Milton Friedman’s Interest Rate Fallacy
maroonmacro.substack.com
maroonmacro.substack.com
Modern economists talking about "interest rates" are talking about the base interest rate which is the cost of bank borrowing which creates new money. Friedman was also interested in regulating the supply of new money but wanted to try to fix the quantity of a monetary aggregate, which could be achieved by.... tweaking base interest rates. The modern central banking approach is to fix the base interest rate (essentially the price of creating money) for a fixed period and be more cautious about adjusting it rather than try to directly fix the quantity of money. Central bankers tried Friedman's approach of fixing the quantity of [a particular aggregate of] money in the early 1980s, it was extremely unstable with wild interest rate lurches needed to fix the quantity of the monetary base (and the monetary aggregates the bank wasn't targeting still wildly fluctuated in volume) and even Friedman conceded that with hindsight he might have made different recommendations. So they switched to fixing the price of credit rather than the quantity instead
The modern policy is consistent with what both Friedman and central bankers wanted to achieve (a relatively low and predictable rate of inflation). They raise base rates because the economy is growing and the level of borrowing with it. But they're not interested in raising interest rates so rapidly that firms end up with the same low level of borrowing as before, merely in stopping credit expansions from growing too fast and creating price inflation (and conversely, making it cheaper and easier to borrow when lending drops) so the interest rate rises tend to track rather than halt the natural rise in lending.
Is it really though? It seems like we have less and work more. Could some of our measurements be wrong?
Believing that economies like the US are growing often requires accepting beliefs like the economy being disassociated from the physical world. On the one hand, that is a defensible position. On the other it is stretching - some people care more about the physical world.
The USD is a reserve currency which has many profound effects associated with that it is not a "bubble" asset class at this point.
When the USD expands its currency base it actually does reduce the the USD valuation relative to other countries.
That is the definition of a bubble. If people buy Tesla because they think others want to buy Tesla stocks rather than thinking the company will do well, then Tesla stocks are in a bubble. The same thing applies to USD. It being a reserve currency means it can keep its value without having assets backing up that value, that is how we define a bubble. Of course bubbles can last a long while, which is probably what you mean, but it is still a bubble and it will pop at some point.
Another reserve currency right now are bitcoins. Bitcoins being used as a reserve currency means people buy it to keep the value high, so that their savings doesn't go to waste. I'd still argue that bitcoins are a bubble, like the USD.
FYI: Money has three functions: a store of value, medium of exchange and a unit of account. Fiat currency does not have assets backing it up for that you would need the gold standard that we abandoned in in the 70s.
A bubble: "Bubble, in an economic context, generally refers to a situation where the price for something—an individual stock, a financial asset, or even an entire sector, market, or asset class—exceeds its fundamental value by a large margin."
And to your bitcoin comment: not even the slightest - bitcoin is not money it does not have the same functions it is a speculative asset investment (taxed on your gains, which money doesn't have).
lol no. Do you have any proof of this that's not a crypto blog?
>stop using USD as a global reserve currency
Not gonna happen.
> Not gonna happen.
Why are you so sure of that? Things can happen extremely quickly once it starts, it is when people believe it wont happen that the crash is the worst.
Because I understand basic macroeconomics and how prolific and dependent global finance is on the USD.
These conversations are always pointless though. The economy is so high dimensional that any conversation about it is going to be missing most of what is actually happening.
1. There is increased consumption (as in, increased unlocking and using of energy and resources to fulfill human desires we already know) 2. There are new human desires being made and valued higher than just fullfilling the existing ones more, mainly in the non-physical domain of culture, social value etc. and (nowadays) mainly digitally
And you are skeptical about the second one because some people care about the physical world?
Eg, am I supposed to care about inequality caused because some people don't have a Facebook account/access to the Facebook ad market/a stake in managing the company? The accounts are basically free anyway. I'm convinced that Facebook has generated a lot of value, but I'm sceptical that anyone cares about the inequality of its distribution.
Compare that to food, energy, etc, where it is easy to see how lack of access/no ability to influence the decisions made would cause screams to echo throughout the land. I think that is probably what people care about when they talk of "the economy".
What does wealthy people consumption have to do with inequality? The wealthy create wealth by investment, and there is a massive amount of investment going on in the past few years, yielding unheard of returns.
I don't think that's really true. There is a lot of physical stuff going on but it's being pushed out of sight and done by cheap labor. A lot of the shiniest companies wouldn't look that great if they didn't have this supply of cheap invisible labor.
The shiniest companies look great because they are able to automate and scale with incredible margins.
>The wealthy create wealth by investment, and there is a massive amount of investment going on in the past few years, yielding unheard of returns.
Who is doing the work? Are these rich people working 1 billion hour work days?
Sure, things look drastically different if you're no longer working in your pandemic affected role, if you have a minimum wage skillset or if you've spent the last half century in Detroit, but that's entirely compatible with growth being unequal
> other countries are getting relatively richer
There's nothing fundamentally wrong with wealth inequality (see Denmark), or fundamentally right about wealth equality. How many "rich" countries with extremely low wealth inequality exist? Meanwhile the least wealth unequal countries are also the poorest. It's almost like wealth inequality is highly correlated with overall richness and quality of life of a population.
The rich get richer while the poor get poorer is a myth. Economies are not zero sum. Just because the wealth of the wealthiest is increasing faster than the wealth of the poorest doesn't mean the poorest aren't gaining wealth faster and faster with time too (which they are in basically every first world/rich republic/democracy).
This is sometimes called the cost disease. Of course for services the cause is mostly the Baumol effect, but for land, housing, and energy it's mostly because supply is constrained.
http://rationallyspeakingpodcast.org/236-why-are-the-prices-... and https://slatestarcodex.com/2019/06/10/book-review-the-prices... and https://randomcriticalanalysis.com/why-conventional-wisdom-o...
also very interesting and important aspect https://www.phenomenalworld.org/analysis/the-class-politics-... !
Ultimately, the returns on capital are paid by the working class and paid to the rentier class, that owns exclusive access to publicly created value (the rich obviously have more money and land than the poor).
I find it interesting how fundamentally this "base interest rate" has changed after transitioning away from a gold standard. During the gold standard, this interest rate was simply the short term interest rate (also called the "discount rate") and did not involve the creation of new money (gold). So, during the gold standard, it was paid out of the existing supply of money (gold), whereas now it's created out of thin air.
This is covered in depth in “Monetary Policy Under the Gold Standard, 1880 to 1914” by Bloomfield - there’s an online copy here https://fraser.stlouisfed.org/title/monetary-policy-internat...
>> did not involve the creation of new money (gold)
New money was created all the time - it was supposed to be backed by an amount of gold reserve. That was the whole point. It is not disputed that this is not what happened at all times.
I hope people notice the absurdity of valuing a company that produces more food less than a shiny metal that lets you speculate that you can buy food with it, even beyond the point where the food manufacturer had to shut down because you didn't pay him.
Money and debt are created and destroyed together, much like matter and antimatter.
https://www.bankofengland.co.uk/quarterly-bulletin/2014/q1/m...
When you deregulate the banks enough so that the 80's mechanism the GP talked about isn't working anymore, dealing with oscillations on the deposit rate becomes a major bottleneck for banks to issue new money.
I don't know enough to claim it's the largest bottleneck, but governments everywhere act like if it is. ("Governments everywhere" have mixed results on getting economics right, so take what you want from that.) But whatever the relative size, it's a relevant one.
Maybe I misread the entire paper - but it seemed that the premise was low interest rates are correlated with or cause low volume of credit.
My understanding is that government, personal, and business debt have all grown at one of the fastest paces in history.
Am I just completely wrong? Did I misread this post entirely?
https://www.statista.com/statistics/248283/household-debt-ra...
FRED is a better source: https://fred.stlouisfed.org/series/HDTGPDUSQ163N
It even has a chart [=
I guess to the author's point - HH debt to GDP was much higher before 2008 when interest rates were much higher.
However, lowering interest rates recently coincided with a DRAMATIC increase HH debt (the largest jump on the chart by far).
If you take the rate of change, I guess it slowed its descent about 2015, which happens to be when rates were increased from 0.25%.
Seems that increasing rates causes the rate-of-change of debt to increase
But that's by the point. Your claim was
> Is the volume of personal credit not absolutely exploding right now because of the real estate boom?
Well not according to the graphs you provided. Q2 2021 debt was 77.7%, down 0.9pp on Q1 2021.
The boring reality is that "savers" can keep their money in demand deposits and never spend them and they do this because the spread between the lowest deposit rate (0% because of cash) and interest paid on long term deposits is below their liquidity preference.
This forces companies and consumers to borrow new money back into the economy to keep the money that is actually circulating at the same level. Since nobody actually wants to take on more loans, interest rates keep dropping.
It's like saying "Insulin reduces blood sugar, but our data shows that blood sugar is highest when insulin is administered."
The fed's control over interest rates is complete, but not the market's response to rates. And when do you increase interest rates? When the market is offering credit at a pace faster than you want. So it seems intuitive that lending is highest during high interest rates (or at least significantly overlap)?
It's popularly believed that furnaces provide heat, but in fact, furnace activity closely correlates with low temperatures, and indeed furnaces are actually off entirely during the hottest times of the year.
I've never seen a large real world system that has instantaneous response in any field. It always trails the stimulus by some time.
That said, I'd like to hear from someone who has thought about it more why they simpler explanation doesn't work.
Maybe, but that is actually kind of the point. The bailouts were inevitable. It is simply not possible to structure an economy in such a way that the consequences of bad decisions fall solely on those who made the bad decisions. There are always externalities, moral hazards, and politics. If Friedman was intellectually honest then he was also hopelessly naive.
His central message was do not think that market failure means the government has the solution: https://youtu.be/Moc7gwMJabM
And BTW, with regards to that video link, it's pretty easy to cherry-pick an encounter between Friedman and a woefully underprepared student that makes the student look like an idiot. But in fact the student is correct. Government is much better at providing infrastructure than the private sector, with the internet being exhibit A.
And yet people seem to view this as a success for him. Strange.
> do not think that market failure means the government has the solution
Should the UK have said "sorry, if your bank account was with RBS, you don't have a bank account any more and you'll have to see what is left after the recievers have sold off the office furniture to see if you get any money back at all"? Including all businesses which bank with RBS? Many of whom themselves would be bankrupt as a result?
That said, there was a lot of choice in how the bailout was done, and in many cases it was done badly. Things like the robosigning fraud in the US should have been prosecuted more aggressively.
Milton Friedman was libertarian, but not anarchist, IIUC. You may have conflated him with his son, David D. Friedman, who wrote The Machinery of Freedom.
That's splitting a pretty fine hair IMHO.
Bottom-up vs top-down.
And what if people use the roads without paying? It's not a great commercial enterprise to build most roads, there's no way to have competition, so you'd probably need a large organisation. But then you'd have every user pay the same? Or make the more wealthy pay more? What if this monopoly turned a bit evil, we'd want some way to control who was running it, maybe if we were all members, and voted on who should run it perhaps?
But I'd like to believe that people would make stuff for use by people. People need to move? Cool. What's a good strategy? Isn't necessarily cars and roads. We'd probably have better land use policy and mass transit to optimize for moving people around.
Also, the engrained corporatist rhetoric is that every belief to the left of Grover Norquist is against capitalism, markets, competition, profits, and Freedom Markets™ in general. Nope. Not true. We love that stuff.
Corporatists (monopolists) hate competition, free enterprise, and so forth. All the anti-left screeching is pure projection, kabuki for the news cameras.
Every society created a government, because it's useful.
Mass transit is the epitome of large scale government intervention for the good of the people.
So asking again: why is the mismatch between interest rates and credit volume not just explained by the delayed system response to the interest rate change, versus the extremely complicated supply-side explanation in the blog post?
The fact that the cohort of people that would be taking on these business loans today are already strapped with 6 figures of college debt might have something to do with it
Does it not once occur to people who play the incredibly tired libertarian lines that in fact we do live in a society that exerts constant coercion on how we lead our lives? As unhelpful as this rhetorical frame is, taxes aren't the only thing that is being stolen... so is agency.
I'll take the UK for example, as I'm most familiar with that:
The Bank of England publish their Inflation Report [1] every quarter. There's quite a lot of interesting information in there. Credit conditions are mentioned in the linked article, which there's a specific report for, called Credit Conditions Survey [2]
Lots of people know what money is. Sort of. The article also mentions volumes of lending. This comes in monetary statistics too, but you have to dig for it. [3], from the URL the phrase 'need to know what you're looking for' - this is what the author may be looking for in terms of interest rates and volumes of lending.
Money, as an economic concept, has been out of fashion for several decades, ever since velocity of M0 started doing funky things that should have been well understood and anticipated and never used as a monetary target under those conditions. It remain no less relevant however. To make sense of it does takes some analysis.
[1] https://www.bankofengland.co.uk/inflation-report/inflation-r...
[2] https://www.bankofengland.co.uk/credit-conditions-survey/201...
[3] https://www.bankofengland.co.uk/boeapps/database/FromShowCol...
Other central banks do have, and most provide, similar data. The format's a bit different. ECB and Eurostat for the Euro area, various FEDs for the US, etc.
I suppose
> Modern economists and financial analysts
may find the above useful if they with to become less 'average' as the article mentions. I assumed the average economist would be aware of these. Disclaimer: I am not an economist, just someone that takes an interest.
In summary, Friedman’s fallacy is derived from two fundamental, yet counterintuitive, observations of economic history. One, when the economy is rapidly and robustly growing, and there are plenty of profitable investment opportunities, interest rates tend to increase, as both financial and non-financial institutions bid for funding/financing to take advantage of the differential between the current interest rates and the future returns on invested capital. Two, rather than differentiate between good or bad credit based only on price (via higher or lower interest rates), banks and institutional investors also differentiate between good or bad credit based on access, so that uncreditworthy businesses are altogether excluded from global debt markets, counterintuitively causing falling, rather than rising, interest rates as credit is contracting.
The Fed's operations, however, are not free banking, but bureaucratic banking.
First of all, and most obvious, fed rate is controlled variable which regulator can change in response to what is happening to economic metrics.
The article somehow glosses over the fact.
I think, FRS changes base rate at least partially in response to amount of credit issued and total amount of money in circulation.
It takes in account many other variables, of course, but still. I think it is possible that fed will raise base rate immediately following rapid expansion of credit to prevent overheating and inflation. On the other side, when lending is insufficient, FRS might consider lowering rates. There is no surprise in that. It will lead to somewhat correlated graphs of credit issued and rates.
I would like to see if graphs and their derivatives could be predicted from one another.
The inflation of the 70s wasn't caused by the cost/availability of credit, it was caused by the fact that oil prices jumped from an average of $4 in 1973 to $13 in 1974.
For some reason we're supposed to pretend this had no significant effect on prices in an economy largely powered by oil.
It's baffling that educated adults can still take this seriously.
> For some reason we're supposed to pretend this had no significant effect on prices in an economy largely powered by oil.
Because there are different types, or sources, of inflation:
* https://en.wikipedia.org/wiki/Demand-pull_inflation
* https://en.wikipedia.org/wiki/Cost-push_inflation
* https://en.wikipedia.org/wiki/Built-in_inflation
* https://en.wikipedia.org/wiki/Inflation#Keynesian_view
And not all of them are caused interest rates and the availability of credit.
> It's baffling that educated adults can still take this seriously.
Perhaps the adults who take this seriously have better educated themselves on the topic. If the experts in a field hold a different view than you, it is often prudent to examine whether you're missing something.
If interest rates are low, money is cheap for Americans and they can buy real things with something that is worth less (not worthless) that it was. Its worth less because Americans didnt have to produce to make that dollar.
On top of that, since the dollar is the reserve currency, all the price inflation is effectively diluted among all countries.
So America gets to print its budget deficit and not even suffer as great an inflation. But the price inflation pressure is there, it must be there.
Its what the French called “America’s exorbitant privilege”
As to the oil shock, of course that affected prices. But the embargo only lasted 6 months, didn't cover Europe and oil is fungible (ie Americans can buy Norwegian oil destined to Ireland at a small premium and the Irish buy oil from the Arabs [1])
[1] this is an illustrative example. I don't know or care where the Irish buy oil
I'm not sure this is any kind of explanation to the contrary. Credit issuance means someone took advantage of credit offered, not a total of the available credit (offered).
I got a home mortgage 2.75%@30yrFxd with 7%! down for hundreds of thousands of dollars this year. I have a friend who has almost 100k in debt, which she cannot service, and a credit score of just over 640 (by gaming the score during the pandemic from 500s) and has credit cards with 10k limits coming in the mail.
Credit IS cheap and plentiful and the same mistakes of 2007 have been amplified by the banking system (Fed + too big to fail cronies).
That's the fallacy, right? One would think it is plentiful given the low rates, you have an anecdote that it is, but look at the data. Lending is fraction of what it was in 2007.
https://cdn.substack.com/image/fetch/f_auto,q_auto:good,fl_p...
There's no accurate aggregate measure of lines offered (only those issued), which is the subtle problem with the (most) analysis about credit gluts vs interest rates.
Edit: And also, at the time, even people with bad credit were still getting those offers. And my credit history was really short at the time.
The EFFR is exactly incrementally increased in a way to not immediately perturb markets, to slowly approach its target. It is also well known that there is delay expected between prices of all assets (including credit) to react to monetary conditions.
Boomers are retiring or getting damn close. They are moving their investments to 'safe' options like bonds. In reverse the system has to match up those bonds with someone issuing a bond. This is typically cars and houses. So for a boomer to invest in a bond, someone had to have bought a house. If interest rates were high, then people wouldnt be buying houses. So interest rates must drop so that the investments can happen.
Furthermore, it's also those same boomers who are selling their large house to 'downsize' or whatever. They cant sell unless someone is buying.
The even crazier thing, the real yields on bonds are negative right now. Interest rate is 0.25% in Canada while inflation is at 4.7%.
So retirement funds are effectively losing the difference. The boomers thought they could retire because they have some nice big numbers but it's double edged. They might have a big number but it doesnt grow much at 0.25% and their costs to buy things is 4.7% higher. So in a few years many boomers who retired may find out they cant afford to be retired anymore.
That is all. Only micro existed in Chicago school in those day I thought.
"The success of the article was not because the arguments were sound or powerful, but rather because people desperately wanted to believe."