The two previous plates left the rate divided. The loanable-funds theory made it real — the price that clears thrift against investment; liquidity preference made it monetary — the price of holding money, movable by a central bank. This plate takes up the synthesis that joined them, and it is Wicksell's: the distinction between two rates, the natural and the market, and the cumulative process that the gap between them sets in motion. The natural rate is the real rate of the loanable-funds theory — the rate that would equate saving and investment, the rate of a world where money stood neutrally aside. The market rate is the monetary rate of liquidity preference — the rate the banks actually charge, which money can pull away from the natural. And Wicksell's great insight was that when the two diverge, the price level does not settle at a new resting-place but moves cumulatively, without limit, so long as the gap remains: a market rate held below the natural breeds an inflation that feeds upon itself, one held above a deflation that does the same. The natural rate is thus the rate that would steady the economy — the still point the market rate should track — and this plate will follow it from Wicksell's cumulative process to its modern ghost, the unobservable r-star that the central banks chase; and will find the volume's question take on, here, a normative edge: that there is a right rate, and that money's straying from it transfers wealth between debtor and creditor by the hidden hand of the price level.
Begin with the distinction, which is the plate's foundation. Wicksell saw that the rate of interest is not one thing but two, and that the confusion of the two had muddled the science. The first is the natural rate — what he sometimes called the real rate, the rate that would rule in a pure economy of goods, where capital was lent not as money but as wheat and steel and labour. This natural rate is the one that equates the supply of saving with the demand for investment: the loanable-funds rate of an earlier plate, set by the real forces of thrift and the productivity of capital. It is the rate the economy "wants," in that at it, and only at it, the resources people choose to save are exactly the resources firms choose to invest, and the demand for goods just matches their supply. It is kin, in this, to the classical economists' natural wage and natural price — the long-run level the market only hovers about. The second is the market rate — the rate the banks actually charge upon their loans, the money rate, the loan rate. And here is the crux: the banks, because they can conjure credit, are not bound to set the market rate at the natural. They can set it lower, or higher; they can hold the price of borrowed money away from the real return on invested capital. The two rates are distinct, and they need not agree.
What happens when they disagree? Here is Wicksell's central and startling answer: the price level moves, and moves cumulatively. Suppose the banks hold the market rate below the natural — lend money more cheaply than the real return on capital warrants. Then it pays to borrow and invest: a firm borrows at the low market rate and earns the higher natural return, and so firms together invest more than the public has chosen to save. But the resources to embody that investment must come from somewhere, and if the savers have not released them, they are wrested from consumption by rising prices — the excess of investment demand over saving drives the price level up. And this is the startling part: the rise does not stop. So long as the market rate stays below the natural, the incentive to over-invest persists, and prices climb period after period, in a cumulative inflation that has no self-limiting term. There is no new equilibrium at a higher price level; there is only the continuing ascent, until the gap is closed. Hold the market rate above the natural, and the mirror image unfolds: saving outruns investment, demand falls short, and prices fall cumulatively, in a deflation as endless. The natural rate is the rate of rest, the only rate at which the price level holds still; the gap between the market rate and it is the engine of every cumulative inflation and deflation there has ever been.
The natural rate is the rate of rest — the only rate at which the price level holds still.
And in this Wicksell achieved what the older monetary theory never had: he showed how money moves prices. The crude quantity theory had asserted a bare proportion — double the money and you double the prices — but it could not say by what road the new money reached the shops, nor why the prices rose. Wicksell supplied the road, and it ran through the rate of interest. New money enters the world as bank credit; bank credit, freely extended, drives the market rate below the natural; the gap sets off the cumulative process; and the cumulative process is the rising of prices. Money bears upon the price level, on this account, not directly but through the interest-rate gap — through the wedge it drives between the rate the banks charge and the rate the real economy warrants. This is the deepest reason the natural rate matters, and the reason a later volume must take up the price level as a subject in its own right: for that great aggregate, the general level of prices, turns out to be governed by the gap between two interest rates, and inflation is, at bottom, the symptom of a market rate too long held beneath the natural. The price of time is the hidden lever of the value of money.
Wicksell's natural rate did not die with him; it lives on, under a new name and a star, at the heart of every modern central bank. They call it now the neutral rate, or the equilibrium real rate, or simply r-star — and it is precisely Wicksell's natural rate, the rate that would hold the economy in balance, neither stoking inflation nor breeding slump. The whole art of modern monetary policy is, in Wicksellian terms, the art of setting the market rate to the natural: raise the policy rate above r-star to cool an overheating economy, drop it below to warm a cold one, rest it at r-star to hold the economy steady. But here the theory meets a cruel practical difficulty, and the plate must not hide it. The natural rate cannot be seen. It is not a number posted anywhere, not a price quoted on any screen; it is a theoretical magnitude, to be inferred, estimated, guessed at from the behaviour of the economy — and the estimates are wide, uncertain, and forever shifting, for the natural rate itself drifts with the deep tides of thrift and productivity and the age of populations. The central bank is thus charged with steering the market rate toward a target it cannot observe, like a pilot told to hold a course by a star hidden behind cloud. And much hangs on whether the star has moved: the long debate over secular stagnation is, at bottom, a debate over whether the natural rate has sunk so low that the market rate, unable to follow it beneath zero, is chronically too high — the matter of a later plate, on the zero bound. The natural rate is the most important number in monetary policy, and no one knows what it is.
And now the volume's question, which the macroeconomic drama can make us forget. For the gap between the market rate and the natural rate is not only a matter of the price level in the aggregate; it is a matter of who gains and who loses, and the sums are vast. When money holds the market rate below the natural and prices rise, the rising prices erode the real value of every debt and every fixed claim: the debtor repays in cheaper money than he borrowed, and the creditor is repaid in coin worth less than he lent. Inflation, the child of a market rate too low, is thus a great transfer from creditor to debtor — from the saver, the bondholder, the pensioner on a fixed income, to the borrower, the mortgagor, the indebted firm, and, not least, the indebted state. And deflation, the child of a market rate too high, runs the transfer the other way, and more cruelly: it swells the real burden of every debt, enriching the creditor and crushing the debtor, and can set off the vicious spiral in which falling prices and mounting real debts feed upon one another and drag a whole economy down. So the gap that Wicksell discovered is a redistributive engine: every divergence of the market rate from the natural moves wealth, silently, by the hand of the price level, between those who have lent and those who have borrowed. The price of time, when money pulls it from its natural place, becomes a hidden instrument of transfer — and one that no one votes for.
The price of time, when money pulls it from its natural place, becomes a hidden instrument of transfer — and one that no one votes for.
What, then, does the natural rate say to the volume's question — earned, or extracted? It says something new, and the most normative thing the volume has yet found. For the natural rate is a "right" rate in a sense none of the earlier accounts supplied: the rate at which interest is purely the real reward of thrift and productivity, untouched by monetary distortion, and at which the price level holds still and no hidden transfer is worked between debtor and creditor. At the natural rate, interest is as earned as it can be — the clean reward of waiting and the fruit of the detour, with money standing neutrally aside. The extraction, on this account, enters with the gap: when the sovereign of the last plate holds the market rate away from the natural, it sets off the cumulative process, and the cumulative process is a transfer — the inflation tax upon the creditor, or the debt-deflation upon the debtor — levied by no legislature and owed to no principle of desert. The natural rate thus locates the volume's seam with a new precision: the earned rate is the natural rate, and the extracted part is the deviation. But — and here the reassurance fails once more — the natural rate cannot be seen. The very benchmark that would tell us whether a rate is earned or extracted is unobservable, a magnitude to be guessed; and so even a scrupulous central bank, wishing only to hold the market rate at the natural and to work no transfer, may miss its mark, and redistribute great fortunes between debtor and creditor while believing itself wholly neutral. The right rate exists; that is Wicksell's gift. Whether it can be hit is the standing anxiety of every central bank that ever lived.
So the third answer to how the rate is fixed is also the reconciliation of the first two. The loanable-funds theory gave the natural rate, the real rate of thrift and productivity; liquidity preference gave the market rate, the monetary rate the banks can move; and Wicksell joined them, showing that the gap between the two is the engine of the price level and the hidden transfer between debtor and creditor. The natural rate is the still point — the rate that steadies the economy, holds prices level, works no redistribution, and at which interest is purely the earned reward of waiting and productiveness. The market rate is what money makes, and money can pull it from the still point; and when it does, prices climb or fall, and wealth moves from the lender to the borrower or back. The whole task of monetary policy is to hold the market rate at the natural; the whole difficulty is that the natural rate is hidden behind cloud, a star to steer by that cannot be seen. The volume's question, here, takes its sharpest and its strangest form: the earned rate is the one that steadies the economy, and the extracted part is the deviation from it — but the rate that steadies cannot be observed, so the justice of the price of time comes to hang upon an authority's power to find an invisible mark. How that authority actually proceeds — the short rate it sets, and the architecture that hangs from it — the volume's last plate must take up; how the gap drives the price level, a later volume, on the level. And through all of them, as the table says of every price, the argument remains open.