The mechanism of interest based inflation control is affective but not effective
The most significant factor to inflation is workers effectively using both capital and technology. A strong coupling is necessary for these three to work. Inequality tends to alienate these three factors of production, leading to less effective production.
This is the entire real resource story, whatever is required to get workers, capital, and technology to coordinate effectively. It is better when the workers have a strong democratic and financial voice, and technology is also democratically managed: open source software, public research(software, science, and arts), etc.
On the other hand, you have the conventional mainstream view of how to fight inflation, and it works on an extremely superficial level by manipulating class based income distribution with financial markets, as well as by trying to borrow real resources from abroad.
This program is much more "affective" or emotional and outwardly manipulative, than it is "effective", in solving the diverse supply and coordination issues countries deal with. But despite working on a superficial level, it still technically "works", if you are willing to jeopardize long term health to maintain a disfunctional status quo.
The two potential mechanisms are: upward income transfer, or an increase in real resource borrowing. Interest is either a transfer, real borrowing, or a redenomination of money itself. As a transfer it moves money from borrowers to savers. If all forms of money earn interest, then it is a simple redenomination. As a transfer, this payment is typically upward and highly regressive.
Mainstream economists point to a complex and inscrutable body of statistical work to try to prove that interest rates are effective. Unfortunately, all they have proven is that interest rates are affective, that they manipulate motivations and emotions. While you can claim this "works" it is not for the reason many suppose.
When workers lose income they MUST work harder.
The mechanism of interest as an inflation fighting tool is not hard to understand. Interest is a transfer, and typically an upward transfer, from workers to non-workers. When interest rates are hiked, richer people get more income, poorer people get less. The spending habits of rich people tend to be much stickier, as they have a significant savings buffer to smooth over their spending habits, so much so that they might not notice increased or lost income until years down the line. Additionally, the group of the wealthy and their share of income has only expanded in recent decades. If their income share is fixed and non-negotiable, than policy changes which target the poor will appear more effective.
When workers lose income, they work harder. This hard work temporarily reduces inflation. It could even reduce inflation in the long term if the workers are sufficiently productive to cover the expenses of both workers and non-workers. As I pointed out in the first post on this blog however, an interest rate locks in a minimum rate of inflation, through the mechanism of intertemporal exchange rates, or forward prices.
The Myth of the Price of Money
Many economic commentators, including selective comments from Marx and Milton Friedman, have appreciated the fact that there is no price for money, that money is merely the unit of account to price things. A dollar costs one dollar. If there is a price for money, it is the price for everything else.
But what few explain clearly, is the pricing of credit. Credit in fact is not money, but upgrading from one form of money or security to another. This has a symmetrical component but also an asymmetrical component. The symmetrical component of credit pricing is merely the exchange rate. Whether you are converting from dollars to pesos, or from consumer debt to bank deposits, there is a going rate for this conversion. If the two assets use the same unit of account, this symmetrical aspect of credit is simply 1.00.
Importantly, the symmetrical aspect of credit price applies to the exchange in both directions, both the borrowing and the repayment. But credit pricing also includes asymmetrical fees, which may be applied for various reasons. But frequently, because credit is about UPGRADING between forms of money, one party must be convinced to hold an inferior form of money, and a credit fee must be offered to one party that is asymmetrical. Credit fees assessed in proportion to the volume and time of outstanding debt are called interest. Flat fees or variable fee schedules and penalties are also possible.
Money is Always a Monopoly
Money is always a monopoly, and it is much better when it is a public monopoly, not a private one. Even commodities like gold or cowrie shells, were chosen specifically to serve as money because these are easy to monopolize. A monopoly lets you stabilize prices and regulate the quantity consumed, albeit not independently. By creating a perpetual need for savings year after year, taxes smooth out the relationship between the purchasing power and supply of money. The supply of money can float, with stable prices, because there is nothing sure in life but debt and taxes.
If prices fluctuate or go up despite the perpetual tax debts on all of us, that typically means that production and consumption are out of whack in some way(leading to a temporary price divergence), or the money monopolist has inadvertently or deliberately untethered the price level, either by trying to bid directly against the private market, instead of regulating the level of unemployment, or by enforcing some interest rate regime which either serves as a regressive transfer or a flat out inflationary redenomination(if all forms of money earn interest).
The last form of money to earn interest is always physical cash. But typically cash is not sufficiently significant to avoid this redenomination effect.
The Final Effect of Rates, A Form of Foreign Real Resource Borrowing Using FX Boosting
Domestically, public money should always be the highest form of money, and thus require no interest offering to induce its acceptance. Tax payments are forcibly "accepted", and a requirement for saving any form of wealth or property that has public recognition. Taxes are a public fee, for a private reservation of property or resources, and these taxes do drive a currency's acceptance, but they do not fund the spending of that currency, because unemployment "funds" spending, whether that unemployment is from taxes, productivity gains, distributional effects, or technology. Unemployment funds spending.
But abroad, currencies compete with each other, in an environment where they no longer benefit from tax credit status. For this reason, offering interest in a currency, whether on bonds, reserves, or deposits, whether that interest comes from government payments or supposedly market mechanisms, such interest can be an inducement to foreigners to hold a currency.
But this interest inducement just serves to increase borrowing, and like all borrowing, it has an immediate and long term effect. The immediate effect improves your financial position, but the long term effect depends on leveraging the short term benefits for real benefits over the long term. In strictly financial terms, borrowing is always a net loss, but if you can use real resources, then borrowing can work out for good.
Again, it is important to note that the domestic costs of borrowing in your own currency are technically zero, although when your populace is heavily import dependent, any domestic costs quickly are transformed into foreign costs.
But there is a caveat to this FX foreign borrowing effect. It only works if domestically you are anchoring your price level in some way. If domestic price levels are not anchored, then own currency interest will not work in FX markets, as the inducement effect of interest rates only works if it is a transfer, and not a re-denomination. exchange
So in countries like Argentina, the effect of interest and inflation is simple. It is a locked in re-denomination, and it might as well be zero. If argentina were to price anchor domestic prices, then interest could serve as a transfer to induce FX borrowing. However, this is not the case.
Notably, the issue of own currency rate hikes for an FX boost can be achieved by directly borrowing in foreign currencies, instead of an interest offering with domestic price anchoring, which only hurts you domestically and forces you to export more over the long run. Either way, you are obligated to export more real resources.
Summary
So we have outlined three effects of interest rates: Upward transfer, redenomination, and foreign borrowing.
Firstly, the upward transfer effect can squeeze workers harder, thereby reducing inflation, through a class redistribution that extracts more work from an increasingly compressed work force. This may even "work" over longer periods, if technology, logistics, or foreign expropriation and unequal trade help support it.
Secondly, there are FX considerations, in which rate hikes with domestic price anchoring can simulate foreign currency borrowing. Finally, interest can simply be a re-denomination as captured by forward pricing markets or intertemporal exchange rates.
We have also contended that the "credit pricing" channel of interest inflation control is a non-starter, because private parties need an interest inducement is totally non-e
This shows two channels where the conventional interest rate mechanisms can have observed/prescribed inflationary control effects, without actually being "effective" or "advisable", as it is merely kicking the can down the road in dealing with inequality and real resource exhaustion.
This resolves the apparent mismatch between what mainstream theory claims to observe through complex econometric manipulations, and the accurate reality based economic description. While manipulation can induce an apparently "effective" response, it is more illusory and delaying larger catastrophe.
High Powered Money Never Needs to Offer Interest
The facts are simple, high powered money, as the highest and most superior form of money, stabilized with perpetual tax flows, supported by public infrastructure and public provisioning, and backed by the political consensus it represents, never needs to offer a rate inducement to finance domestic spending. If an economy is truly free of slack: excessive luxury consumption, diminished labor force participation, prime age workers living off of savings, and passive income, then spending must displace some necessary private provisioning. But a truly "slack free" economy has never occurred in history. In fact, I would contend that economies, like computer RAM, operate best with a perpetually high amount of slack, which they engage only on a short term basis in response to shocks or crunches.
In this case, if you have price anchoring, the currency inflates until public resource bids go unfulfilled and can be used for the necessary private provisioning. If you do not have price anchoring, the public may try to bid higher to provision its perceived necessary public expenditures.
Private Spending on Necessities Is a Higher Priority Than, and a Pre-requisite for, Public Spending On Efficiencies
In order for the public to provision itself, private parties must first be able to provision themselves with necessities. Indeed individual self sufficiency is a requisite first condition for ANY public provisioning. However, unemployment does not mean the private market cannot provision itself. In fact it is quite the opposite! Unemployment means the private market is over-provisioned relative to its desire to save money, and thus some labor bids are not accepted, and there is slack. The price level of the slack is overall unimportant, if any slack exists, it can clear at any price until it is gone.
So while real resources exist first from private provisioning, money enters first from the public as a payment for public service and as a credit to pay taxes to reserve property for exclusive private use.
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