An Interesting Theory -Why interest rates are important- but not for the reasons commonly assumed

Synopsis

At the heart of modern economic theory is the concept of interest rates being used to control the economy by striking a balance between growth and inflation. It is a concept that is so well entrenched that few would challenge its validity but when the policy is matched against outcome its track record is disappointing to say the least. Low interest rate policy has failed to stimulate the post-crash economies of Japan and Europe and the marginal success in the UK and USA has more to do with Quantitative easing. This is not its only failure when high interest rates were used to squeeze out inflation in 1980's Britain it remained stubbornly high. As a theory it is not fit for purpose and we should be looking for alternatives.

An Interesting Theory presents one alternative. In this book inflation, growth and interest rates are still linked but not as commonly assumed. Not by balancing the two but rather as a means of controlling the money supply that in turn has a knock on effect on both growth and inflation. This simple notion can be used to explain why cheap money policies have not worked in Europe or Japan and the failure of that monetarist experiment in Britain along with underlying inflation, stagnation, hyperinflation, bubbles and the success of forward guidance.

The arguments made here will be considered counter-intuitive to students of mainstream economics and the danger is that they may be so revolutionary that it is considered just another crank theory. However it fits the data so well that they even provide an explanation as to why the current monetary tools including the Monetary Exchange Mechanism works in the short term.

Summary

'An Interesting Theory -Why interest rates are important- but not for the reasons commonly assumed' is approximately 17,500 words long including appendix and contains 18 graphs based on Data from among others the Bank of England, the ONS, the Federal Reserve Bank, the European Central Bank and the World Bank.

From the introduction of An Interesting Theory

The principals of today's economic theory have been developed over a number of years and draws from a number of traditions. However at its core is the notion of balancing growth and inflation through the cost of money. This theory seems to work well enough when economies are in good health but has proved unreliable in the years following the 2008 crash. Some put this breakdown to an anomaly but as the same circumstances arose following Japan's crash some two decades earlier it would suggest that there are more fundamental issues at play. This appears to be a total misunderstanding of the role of interest rates in a modern economy. This should not be too much of a surprise when even central bankers confess that they do not fully understand the process as the former Governor of the Bank of England, Mervyn King, has admitted as much.

At the heart of this misunderstanding is how fiat money is created. Traditionally it has been supposed that it was purely down to public demand for borrowing from high street banks that in turn could facilitate them from the central bank which can ultimately draw from an endless stock of government bonds. Whilst this may remain a mechanism during periods of exuberance or hyperinflation further analysis of the data suggests that in more normal times the banks' lending decisions are much more conservative. That they limit any increase in lending to an increase in deposits which grow at a rate similar to the interest charged.

This in itself offers an explanation as to why the low interest policies recently deployed have not led to the expected growth but it does not explain the corundum of inflation. Previous theorisers may be forgiven for thinking that raising interest rates does reduce inflation because it does but the effects are relatively short term and have remained hidden as governments or central bankers have tried to micro manage the economy. Nevertheless recognition of the relationship between interest rates and inflation goes back to 1930 when Irwin Fisher developed the equation that linked nominal interest with real interest and inflation. Fisher and those that followed him drew the conclusion that interest rates somehow predicted inflation rather than the cause it. This is again is understandable because at that time the world was on the Gold Standard when the quantity of money was supposedly fixed. Once more an analysis of more recent data suggests otherwise. This shows that the ratio of inflation to growth is very similar to the ratio of lending on property to the whole suggesting that mortgages are the root cause of underlying inflation.

This book presents the evidence for both of these observations and suggests mechanisms to explain them. From this starting point comes a new understanding of macroeconomics that not only explains some of the forms of inflation, including stagflation, hyperinflation and underlying inflation, but reveals the elegance of simple arrangement that matches material growth with the money supply. Unfortunately this elegant system is now breaking down with the move from a cash to a cashless economy.

The book mainly uses data from the UK to illustrate the points made but the principal of interest created money applies to any economy that uses a fractional banking system and this is backed by data from both the US and the Eurozone.

The first chapter presents the evidence for interest rates determining the money supply. It starts with a brief review of the history and current theory regarding money supply to establish the context and the small jump in thinking required to understand the alternative mechanism proposed. It then compares the growth of money supply in the UK, the USA and the Eurozone with annual aggregate interest payments. Finally this new theory is applied to economic events of the past including the Thatcher administration's failed experimentation with monetarism and Volker's successful establishment of the principals of forward guidance.

Chapter 2 looks at the link between interest rates, growth and inflation. For growth it shows a link between an increase in money supply from interest repayments and increased economic activity or GDP. For inflation a link is made between what is known as underlining inflation and lending on property that closely follows Fisher's observation on real interest. The chapter then develops an explanation for the relationship between the two which can also be applied to other inflationary conditions such as hyperinflation. This chapter also has sections on the exception to the augment presented including the apparent success of the Monetary Exchange Mechanism.

Chapter 3 looks at the wider implications of interest payment money growth in the modern economy and how the move from a cash to cashless society maybe the cause of many of our current economic woes.

The final section offers a summary and possible solutions to the issues raised in Chapter 3.

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