Collateral is the Price of Money, Interest is the price of Credit
There is a common myth that interest is the price of money. This myth is easily dispelled by realizing that interest is merely a financial inducement to upgrade one type of money into another. The cost of this upgrade depends on which form of money one starts with, and what form they want to end up with.
The price of money is in fact the collateral one must offer in case of default. This is what sets the price level. Lenders from pawn shops to banks all require some form of collateral. How much collateral must be offered against a dollar of lending, is the measure of what a dollar is worth.
It is possible for central banks to directly target how collateral value is measured, to manage the price level. This is generally frowned on for two reasons. First of all, this requires a thorough assessment AND appraisal of bank assets. Typically in an audit, what happens is that we check that bank records are accurate. However, if you are trying to use collateral to control the price level, then this requires an independent appraisal of all the bank's assets, that isn't just based on mark-to-market figures.
The difficulty and political landmines associated with appraising all of a bank's balance sheet, means that this approach is not exactly popular.
In addition to these issues with appraisal, on a philosophical level, many people want markets to set prices, not government. However, because the government is using these assets to decide how money should be issued, I believe this point should be moot. Additionally, the government has an interest in financial stability. Because it often backstops volatile financial markets, it needs to have its own metrics for pricing assets.
Asset side regulations are another possibility, that may not require full-blown appraisals, but merely constrain banks to take a more conservative approach to value the collateral they accept. One example is Mosler's suggestion to require banks to hold mortgages on their own balance sheet, until maturity, and not sell them on secondary markets. These secondary markets seem to be especially good at pushing up the price of these assets, because this allows these brokers to make a healthy profit. Without the secondary market for mortgages, which is ultimately backstopped by a central banks commitment to price stability, banks would be much more deliberate and conscientious about not only who they lent to, but how they value the home that they are lending against.
Interest is a Transfer Payment
Interest is a transfer payment. As such, unless the interest is paid from the public to private parties, interest itself has no effect on the total amount of money. However, interest is also paid from borrowers to savers, and it seems a pretty safe bet to say that savers have a lower propensity to consume.
So while we are transferring money from people who like to spend it, to people less likely to spend it, the total of money is also being increased, because the government is a net debtor.
Velocity of Money Doesn't Matter If All Exchanges Involve Equal Value
Velocity of money mostly happens through money substitutes. People can easily create and spend credit, using collateral, leaving the original money untouched. This does not itself determine how much value gets created or destroyed by financial transactions, although there is a rough correlation.
So it's not that money moves very quickly, it's that people are able to create alternative forms of money to transact with.
But none of this matters by any account if exchanges involve swaps of equal value. If all exchanges involve equal valued swaps, then the price level is stable.
The counterargument is of course that more spending pushes up the price level along an aggregate supply curve. There are two problems with this. The first is that an aggregate supply curve is not a function of money itself.
The second problem, is that because anything can be used as collateral for creating money substitutes, a rise in prices is only possible by changing the value of collateral. If more transactions push up prices, then those now higher priced assets can be used to create more collateral, but also, the existing collateral is more valuable. Because money substitutes use collateral, additional spending has no inherent price bias.
The Money Stock Doesn't Matter if Net Spending Is Zero
We just described how money velocity may not matter, now we will describe a scenario where the money stock itself is irrelevant.
If you start and end the day with the same amount of money in your bank account, it doesn't matter how much money is in there. If you earn $100 dollars, and spend $100 on average, on a given day. It doesn't matter, for inflation if you have $1,000 or $10.
People typically save for life events like retirement, vacations, etc. For these events they will have spend more than they earn. But they save assets and not just money. The value of their assets affects their purchasing power.
The Problem With the Equation of Exchange
The problem with the equation of exchange is that it looks to all economic activity to explain the price of currency, instead of viewing the currency as a government security. But you could do this for any asset. You could denominate bank deposits in terms of apple shares, and then call credit a substitute for apple shares. However, Apple shares are valued based on the value produced by Apple, inc. Using Apple shares as a unit of account, would not change how apple shares are valued in the long run.
It gets confusing, because public value comes in large part from externalities, when the public sector makes the private sector more productive. So the rest of economic activity does matter, but not the way the equation of exchange suggests, in terms of economic transactions only. Wealth and productivity are more important, than economic transactions.
As a security, national debt, and the liquid portion, reserves and cash authorized by the U.S. government, is valued based on the value the U.S. government provides, which facilitates people to save further into the future, and also support a higher tax burden.
The Costs of Default
One way in which interest hikes may destroy money, is in fact by leading to more defaults. This makes it harder to create money substitutes.
So interest hikes can reduce
Interest is a Signal
In addition to its mechanical effects, interest rates also tell us what a central bank wants, and may be indicators of other coordinate actions, such as stricter regulatory oversight, or other institutional actions like going after financial bubbles, fraud, or environmental problems.
As a signal, obviously, this depends very much on the goals and "guiding principles" of our institutions. So long as a central bank believes an interest hike is an effective and appropriate response to inflation, its other coordinated and parallel measures, whether or not they can be quantified specifically or defined concretely, can also affect trends in inflation and financial stability.
"Risk" is an After-The-Fact Catch All Used to Explain All Disparities In Credit Costs
It is always possible to attribute any disparity in credit prices to risk, when in reality, a wide variety of factors influence the price of credit.
Risk is at best a heuristic. Ones overall access or lack of access to financial tools, might be a better predictor of the rates they get, and not their specific probability of default.
As a means of financial segregation, risk assessment is reminiscent of "pre-crime". You are judged by your cohort, before something happens. While this may be necessary for private financial intermediaries, public policy should be aware of, and seek to mitigate, the overall disparities in financial access and resources. On an individual basis, good financial choices will always be the most impactful factor, assuming no uncontrollable events like health crises or natural disasters.
How Policy Rates Actually Work
Explaining how policy rates affect money markets, credit markets, mortgage rates,
car loans, and more, is a complex issue. But we should be aware of at least the basic tools of central banks, which are open market operations, discount windows, and regulatory powers.
I'm not going to go into this so much in this post, will hope to get into that more in the future.
The Market Cap View of the Price Level
The currency is just the liquid portion of the national debt. How much the currency is worth depends on how markets value your national debt. We can say the U.S. is "worth" $30 trillion.
The Empirical Effects of Rates Are Good to Know But Not For The Reasons Economists Suggest
Many people obsess about observed empirical effects of policy rates. While this may be very useful for understanding the connection between policy rates and other market rates, what it is not so useful for explaining, is inflation.
There may be stable effects of a policy rate on inflation under a certain financial framework. This could be a direct effect, based on credit costs and by financially destroying money substitutes through margin calls, or it could be an indirect effect, as the interest rate signal may be intentionally or unintentionally coordinated with regulatory or political pressure, which itself may be the reason for inflation reduction.
Such potential coordination between rates and other forms of regulatory financial discipline, is far from a bad thing. It is much more important to rein in inflation, than to be certain that one tool or another is responsible, or to isolate the exact effect.
Why Interest Based Inflation Control Is Not Like Temperature Control
We just discussed how inflation has many complex causes. But this does not necessarily mean that a simple control mechanism is not possible.
The temperature of a building also involves complex dynamics, sunlight, ground temperature, air flow, radiation, surface area to volume, etc. Yet temperature control is very simple. If the building is too hot, run the AC.
The problem with interest based inflation control is not that a simple tool cannot control a complex phenomenon, it is that interest itself is no simple tool. Interest has many, many, many, effects. It transfers wealth, it changes asset prices based on duration. It creates certain financial incentives, it can lead to margin calls and defaults for specific investors, regardless of how
Given the number of different effects of interest rates, and the difficulty of attributing empirical observations to a specific effect, it may be much more sound to use a mixed approach of collateral appraisal, asset regulation, and fiscal bid discipline, to manage the price level.
Instead, Interest based inflation control could be thought of as akin to opening or closing windows in a building. The effects of this are highly dependent on other environmental factors. It is conceivable that such "outside airflow control" could have a net positive benefit, and yet still be poorly targeted.
This means it is perhaps possible to identify more precisely when interest hikes tend to have the desired effect and when they don't. Additionally, isolating other "coordinated signals", would be useful, because we could use those signals, while avoiding some of the costs associated with higher rates, including higher interest on the national debt, higher debt burdens for private parties, and higher overall credit costs.
It is conceivable that one could even restrict the volume of credit, independently of the price of credit.
Cash is trash, Cash is king
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