credit cards are issued by banks, so banks could issue money. If they like banks could back it with real assets or not. The supply and demand of money adjusts quickly and business cycles are averted or tempered.

This has worked in the past, but in our modern economy it is only a libertarian pipe dream. That is our economy is stuck in long-term low gear because of a negative real rate of interest, that does not respond to government action. Take a look around and see if this is the case or not today, that is a long-term sluggish economy, despite low interest rates.