Understanding The Interest Rate Fallacy: The Risks Of Holding Fiat

The belief that low rates lead people to borrow more and expand credit, or are stimulus, is wrong.

Understanding The Interest Rate Fallacy: The Risks Of Holding Fiat

Originally published on Bitcoin Magazine, then on BTCM.co

“After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die.”
-Milton Friedman, “ Reviving Japan,” 1998

In this article, I want to take a deeper look at a very common misconception about interest rates, namely that low rates are a sign of easy money and stimulus. This misguided belief can lead people to make incorrect assessments about inflation and, hence, their investment thesis. Today, we cover the “interest rate fallacy.”

A large part of the inflation story drilled into us by the negligent economists in academia and at the Federal Reserve is the belief that low rates lead people to borrow more and expand credit, aka, print money. They want us to believe that the Fed sets rates low as an easy money policy to cause growth and inflation. On top of this, they have built the idea that low rates plus quantitative easing (QE) is very inflationary, as if they are unleashing a biblical flood of liquidity and money printing.

All schools of thought that I’m familiar with agree that low rates are stimulatory: Classical, Keynesian, Monetarist and even my beloved Austrian School. It’s a nearly-universally held dogma that is objectively wrong.

Milton Friedman And The Interest Rate Fallacy

The interest rate fallacy was outlined by Milton Friedman all the way back in 1968, in “The Role Of Monetary Policy,” published by The American Economic Review. He wrote this prior to the Nixon Shock, when the U.S. was still on a gold standard, but the monetary system was already working as if it were a 100% credit-based system. Here is the important bit:

“As an empirical matter, low interest rates are a sign that monetary policy has been tight — in the sense that the quantity of money has grown slowly; high interest rates are a sign that monetary policy has been easy — in the sense that the quantity of money has grown rapidly. The broadest facts of experience run in precisely the opposite direction from that which the financial community and academic economists have all generally taken for granted.
“Paradoxically, the monetary authority could assure low nominal rates of interest — but to do so it would have to start out in what seems like the opposite direction, by engaging in a deflationary monetary policy.”
-Milton Friedman, “ The Role Of Monetary Policy,” 1968

Friedman clearly said that interest rates follow from monetary conditions — “has been tight” or “has been easy.” Interest rate moves do not lead to the monetary conditions. Low interest rates do not cause monetary expansion, it is a deflationary environment that causes low rates.

How do you get monetary expansion? “Lower rates,” one might say, but according to observations, that doesn’t work. If we are stuck in an ultra-low interest rate environment, either the monetary conditions are naturally tight, or the Fed has artificially made those conditions tight somehow. Low rates are not due to monetary conditions being easy.

It just so happens that there are two options for prevailing monetary conditions, expanding or contracting. That means any period of contraction with low interest rates can only be followed by an expansion and its resulting rising interest rates. This creates a pattern for our primate brains: “Low rates are followed by expansion.”

While technically true, it is not a causative relationship. Low rates could be followed by continued tight monetary conditions and yet lower rates, but we wouldn’t see this as a separate incident of low rates. Eventually, expansion will come back and rates will begin to rise. Voila, you have low rates leading to expansion.

Although Friedman said that “monetary policy has been tight,” he did not mean “interest rate policy.” I interpret this term as monetary conditions, because he did not see interest rates as the all-consuming policy choice, or even a possible one.

“These considerations not only explain why monetary policy cannot peg interest rates; they also explain why interest rates are such a misleading indicator of whether monetary policy is “tight” or “easy” [because of the interest rate fallacy]. For that, it is far better to look at the rate of change of the quantity of money.”
-Milton Friedman, “ The Role Of Monetary Policy,” 1968

Friedman tied low rates to a prevailing monetary condition, but stopped short of tying low rates directly to the level of economic growth. He stated that monetary growth can only provide a “climate favorable” for economic growth.

“But steady monetary growth would provide a monetary climate favorable to the effective operation of those basic forces of enterprise, ingenuity, invention, hard work, and thrift that are the true springs of economic growth.”
-Milton Friedman, “ The Role Of Monetary Policy,” 1968

Richard Werner On Growth And Interest Rates

Five decades after Friedman, Richard Werner would find the empirical link between monetary conditions and economic growth when paired with the interest rate fallacy.

Werner, the German economist who coined the term “quantitative easing,” published a study in 2018 examining 50 years of data from the four major central banks (in Germany, Japan, the U.K., and the U.S.), comparing economic growth and interest rates from 1957 to 2008.

What Werner found was that interest rates followed the direction of economic growth. Interest rates are the dependent variable that follows levels of growth in the economy. This is exactly the opposite of how most people think of interest rates as the causal factor of economic expansion. In other words, after collecting and applying statistical processes to 50 years of post-World War II data, Werner found that lower interest rates do not stimulate the economy, low interest rates meant there was low growth.

Now, we have two insights from the fact that Werner’s findings are very similar to Friedman’s interest rate fallacy: In Friedman, tight monetary conditions led to low interest rates and in Werner, low growth led to low interest rates. Therefore, we can say that low interest rates mean tight money and low growth in a credit-based system. Conversely, if there is easy money — aka, accelerating money printing — rates will not be low.

Today, our low and negative rates around the world cannot signify high levels of money printing. In fact, they tell us that money printing has been muted or declining.

Credit-Based Systems

This makes sense if you understand money in the current system is credit based. Inflationists are correct, money printing is inflation and causes interest rates to rise, but they are incorrect in claiming that we are in an easy money environment of massive money printing.

Money is created in the process of a bank making a loan and destroyed in the repayment of the loan or default. It is the net change in credit that is a change in supply. $1 billion in new loans can be made, but if $2 billion is repaid or defaulted on, the net change is a shrinking of total credit. Inflationists can be correct that money is being printed, but if the interest rates are low, nearly all of that is being destroyed again.

If the economy is growing, the net change in credit will be positive, and money supply will grow. This inflation gets transmitted through the economy, causing higher prices. Only then do inflation and inflation expectations increase, lifting interest rates. This does bring up another aspect of recent small rises in interest rates, which are not caused by inflation but by impaired liquidity. More on that in a future article.

The opposite is true for slowing credit growth or straight out contraction. Economic calculation done under a higher growth rate are met with a slowing economy. This makes loans harder to service in a tightening financial climate, even if credit is still expanding nominally. All that is needed in a credit-based financial system is for credit growth to slow for financial conditions to tighten. Low rates signal low growth and a bad economic environment, forcing banks to tighten lending standards to more credit-worthy borrowers. Low rates disincentivize money printing.

When we combine these two insights from Friedman and Werner, it becomes apparent that we need economic growth and monetary expansion for interest rates to rise sustainably. In a credit-based monetary system, the tie between these two (growth and monetary expansion) is so closely linked that they can be considered as the same thing. Monetary expansion cannot happen without economic growth and vice versa. Therefore, today with a growth rate around zero and interest rates at 40-year lows, we know there cannot be net monetary expansion happening.

Low Rates And Lending Behavior

Most people believe borrowers want to borrow more if rates are lower. This is not necessarily the case. Low rates mean the economy has low growth and borrowers are generally experiencing bad times. In this environment, borrowers see their income as less secure, they naturally minimize their bills, and don’t want more debt than necessary to make it through the rough times.

In a bad economy with low rates, it is the less responsible borrowers who are seeking out new debt, which translates into an increasingly risky environment for lenders. For that reason, lenders on the supply side also become hesitant at lower rates. They don’t want to lend at rates that don’t compensate them for this risk. As rates increase, more borrowers qualify for loans. As rates decrease, fewer borrowers qualify.

Bankers want to make money; they want to lend money to people that pay the loan back plus interest. The security blanket of a government bailout doesn’t matter all that much. All the crises since the Great Financial Crisis have proven that the market will freeze up prior to the central banks reacting. The Fed is a follower, and crises happen fast. The bank doesn’t want illiquid risky assets in a build-up to a crisis, let alone as the crisis is in full swing. They know the Fed is always late to the party and don’t want to be the next Lehman.

Low rates tell lenders that risk is elevated, and instead of stimulating credit creation, they cause lending standards to tighten. This limits who and what are worth the risk. Only the most creditworthy companies and individuals will be able to get a loan. Large public companies are a better credit risk than smaller businesses.

Secured loans are also lower risk than unsecured ones. Many people claim spiking housing prices are a sign of money printing, when in fact they are a sign of tightening lending standards and low rates. When buying a house, the headline total price of the home doesn’t matter. It is the monthly payment — the affordability.

As rates lower, monthly payments go down, and since mortgages are secured by the property itself, the same quality of borrower can afford a larger mortgage while remaining at relatively the same risk. This is the process by which asset prices rise in tight monetary conditions. Loans get naturally concentrated in lower risk, higher quality loans and higher growth sectors.

In Summary, And Bitcoin’s Potential

We can summarize then that interest rates go down because of slowing growth and the associated rise in general credit risk. Access to credit will naturally constrict along the lines of credit worthiness, which explains rising wealth inequality, sector disparities and even manifests itself as a greater role of government in the economy (because the most creditworthy borrower is likely the government itself). Low rates do not signify money printing, they mean tight monetary conditions, lack of confidence and an increased perception of risk most likely due to direct experience in the market.

Some readers might mistake this article for indicating that I approve of the current economic conditions or monetary and fiscal policies. I do not. However, I also do not see the current economic and political situation as the result of a unique, malevolent ideology or central plan. As Friedman spoke of a “climate favorable” to economic growth, I believe these economic conditions create a favorable climate for extremes in ideology and politics.

Lastly, the extreme dynamics illustrated in this post between interest rates, printing and growth are due to the 17th century form of money and monetary system currently dominant in the world — credit-based money. These effects would be significantly reduced if bitcoin were the primary money.

Credit is still possible with bitcoin, but commodity money is a financial asset without counterparty risk, and therefore, would go a long way to constraining the spread of contagion in the economy. Balance sheets would inherently be more secure with bitcoin than when all financial assets are someone else’s liability.