Monday, April 28, 2014

A Discussion of the Merits of Short Term Interest Rate Management, Part I

4/28/2014 Portland, Oregon – Pop in your mints…

One of our working hypotheses here at The Mint is that short-term interest rate management, the primary tool employed by the Central Banks of the world to implement monetary policy, is necessarily harmful to the economy by providing incentives for achieving what otherwise would be suboptimal economic outcomes. By extension, we believe that these suboptimal outcomes are not simply a lost opportunity or a generator of wasted efforts and resources, but a primary contributor to the imbalances in the environment which today bears the label “climate change.”

Recently, we were invited to present our hypothesis at a Global Macro Roundtable for discussion. Today and over the next several days, we will present a slightly redacted transcript of the roundtable for the consideration of our fellow taxpayers. Names (with the obvious exception of our own) have been changed to protect both the innocent and guilty.

As you will see, the discussion (which we have color coded in order to help follow the cast through the maze of discussion) takes many twists and turns, and in a way reveals how far-reaching the influence of short-term interest rates has become, as well as the broad misunderstanding of the concept of money that persists to this day.

Enjoy!

A Discussion of the Merits of Short Term Interest Rate Management

The hypothesis:

Why Short-Term Interest Rate Management is Harmful to the Economy: The Unseen Funding Dynamic 

While the evidence is clear that centralized planning is a failure, pointing to the reasons why can prove elusive. Recently, a revelation regarding the problem with centralized management of short-term interest rates came upon us. The revelation is the following: Imagine you are a banker who needs to fund a loan. In order to fund this loan, you would presumably need to have the money available with which to fund it. This is simple logic, however, in the real world of banking, the decision of whether or not to fund a loan is completely disconnected from the availability of funds, which is primarily determined by the overnight funding markets which, in turn, are completely reliant upon short-term interest rates.

In a world that followed the rules of financial physics, the short-term interest rates would be completely dependent upon the availability of funds in the system. However, the centralized management of interest rates makes this critical data point, which would otherwise provide a snapshot of the amount of capital in an economic system which is held in liquid form and available for deployment, irrelevant, as the amount of capital available in today’s centrally managed system can be determined on whim.

As such, the ability of the banker to fund the loan is not dependent upon an availability of funds that represents the amount of capital available in the real world, rather, his ability to fund the loan is completely dependent upon the borrower’s ability to pay and the size of the loan in relation to the structure of the bank’s balance sheet.

The three criteria above are important, as any underwriter will tell you, but the invisible fourth criteria, the true availability of the funds for the loan, or funding dynamic, is completely ignored in the following fashion:

When the short-term interest is managed to be low, as is the case currently, any borrower who has the capacity to pay and has a lending need that fits well with a certain bank’s loan mix is extremely likely to get funded, regardless of whether or not the economics system as a whole has the capital available to fund his or her loan. When the short-term interest rate is managed to be high, as it was in the early 1980’s in the US, funding any loan, regardless of the ability to pay and fit within bank’s balance sheet, becomes impossible to fund.

In both cases, both borrower and banker are left completely in the dark as to whether or not there exists the necessary capital stock or productive capacity in the economy for the funds to be deployed in the manner that the borrower envisions, for the short-term interest rate signal has been genetically modified to send a common signal to all participants.

Unfortunately, it is a signal that blinds everyone to the facts of the situation. For many are the hopes, dreams, and ideas of mankind, but it is the funding dynamic which keeps these hopes, dreams, and ideas in harmony with the natural world upon which we all depend.

Right now, we are floating in the clouds, completely disconnected from reality. The landing caused by the next round of high rates, via a natural rebalancing of accounts or further genetic modification of the short-term rates, will be very hard indeed.

The funding dynamic is so delicate that mankind cannot hope to optimize it via genetic modification, for when left alone, it is optimized by definition. Again, by definition, every attempt to modify will bring about sub-optimal results.

As with all complex economic and political systems, dissent is information, and serves to manage the system’s outputs while at the same time increasing the resiliency of the system, making it less susceptible to shocks.

Centralized short-term interest rate management must be abandoned before it is too late, for it is leading the activities of mankind towards a dangerous showdown with the limitations of the natural world.

Discussion

Contributor A: This brings to mind the Pareto curve reaching a knee limit and catastrophe theory when there is a Quantum state change in the system being considered (the twig will snap, the water will boil as energy (money) is added, etc.). We are expanding the money supply and disregarding that eventually an infinite amount will be needed.

One other point is the Multiplier effect at the Bank who gets $ 1 Million from the fed and uses a low Reserve to make loans greatly exceeding that because the Loans are an asset on their books ; and, as repayments come in multipliers on those. Where does it stop? When the twig snaps and then raging inflation must kick in at an Exponential level with time. Then SNAP!

Contributor B: I have no disagreement with the conclusion, however, the facts leading there need to be adjusted/considered. For example, in the early 80′s, liquidity was not nearly the issue as it was raised in the statement. Not only did my clients acquire funding as required in that period, but I [stupidly] agreed to a mortgage in that period with an interest rate that still gives me nightmares. For the last few years interest rates have been suppressed, but at the same time my middle market clients have complained of there being insufficient liquidity to fund their business loans, meaning that new business ventures were not realised. This has relaxed in the past year or two slightly, but you need to remember one of the issues regarding the vast amount of dollars being held in banks.

When the FED began shipping huge quantities of dollars to friendly banks after the 2008 crash in order to stabilise some very shaky balance sheets, the FED promised to pay interest to the banks on those funds kept in storage with one absolutely unbreakable codicil: under no circumstances could the banks use those funds as part of their asset base in making loans. In other words, none, zero, zip, nada, NONE of those FED funds could be used for loans. Clearly, this move suppressed what would have been an immediately inflationary environment in the US, a highly destructive inflationary environment. But it also left these banks which were otherwise strapped for funds floundering for any money to loan out to their best small business customers. The banks may have stabililsed in the past few years of lean flow of funds, but it is not that much better in the commercial market for small and mid-sized customers.

The Mint: As Contributor A highlights, the entire modern monetary system is extremely fragile and, given its debt base, could quickly disintegrate were a crisis of confidence to emerge or a widespread failure of technology make it inaccessible.

Contributor B (to whom I will defer on funding experiences of the early 80′s) brings up an important point in the form of the “unbreakable codicil” of the FED with regards to funding intended to shore up the Federal Reserve system. While this move made the banks and system technically solvent, the Fed has ignored the fact that the US economy has outgrown the Federal Reserve system, as the economy is starved for money at a time when the Fed’s measurements indicate that quite the opposite is true.

In the 2008 panic, the Federal Reserve deviated significantly from its traditional funding mechanisms to save its system and has altered the normal monetary transmission protocol. I believe that this has created a feedback loop which will result in the Federal Reserve system receding and other mediums of exchange posturing to take its place.

Contributor B: I thoroughly agree that it will be reset, David. However, while you may see market forces and evolved consumer needs driving this reset, I tend to pay attention to the political aggression of states not at all amicable to the interests of the FED and believe the geopolitical transformation we will witness may be the lynchpin upon which the existence of the FED depends. In the long run it will not really matter to the FED whether it is driven by the economic needs of the consumer or the geopolitical ambitions of another nation, but it will matter to the ordinary participants, I suspect. The withering of FED control worn away by alternative exchange mechanisms will provide a much different life at ground level than the sudden repudiation of the USD as the world reserve currency as anticipated (and desired it seems) by the Chinese military (along with a few others who are tired of US economic hegemony). The former is a transformative change more gradual in nature while the latter can be far more sudden in keeping with the rapid shifts in the global market; the former providing the opportunity to adjust more peacefully while the latter is expected to lead to widespread disruptions in service, food, and support delivery at the ground level. Food riots, water riots, just plain riots, and toilet paper riots… sorry, basic staples of urban and 21st century life will be in short supply. I think I’ll find farmland in another country far away. ;-)

For ease of transition, I’d vote for alternative exchange mechanisms. Curiously, I saw an article a few weeks ago that noted extreme activity increases in southeast Asia on Bitcoin and the development of alternatives… either opportunity or another front in the attack on the USD. It can be both.
Now, to envision a world without central banks. That takes us back a while in history…

Then again, perhaps this graph {Editor’s Note: Regarding the Longevity of currency reserve status over the past 600 years} tells it all:
http://www.zerohedge.com/sites/default/files/images/user3303/imageroot/2012/01/20120103_JPM_reserve.png

… and speaking of market competitors, Googlecoin? it is being touted already.

Contributor C:
“Centralized short-term interest rate management must be abandoned before it is too late, for it is leading the activities of mankind towards a dangerous showdown with the limitations of the natural world.”
I like above statement. 

This game of interest rate putting up and down could create a crisis if somebody implemented at the wrong time. I consider interest rate as a weapon of mass of destruction if we manage it recklessly. Interest rate volatility creates problems for investors, homeowners and other savers. What about instruments linked to interest rates? What will happen if we don’t carefully manage or misuse those instruments? Why do we see higher interest rates in some periods and lower interest rates in some periods? Can’t we find solution to fix interest rates without creating volatility?”

The discussion, which is about to take many an unforeseen turn, continues tomorrow…things are about to get lively (at least lively as far as short-term interest rates discussions go) indeed!

Stay tuned and Trust Jesus.

Stay Fresh!

David Mint

Key Indicators for April 28, 2014

Copper Price per Lb: $3.07
Oil Price per Barrel: $100.93
Corn Price per Bushel: $5.07
10 Yr US Treasury Bond: 2.68%
Bitcoin price in US: $431.71
FED Target Rate: 0.10%
Gold Price Per Ounce: $1,303
MINT Perceived Target Rate*: 0.25%
Unemployment Rate: 6.7%
Inflation Rate (CPI): 0.2%
Dow Jones Industrial Average: 16,361
M1 Monetary Base: $2,721,500,000,000
M2 Monetary Base: $11,353,000,000,000