2008-10-26

How domestic interest rates influence trade and production

Okay, here's some theory for you. Let's pretend things are going along fine - there's no second great depression heading our way and the markets are humming along the way they were over the last 10 years or so.

Now let's pretend that, for no reason whatsoever, that the Federal Reserve Chairman and the FOMC decide to raise interest rates from, say 4.5% to 8.5%.

And let's also assume that there is no inflation problem on the horizon. And let's also assume that congress won't fire the board and the chairman. And let's also assume that no political pressure is placed upon the Federal Reserve. In other words, the hike in interest rates stays.

So what will happen?

Well the first thing that would happen is that international investors will see the US Dollar as more attractive to invest in. A rise in the US Dollar is a given. But at some point, the rise will stabilise at an upper level. The rise won't create an ever-rising dollar, but will create a higher point of value.

The reason why the dollar is more attractive to invest in is twofold. The first is that raising interest rates to such a high level automatically causes dollar investments (like treasuries) to compete more effectively with other international investments. The second is that raising interest rates will have a restrict the growth in the money supply or even reduce it. Since money has value, the effect of reducing its supply will be to increase its demand and thus its price. In the international world, this would end up increasing its value.

The other thing to happen, of course, would be that the US Dollar could buy more imports while simultaneously restricting exports. Buying overseas goods would be a lot easier and exporting goods overseas would be harder if the US Dollar was set up so high.

But unfortunately this is where a lot of experts have ended their analysis. It goes like this:

Since:
High Dollar = More Imports = Less Exports = Current Account Deficit

and since:
High Interest Rates = High Dollar

then:
High Interest Rates = Current Account Deficit

(Sorry about my Austrian aversion to mathematical formulas but I'm better at thinking axiomatically)

Let me just point out that whenever anyone examines an economic model, the best way to do it is to examine it dynamically. In other words, movements in equations need to occur.

Let me add a spanner in the works:

Since:
High Interest Rates = Drop in Aggregate Demand

and since:
Drop in aggregate demand = Less Imports = Trade Surplus

then:
High Interest Rates = Trade Surplus

So rather than High Interest Rates leading to a higher current account deficit, such rates could actually result in the opposite - a current account balance or surplus.

At issue is this equation:

Since:
High Dollar = less expensive imports

but since:
High Interest Rates = Drop in aggregate demand

then:
Net result = ??

And that's the question. If a nation increases interest rates - a process that reduces demand while making imports less expensive - then what will the net result be? Will it increase the demand for imports or decrease the demand for imports?

In the end, the price of the currency depends more upon the economy as a whole rather than just the interest rate paid on risk free securities. While higher interest rates would most certainly result in an short-term inflow of investment, it would also reduce aggregate demand, thus making other areas of the economy less likely to be invested in. So while risk-free securities might benefit (such as government bonds) other areas might be harmed (such as the sharemarket, property and corporate bonds). The result would have to be a net drop in overall demand, and thus a drop in demand for imports as well.

The way to determine this is to go overboard with interest rates. Let's say that, instead of raising rates to 8.5%, the Fed raised rates to 850%. This would essentially destroy all demand in the economy. For a short while, the currency would explode upwards but, as the interest rates murder demand, people would be investing out of the economy almost immediately. Eventually the currency would drop despite the high interest rates being offered.

Keep this in mind and then think about what would happen if rates were raised more realistically. There wouldn't be a shock death of the economy, but the effect would be contractionary. There wouldn't be capital flight, but some investors would see better opportunities offshore. Moreover, as time went by the price of the dollar would devalue somewhat to take into account the more attractive offshore investments.

I know this is all axiomatic and there's no equations being put forward here. But I will say this as a conclusion:

Higher Interest Rates = Movement towards Current Account Surplus

and thus

Lower Interest Rates = Movement towards Current Account Deficit

Thus if an economy has a current account deficit, raising interest rates will result in the current account swinging into balance. And if an economy has a current account surplus, lowering interest rates will result in the current account swinging into balance.

In practical terms, had the US had higher interest rates in the last 10 years, and if Japan had lower interest rates over the same period, the current accounts of these two nations would be more in balance, rather than being in deficit (US) or surplus (Japan).

(And it goes without saying that the Bank of Japan didn't help the situation by buying US treasuries over the past 15-20 years)

12 comments:

Eclipse Now said...

But for the USA at least, the overwhelming factors are importing oil, importing goods made by cheap labour in China, and... funding 2 wars.

So again, everything's relative.

One Salient Oversight said...

So if the US increased rates, the demand for oil and cheap Chinese goods would have dropped, thus moving the current account into balance.

Eclipse Now said...

It depends on the figures. "Balance" is something so enormous in this context that it would remain unachievable.

Also, demand for oil and Chinese goods would decrease, but not end. (Unless of course they could persuade American factory workers to work for 1/4 market rates). At some basic level oil and cheap goods HAVE to be bought to keep society functioning, and if those goods remain cheaper in China, then that's where they are going to come from.

One Salient Oversight said...

It depends on the figures. "Balance" is something so enormous in this context that it would remain unachievable.

I'm talking about the current account deficit. Balance is achieved when the amount of money leaving the economy matches the amount of money entering the economy. Oil and Chinese goods don't have to be completely gone for balance to be achieved.

Also, demand for oil and Chinese goods would decrease, but not end.

That's true. I'm not saying they would.

The Social Pathologist said...

Australia currently has some of the highest real interest rates in the world, and still a large current account deficit. Furthermore we have just managed to have a slightly positive trade surplus over the past few months. In effect high interest rates have caused a trade surplus and current account deficit.
Huh? What gives?

1) Interest rates are too crude an instrument to influence the current account deficit.

2)The affect of a change in aggregate demand is dependant on the nature of aggregate supply. If most of your essentials are imported and most of your luxuries locally made. Raising interest rates would widen the current account deficit and worsen trade since a decrease in aggregate demand is most likely to affect non-essentials rather than essentials. The nature of aggregate supply determines the consequence, amongst other factors of the effect of a change interest rates.

3)Interest payments can be thought of a tax payable to the owners of capital. If an economy has low levels of debt relative to GDP, a raise interest rates is going to cause a relatively mild reduction in aggregate demand. If an economy has high levels of debt relative to GDP, like the U.S. or Australia, raising interest rates is going to crush aggregate demand. However, in Australia's case, a huge proportion of our GDP growth is fueled by debt increase. Raise interest rates here, and the economy goes into a death spiral.

One Salient Oversight said...

Social Path,

You raise some good points. I'll address the in turn.

1) I'm beginning to think that the issue here is not interest rates per se, but very low levels of inflation (even absolute price stability). Interest rates are "crude", yes, but raising or lowering rates affects the value of currency and how businesses and households spend their money. If we're concerned about how the market is making decisions, and if the market is investing in areas it shouldn't, then raising the value of money will make investors more careful and circumspect. Raising rates ensures that money becomes more valuable. I'm increasingly of the opinion that interest rates are even more important than people think.

2) Your point here is well thought out. However I would point out that nations in this situation are usually those with current account surpluses. Japan, for instance, can't really feed itself but manages to sell luxury goods and cars and high tech equipment to pay for essentials. In the case of a nation with a current account surplus, I would argue for lower rates.

3) At this present moment in time I would not be supportive of a rise in interest rates. In nations where large amounts of debt fuel the economy and which have large current account deficits, raising interest rates would not have to be "deadly" (rates don't have to be lifted suddenly). Nevertheless, in order to bring these nations "back into balance", a period of higher interest rates would ensure this occur (saving instead of borrowing, producing instead of consuming).

My point is that the more a nation deviates away from a balanced current account, the more unstable their economy becomes. This includes current account deficits by nations like Australia and the US, but also current account surpluses by nations like China and Japan.

The Social Pathologist said...

but raising or lowering rates affects the value of currency and how businesses and households spend their money

Raising or lowering interest rates does not largely effect how people spend there money, rather it affects how much money people have to spend. My parents both knew famine, when interest rates went down they used the extra money to pay down their loans. Their habits did nothing for aggregate demand. Their friends on the other hand went out and spent it. Two different responses to the same effect.

raising the value of money will make investors more careful and circumspect.

I doubt it. Financial rationality has not been a strong point of the current Australian, American or British person. If a Ponzi scheme is returning 50% per year, an interest rate of of 25% is not going to be a deterrent, no matter how doomed the scheme is to any half-witted reflective investor. The sheeple will demand access to it and stone those who stop them.
I still imagine that even with high interest rates, many young couples would rather go further into debt in order to get a trendy little house in the inner city rather than an affordable house in the outer suburbs which would provide them with greater financial security.
Financial common sense is but one and not necessarily the overriding factor, which determines how people spend their money. Other factors such as prestige, aesthetics, family, impulse gratification, etc, all influence where one's money is spent.

(2)As a massive net exporter, Japan even in a higher interest rate environment, is likely to see a fall in local aggregate demand but what happens to its exports is a complex relationship between external aggregate demand--which the industry is trying to satisfy-- and currency appreciation. External aggregate demand--determined by forces outside their government's control-- has to collapse in order for their economies to really suffer pain. High technology products such as cars, computers, electronics do not operate like commodity items. Coal is coal, but a Toyota is not a Volkswagen, the Volkswagen usually commands the premium. Commodities are far more price sensitive than manufactured goods. If your product's good enough, people will pay more for it.

3) I disagree that lower interest rates increase the monetary supply--I can go into this later--interest rate manipulation is not the way to bring the economy back into balance. Personally, in a situation like Australia, I would lower the interest rates while at the same time limit gross imports to a proportion of exports.

That way we can pay down our external debt while at the same time keep aggregate demand from collapsing.

My point is that the more a nation deviates away from a balanced current account, the more unstable their economy becomes

Agreed, Large sustained positive or negative current accounts are not a good thing.

One Salient Oversight said...

Raising or lowering interest rates does not largely effect how people spend there money, rather it affects how much money people have to spend.

I'm working on the assumption that money is a commodity that is bought and sold. When money growth is restricted, it is the same as restricting supply. Money is subject to the laws of supply and demand like any other commodity. If you reduce the supply, the market values it more.

Empirically, this is to be seen in Japan. Japan has had deflation for the past ten years, and this has seen a substantial amount of personal saving.

The idea is that whenever monetary conditions head towards deflation, the market will always save money.

Raising interest rates is one way of pushing towards deflation.

In reality, I would argue that neither inflation nor deflation be experienced over the course of the business cycle. This is the Absolute Price Stability that I have often referred to in my past analysis.

But that's a bit off topic. Back onto your points.

Financial rationality has not been a strong point of the current Australian, American or British person.

I would agree. However I would also point out that higher interest rates DO affect the way the market handles their money. Not everyone is attracted to a 50% annualised return Ponzi scheme, otherwise the market would only ever invest in things which have the highest return. This is where risk analysis comes in, and higher interest rates are a indicator of risk. But if risk-free securities (government bonds) command higher interest rates, all forms of borrowing are affected.

At no point would I ever argue that the market is "rational". The reality is that the market moves between more rational and less rational choices. Higher interest rates WILL make the market choose more rational choices.

I disagree that lower interest rates increase the monetary supply

I'd like you to go into this further. The area of fractional reserve banking is an oft misunderstood field. Suffice to say that the relationship between money supply and interest rates has been proven time and time again (eg Volcker's rate hikes in the early 1980s)

The Social Pathologist said...

I'm working on the assumption that money is a commodity that is bought and sold.

Well this is where I disagree. Money is not really used as a commodity, rather as a medium of exchange. Unlike a lump of ore which is intrinsically useful, a fiat currency's value is defined by convention. It's a derivative note.

One accumulates money not for itself, but for the exchange potential that it has.

Suffice to say that the relationship between money supply and interest rates has been proven time and time again

How come money supply is now decreasing despite worldwide falling interest rates? The U.S. figures are here. The discontinued M3 data is pertinent.

Firstly what is money supply. My definition is M1+M2, the traditional definition used to be M3.

Fractional reserve banking does not create any new money, it merely sub-lets existing money to more and people. Imagine I have 100 gold coins, I deposit them in a bank. Assume a reserve requirement of 20% and some rough maths. Bank lends to customer A, 80 coins, who then deposits them back in the bank, then the bank lends lends B 64 coins and so on...
Traditionally it has been considered that the bank created 1/fractional requirement x deposit money. But how many coins are there at any one time. 100!

What in effect happens is A gives money to b, who can only give a proportion to c who then gives it to d and so on. It's like being give a farm and then subletting a portion to someone else who in turn sublets to someone else and so on. Banking basically establishes a liability chain--for a given sum of money--limited in number by fractional reserve rules.
Nothing new has been created except obligations to others expressed in monetary terms. Traditionally these obligations have been netted and called "new money". It's an intellectual fallacy.

Now take a silly example, suppose you were free to borrow all the money you wanted from the bank at low rates, but had a 80% chance that the government would confiscate your business after 2 years. Would you borrow the money? Even at low interest, I wouldn't, nor would sensible people. Suppose interest rates were high, but you knew for certain that your business was going to be profitable would you borrow, yes.

Demand for capital is based upon a premise of decent return, access to capital is dependent on its availability. Low interest rates but a bank refusal to lend will not cause a rise in money supply. i.e. what is happening now. Business may not borrow if even if capital is available if economic prospects are dismal, would you borrow large sums at low interest to buy a house if you expect prices to go down. Money supply is the availability of capital, the willingness to borrow is dependant on the price of capital and economic opportunity. Low interest rates do not automatically lead to increased borrowing(traditional money creation), especially in a climate of economic disaster.
Here's something pertinent.

One Salient Oversight said...

First, Shadowstats. I don't use that site as a reliable means of gathering information. Econbrowser, an economics website I visit daily, does not think much of them.

Secondly, your statement
Money is not really used as a commodity, rather as a medium of exchange. Unlike a lump of ore which is intrinsically useful, a fiat currency's value is defined by convention. It's a derivative note.

Let me say at the outset that I believe in fiat currency. I don't want to go back to the gold standard. Gold or even a lump of ore is only useful because humans make it useful. It is the same with currency. Currency has value because it has a monopoly in exchange.

You are right in saying that currency is a unit of exchange. Yet it is also a unit of measurement (it measures how much goods or services are worth according to the market). Yet it is also a commodity in and of itself. Yes you are right in saying that currency's value is in exchange - but humans tend to hold things that they value. That's why we have money in our bank accounts rather than having our accounts empty as money goes out as fast as it goes in.

Whether we like it or not, money is a commodity. People want it. People want it because it allows them to consume a certain amount or invest it to watch it grow.

And like all commodities, its value depends upon the mixture of its supply and demand.

Here's some points:

Inflation = money losing value in relation to goods and services.

Deflation = money rising in value in relation to goods and services.

So when Zimbabwe decides to print money, the result is hyperinflation. Why? Because there is an oversupply of money.

You ask about why it is that low interest rates and a drop in M3 is occurring at the same time. Interest rates are dropping in response to a drop in M3. In other words, central banks all over the world are creating money (by fiat) to increase the money supply in the face of an economy that is reducing it.

Money is created by both central banks and commercial banks. With this economic crisis, banks are no longer lending out money, which in turn leads to a reduction in the money supply (Money has to circulate in order to be created. Once it stops circulating money begins to disappear). In response to this action, central banks are now creating money (by fiat) to increase supply.

The situation is currently deflationary - unless the US dollar crashes and then it is all over red rover for the US.

The reason why I have come to a contrary opinion to the "Gold brigade" (those who hate fiat currency and who want a gold standard) is because I believe that the fractional banking system is not inflationary. A fractional banking system can be inflationary or deflationary or neither if policymakers so choose.

Sadly, policymakers have chosen inflation, which means that currency loses its value over time.

And the way policymakers can adjust money creation? Interest rates. By removing or creating money from the money supply, central banks can create inflationary or deflationary conditions.

You might think the current crisis is a permanent state. ie central banks creating money but commercial banks too scared to lend it out.

If commercial banks were too scared to lend money out, then this would be felt as deflation. Central banks can then simply increase the money supply to fix it.

Check out this graph to see what I am talking about.

The graph shows two things - inflation and GDP growth. As you can see during the great depression, deflation was the major problem. But it was not until around 1935 that a recovery began - and this occurred at the same time as a movement out of deflation.

The Social Pathologist said...

Gold or even a lump of ore is only useful because humans make it useful.

To a certain degree yes, to a certain degree no. Look if you wanted a piece of gold or ore, you would have to put some effort into getting it out of the ground, you simply can't create it out of thin air like fiat currency. True commodities are tangible stores of value, paper money on the other hand is not. Its value is derived from some other thing. It's value lays in social convention not intrinsic worth.



I'm not necessarily a gold bug, though a fixed standard certainly has some very positive features. The Zimbabwe situation is precisely stopped by a fixed standard, but a fixed standard does not stop inflation or deflation, though it seems to mitigate the extremes.

Money is is held in our bank accounts not for its own sake but for the future transaction potential that it represents. People hold onto the money not for the thing itself, but for the things it can be exchanged for in the future. If a pile of notes cease to be legal tender it is worthless, the money's transaction potential has been destroyed. Once again its "value" is derivative. If the reference entity becomes decoupled from the note, value is destroyed.

I have no problem with fractional reserve banking withing limits and prudent lending practices, as I agree with you, its value altering potential with respect to money is probably neutral.

inflation and GDP growth.
That's a funny way to interpret the graph. Just before the GDP starts to rise CPI is low, as CPI rises, GDP rises, that is until CPI starts to become inflationary, then GDP subsequently falls. Moral of story, inflationary CPI leads to falling GDP. From the graph it would appear the best thing for healthy GDP growth, is zero inflation inflation/modest deflation.

If I remember correctly the U.S still had about 15% unemployed at the beginning of WW2. Objectively, the New Deal was not a big success.

Interest rates are dropping in response to a drop in M3.

I think you have confused cause and effect. Bernarke started cutting interest rates early 2007, and M3 has been falling since then. Recent interest rate cuts have not resulted in raises in M3. Sure more interest rate cuts are coming because its one of the few tools they have to try and fix this mess. The theory says it should work, but the theory is wrong.

As for Shadow Stats, it has it's flaws, but many people seem to think its methodology reasonable. Orwell once said, that the struggle is to see what is in front of one's nose. The Shadow Stats CPI figures confirm what Joe Average experiences at the supermarket, government CPI does not. Hedonic adjustments, substitution adjustments and so on set a negative bias in CPI calculations. Barry Ritholz and Bill Gross have both come out publicly questioning the veracity of government CPI figures. His figures may not be perfect but they are best estimates. By the way, the endorsement of the economic community is no badge of honour. Nouriel Roubini was ridiculed for his predictions by the majority of mainstream economists, the fraternity's imprimatur is of no value. Most of the brotherhood missed the current disaster.

The Social Pathologist said...

For your perusal.