Re: Interest Rates, Inflation, Exchange Rates and Credit in Bull And Bear Markets

[Basil Moore <bmoore@xxxxxxxxxxxxxxxxx>]

Henry
I very much like the attached. I am a cheap money man. Lower interest rates
are always desirable, so long as they do not result in excess demand, if
only because they result in higher wealth values, a positive sum game.

But in my mind your story though very elegant is tarnished and even
polluted by your frequent appeal to equilibrium concepts.

As we both know, the real world is complex. In complex systems the concept
of equilibrium has no meaning. Since complex systems, if they are to be
modelled, must be modelled by complex nonlinear dynamic models, no
equilibrium solution exists, even conceptually. There can never be a
general or even a partial equilibrium situation, because, ultimately, all
economic behaviour is forward looking. Since the future is unknowable, our
expectations of the future are continuously changing. Equilibrium means
'sarcophagus' for all complex systems.

Could I ask you to try to rewrite your story without reference to
equilibrium? I suspect it has become what my Doctor-Father Fritz Machlup
used to call a "weasel word"?

Basil Moore

At 08:06 AM 12/1/00 -0500, you wrote:

>The debate on whether high interest rate is inflationary or
>deflationary seems to be a puzzling controversy in economics.  Within
>the current international financial architecture, interest rates
>cannot be fully understood without taking into account their impact on
>exchange rates and credit markets.
>In a globalized financial market, if the exchange rate is artificially
>sustained by high interest rate, there is little doubt that the impact
>would be deflationary on the local economy.  This logic is also
>supported by empirical data in recent years.
>
>Yet many astute economists insist that high interest rate causes
>inflation, at least in the long run.  Perhaps this can be true in
>closed economies, but it is no longer necessarily true in open
>economies in a globalized financial market.
>
>Interest rates are the prices for the use of money over time.  These
>prices do not always track the purchasing power of money which is the
>monetaized expression of the market value of commodities (the
>transaction price) at a specific time.  The purchasing power of money
>fluctuates over time, expressed by the prices of futures and options
>which are functions of the uncertain elasticity between interest rates
>and inflation rates.
>
>As the price for the use of money over time rises, the general effect
>will be deflationary if money is viewed as a constant store of value.
>Otherwise, money will forfeit its function as a constant store of
>value.  On the other hand, if money is viewed as a medium of exchange,
>the ultimate liquidity agent, then rising price for its use over time
>is inflationary as a cost.
>
>Now, in any economy, money tends to play both roles, though not
>equally and not consistently over time.  For market participants,
>depending on their positions (borrower or lender) at specific points
>of the economic cycle (expanding or contracting liquidity), they will
>find different views of money (exchange medium or value storer) to be
>to their financial advantage.  Thus borrowers generally consider high
>interest rate as leading to cost inflation (bad), and lenders consider
>high interest rate as leading to asset deflation (good up to a
>point).  Asset deflation offers good buying opportunities for those
>who have money or have access to credit, but bad for those who hold
>assets but need money, and the pain is proportional to asset
>illiquidity.  Since most holders of ready cash also hold assets,
>deflation has only limited and short-term advantage for them.  For
>inflation to be advantageous, continued expansion of credit is
>required to keep asset appreciation ahead of cost inflation.
>
>The problem is further complicated by the fact that inflation is
>defined mostly by manistream economics only as the rising price of
>wages and commodities, and not by asset appreciation.  When it costs
>10% more to buy the same share of a company as yesterday, that is
>considered growth - good economic news.  When wages rise 5% a year,
>that is viewed as inflation - bad economic news, despite the fact that
>the aggregate purchasing power is increased by 5%.  Therein lies the
>fundamental cause of a bubble economy - growth and profit are
>generated by asset inflation rather than by increased aggregate demand
>stimulating aggregate supply.
>
>Thus the relationship of interest rate to inflation is dependent on
>the definition of money.  But that is not the end of the story.  Under
>finance capitalism, inflation is not merely too much money chasing too
>few goods as under industrial capitalism.  Under financial capitalism,
>two elements: credit avaialbility and credit markets, have
>overshadowed the traditional goods and equity markets of industrial
>capitalism. This makes it necessary to re-examine the traditional
>relationship of interest rate and inflation.
>
>In a bull market, the buyer has the advantage because the buyer has
>the final upside. In a bear market, the seller has the advantage
>because the buyer is left holding the downside bag.  Of course one
>must avoid buying at the peak and selling at the bottom.  And such
>strategies have self-fufilling effects, as technical analysts can
>readily testify.  These effects are magnified in long-run bull or bear
>markets which is represented by a rising or falling sine curve.
>However, the buyer's advantage  in a bull market may be neutralized by
>the inflation that usually accompanied bull markets.  Thus a true bull
>market must yield net capital gain after inflation and real interest
>cost, i.e. interest cost after inflation. And in a deflationary bear
>market the seller's advantage is reinforced by deflation for he can
>repurchase at a later date with only a fraction of his realized cash
>from what he sold previously.  Not only would the seller avoid
>additional loss of holding the unsold asset in a falling market, the
>cash from the sale apprepciates in purchasing power with every
>passsing day.
>
>Thus money plays a passive role as a medium of exchange and an active
>role as a store of value on the movement of prices.  The conventional
>view that inflation is caused by, or is a result of  (the two are not
>identical) too much money chasing too few goods then is not always
>operative.  This is because the availability of credit and the
>operational rules of credit markets can distort the traditionsal
>relationship.  Credit markets, which have expanded way beyond
>traditional credit intermediated by the banking system, operate on the
>theory that money generally must earn interest, whether it is actually
>put to use or not.  There are of course abnormal times when money
>actually earns negative interest becuase of government policy or
>foreign exchange constraints, as in Hong Kong in the early 1990s and
>Japan in 2000.  When idle money earns no interest, credit reserve
>dries up, because it creates greater incentive to put money to work,
>i.e. investing it in productive enterprises. For money to remain idly
>waiting for better opportunity, interest rate must equal or exceed
>opportunity cost of idle cash. Interest then acts as a penalty for
>idle money.  When idle money earns interest, the interest payment
>comes ultimately from the central bank who alone can create more money
>with no penalty to itself, though the economy it lords over is not
>immune. Since late 1999, the Japanese monetary authorities have
>repeatedly reaffirmed their commitment to maintaining their zero
>interest rate policy until deflationary forces have been dispelled.
>The result is a great deal of idle money in Japanese banks with no
>credit worthy borrowers. Japanese savers are foregoing interest income
>for increasing purchasing power of their idle money in an unending
>deflationary spiral.
>
>Efficiency in the credit markets pushes money towards the highest use
>and willlingness to pay the highest interest.  Thus when the central
>bank tightens money supply, the market will drive up interest rate and
>vice versa.  Thus interest rate is a credit market index.  When
>central banks, like the Fed, use interest rate policy to manage the
>money supply, they are in fact uing a narrow market index to
>manipulate the broader market.  It is not different than the Fed
>fixing the DJIA by buying or selling bluechip share to influence the
>broad S&P.
>
>When prices fall, one reason may be that consumers do not have money
>to buy, as in most recessions with high unemployment. Or it may be the
>result of potential consumers withholding their money for still lower
>prices as in Japan now, and in some degree in China in 1998-2000.  So
>deflation is caused by too many goods trying to attract too little
>money entering the market, but not neccessarily too little money in
>the economy.  But if every sellers can realize a cash surplus in a
>subsequent repurchase in a bear market, where does all the surplus
>money go? Obviously it goes to pay interest on the idle money waiting
>for a cheaper price, reducing the central bank's need to issue more
>money to carry the interest cost on idle money.  The net effect is a
>removal of money from the market and increase the amount of idle money
>in the economy. So deflation actually pushes up interest rates without
>necessarily altering the aggregate money supply.  The effect is that
>until prices fall at a lesser rate than the interest rate on idle
>money, there is no incentive to buy.  Thus deflation-driven rising
>interest rate creates more deflationary pressure in a bear market.
>High interest rates moved more wealth from borrowers to lenders and
>from bottom to top in the wealth pyramid.   Moreover, the impact of
>high  interest rate modifies economic behavior differently in
>different groups and even on different activities within the same
>individual.  When the prime rate for some banks reached over 20% in
>1980, credit continued to expand explosively. The opposite happen when
>the Bank of Japan reduced interest rate to zero. High rates only work
>to slow credit expansion if the rates were ahead of inflation. And
>zero rate only works to accelerate credit expansion  if there is no
>deflation. So raising interest rate to combat inflation or lowering
>rates to combat deflation can be self-defeating under certain
>conditions.
>
>Now if two economies are linked by floating exchange rates, free trade
>and free investment flows, the one with a high rate of inflation will
>see the exchange rate of its currency fall.  But a fall in its
>currency will increase the cost of its imports thus adding to its
>inflation rate. and the further rise in inflation rate will push up
>interest rates further.  But a rise in domestic interest rates will
>stop or slow the fall of its currency and attract more fund inflows to
>buy its goods and assets. It also increases its export which reduces
>the supply of goods and assets in the domestic market, thus psuhing up
>domestic prices, while pushing down the price of imports.  The net
>inflation/deflation balance will then depend on the trade balance
>between exports and imports.  This had been given by the ECB as the
>logic of raising euro interest rates to fight inflation.
>
>The availability of financial derivatives further complicates the
>picture, because both interest rates and foreign exchange rates can be
>hedged, obscuring and distorting the fundamental relations between
>interest rates, exchange rates and inflation.  The recurring global
>financial crises in recent years were manifestations of this
>distortion.
>
>The theory of market eqilibrium asserts that market tends to reach
>"natural" equilibrium as it approaches efficiency which is defined as
>the speed and ease with which equilbrium is reached.  Yet the market
>is complex not only because the relationship of market elements is
>poorly defined or even undefinable, but also the very instruments
>designed to enhance market efficiency tend to create wide volatility
>and instability.  Thus a "natural" equilibrium state can in fact be
>defined as the actual state of the fluctuating market at any moment in
>time. With 24-hour trading, the notion of a milestone moment of
>equilibrium is problematic. Further, the vey financial instruments
>created to enhance market efficiency toward its "natural" eqilibrium
>state makes the equilbrium elusive.  Such instruments are mainly
>designed to manage risk generated by both broad market movements and
>momentary disequilibrium.  Structured finance mainly involves
>unbundling financial risks in global markets for buyers who will pay
>the highest price for specific protection. Beacuse users of these
>instuments look for speical payoffs thorugh unbundling of risk, the
>cost of managing such risk is maximized,  The disaggregating renders
>notion of maket equilibrium is not unifiable.  The unbundled risks are
>marketed to those with the biggest apetite for such risks, in return
>for compensatory returns.  Thus market equilibrium is not any more
>merely a large pool of turbulent tranactions with a level surface.  It
>is in fact a pool of transactions with many different levels of
>interconnected surfaces, each serving highly disaggregated specialty
>markets.  Equilibrium is this case becomes a highly complex notion
>making the impact and propect of externalities highly uncertain.  That
>uncertainty cause the demised of Long Term Capital Management.
>Interest swaps, for example, are not single purpose transactions for
>mangaging interest risks.  The can be structured as inflation risk
>hedges, or foreign exchange risk hedges, or any number of other
>financial needs or protection. And the impact is not limited to the
>two contracting parties,  since each party usualy hedge again with a
>third counterparty. Tha is what makes hedging systemic.
>A further irony is that the very objective to insure against
>volatility risk by covering the market broadly increases risks of
>illiquidity.
>
>Henry C.K. Liu
>
>