by Gary North
The financial press returns to the theme of interest rates again and again. This concern is not limited to the modern financial press. The investment world has always been concerned over the direction of interest rates. The problem is, there is so much confusion about the origin of interest rates that the analyses presented in the press are often conflicting. Their readers rarely can sit down and explain to a novice what they have just read and why it is important.
The concern over interest rates is not wasted by the press. Interest rates are as important for the man in the street as they are for policy-makers at the highest level of government. But when confusion reigns, as it does today, people are apt to make the wrong decisions regarding their investments, which in turn affect their life's plans. Obviously, it will make a great deal of difference when you retire whether your bank pays you 7% or 1% on your deposit.
1.DISCOUNTING THE FUTURE
The fundamental fact of the interest rate is that it is a discount of the future. Let's say that you win a contest. First prize is a fully restored dream car of your youth. In my day, this was a red 1957 Ford Thunderbird, although a 1955 or 1956 would do nicely as a substitute. Someone might even prefer a 1958 Chevrolet Impala, with 1955—57 Bel Airs as substitutes. Ten years later, it would have been a red Ford Mustang. Whatever it is, you just won it.
You are now given a choice. You can take delivery immediately, or you can wait a year for delivery. The outfit won't drive the car or in any way wear it out, but maybe they want to do research on its suspension system. Assuming that you are not about to be sent to Siberia for a year of research on tundra, which delivery date would you prefer? Do you want your prize now or later?
The answer is obvious: you want delivery today. You don't want to wait. Why not? Well, for one thing, you might be dead in a year. For another, you want to re-live your youth before Alzheimer's arrives. Most important, your responsibility is in the present, not the future. Maybe you want to sell the car and use the money for something else. Whatever it is that you plan to do with the car, you are responsible for that decision now. It is better to own the asset now than later. You don't know what is coming later.
But you are probably willing to forego the delivery if the contest organizer offers you compensation. Maybe you are promised 1,000 gallons of gasoline along with the car if you will wait a year. Maybe they promise to run your photo, your name, and a photo of the car every month in your industry's trade magazine. Maybe you could use the publicity. The point is, if they offer you something of value, either immediately or over the next year, you might decide to accept a later delivery date.
To persuade you to delay delivery, they have to offer something extra to you. Why? Because you apply a discount for delay. Someone wants to use the car — your car — during the interim. At some price, you are willing to forfeit the use of your car. They must pay you more than the discount that you apply to forfeited use.
This same analysis applies to every asset that can provide you or anyone else with benefits over time. Usually, people discuss interest in relation to money. Interest is said to be the price of money. This concept is incorrect if it is said to apply only to money. Interest is a discount applied to every stream of benefits, or as economists say, stream of income.
Different people apply different rates of discount to streams of income. Some people are intensely present-oriented. They want action now. They don't want to wait. This is common among children. It is common in the inner city. A borrower would have to offer a high rate of interest to get such a person to give up the use of his money or any other asset. Think of what you would have to pay an alcoholic on skid row to give up his bottle of Thunderbird — the T-bird of the underclass.
Other people are comparatively future-oriented. They are willing to surrender the use of money or other assets for a third of the discount rate that an inner city resident would. The more of these people in a society, the lower the rate of interest in that society: lots of thrifty people who are ready to lend at low rates. Competition among these people to find borrowers will lower the interest rate.
The central fact of interest is this: we discount the future. Item A is worth more to us today than it is a year from now. We have a year to enjoy it. We therefore have to be offered compensation to persuade us to forfeit the use of it. This is also true of item B.
2.A PROMISE TO PAY
The next factor is the reliability of the borrower. Let's return to that 1957 Thunderbird. You want to take it out for a spin today. You've been dreaming about doing this ever since you were 15. You've waited long enough.
Now the outfit says it wants you to postpone that spin, or any spin, for a year. It promises to let you have the car plus 1,000 gallons of gasoline in a year. That sounds good, but are you sure that the outfit will still be in business in a year? Are you confident that this story about researching the suspension system is legitimate? It sounds fishy. What are they really going to do with the car? Are they going to spend a year joy riding, and then roll back the odometer?
You have already discounted the value of the car. Now you must make an assessment of the reliability of the person making the promise to deliver your car and 1,000 gallons of gasoline in a year. There is risk here. How reliable are these people?
You think it over. You are taking a risk. You are being asked to trust someone. You do not have perfect foreknowledge. A promise to pay is not the same thing as paying. It's one thing to discount the future value of the car. It's another to assess the likelihood of delivery.
So, you tell the company that you want 1,200 gallons of gasoline in a year. Maybe the outfit agrees or maybe it delivers the car to you today. The point is, you want to be compensated for the risk you must bear in accepting a promise to make delivery vs. actual delivery.
In every loan there is a risk premium. This is in addition to the discount that both the lender and the borrower apply to the future. The discount is applied to the value of the expected stream of benefits. "How much do I want to drive that car this year?" The risk premium is applied to the person making the promise. "How much does he want to drive that car, and how good is he at rolling back an odometer?"
3.THE VALUE OF MONEY
You and the contest organizer would be wise to take into consideration the value of money. He says he will give you a credit for 1,200 gallons of gas when he delivers the car. If you think the dollar is going to depreciate by 5%, that's a good deal for you. But if he thinks the same thing, he has to factor this expense into the price he will have to pay to get the use of the car to study its suspension system, either in the garage or on the highway at 90 miles an hour.
I am not talking about the rise or fall of the price of gasoline alone. The gasoline futures market allows people to lock in the future price of gasoline, either as buyers or as sellers. I am talking about changes in the value of the dollar.
If you think the value if the dollar will rise, you are predicting price deflation. You would then rather receive a fixed quantity of money for gasoline instead of actual gasoline. The contest organizer would prefer the reverse, assuming that he agrees with you about the rising value of the dollar. He would rather give you a credit card for gasoline. On the other hand, if you both expect price inflation — a lower dollar — then you want the gasoline, and he prefers to promise you money to buy as much (or as little) gasoline as the fixed sum of money will buy when you want to buy it.
So, there is a discount for time that both you and the contest organizer apply to the future. There is a risk premium that you, as the lender, apply to the organizer and his promise to deliver the car. Finally, there is an inflation or deflation premium that both you and the organizer apply to the value of money, assuming that any aspect of the payment is tied to money. In a high division of labor economy, some part of the payment will be tied to money.
It is time to cease discussing 1957 T-birds and start discussing 2004 T-bills. Reality intrudes.
When discussing free market interest rates, economists prefer to begin with T-bills. This is because a U.S. government T-bill is considered as close to risk-free as any investment on Earth. The U.S. government is probably not going to default. Also, a 90-day T-bill is unlikely to depreciate or appreciate as a result of changes in the rate of price inflation. The time period until maturity is too short, and Federal Reserve monetary policy is too stable. So, when we discuss the rate of interest, we are discussing the discount.
Or are we? Financial commentators watch T-bill rates, not as indicators of a society's discount on the future, but as indicators of FED policy. The FED drove down the T-bill rate from over 6% in late 2000 to a little over 1% in mid-2003. That enormous fall surely did not reflect a change in world opinion regarding the appropriate discount for the future. It reflected a change in monetary policy.
To sort out the confusion, we need advice from parrot #1. "Supply and demand. Supply and demand." Parrot #2 is still calling out, "High bid wins," but he is less important at this juncture.
The interest rate allocates capital. That is to say, it allocates expenditures between present consumption and future consumption. People with high discount rates allocate most of their money to present consumption. Call this the pawn shop rate. People with lower discount rates allocate a larger percentage to future consumption. Call this the T-bill rate.
The members of the Federal Open Market Committee (FOMC) of the Federal Reserve System decide how many T-bills to buy or sell. These members have a very low discount rate — not for themselves, of course, but for money they create to buy T-bills. They are like counterfeiters. A counterfeiter has a much higher rate of discount for goods that he loans out compared to any counterfeit money that he loans out. An FOMC member is not lending his own money. He is also not lending depositors' money. He is lending counterfeit money. The difference between counterfeit money and FED money has more to do with trademark analysis than economic analysis.
Economist Murray Rothbard once described a cartoon of a bunch of counterfeiters at their printing press. One of them says, "The local economy is about to get a shot in the arm." Again, the issue here is trademark infringement, not economic analysis.
The FED drove down interest rates in 2001 through 2002 because it bought T-bills with abandon. It bought T-bills with newly created money. "Supply and demand. Supply and demand." The supply of money went up, so the price of money went down. That is, the interest rate on T-bills went down. O, happy day for the Treasury Department. What the U.S. government had been paying to lenders in early 2001 fell by a factor of at least 5 by mid-2003. O, happy day for all other borrowers. O, woeful day for retirees with most of their money in the bank.
People's discount rate did not change. The risk premium on T-bills and other short-term loans did not change. Even the price inflation premium did not change, although it is changing now: upward. What changed was the supply of money being funneled by the FED into the market for T-bills. "Up, up, and away!" as radio's Superman used to say. "To infinity and beyond!" as Buzz Lightyear says.
A SHOT IN THE ARM
Like that counterfeiter in the cartoon, the policy-makers at the FED wanted to give the American economy a shot in the arm. The FED has few ways to do this. Buying T-bills is the main one. But, this time, the shot in the arm did not produce much economic euphoria. The economy barely recovered until late 2003. The housing market continued to boom during the recession of 2001 and the aftermath. The public kept buying consumer goods and running up credit card debt. But the economy barely recovered, and profits remain a disaster zone.
The shot in the arm did not accomplish much, despite a 1% federal funds rate — the rate at which commercial banks lend money overnight to each other. The economy today is growing, and price inflation has returned. But this has been the weakest recovery on record.
The Dow Jones recovered, but seems to have stalled in the mid-10,000 range. It is now falling back. It never regained its 2000 high. The NASDAQ has also stalled, and is well under 5040: March 10, 2000. The stock market has sent a signal to investors for four years: the days of wine and roses are over. The boom of 1982 to 2000 is over. The dreams of compound annual growth rates above 10% are still alive, but the American stock market has not met these dream world expectations for four years. Now it is heading down again.
Fiat money has created comparable price inflation, but it has not sustained the boom except in housing. The shot in the arm has lured millions of Americans to pile up layers of debt. When the price of anything falls, more will be demanded. The price of loans has fallen. The result is the expansion of debt.
When will the boom in financial assets reappear? Even the optimists have no clear answer.
The boom in housing is being sustained by fiat money, which in turn has driven down interest rates. This fiat money came from the FED in 2001 and 2002. Today, it comes from Japan and China, whose central banks have been buying T-bills with the dollars they bought in the international currency markets with newly created yen and yuan.
The problem is, our personal discount rates have not fallen, even though T-bill rates have fallen. People may lend money at low rates because they expect an economic crisis, and therefore they remain content with low rates because of what they perceive is much higher risk of non-guaranteed investments, such as stocks. That is, people accept low rates of interest because of their fears regarding other investment avenues. But when they lose this fear of other investment avenues, their underlying discount rate will reappear in the credit markets.
The boom, if it continues, will push interest rates up.
The world's investors did not move from a personal 6% discount for time (late 2000) to 1% (2003—2004) just because the FOMC's members decided 1% is better. What changed was the quantity of money being allocated to T-bill purchases. The officially licensed counterfeiters gave the T-bill market a shot in the arm. They still are doing this.
The day that these counterfeiters decide to stop supplying the euphoria-inducing substance that allows the Treasury Department to mainline at below-market prices, interest rates will rise as surely as a drug addict has withdrawal symptoms.
I think this is why the stock market has stalled. Investors look into the glassy eyes of the U.S. government and conclude: "Even counterfeiters want a more reliable borrower than this spaced-out wastrel." They think the counterfeiters will find other borrowers. When that happens, the FOMC will have to replace the Asian pushers. If the FOMC refuses, then there will be withdrawal symptoms on a scale not seen in decades.
May 19, 2004
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