Understanding the Mechanical Elevation of Inflation Instigated By Elevated Policy Rates

If you can achieve a positive real yield on bonds, you could have achieved zero inflation under ZIRP.

Central Banks Have Credibly Learned To Deal With The Hard Problem of Banking: Financial Instability

One important point we must acknowledge, before we discuss how current central banking practices for inflation control are misguided, is that, to their credit, central banks have largely figured out how to do their primary job. This is the hard problem of banking, addressing financial instability. Having solved the hardest part of their job, it has been less clear historically and politically how central banks should best deal with the remaining issue of inflation. Before we get to discussing this inflation problem, let’s review the problems that come with financial instability and how modern central banks deal with this.

When I say that central banks have “solved the hard problem of banking”, that does not mean financial instability can never happen, nor that central banks can always see it coming, only that modern central banks have learned how to respond to stabilize payment systems and avoid the contagious financial destruction that can come after a crash.

In a crash, when one debtor fails to make payments, their creditor then has less income, and is themselves less able to make payments. Thus a financial crash is contagious. This tends to coincide with financial instability: when the value of a bunch of collateral assets all go down at the same time. In such an environment banks will not only deal with defaults, foreclosures, and losses, but they can in fact go insolvent from the loss to their equity as collateral assets decline in value. The reduced value of assets then does not sufficiently cover their liabilities. If banks cannot make their payments then any business or individual customer of the bank will likely also be unable to make payments, and the resulting loss of jobs, income, and livelihoods can be devastating.

Because the fallout of the problem is much larger than the original instigators, there is seen as being a legitimate public role to play in arresting the damage of financial crises and stabilizing the financial system. It is not crazy to compare this to the need for public firefighting. A financial crisis can spread beyond its source because balance sheets of different banks can be deeply interconnected through lines of credit, shared ownership of assets, or parallel movement of prices downward across an entire asset class. Because fires can easily spread, we focus first on putting them out, and then ask questions later.

In this role of addressing crises, central banks are dependent on the support of and coordination with a political authority, and so financial instability that also involves a political crisis, has no simple or universal solution. You cannot have a stable society without political stability. The way that central banks address financial instability is to move the problem of unpaid debts from a financial sphere to a political sphere.

Practically, this is essentially a massive financial bankruptcy process for the economy as a whole. When an individual borrower declares bankruptcy, they are then subject to the authority of some judicial process, which assumes temporary ownership of their assets and decides how they will be distributed among creditors, and what assets may be retained.

The Political Process of “Bailout” is Essentially a Mass Bankruptcy

When the entire financial system goes through this “bankruptcy” process, the central bank buys a bunch of bad debts, and then the enforcement of debt becomes a political problem, comparable to a taxation issue. Many rightfully complain how this process was conducted around the world in 2008, and during other crises, because historically the instigators of the problem have ended up getting off the hook and in some cases coming out ahead. But for the purposes of immediate financial stabilization, punishment is not the important part. This is not to say that instigators of financial crises and fraud should not be prosecuted, only that this is more for the purpose of accountability and preventing a repetition, rather than being necessary to stop the damage.

Continuing with the fire analogy, when an arsonist or a careless homeowner starts a fire, the firefighters need to focus on putting it out, and only later do legal and investigatory processes determine if a perpetrator is responsible. But these are two different matters. Unfortunately, sometimes this response amounts to little more than a stern scolding and while handing the perpetrators a fat paycheck.

A Zero Rate Represents Efficient Credit With No Markup, Not Free Money

With a zero interest rate, that means you can perfectly efficiently turn collateral assets into the settlement asset with no overhead cost. How much of the settlement asset you can get, however, depends on collateral appraisal. As I explained in the last two posts, the appraisal for financial assets being used as collateral can be conservative, because if the loan is repaid then the collateral is retained or recovered.

Practically speaking, private financial entities do need to charge some level of interest, fees, or markup, in order to cover their operating costs. Whether this is measured as an interest rate is arbitrary. If the costs of this overhead scale proportionally to the capital involved, then an interest rate makes sense. However, if the overhead costs of lending are fixed costs, then it is cheaper or more competitively priced to charge this in the form of fees.

The Fallacy of Composition In Interest Rate Setting

Because we charge individual borrowers interest as a way to cover the overhead costs of borrowing, as well as to incrementally enforce credit limits, central banks and economists have erroneously supposed that this practice of charging higher rates can be extended to the economy as a whole.

In other words, if we can raise rates on one borrower to try to limit and charge them for their credit usage, why can’t we do this for the economy as a whole?

The problem comes in that much of credit is a horizontal and not a vertical transaction. In this environment raising rates is essentially an act of financial redistribution. Ignoring duration and fixed instruments, borrowers pay more while creditors earn more.

The glaring issue, once you reframe the credit system using direction of borrowing and lending, is that governments carry a large amount of debt, so from this perspective the act of increasing interest rates as a vertical transaction becomes a huge payout to the government’s creditors. So we have two financial branches of government: the fed and the treasury, and the fed raises rates on the treasury. And then everyone who extends the government credit from that point, gets a huge government handout in the form of greater interest payments.

Interest as an Intertemporal Exchange Rate

While this horizontal and vertical framing is important, there is an even more basic reason why elevated rates devalue money. And that is viewing interest as an intertemporal exchange rate.

Before we get to the temporal aspect of this, let’s imagine that you issued a currency and then you decide to reissue a new sequence of bills (Perhaps you are a recently elected president and you want to put William McKinley on the $5 bill and “upgrade” Lincoln to the $500 bill). For this process, you decide to let anyone exchanging get 5% more for exchanging their money, in order to encourage them to turn in their old bills.

What would be the simple and direct effect of allowing this exchange?

Well, to simplify our scenario imagine that all money is in the form of circulating currency. Then, allowing anyone to get more money in new bills, by trading in old bills, would have the generally expected effect to devalue the currency by the amount issued. This is essentially what happens in a stock split.

Now we will consider what would happen if you did this every year. Destroy old notes, and reissue new notes, and offer people a reward for exchanging their money.

Year over year, it would not be crazy to expect this to have the same inflationary effect as people earned more money from this exchange.

What’s the Difference? Are Bonds Liquid?

So the only difference between our described scenario, and earning money on treasury bonds, is that you have to turn in your money at the beginning of the year, and then you have to wait until the end of the year to cash out. But because you can always sell those treasury bonds early, potentially you can cash out any time you need, and someone can buy a bond as soon as they are paid. So long as you wait to sell the bond, when you want to spend the money, and the person receiving your cash promptly buys a bond after they receive it, then it becomes very similar to holding that as cash all along. The issue here is “how liquid are bonds”. That is an issue that central banks deal with, as they still believe costly rate hikes, and not disciplined collateral appraisals, are the solution to inflation.

But if the interest rate is stable, then bonds are completely liquid at that rate. So in normal operating conditions, the risk of holding bonds, compared to holding cash, is that if the fed raises rates, you will have to wait until the bond matures to get the full amount of cash. Otherwise bonds are completely liquid.