R Star Star Wars: The Phantom Menace

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Last year, some economists caused a little commotion by suggesting the concept of something they called R**. This seems pretty prescient in light of the recent US banking mess, and they’ve now updated their article with more details.

First, a little background. In economic equations, R stands for interest rates and stars are used to denote long-term variables. SO R* has become shorthand for the idea of ​​a long-term “neutral” interest rate that neither slows nor accelerates economic growth and inflation.

It’s a theoretical unknowable number until you Really know you raised the rates beyond that but R* became such an eco-nerd meme that Alphaville even used it for our own swag line.

Anyway, at a conference at the New York Federal Reserve last fall, economists Ozge Akinci, Gianluca Benigno, Marco Del Negro and Albert Queralto presented a paper on what they dubbed R**, or R-double star (yes, really).

The idea is that there is also a neutral level of interest rates for financial stability, and, importantly, it is not the same as R*. Basically, R** is a measure of the financial strength of an economy. When it is low, a country is vulnerable to financial shocks linked to rate hikes, and when it is high, it can more easily ignore them without major accidents.

Especially, if R** drifts lower than R* — for example, if prolonged low interest rates encourage leverage, risk taking and general stupidity — Central bank rate hikes can cause financial calamity long before they get to the point where rates actually begin to contain inflation.

The fact that the Fed’s rate hikes precipitated a banking crisis before bringing inflation even vaguely close to target seems to be a good example of what Akinci et al were arguing about last year.

They now have revised the paper to flesh out some R** details and models. You can also read a summary from the New York Fed Liberty Street Economy Blog.

Since R**, like R*, cannot be observed directly, economists have tried to model what it probably is, constructed from other measures of financial instability and using machine learning (naturally). The fundamental question they wanted to answer is: how big of a real interest rate shock can the financial system experience before entering a crisis?

Here’s what some R** variants have looked like over the past 50 years:

You can probably spot some issues just by looking at this chart.

The problem is that R** cannot in practice be used as a means of predicting financial catastrophes. So unless we’re missing something, its practical utility is questionable, beyond a new conceptual take on an old achievement: rate shocks often reveal financial flaws.

As the article points out, modeled R** readings seemed comfortably high in the late 1990s – until LTCM suddenly exploded. He was equally optimistic in the 2000s – until the global financial crisis hit.

Still, it’s a pretty fascinating paper that the researchers promise to follow up with more work. And the fact that financial and economic stability is multifaceted, dynamic and sometimes contradictory deserves more attention.

Further reading
— Blame the R-stars