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For
many years, I (and others) have been pointing out that the demand for base
money is not all that stable, in fact it is highly variable. I like to use
the word "chaotic." What does "chaotic" mean? It means
that it is not a matter of If-A-Then-B. If you have A, then sometimes you get
B, sometimes C, sometimes D. The result is that the "steering wheel and
brake pedal are disconnected." If you turn the wheel to the right (If
A), then the car doesn't necessarily turn to the right (Then B).
November 26, 2005: The Steering Wheel and
Brake Pedal are Disconnected
November 20, 2005: Does "inflation
targeting" work?
This is particularly true with today's system of targeting an overnight bank
rate. This is NOT the same system as was used during the gold standard years.
Yes, there was an overnight bank rate, but the mechanism of the gold standard
was a value target, not an interest rate target. The value target was of
course the value of the currency, pegged to gold. So, although there was of
course some rate at which banks lent to each other, this was more in the
nature of a regular market. When you have a value target, and adjust base
money accordingly, then the steering wheel and brake pedal are connected
again. It is a relationship which is not chaotic, but rather one in which
certain actions (increasing or reducing base money supply) reliably lead to
certain conclusions (supporting or reducing the value of the currency). This
is why gold standard systems work and floating currency/interest rate
targeting systems do not. This is also why you cannot use an interest rate
target to operate a gold standard.
Even within the context of a floating currency, sometimes a government wants
to raise or lower the value of the currency. The typical notion is that a
higher short-term interest rate target will lead to a higher currency, and a
lower short-term interest rate target will lead to a lower currency. This
idea persists for year after year even though the evidence shows it is
plainly wrong. Japan has had a minimal interest rate for decades, but the yen
remains one of the world's strongest currencies. Other countries, like
Turkey, have a short-term rate of 60%+, also for decades, but experience
nothing but continuous inflation. The main reason this idea persists is, in
my opinion, because of denial and embarassment. If the economists and central
bankers were to admit that this doesn't work, then they would have to admit
that they have no technique that works. That, in other words, they are
incompetent boobs at the mercy of chaos and dumb luck. Which is, actually,
the fact of the matter.
Now let's get a little more specific. Let's say a country wants to
"support its currency" somehow, and decides to raise its interest
rate target. After all, they are not going to lower the rate target, right?
And leaving it the same is a lot like doing nothing. So they conclude that
the right move is to raise the target. (The right move is to reduce base
money supply directly, and let rates fall where they will, which might be
lower not higher, but that is much too sophisticated for these dummies.) So
the rate target goes up.
Then what happens?
Usually this rate hike is interpreted as an economic negative. Don't fight
the Fed. This is particularly true if the rate hike is big, like to 15% or
25% or 50%, as does happen sometimes especially to emerging market countries
suffering a currency crisis. If your currency is in a crisis and the
short-term interest rate goes to 20%+, don't you think that is sort of a bad
sign? Anyway, the result is often that people become rather cautious, the
economy suffers, and this results in a reduction in base money demand. The
currency ends up falling, not rising.
Just take a simple thought exercise. Let's say the Fed, without any previous
warning, just raised its interest rate target to 10%, from around 0% today.
Imagine what would happen to the stock and bond markets. Turmoil! Now, answer
this: would the dollar go up or down? Think out a little bit on the
timeframe. Not just ten minutes after the Fed's announcement, but a week
later. A month later. Six months later. A year later.
Who votes for up? Who votes for down? It's hard to say, right? In that
environment of economic turmoil and panic, financial system convulsions and
probably expectations of dramatic economic slowdown, the dollar might fall.
On the other hand, maybe people would take it as some sort of committment to
a stronger dollar by any means, and the dollar would rise. Like I said, it's
chaotic. I would vote for down myself, given the present situation. However,
in a different situation, I might vote for up. Chaotic.
There's another factor worth considering. When interest rates are high, then
the opportunity cost of holding non-interest-bearing cash (base money) is
high. Thus, people want to hold less of it. The demand for base money
declines. However, when interest rates are low, then the opportunity cost of
holding non-interest-bearing cash (base money) is low. You can hold lots of
it with no negative consequences. In other words, a lower interest rate leads
to more base money demand, and possibly a stronger currency as a consequence.
Likewise, a higher interest rate leads to less base money demand, and
possibly a declining currency.
I have been aware of this for some time, but always at a somewhat anecdotal
level. John Hussman has recently quantified this relationship, and it turns
out to be a tighter connection than I anticipated. Read his whole writeup
here:
http://hussmanfunds.com/wmc/wmc110124.htm
This graph is maybe a little hard to interpret at first. The bottom axis is
the ratio of base money to nominal GDP, as indicated. We see that it varies
from about 0.05 (i.e. 5%) to about 0.15 (15%). In other words, sometimes the
total base money outstanding is 5% of GDP and other times it is 15% of GDP, a
factor of 3! Also, we see that this relationship is related to short-term
interest rates. From this we can get a rough guess about what might happen if
the Fed went from 0% to 10%. "Liquidity preference" (demand for
base money) might go from about 13% to about 5%. Which is a big move, and not
necessarily currency-supportive. At all.
However, especially in the case of the U.S., the validity of this is rather
hypothetical, because most base money holders are not even in the U.S.! The
dollar is an international currency.
January 16, 2011: The Composition of U.S.
Currency
You can see the problem of relating base money demand, which is global, with
the nominal GDP of just one country. There's so much more to it than that.
Which is what I mean by "chaotic."
That's probably enough for today. I'm going to have more examples of these
sorts of base money/"liquidity preference" things in the future. It
is important to understand how economies really work, not how people would
like them to work. Economies are much more variable and flexible than people
imagine. All of Monetarism was based on the assumption that
"velocity" (the "money"/GDP ratio) is stable. But as we
can see, it is nothing remotely resembling stable. It is all over the place.
This is because an "economy" consists of people. It is not some
sort of ideal gas in a system of pipes. People are variable and flexible.
Sometimes they want to hold shoeboxes of dollars. Sometimes they want
short-term debt. Sometimes they want long-term debt. Their preferences may be
rational, or they may not be. They may be driven by fads, manias, panics,
whatever. Do you see what I mean by "chaotic"?
Nathan
Lewis
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