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Sunday, August 29, 2004

Money and Growth

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Note: I have edited this post at 5:21 p.m. on August 30th, to correct a reference to MZM - Money At Zero Maturity - which is technically wrong. The Fed controls the money base directly via changes in reserves, but there is no guarantee that a decrease in the growth rate of reserves will result in a decrease in the growth rate of MZM... which can be defined - roughly - as M2, less small-denomination time deposits, plus Institutional Money Market Funds. So while the Fed can affect the money base, the link to the growth of MZM is indirect; it is therefore incorrect to say that the growth rate of MZM must slow. Sorry, but it's been ten years since I did Monetary Economics. - GT

The Mighty Mauombo asked a question that prompted serious consideration; rather than bury it somewhere in the "Comments" I thought I would give it a home of its own.

It concerned the mechanism by which interest rate rises work their way through the economy... here is an attempt to cover the ground. It is necessarly brief, and not comprehensive; it covers primarily first-round effects.

Core Effect: the Money and Debt Markets.

The first effect is that the growth of the money supply must slow (by which I mean "money at zero maturity" - the money base).

That is because the Fed's target funds rate is met by adding to, and draining, reserves through open market operations. If they simply stated "the Fed Funds rate is 1.5%" and did nothing to see to it that the target rate was met, nothing would happen to official interest rates.

A slowing in the growth of MZM (money at zero maturity) will slow the growth of other monetary aggregates by narrowing the spread between borring costs and lending rates; this will (generally) make banks less willing to extend credit at the margin. So the banks will move their "asking rate" upwards at all points of the credit risk spectrum - widening the spread back to - and beyond - its pre-rate-hike level. This is driven partly by a straightforward substitution effect: "risk free" asset prices - government bonds at all points of the yield curve - will fall (yields will rise), making corporate debt less attractive at pre-hike prices.

Usually the increase in risk premia down the credit risk spectrum are "skewed" as well; rates on riskier loans will increase far more than rates on "safer" loans (but generally all points of the credit spectrum will increase by more than the increase in the Fed Funds rate). this is a way for banks to try and offset the fact that higher rates on riskier loans translates into higher default percentages on their books.

The Components of GDP

GDP by expenditure is the following identity:

GDP = C + I + G + (X-M)


  • C= Consumption
  • I = Investment
  • G = Government Spending
  • X = Exports
  • M = imports

Investment - I

Usually considered the most sensitive to interest rates, so that's the first port of call.

Higher rates - across the spectrum - means that fewer new projects pass a "net present value" calculation. This is because the required rate of return increases unless the funding mix changes (that is, unless the funding mix tilts towards cash/equity and away from debt).

There is also the crimp in corporate cash flow for those companies who have issued (or swapped into) floating rate debt; this tends to manifest itelf in a rise in interest expense (and an increase in attempts to swap out of floating rates, which moves swap spreads to the detriment of floating-rate debt holders). The requirement to dedicate a larger proportion of cash flow to debt service reduces the capacity to dedicate cash flow to project funding.

This lower rate of gowth in investment demand, means a lower rate of output growth (generally speaking), and slower growth in employment.

Consumption - C

Higher interest costs make additional debt unattractive, and so purchases of durables are affected (since most people buy durables using debt). More important, in the highly-leveraged situation that we find ourselves in, is that existing floating rate debt attracts higher interest charges. These higher interest costs cannot be "substituted way" - except by retiring a portion of the debt completely.

Rising interest costs are similar to rising oil prices, in that they are a highly specific inflation in a segment of the household budget for which there are few substitutes. Effectively, interest charges are part of the "subsistence" budget for households. That means that consumer discretionary spending slows.

Note that this has not touched on the effect of a slowing investment market on employment (and therefore incomes, and therefore expenditure).

Government Spending - G

A lower rate of output growth, coupled with slower growth in discretionary spending (which affects indirect tax collections), means that the rate of growth of tax collections falls.

That is only indirectly linked to government spending - after all, governments can run deficits. but the tendency will be for the budget surplus (if any) to move towards deficit.

To run deficits requires that the government can sell bonds to fund the deficit. Since bond prices fall (generally), and longer-term prices fall farther than short-term prices, the government's tendency is to shorten the duration of their debt issuance, which can be bad if the government is primarily funding longer-term projects (a project-life/funding duration mismatch can be catastrophic).

Funding-duration issues aside, new debt will be issued at a larger discount to face value than old debt - so for a given budget deficit, future budgets will also be saddled with higher interest payments as debt rollovers take place at disadvantageous terms. As such, the effect is to moderate government spending - but only to the extent that government considers the ramifications of its actions on future generations (i.e., after the next election).

Net Exports - (X-M)

There is only one 'first round" effect of a rise in interest rates on the balance of trade, and it's all via the change in the currency.

Higher interest rates encourage an appreciation of the currency via interest arbitrage - some of the money that was previously elsewhere in the world will be drawn to the higher returns offered as a result of the interest rate rise.

Paradoxically, the appreciation will eat into those returns (reducing the foreign-currency equivalent return) to an extent, but the overall effect will usually be an apprecation.

The currency appreciation - again, generally speaking - will cause an expansion in the trade deficit (as it happens, this will only be the case so long as the Robinson-Metzler-Bickerdycke criterion is met... but that is so boring that it should be ignored - involving the elasticities of demand and supply for imports and exports).

The standard idea is that imports become less expensive in domestic currency terms, and exports become less compeettive in foreign currency terms.

There are also some second-round effects due to things like the factor share effect which is in itself affected by import and export price share effects. but generally, a stronger currency will mean a wider trade deficit than would otherwise be the case.


On balance, the overall effect of a rise in interest rates is negative for economic growth; that's why they all it "tightening". Note that I have been careful always to speak in terms of slowing of rates of growth rather than rises or falls in GDP aggregates. Tightening monetary policy doesn't "cause" recessions until central banks overtighten, which they always do, after overloosening during downturns.

Time Lags

Monetary policy is always referred to as a "blunt instrument", except by Americans, who think that Greenspan is some sort of consummate central planner (remember the Cold War? Central planning was supposed to be BAD - we spent trillions of tax dollars trying to stop it).

Anyhow, the lags stem from things like product-replacement cycles for durables, and the time taken from planning a project to the time of its implementation.

The lags are important here, because we are now in a world where banks and others have a "truncated horizon".

Corporate officials are remunerated based on quarter-by-quarter numbers, and their remuneration is concentrated in one-sided leveraged bets on the stock price (i.e., options). Furthermore, so long as things "pan out" for two years or so, the aggregate benefits from corporate office are staggering.

As such, growth in the size of the "book" is more important than its composition - by the time a chunk of the debt goes sour, the official responsible for it will have retired with his golden parachute... or moved on.

If you have a long-tailed portfolio being grown with a short-term view, where the size of the book is more important than its composition (and the cost of funds is historically low), you wind up with what I call "Wile E Coyote" behaviour; as official rates start to rise, the credit market simply pedals faster, growing its book (mortgages, especially). Eventually, the book is so bloated that it is actually past the edge of the cliff... still pedalling.

This goes double for "vendor financed" debt, where people get "zero interest until 2006" on everything from electronics to new cars (in the US... there has been no zero rate car finance here to my knowledge).

Usually the vendor-finance loan book is periodically "packaged" as "Collateralised Debt Obligations" (CDOs) and issued as a bond-like instrument; in order to have these "bonds" rated highly, vendors can purchase "default insurance". So you can have a segment of a risky loan book coupled with some default insurance, and thanks to an AA rating, get top prices for them (and of course this counts as "earnings". This is particularly popular for US banks (and GSE's like Fannie Mae and Freddie Mac) for their mortgage books.

The resulting bond includes an instrument (notionally) which shifts default risk to the insurer; insurers are happy because they get to collect all that lovely premium.

Where it comes undone, is the assumption of independence of default risk across the entire CDO - that is, the default insurance premium is calculated as if the risk of default of one loan within the CDO is independent of the risk of any other loan within the batch.

Think for one second about that: in a world where mortgages are increasingly being extended to less and less creditworthy individuals (have you seen the commercials on TV lately?), the "correlation" between defaulters is likely to be much higher than zero. Things that make one sub-prime borrower default are highly likely to make other sub-prime borrowers do likewise: rising uneployment or slower real wage growth are felt overwhelmingly at the lower end of the creditworthiness spectrum.

Folks who run banks don't care a damn about anything that happens to their book, so long as it happens after they leave. The people who take their place can use the previous incumbent as the fall guy, or initiate an "inquiry" which exonerates everybody... behaviour typical of bureaucracies.

We are at the "Wile E Coyote" stage now; people are borrowing floating-rate money to refinance fixed-rte obigations, and are adding to debt on top of that in order to fund the gap between the lifestyle they can afford and the one they think they ought to have. Banks andother financial intermediaries are in no way discouraging this, because so long as everybody is pedalling and inflation is depreciating debt over time, things have a chance of working out just fine.

People are relying on inflation to bail them out - as it bailed out an entire generation of mortgage holders in the 1970s. These are the current 60-somethings who are the genesis of the national mindset that property is a "slam dunk", and who have passed that investment whackery on to their kiddies, who are currently engaged in financial-suicide-by-property-speculation. They don't realise that it was massive inflation and incredibly low fixed mortgage rates that made their parents' homes such a stellar investment. And in the 70s, debt ratios were nowhere near where they are today... we are beyond redemption now, and all that we can do is prepare ourselves for the reckoning.