A new paper has come out in the Journal of Policy Modeling (vol. 37, 189-207) by George Selgin, David Beckworth, and Berrak Bahadir. The paper essentially shows that the fed funds rate was too low relative to the natural (aka neutral) rate of interest. It’s a more-or-less neoclassical paper, with a straightforward utility function for a representative household, and a Cobb-Douglas production function. Along with budget constraints, they solve for consumption and derive an expression for the steady state real neutral rate of interest. This is the level the fed funds rate should be set at to maintain a neutral monetary policy – a policy that won’t create distortions in the economy. As I said, it’s a really nice paper and easy to understand.

Selgin et al. conclude that, by holding interest rates too low, they contributed to the boom in the subprime housing market. Their work shows that, due to the productivity boom of the early 2000s, the Fed should have let interest rates increase, which is what should normally happen in a boom time. They also conclude that either following a Taylor rule or an NGDP growth rate target would have been better than what did happen, but come out more in favor of the NGDP rule since it accommodates rapid productivity growth better than a Taylor rule.

There’s a sort-of follow up blog post from David Beckworth here.

As I said, I don’t really have any complaints about the paper or blog post. I bring them to your attention because the paper is evidence in favor of the Austrian theory of the business cycle – or at least a main part of it. The theory states that holding the policy rate below the natural (or neutral) rate will lead to distortions in the economy (malinvestment). The paper and the blog don’t mention the ATBC, but I believe Prof. Selgin is familiar with it. I think it was probably a strategic move not to mention it in the paper, because when submitting to a mainstream journal, one doesn’t know the biases of the referee and what sort of baggage they infer to a particular theory. What’s so nice, then, about this paper is that it uses a very conventional neoclassical approach to make a point that is consistent with the Austrian approach. That gives some confirmation to the validity of the conclusions surrounding the theory.

It would be nice to say something about where the policy rate should be right now, but alas! their data set ends in Q42006. Perhaps an enterprising author (me) will get on that task in short order.