Interest Rate Myths

This is one of the more contentious chapters. The MMT lens suggests the inflation rate is the interest rate, or at least a high enough interest rate will equal the inflation rate. But not all MMT informed economists would agree, and that is pretty much only because the econometric data analysis is inconclusive. However, we are working on analysis to show the MMT base case is correct under most “normal” opening circumstances, which is that in normal times an upwards adjustment in the interest rate is inflationary, one-for-one.

This occurs when the own price for the currency dominates the general price level. (The “own price” being the interest rate).

This is because the interest rate directly, one-to-one, raises forward prices, as well as provides the necessary free money to afford those prices (through interest income).

This is the “first order” effect of interest rates — raising rates heats up the economy, contrary to all mainstream academic thought. Yet consistent with MMT thought. Empirical studies confirm the MMT account, I can mention at least five studies in a sequence, Sims (1992) , Hanson (2004) , Wray and Tauheed (2006) , and Werner (2022) . There is also Milton Friedman (1968) , not a great paragon of realism, admitting all the empirical data suggests interest rates have the exact opposite effect to what orthodox economists all think.

The nuance is that for people who are forced by circumstances to take out bank credit, this way of generating inflation is incredibly unjust and regressive. It feeds interest income to people who already have money, fueling the economy at the top, but crushes the poor who are reduced to buying food on credit cards.

It is also a very seriously dumb way to stimulate the economy, because it targets all the money gains to the rich, and does not target any specific production that might be causing supply shortages and hence cost-push inflation. Of course, central bankers are not entirely dumb, they see interest rate increases as cooling off a hot economy, so they are not trying to boost supply! They think they are trying to suppress demand. They’ve got it all backwards, but at least they are not so stupid to believe giving people free money while simultaneously crushing those in debt will help move food and furniture on truck and rails, or make nurses and teachers function better.

The bankers are far more psychopathic. They actively want to crush workers. FED chair Powell: “There is no painless way to get out of a recession.” — Us: “Yeah right, pain for the poor, free money for the rich.”

The instability of high interest rates is thus more a social instability. The purely monetary nominal inflation can be sustained for ever, but the debt burden faced by the poor cannot. They will either die or file for bankruptcy and thus incur all the downstream costs of having filed for bankruptcy (credit downgrades, loss of houses, and all that).

The fair discipline on a booming hot economy is thus not the interest rate upwards adjustment. The discipline has to be on real resource rationing and fines and taxes on unnecessary pollution, waste, fraud and corruption. The latter methods of discipline hit the rich the harder, but never unfairly.

It is not easy to prove the myth is false

The reason this is not so simple to prove is because prices are given in per-sector data, and prices in any given sector will not track one-to-one changes in the general price level. And what is the “general price level”? It is set by government policy — the issuer tells you what you need to do to get their IOU. But no one knows how to compute it very precisely, since government pricing policy is a total mish-mash of confusion about what capacities the government thinks it has, or does not have. So people use metrics like the CPI index, which is not a very accurate measure of the general price level. So it is difficult to extract the proof that the ‘interest rate is the inflation rate’ from metrics like the CPI.

Underlying the myth

The basic thought behind the interest rate myth is that lowering the interest rate lowers the costs for borrowers, so fuels expansion; while raising rates incentives savings, and crushes borrowers with higher costs. The former should thus increase demand (by bank credit expansion) while the latter should suppress demand (via savings, people getting “out of cash and into bonds”).

This sort of analysis is often simplified into the meme that interest rate changes alter the consumer behaviour, from borrowers to savers, or vice versa.

It is a nice fairy story, but that’s all it is.

You cannot “turn” someone who needs to eat into a saver, not if their income is entirely spent on rent, electricity, transport to work, and food.

Interestingly, the more sophisticated financial bros know this, they call it an absorbing barrier. Prices cannot climb up forever, even with hysterical mob ponzi psychology, because eventually a seller cannot find a willing buyer. The only buyer that can afford any price is the monopoly issuer of the currency, and they (aka. governments) are not well disposed to just buying ponzi positioned assets or commodities. (Most finance bros do not recognize this in the interest rate policy though, sadly. It is like knowing gravity works on Earth but not understanding it works on the Sun the same way.)

In the real world the critical understanding is not found in this simplification of “turning borrowers into savers,” but rather in the more subtle distinction of propensity of borrowers to save versus propensity of savers to spend
Any difference in these two metrics will have either the desired monetarist policy effect, or if the monetarists are truly hapless the opposite effect.

All the econometric analysis anyone has ever done has found almost no significant difference in these propensities. Some analysts claim to have seen a small difference in propensities, but it is not enough to justify the efficacy of monetarist policy (using the interest rate as a lever).

So in the real world, the interest rate is largely ineffective as a policy tool, and when effective tends to have the opposite effect to that which mainstream economists and central bankers think.

The MMT claim is that the interest rate is the inflation rate, and so raising the interest rate is stimulus, and heats up the economy, while lowering the rate${}^\ast$ does the opposite, all other things being equal.

${}^\ast$ There are many prices for money in any economic system, the rate here refers to the central bank corridor rates.

Proving Interest Rate Hikes are Pro-Inflationary

We are working on this for the case of New Zealand. But for a few cases Richard Werner has already done some of the analysis. In his paper Reconsidering Monetary Policy: An Empirical Examination of the Relationship Between Interest Rates and Nominal GDP Growth Werner shows that for the UK, USA, Germany and Japan:

In 6 out of 8 cases the hypothesis that “low interest rates cause economic growth” can be rejected.

This goes against the grain of about 95% of all economics analysis by the major schools of thought for over 200 years. Yet it is fully in accord with the MMT lens. High interest rates add to bank reserves whenever the government Treasury issue is above about 50% of GDP. The reason? When government Treasury bill issue is above 50% of GDP the government is a huge net payer of interest, which prevailing tax return cannot fully drain.

Yet it is highly regressive stimulus, and it is basic income but only for people who already have money, but it is a stimulus nonetheless. MMT people do not advocate for this type of stimulus, and would prefer the central bank interest rate to be dropped to zero.

The way to stimulate an economy is to invest in productive fruitful jobs, and the government, as the monopoly currency issuer, can always do the minimum necessary by hiring all sustainable resources (especially labour) which the private sector is unwilling to hire.

This results in higher purchasing power in the pockets of labour, who spend most of their income, which drives sales for firms. That is the correct functionally targetted type of stimulus a failing economy needs, not higher interest rates.

A more recent study by Werner and Lee (2020) of 19 major economies had similar conclusions.

• Normally higher interest rates correlate positively with higher GDP,
• when the correlation is negative the causation is reversed: the causation more often runs from GDP (growth) to interest rates, not the other way around.

Werner’s results reject all the mainstream economic school’s basic assumptions.

Furthermore, Werner’s results are more consistent with the story that central banks raise interest rates always “too late,” after a supply shock has already caused cost-push inflation. The recession is then already baked-in and the inflation pressure eases as lower income households get crushed. Then again, too late, the central bank takes their foot off the gas pedal and lowers the interest rate, which accelerates the recession. (Note: the central bankers think they have their foot on the brake peddle, and they do not realize it’s the gas peddle.) Although by this time it has little impact, since in a recession it is a relief to the poor and lowest wage earners to see low interest rates, and the decline of unearned income for the bond holders is nothing great to cry about.

It is all a bit perverse and backwards you see. There is no good reason why the monetarist policies will work as advertised (there are some bad reasons, and naïve reasons), and they never really do, and what is really driving the macroeconomic cycles is the government’s automatically baked-in fiscal stabilizers (tax revenues and welfare spending).

The central bankers think they are doing the job, but they’re not, and what they might be doing to counter the cycle at the credit margins is backwards, pro-cyclical, not counter-cyclical, and regressive (favouring the rich, hurting the poor). As Werner’s data analysis shows, for the most part.

Methodology

Initially we are going to redo Werner’s analysis for New Zealand. Our conclusion will differ though, since Werner thinks central bankers dominate, whereas MMT analysis shows the fiscal authority is by far more dominant.

At Ōhanga Pai we favour stimulating an economic system from the base, from where real people are in desperate need for spending power, and not from the top where excess spending power already exists. So we would advocate zero interest rate policy, coupled with a Job Guarantee and targetted fiscal stimulus — such as government direct investments (no “borrowing” your own IOU) in start-up worker cooperatives running sustainable production enterprises.

This advocacy sounds good to us, but to be credible we will need to show that the low interest rates are not a stimulus, and the high rates are a stimulus under certain conditions, but in a terrible socially unjust way. We can do this by looking at how the lags and leads in the time series go, using Granger Causality tests, and if possible by looking at rate of change of household debt/credit by income levels, if the data has been published.

The MMT Story

MMT typically (base case and all that) says a few things about the impact of monetarist policy:

1. Government deficit adds to GDP, so tends to imply a central bank reaction function to desire to “hit the brakes” (raise rates) which is actually hitting the gas peddle - so GDP grows more. (The positive correlation Werner and Lee found.)
2. In an inflationary period the central bank does the same, wants to “cool” thing s off, leading to the same short-run effect = higher GDP and sustained inflation. (The debt-deflation crash comes much later, when the poor get crushed.)
3. In a low inflation era the CB wants to put their foot on the gas to raise inflation up to “target”, so they lower rates, which lowers government net injection, so in fact cools things off relatively, so the CB foot is actually on their brake. But in this case if GDP is growing debts are being paid off and the central bank reaction is being caused by GDP growth with low inflation. The GDP growth in this sort of case is probably being driven by the government fiscal injections, pretty much independent of the central bank rate (except for a small effect that credit expansion has on tax drain).

Tax here is the automatic stabilizer, not the interest rate. The interest rate is a repeller in dynamical system terms, not an attractor.

The third point here suggests Werner and Lee ought to look at the causality between the CB reaction and the inflation rate, not just GDP. This is the relationship which MMT suggests should be tighter. However, it is tighter according to MMT only because of central bank mindset or groupthink (which can change, e.g., supposing they start to consider MMT seriously, then the reaction function could flip - or not - depending upon whether they are psychopaths or not).

Before getting to the data analysis for New Zealand, we can at least run through some of the narrative. Since this is only a story, you need to put on your bullsh*t detectors. Fair warning ok? I am not claiming in the mess of the real world this story is always going to be true, I am only (i) claiming it probably is mostly true, and that (ii) later I hope to show it checks with empirical analysis.

The critical MMT insight is,

The interest rate is not an endogenous variable (is not set by “the market”) but rather the central bank chooses the interest rate.

This insight is critical to understanding how the interest rate effects the economy. Since the IR is an exogenous policy variable chosen by the monopoly currency issuer (the government, through it’s agency the central bank) all effects of the interest rate need to factor into account the prevailing economic conditions that influence the votes of the central bank boards to alter the interest rate.

Without this insight you’ll be as stupified and perplexed as old crusty Uncle Milton the-more-unrealistic-the-model-the-better Friedman.

We take as a base case an economy operating fairly normally, no war, no pestilence, moderate political turmoil as usual.

• the economy starts to boom with a bank credit expansion,
• the government fails to support the credit expansion, so moves closer to a surplus position (more currency withdrawn via tax than investment added),
• firms and households enter into positions of foreseeable unpayable debt burden, so contract their spending,
• this puts massive pressure on prices, as the bank credit continues to flow, prices rise, since the government is not filling the “hidden” (but not truly hidden) debt burden,
• central bankers eye a possible recession, they see the inflation not as a boom in credit, but a result of workers demanding wages (this is usually false),
• believing the wages are causing the inflation (too much spending power) the central bankers think they have to put their foot on the brakes to cool off inflation, which means they want to put people out of work,
• they believe hiking the interest rate will do this (making credit tighter), so they step on this peddle, but it is the gas peddle, not the break.
• This makes the inflation worse, since the interest rate is the fundamental critical price, the own price of the currency, so when the IR goes up, so do prices,
• the central bank cannot see why their model is not working, so they step harder on the gas, thinking it is the brake,
• but interest rates (and this sort of central bank) are acting pro-cyclically, so they are driving the financial system off a debt burden cliff, private debt that is, putting precarious firms and households into more unpayable debt positions,
• so eventually it is not the inflation that stops, it is the sales, as households and firms cannot pay back their debts, they drop prices in fire sales shrinking their buffer stocks, and start trying to tighten their budgets,
• so eventually the inflation stops as the supply of credit and profits from sales drop off.
• Mass unemployment results,
• government welfare payments rise,
• so net currency is injected,
• and the sales pick up again, back to normal with some lags and hysteresis for the poor, and the cycle begins again.

It is a sad story, it is slow, but this is how “capitalism” (aka. free market ideology, not necessarily Marx’s specific version of Capitalism, but maybe that too) could eventually end, with government being finally recognized as the life support for capital.

However, we currently have no idea how many of these crippling cycles it will take to so impoverish the middle class that we get actual calls for government take-over of primary industries and whatnot. Each cycle the lowest wage workers get screwed ever more, but some rise up out of poverty, and some in the middle class bullsh*t professions drop down to the lower class. So the cycle can go on for some time.

My own private opinion is that something worse is likely to upset the capitalists apple cart, like environmental catastrophe of some sort, before any socialist revolutionaries figure out how to overthrow a police state that has nukes. But I am also a big believer in the power of education, as long as it’s not bullsh*t fraudulent education like mainstream economics. Younger people learning correct things faster than us is a pretty powerful driver of positive systemic change. We just cannot easily see it within our own time horizons. The characteristic time scale of good education-instigated system change is something like 25 years I think. That is too long for me to palpably see great hope. But understanding this I can have an abstract sense of optimism.

The story in the other cases

The above narrative is specific to certain initial conditions. To fully understand the effect of the central bank power to set the interest rate as they choose we need to consider other scenarios with different starting conditions. This is because how the central bank voting decisions on setting the interest rate are very much determined by what conditions they observe.

TODO: the other starting positions.
CB sees sluggish economy, so lowers the IR (Japan!).

Role of the Central Bank

We should of course mention that the Central Bank is always a branch of government, it is never independent. The nuance is that the central bankers do not get voted into office, they are appointed by the politicians. So the electorate has to learn to be a bit more wise and vote for politicians who will promise to appoint MMT economists onto the central bank governing board, or even better than that, vote for people who understand — because they have lived it — the weight of poverty, vote them onto the central bank board.

It is vital that we think about not just our elected representatives, but also those they are favourable to appointing. They extend the reach of democracy, but not if we all ignore them!

In the USA it is no different. The bankers association elect the FED Boards, but Congress is the authority making that rule, they can change it. I’d change it so that every state Federal Reserve Bank has a board elected by the people in the local state, not the bankers in that sate.

In New Zealand we only have one central bank, so the RBNZ Board should be elected by local government ballots: each local district gets to elect one member of the RBNZ. The nominees could be required to have some farming or banking experience, but they do not have to be credentialed (at least I don’t think, they should be able to read and pass a test of honesty). It is more important to have governors of the RBNZ who understand ordinary people, workers, and the plight of the poor. The permanent hired staff at the RBNZ are quite capable of maintaining the payments system. They do not need professors of economics telling them what to do with the software. They just need honest, diligent and caring people to keep them honest.

The other MMT story

The MMT view is that the interest rate has only second order effects on the economy, and so the central bank should just get out of that game entirely, set a permanent zero interest rate, and change their job descriptions to guarantors of full employment. Or back off entirely from fiscal and monetary policy and simply run the payments clearing system, and do proper regulation to shut down fraudulent banks.