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Paul Krugman's argument against MMT, Functional Finance and using fiscal policy to achieve full employment hinged on the existence of a 'natural rate of interest'. But such an interest rate does not exist and therefore monetary policy cannot achieve full employment.
The natural rate of interest is a theory that's over 100 years old and has taken many guises. It's essentially the interest rate that equates investment and saving, ensuring stable prices and full employment.
Whatever the guise it takes, it cannot be justified either theoretically or empirically.
The natural rate of interest as defined by Wicksell is equal to the marginal productivity of capital (mpc). An interest rate that is too low compared to the mpc Will create over-investment and inflation (and vice-versa)
Inflation then brings the interest rate back to its natural rate. This could either be done through a real balance effect, as inflation erodes the real quantity of money, or through inflation expectations raising interest rates in the credit creation world.
Paul Krugman and other New Keynesians believe that it's this natural rate of interest that monetary policy should be concerned with in order to achieve price stability.
The Cambridge Capital Controversies effectively nullified this theory, at least in the precise way that Wicksell formulated it. The Capital debates demonstrated how relating the interest rate to the marginal productivity of capital was akin to arguing in a circle.
It relies on capital being measured by its exchange value (as heterogenous capital goods cannot be aggregated). But the rate of interest cannot be determined by the value of capital goods, as the value of capital goods is determined by the rate of interest
This isn't a misunderstanding of simultaneity, as neoclassical defenders have urged, but recognising that in the natural rate of interest theory capital is treated as both an endogenous and an exogenous variable.
Ultimately the marginal productivity of capital cannot be observed or calculated, and so cannot be the basis upon which to build a theory of interest rates.
The other way in which the Capital Controversies tore down the natural rate of interest was through the discovery of capital reswitching and capital reversal.
This is the process whereby at certain interest rates demand for capital is *positively* correlated with the interest rate, while at others it is negatively correlated. This makes it impossible to derive a unique equilibrium.
There is another fundamental problem with the natural rate theory, and that is that it is anything but natural. The interest rate is set by the monetary authority, and it can only be this way.
In short, there is no natural (read: market) way for interest rates to converge to the natural rate. The real balance effect is patently absurd in a world characterised by endogenous money.
Even the more realistic view of inflation expectations raising interest rates, this can only happen if the monetary authority responds to inflation in this way.
Perhaps even more important than this, is the fact that the natural rate theory (as many market mechanisms in neoclassical economics are) is undone by considering income effects.
Even in a loanable funds world, the economy would not necessarily adjust to the natural rate position, nor is the natural rate determined solely by the supply side (productivity and thrift)
Because investment and government spending (which we're told compete for loanable funds) raise income, they also raise savings (which are a function of income). This shifts both the supply and demand curves for loanable funds and changes the natural rate of interest.
This is why Keynes said there was a different natural rate of interest for every level of income.
Even more important than this is the fact that output is a significant influence in investment activity. This means that even if interest rates do rise in response to greater investment or deficits, they may not equilibrate the system.
In fact, it is extremely likely that they will in fact not bring the economy back to equilibrium, as study after study finds that quantity variables (such as output, cash flow) outweigh price variables (interest rate)
Which would mean the positive feedback loop from investment to income and to investment outweighs any negative effect on investment or consumption that interest rates might have
It is also possible, considering the insights of Minsky, that the impact of interest rates on the demand for credit is dependent on the stage of the cycle and/or the financial structure at the time.
If, for instance, the financial structure is characterised by ponzi finance whereby the interest on debt is paid down using new credit, then the demand for credit becomes extremely inelastic
Interest rate hikes could, if anything, increase the demand for credit as agents try desperately to avoid default.
At the other end of the scale is the case after this phase, where animal spirits run low and liquidity preference is high. In this case interest rate policy is ineffective at stimulating demand.
Finally, the idea that there exists one overarching price, the interest rate, that can coordinate activity for the whole economy, with all of its diverse sectors and areas, is hubristic.
Stimulus has to be targeted, and 'the interest rate' cannot do this.
Note that while this argument has referred to the efficacy of monetary policy, it's potency in influencing demand is not what's at issue here. The issue is whether it can bring the economy to a stable equilibrium.
