40. The Interest Rate
In introductory Money and Banking the first thing we learn is that fiat money has three characteristics: 1) It is a unit of account, it allows us to form accounting and tax principles and allows us to compare value between different items. 2) It has a transaction value, rather than exchanging objects directly money is an intermediary. 3) It is a store of value because unlike crypto or gold it has a price and the price of fiat money is the Interest Rate.
In an open economic system, the unfettered price of money will have a positive value and this value can be measured by the interest rate associated with it. The interest rate will be the sum of the existing inflation rate (I) plus some positive time value of money (pv). When risk ( r) of repayment exists the Price of Money = I + (pv) + r. The Price of Money is usually conceived of as opportunity cost in a near riskless loan. We use 2% annually as the time value of money for the almost riskless Federal Funds Rate, an overnight loan from the government to member banks. With regularity when central bankers wish to stimulate an economy, they will artificially lower interest rates they control or believe they can affect. The Federal Funds Rate referred to hereafter as “FFR” is the interest rate of choice. This intervention in the pricing process often artificially discounts the price of money. Prolonged periods of discounting the Price of Money may have derogatory effects on society’s societies’ wealth and welfare, not contemplated by the policy initiative. If the discount is so great that the interest rate falls below the inflation rate, the real interest rate becomes negative. A negative real interest rate means that the central bank is valuing loans to member banks below zero percent. A negative real interest rate means the Federal Reserve is paying banking institutions to borrow from the Fed. In that case, money no longer has a positive value.
For a zero nominal FFR rate to remain marginally stimulative, inflation must remain above zero. As federal debt approaches 100% of GDP, inflation may become increasingly unlikely during the deleveraging period while debt is retired or fails. The ineffectiveness of monetary policy to stimulate during this debt deleveraging period is complemented by the diminished influence of fiscal spending by partisan incumbents [graph attached].[1]
The evidence from reflations since 1974 clearly shows that traditional monetary and fiscal tools relied on in the past have become greatly diminished or are ineffective in stimulating GDP. Rather than a careful examination of the causality of their dysfunction, this has led to the present period of massive interventions in a joint effort by partisan incumbents and the Federal Reserve to stimulate without any evidence to support its effectiveness. With the failure of traditional monetary tools not widely understood, the central bank did not hesitate to broadly expand its scope of interventions in the 2007–2009 financial crises. One common feature of the new tools being employed: “They all make use of the asset side of the Federal Reserve’s balance sheet. That is, each involves the Fed’s authorities to extend credit or purchase securities.” [Credit Easing]. In so doing the separation between fiscal and monetary stimulus has been blurred. As traditional tools of monetary and fiscal intervention are dulled or ineffective, expansive new interventions are introduced in the absence of a clear understanding of the dysfunction of the traditional tools or a thorough vetting of the effects of the new ones. The Fed has put money in places we didn’t even know existed. The economic buoyancy from this flood of money is artificial. However the debasement from printing money and the public debt left in its wake will lower our standard of living and represent an increased liability on our future income and present wealth. This was precisely the case in 2020, 2021 & early 2022 when a tsunimi of printed money was released into the economy by the Federal Reserve facilitating colossal fiscal spending programs resulting in a debt tap.
In an open economy, where the interest rate is not controlled by the central government (Federal Reserve) and where money growth by government is kept at a level not to exceed the real growth rate in the economy the Price of Money will communicate risk. When the price of money is elevated say to 10%-12% that tells the borrower that the lender is less certain that they will be paid back. Conversely, when the Price of Money is help at a 2% rate above the annual inflation rate the lender is relatively certain they will receive payment. A higher interest rate also communicates to the borrower there is more risk and could likely dissuade them from borrowing if too high. When Governments artificially hold the price of money (the interest rate) artificially low, the thing to remember is they don’t change the risk. Tragically, they give the impression to the borrower there is less risk than there truly is.
In open economic systems the price of money is allowed to inform the citizenry on risk. As governments become more closed(controlling) , they take over a greater control of the interest rate and distort its ability to signal risk, often causing many regrettable loans that would not have been made if the interest rate were not regulated.
Next week we will take a deeper look into the government (Federal Reserve) control over the price of money and its long term effects.
A note to remember: high productivity with low unemployment is the best medicine for the instabilities and imbalances of a deflationary/inflationary environment. From 1996–2004, we experienced high productivity of approximately 3.0% compared to 1.3% during the remaining 26 year period that spanned 1974–2009. This period of high productivity was clearly affected by the extension of the personal computer and Internet to places where they actually revolutionized economic reality. No longer just payroll generation machines, computers added to output by normal people. The technology surge buffered us from the imbalances that would have led to destabilizing deflation and inflation. Abnormally high productivity also minimized the duration and length of the 2001 recession. However, high productivity is unlikely to repeat over the next decade. This has held true from 2004 -2024. Although productivity had a spurt up in 2023 the three tear average ’21,’22,’23 is a paltry .5%. Moreover, high productivity in a low unemployment environment is not present to mitigate the length and depth of the debt spending through 7/24.