Negative Interest Rates: A Delusional Concept Beyond Space and Time

At the time of this writing, the notion of Negative Interest Rates are being pushed forward by central banks throughout the world. Bankers are developing new and improve ways to help stimulate the economy, and the employment of negative interest rates is the latest tool in the banker’s tool kit. Why the use of negative interest rates? How does it actually help the economy?(If it actually does) With this article, it will explore some things that make this concept of negative interest rates against reality. Keep in mind, an entire treatise can be written just on the notion of interest rates.

What Is the Interest Rate?

The non economist(and some mainstream economist) think the concept of the interest rate is exclusively related to the money and finance. There is some truth to this claim. Yes, interest rates are used in the world of finance, for example, loans to obtain a home, cars, or other fixed assets. Most will see the interest rate in these transactions as the “cost” of purchasing the underlying asset.

However, the origins of the interest rate does not begin in the world of Finance. It starts in the world of Economics. One of the forerunners of the development of the concept of the interest rate was Eugen Bohm Bawherk. His critique of Karl Marx’s work(Exploitation theory) lead to an expansion of the interest rate, and subsequent thinkers such as Knut Wicksell continued the development of this notion.

The fundamentals of the interest rate is straight forward: It is all directly related to human action. All behavior is purposeful. Since humans are unable to be in multiple locations in space and time, this means certain actions are done before others. This explicitly means there is a preference in ranking of preferred actions. For example, if three items are preferred, the first item, the second, and the third must be done in order temporally. The utility ranking(as this is called) simply is a preference ranking of the activities the actor chooses to engage. Of course, this example is given for simplicity, as this process is much more dynamic and there are many more options. Nonetheless, the ranking still exists, and due to the constraints of space and time, some items are done now(in the present) others in the later(in the Future).

The interest rate is derived from the economic actors choosing goods in the present versus the future. The prices of those goods–ones purchased in the present versus the ones in the future. That net ratio is the actual “interest rate”. The other consideration: This “interest rate” is unique to each individual. It is subjective to the individual’s preferences, as each person’s utility ranking varies.

Since each person’s utility ranking varies, and the interest rate is unique to each individual, how is it possible for the Central Bank to calculate the overall interest rate? It can not.

The Folly of the Negative Interest Rate

The interest rate, as it is based on present and future transactions, makes the outcome a positive integer. This is the first thing that makes the negative interest rate fallacious. Moreover, in consideration of how man moves through space and time, time travel going backwards in time is not possible. Having a negative interest rate implies the economic actor is moving backwards in time, and currently is choosing things in the past over things in the future. This is nonsensical. Back to the first point, if we take two prices of the same good, a current price versus a future price, how would that yield a negative number? One of those prices, in our ratio, would need to be a negative. Do Vendors sell goods with negative prices?

Vendors with Negative Prices

If vendors(firms) sell goods(currently or in the future) sell goods for a negative price, this would yield a negative interest rate. This also is absurd. The vendor is seeking to sell his goods at the highest price possible, and the consumer is seeking to purchase those goods at the lowest price possible. The optimal point of this scenario is the equilibrium price; this price is not a negative integer. Also, the business owner needs to earn a profit on the sale of his goods. The profit serves several purposes: (1) It allows the owner to cover his expenses to repurchase more goods to sell, (2) The net profit(revenue less expenses) acts as a return on his investment; this is adjusted against the interest rate. Having a negative interest would imply no prices, or no positive integers acting as prices, and the consumers would be receiving the goods plus extra cash(acting as a credit). This also works against the incentives of human action.

Negative Prices

Prices serve as signal callers in the marketplace. They allow both buyers and sellers to realize if there are changes occurring. For example, if prices rise sharply, this could indicate a scarcity issue with that certain good. Perhaps something along the supply change is impaired, causing a delay in the distribution or manufacturing of that good. Note: sharply rising prices will not detail why the food’s price has risen. Based upon that sharply rising price, the consumer can choose to re prioritize his utility preferences and elect to choose a viable substitute, at a lower price, or opt out of buying the good. With this activity, the increased prices discriminate against those who are willing to pay the increases price versus the group of persons who seek to pay for those goods a lower cost.

How would a negative price come into play? If goods became scarce, the owner would not lower the price to the point he give the goods away for free AND provide additional monies to the consumer. The business owner would not stay in business very long. Eventually, consumers would run out of those goods.

Conclusion

As bankers adopt negative interest rates, it simply is a move from the sublime and into the land of folly. Consumers pay for goods with positive integer prices, and firms accept their cash with positive integer prices. This directly correlates into a positive interest rate. Moving interest rates to zero or in the negative simply has a negative impact on the economy, and it should be rejected as a means of monetary policy.

Negative Interest Rates in Sweden a FAIL

The expanding popularity of the employment by central banks of negative interest rate is quizzical. How can so many experts take a wrong turn when it comes to economics? Especially, when these “experts” have learned the fundamentals? Speaking of the fundamentals, I will lay out a proof, in a future blog entry, on how the concept of negative interest rates are simply against nature. It is nonsensical.

Also: These experts use to validate the success or failure of negative interest rates by using the CPI(Consumer Price Index) as support. Using this technique also is fallacious. The analysis on why use of this index is fallacious will come for another essay.


Read more here:

https://mises.org/wire/why-sweden’s-negative-interest-rate-experiment-failure


The New York Federal Reserve: Household Debt and Credit Report

Recently, I posted this article, “Americans: The Increasing Debt Balance”. It referenced the findings from the New York Federal Reserve’s report. Here is an excerpt directly from the New York Fed’s report:

“Household Debt Continues to Rise; Mortgage Originations Hit 14-Year HighThe CMD’s latest Quarterly Report on Household Debt and Credit reveals that total household debt increased by $193 billion, or 1.4 percent, to reach $14.15 trillion in the fourth quarter of 2019. This marks the twenty-second consecutive quarterly increase, with total household debt now $1.5 trillion higher, in nominal terms, than the pre-recession peak of $12.68 trillion, set in the third quarter of 2008. Mortgage originations rose by $224 billion, or 42 percent, in the fourth quarter of 2019 to reach $752 billion, the highest volume seen since the fourth quarter of 2005.”

The one of findings that makes for a strong concern is the number of mortgage originations. It’s difficult to take that figure and draw conclusions regarding the real estate market, but this number does create the need to take a sharp eye at the real estate market.
The overall household debt rising, in my opinion, shows that many households are attempting to maintain a standard of living in this hyper consumption Inflationary based economy.

Read the New York Fed’s report here: https://www.newyorkfed.org/microeconomics/hhdc

The Fed Doesn’t Have the Control Over Interest Rates Everyone Thinks It Does

Strictly speaking, the Fed does set the interest rates, but, from an economic perspective, it does not know what the true interest rate is. It’s impossible to know, yet many assume that the Fed does know this rate. Attempting to set the interest rate is a form of price control, as spawning from this attempt provides a chain of economic events…these events are costly. For example, keeping interest rates too low, allegedly is supposed spawn economic growth, but the trade off cost for this price fixing measure is more inflation. Inflation devalues the monetary base—requiring the consumers to use more monetary units to buy the same goods.

Excerpt from the article:

“Last week, the Federal Reserve did what was expected by leaving their targetfor the fed funds rate unchanged. To the point that a misplaced adverb can cause a mini market selloff, investors meticulously dissect Federal Open Market Committee minutes and hang on Fed Chair Jerome Powell’s every word for language that provides insight into where the Fed may take interest rates. It’s a near universal axiom that the Fed sets interest rates, and we’re all just along for the ride.

How much control does it really have, though?”

https://www.thestreet.com/markets/fed-doesnt-completely-control-interest-rates?puc=yahoo&cm_ven=YAHOO&yptr=yahoo

Who Are the Current Main Players in the Federal Funds Market?

When the Federal Reserve conducts monetary policy, it announces a target for the “federal funds” interest rate. The implication is that if this specific rate rises or falls, it will affect other interest rates throughout the US economy; for example, like federal funds interest rate moves closely together with other key benchmark interest rates, like  the interest rate for overnight borrowing on AA-rated commercial paper. However, the identity of the parties borrowing and lending in the “federal funds” market has changed dramatically since the Great Recession. 

Read more here: http://conversableeconomist.blogspot.com/2020/01/who-are-current-main-players-in-federal.html

HOW FRACTIONAL RESERVE BANKING CONTRIBUTES TO INCREASES IN MONEY SUPPLY

Excerpt:

“In a truly free market economy, the likelihood that banks will practice fractional-reserve banking will tend to be very low. If a particular bank tries to practice fractional-reserve banking it runs the risk of not being able to honour its checks.”

I concur. In the mythical world of free market banking, banks would be incentivize to ensure they have the proper reserves to lend out money based upon those reserves. The implicit moral hazard, from having a centralized bank, would be non existent.

Banks would also have some sort of tangible precious metal or valuable resource to “back” the money. In this quixotic banking model, banks would base their interest rate upon the overall interest rate(inter temporal time preference) of the market place. Banks would stay in(or lose) business based upon their ability run their operations effectively.

Back to reality, or the current state of banking affairs: Banks are de incentivized to run their operations as effectively knowing there exists a series of back stops in the event they err in their aggressive business practices. The Fed can come in and provide a series of tactics, via monetary policy, they will keep them from failing. This typically includes inflationary measures that is beneficial to the banks, but the economic cost is dispersed in the marketplace.

Read More:

https://www.cobdencentre.org/2019/09/how-fractional-reserve-banking-contributes-to-increases-in-money-supply/

The ‘Natural Interest Rate’ Is Always Positive and Cannot Be Negative

The ‘Natural Interest Rate’ Is Always Positive and Cannot Be Negative:

Key Excerpt: “Some economists have been arguing that the “equilibrium real interest rate” (that is the “natural interest rate” or the “originary interest rate”) has become negative, as a “secular stagnation” has allegedly caused a “savings glut…”

The notion of a negative interest rate is against nature. The concept of interest rate is based on the human action of choice and preference, as the actor moves in space and time. For example, we choose things based on the preference of things that will provide us some sort of “pleasure”. If a person chooses item (x) before item (z), this means that in that moment in time, item (x) is preferred over item (z).  This process happens in space and in time. Time has passed forward, as the actor moves from item (x) to item (z). The definition of the natural rate of interest is the price ratio of goods at two different points in time. Based on this definition, and the notion of time, and space, the natural rate of interest can not be negative. Also, we can not go backwards in time based on our actions. This notion makes the concept of negative interest rates fallacious.

More Thoughts on Interest Rate

The Interest Rate: The mystery. The intrigue. Most individuals concern themselves about this when they are purchasing a home loan, acquiring credit cards, or purchasing a new vehicle. However, this notion is much broader than obtaining more debt. It is much broader, yes, much deeper than imagined, as is not well understood, even by philosophers, economists and finance scholars. The natural rate of interest, or ordinary interest, is inherent in every thing we do as actors in a “free market” economy.

What is the Natural Rate of Interest?

Classical Economic Model

There are two divergent models of analyzing the notion of natural rate of interest. The first model is derived from the Classical Economic school of thought.  This model is based on the popular Economic frame work of supply and demand. Simply put: The interplay of the supply and demand of money, produces a particular interest rate.(Ceteris paribus)  For example, if demand is held constant, and the central bank increases the monetary base, the interest rate would fall. Conversely, if the Central bank decided to reduce the money supply, with demand remaining constant, the interest rate would rise (Ceteris paribus) If this is analyzed from the demand side, if demand rises for the currency, and the currency bases remains the same, the interest rate rises.(Ceteris paribus). If the demand for the currency falls, and the currency base remains the same, the interest rate will fall.(Ceteris paribus) This Classical model of analyzing the interest rate views things at a macroeconomic level.

Marginalist Economic Model

This model was specifically pushed forward by Marginalist Economist, Eugen Bohm Bawerk. As per Bohm-Bawerk et al, the notion of the natural rate of interest speaks to the time preference of consumption from the individual actor in the marketplace. To Wit: The time preference of from the individual’s consumption between today’s goods, as compared to future goods. Notice that this definition has little to do with the bank’s rate of interest, although the bank’s rate is a singular actor’s rate of time preference, as that actor would be the bank. This ratio, nets the prices between the two respective time periods. Of course, this activity is not a static, so the interest rate is constantly shifting, modulating and changing, as the actor’s preferences change.

Interplay of Interest Rates to Meet Equilibrium

Going back to the Financial Intermediaries, e.g Banks, Credit Unions, Financial Institutions, Insurance companies, and etc.) need to manage cash and their monetary equivalents, these institutions’ role in the market economy is vital. They are responsible for allocating scarce resources, to wit, providing cash capital to entrepreneurs. Many people mistakenly assume the bank’s interest rate is the same as the natural rate of interest, as this is demonstratively false.

Let us suppose that the bank’s interest rate is 5%, and the natural rate of interest, in the marketplace, was 8%. The bank would loan out, or invest, or place money in capital goods that would yield a 8% return. This process would continue until the bank’s interest rate matched the return on those capital goods. Why does this happen? As the bank continues to invest or loan out money into those capital goods, the demand for those monies and goods rise. As the money demand rises, due to the need to invest in capital goods, the bank’s price on money, the interest rate, rises. Once the bank’s interest rate, and the return on investment in capital goods equals the same rate, it makes no sense for the bank to move money into those capital goods.

What happens if the natural rate is below the bank’s interest rate? If the bank interest rate is 5%, and the natural interest rate is 3%, the bank will not seek to loan or invest into capital goods at that lower rate. What may occur is the following: Banks may continue to hold the cash, at 5%, until the demand for long term capital projects rise above 5%. In this case, as in the prior case, the opportunity cost of the bank’s money must be considered.

Banks are seeking to profit from the arbitrage: In the former case, the Bank seeks to make a profit from the spread of 8%, the natural rate, and the 5%, the bank rate. As for in the latter case, the bank seeks to take a more conservative position and hold onto its cash. In both cases, on the long run, all actions will seek to meet equilibrium.

Based on these two examples, the bank’s interest rate will not equal the natural rate of interest. This is true since there would be no profit seeking opportunities. The bank’s funds would sit idle, no cash capital would move other sorts of capital markets. This sort of analysis demonstrates that these two interest rates are not the same.

An Example of the Use of Interest Rates in the “Real World”

With a business that is capital intensive, management of this capital equipment is vital for the success. When a business owner is seeking more cash capital to acquire a piece of capital equipment, he should be factoring how this equipment can benefit his operation, on the margin. He will look at how the marginal cost impacts the marginal benefit. If the firm has extra cash, or investment capital, it will seek to obtain a return on investment on that capital. So, if the owner of the firm is purchasing a piece of manufacturing equipment, and will yield a return on investment higher than the natural rate of interest, and the current “bank interest rate”, the business owner will invest in that manufacturing equipment. The owner, like all humans, is engaged in a profit seeking enterprise. And, it is that profit that is his return on investment.

Conclusion

As with all things, in the capital markets, actors are constantly pushing towards equilibrium. All actors are seeking a state of peace, or in economic terms, equilibrium. The constant ebb and flow of the play between the natural rate of interest, and the interest rate placed by financial intermediaries demonstrates this. The natural rate of interest simply is an expression of human action, as the individual’s preferences span throughout the space/time continuum.