Two outstanding, less known contributions that Wicksell has made for us
This article was published in Romanian at www.luciancroitoru.ro on 2 January 2017
20 December 2016 marked the 165th anniversary of Johan Gustav Knut Wicksell’s birth. One of the world’s most prominent economists. But, in all probability, the most underrated one as well, as some argue, myself included. His work is important for understanding both inflation and monetary issues and public finance-related matters. There are, however, two enormous contributions that Wicksell has made to the economic research method and that, to my knowledge, no one has highlighted so far.
The first contribution relates to what Plato had called the “second sailing”, a method of knowledge which Plato had credited Socrates for and which is resorted to whenever senses and material evidence can no longer ensure knowledge. In this case, intelligence postulates the existence of entities belonging to a different reality than the physical one, namely to an epistemologically meta-physical reality. The connection between the two realities is made by means of assumptions and reasonings. The “second sailing” is, therefore, tantamount to “reasonings and realities that can be attained only by means of reasonings” (Reale, 2009, pp. 89-90).
In economics, this distinction between the physical and the epistemologically meta-physical levels has led, inter alia, to the observable-unobservable dichotomy as well. Knut Wicksell is, to my knowledge, the first to have employed an unobservable variable in economic theory, while also founding his entire monetary theory on such a variable. Back in 1898, he introduced the concept of “natural rate of interest on capital” (Wicksell, p. 102) or, briefly put, as specified in footnote 1 on page 106, the “natural rate”, namely the rate which ensures price stability.
In this way, Wicksell has brought Plato and Socrates into economic theory in the subtlest and most legitimate manner. When the money rate is higher than the natural rate of interest, inflation diminishes. Conversely, when the money rate is below the natural level, inflation rises. “That there must always be such a rate was the implicit assumption underlying our whole argument. In the next chapter we shall consider whether it really exists, how it could be attained with the object of fulfilling its purpose, and similar questions about the causes determining the rate of interest” (Wicksell, 1898, p. 100). I have italicized those words in order to emphasize that the natural rate belongs to the epistemologically meta-physical reality.
Wicksell also has the outstanding merit of having pointed out that the natural rate is not relatively constant, as assumed in many contemporary papers. Wicksell explicitly says that “the natural rate is not fixed or unalterable in magnitude” (Wicksell, 1898, p. 106). Moreover, he claims that it is reasonable to think that the money rate is “tending to coincide with an ever-changing natural rate” (Wicksell, 1898, p. 117), with the permanent change being underscored in recent econometric studies. Finally, Wicksell concedes that the natural rate of interest may witness abrupt declines. Looking at the steep drop in prices in England in the period from 1815 to 1832, he says “there must have been a rapid fall in the natural rate of interest. The money rate followed only slowly and with hesitation” (Wicksell, 1898, p. 172). As I am about to show, this contribution has been embedded in central bank practice and in the theoretical praxis somewhat recently.
The first who referred to this natural rate in the process of monetary policy conduct was Alan Greenspan (1993), while the first to introduce it in the demand equation in the standard Neo-Keynesian model was Michael Woodford (2003). Since then, both the natural rate and the interest rate gap have become indispensable to monetary policy theory and practice alike. It has taken us 95 years to put this knowledge into practice and 101 years to introduce it into current orthodox theory.
To sum up the references to his first contribution, I would like to point out that Wicksell had as a research program the provision of a tool, i.e. the real interest rate gap, whereby to ensure the conscious stabilization of prices. “[Central] banks (…) and credit institutions have hitherto exerted only an involuntary influence on prices”. But, “if it [the theory] turns out eventually to be correct”, central banks and credit institutions “will be able in full consciousness to pursue their objective, to the indisputable benefit of the world economy”. Today we know that, assuming the divine coincidence holds, over an infinite time horizon, the inflation rate can be written as a function whose sole argument is the difference between the real rate and the natural rate of interest. Within this simplified framework, inflation is equal to the discounted present value of the sum – with a reverse sign – of the expected interest rate gaps over an infinite horizon.
Knut Wicksell’s second outstanding contribution, to my knowledge unnoticed so far, relates to the patterns of preferences. In order to shed light on this contribution, I will recall here the classical expected utility theory and the prospect theory developed by Kahneman and Tversky (1979). The former implies that economic agents have a utility function and an associated restriction, from which they deduct the optimal values that maximize their value (utility). In other words, decisions are shaped as if agents optimize on a permanent basis. In prospect theory, decisions are taken based on comparing potential outcomes, whose probabilities are known. In this theory, the utility function is a sum of the results of multiplying potential outcomes, determined via heuristics, by the probabilities associated with the respective outcomes. These calculations are made after having previously set a reference level and having accepted that any outcome below this level is a loss and any outcome above is a gain.
Kahneman and Tversky claim that the value (utility) function is S-shaped, concave for gains and convex for losses (Kahneman and Tversky, 1979, p. 279). A property of the value function is that “the response to losses is more extreme than the response to gains”, meaning that “the displeasure associated with losing a sum of money is generally greater than the pleasure associated with winning the same amount” (Tversky and Kahneman, 1981 p. 454). In other words, decisions are affected by a certain loss aversion.
With these things clarified, I can say that Knut Wicksell was the first to claim that losing a certain amount of money is more painful than winning the same amount. This does not take away from the merits of prospect theory, which boasts a rigorous demonstration provided by Tversky and Kahneman, for which the latter was even awarded the Nobel Prize.
And here is the excerpt from Wicksell that backs my statement: “the gain due to a fortuitous and unexpected increase in a man’s income is scarcely ever so significant as the injury caused by an unexpected decrease of equal magnitude.” (Wicksell, p. 3).
I have emphasized those two words in order to point out that “fortuitous” indicates here the same risk-based approach, similar to that in prospect theory and completely different from that in the expected utility theory. The term “unexpected” shows that, in Wicksell’s view, there was also an expected level, which – the way I see it – is tantamount to the reference level in Kahneman and Tversky’s prospect theory.
Clarida, Richard, Jordi Galí, and Mark Gertler (1999), “The Science of Monetary Policy: A New Keynesian Perspective”, Journal of Economic Literature Vol. XXXVII (December), pp. 1661-1707.
Greenspan, Alan (1993), “Testimony Before the Subcommittee on Economic Growth and Credit Formation of the Committee on Banking, Finance and Urban Affairs”, US House of Representatives, July 20, p. 11.
Kahneman, Daniel and Amos Tversky (1979), “Prospect Theory: An Analysis of Decision under Risk”, Econometrica, 47(2), pp. 263-291, March.
Reale, Giovanni (2009), “Istoria filosofiei antice: Platon și academia antică (vol.3)”, Galaxia Gutemberg (the work quoted in this paper is the Romanian translation by Mihai Sârbu of “Storia della filosofia greca e romana. Vol. 3: Platone e l’Accademia antica”).
Wicksell, Knut (1936), “Interest and Prices: A Study of Causes Regulating the Value of Money” [Original publication date: 1898], translated by R.F. Kahn, Macmillan.
Woodford, Michael (1999a), “Optimal Monetary Policy Inertia”, Seminar Paper No. 666, Institute for International Economic Studies, S-106 91 Stockholm, Sweden (April).
Woodford, Michael (1999b), “Commentary: How Should Monetary Policy Be Conducted in an Era of Price Stability?”, (September 29).
Woodford, Michael (2003), “Interest and Prices: Foundations of a Theory of Monetary Policy”, Princeton University Press, pp. 381-463.
Svensson, Lars, E.O. (1999), “How Should Monetary Policy Be Conducted in an Era of Price Stability?”, Seminar Paper No. 680, Institute for International Economic Studies, S-106 91 Stockholm, Sweden (November; first draft August, https://larseosvensson.se/files/papers/jh.pdf).
Tversky, Amos; Daniel Kahneman (1981), “Framing of Decisions and the Psychology of Choice”, Science, New Series, Vol. 211, No. 4481. (Jan. 30, 1981), pp. 453-458.
 The demand equation in general equilibrium models contains the natural rate in papers by Jordi Galí (2000) or Edward Nelson and Katherine Neiss (2001), published before Woodford’s major book Interest and Prices (also the title of Wicksell’s 1898 book), but they are quoting chapters from Woodford’s book, with references to the manuscript text. Woodford (1999b), commenting upon Svensson’s paper (1999), claims that the demand equation in Woodford (1999a) is similar to that in Clarida et al. (1999), which is referenced in manuscript form, yet in the published text the demand equation does not contain the natural rate of interest. This has led me to the conclusion that Woodford was the first economist to introduce the natural rate in the demand equation of the Neo-Keynesian model in his comment on Svensson’s paper.