Rate Disparity Book

Rate Disparity

The dilemma of setting interest rates in modern money systems

What must be understood about raising interest rates, is that in modern floating exchange fiat systems, countries raise interest rates on themselves. The rate setting set by a nation's central bank, is what their own treasury must pay on private savings of the country's debt. It is both an incentive to the holder and a cost to the issuer(compared to private parties holding cash). For currency unions, central banks similarly play a role in managing the rate and convertibility of member countries' debts.

The practice of using interest rates to manage the price level goes back to the gold standard.

Please see this article from the federal reserve website: "Historical Approaches to Monetary Policy" https://www.federalreserve.gov/monetarypolicy/historical-approaches-to-monetary-policy.htm

Also, Perry Mehrling has a great online course for understanding the foundations of banking and modern finance.

https://www.youtube.com/watch?v=7iu5xWByF5g

https://www.coursera.org/instructor/~3149120

Yield Curves

Yield curves reflect at least two different kinds of information.

1. The anticipation of future interest rate settings
2. A premium for longer term securities

Note that even securities with far future maturities may trade very actively, and thus be considered highly "liquid". Yields of many assets may also reflect risk expectations, but this may be difficult to assess, or in some cases, not applicable. For fiat in particular, if the risk of convertibility into cash eliminated, then devaluation is possible, but not default.

Temporal Exchange Rates

Interest serves as an exchange rate between money now and money later. This is not simply an expression of time preference, as a debt to pay money, can potentially circulate in markets themselves, or even be used as a payment instrument! As we describe with treasury bonds, they can almost be viewed as merely a different form of money, or nominal purchasing power in a unit of account, which is anchored to their date of maturity, rather than having a specific denomination today.

A temporal exchange rate allows for two things:

1. For traders to speculate on real rates.
2. To devalue the currency in relative terms by offering a yield.

The Most Valuable Traded Asset Likely Yields The Discount Rate

In this sense, we are talking about the rate of discounting used for present value calculations(not the discount window rate). The discount rate is the assumed return that is possible for investors, when adjusted for risk. The discount rate could be denominated in any unit of account, whether that is dollars, commodities like gold, silver, or food, or financial assets like bonds.

If there is a uniform discount rate possible for any size of principle, then it is highly probable that the most valuable asset will have that discounting rate. This means that describing the discount rate in terms of the most valuable asset, will be very close to zero.

With enough financial uncertainty large and relatively stable assets tend to set the rate of discounting, rather than the rate of discounting determining the valuation of those assets. In an uncertain financial environment, it is increasingly more difficult for rates and returns to be compared and compete directly.

Yields cannot be assumed to be uniform for widely variable principle amounts

The ephemeral nature of wealth and value, dictates that yields will always be highly sensitive to the amount of your principle. Indeed. the challenge of wealth management, is a storage problem: "can we anticipate and meet our future needs?"

It does not seem appropriate, to compare yields on multi-billion dollar projects, with yields on $10k being invested at a time, when the more wealth you are trying to store, the further into the future it must last. This is because both absolute and relative yields matter. An absolute yield is simply subtracting the final value of a portfolio from the value of the principle.

The need for more overhead on large projects and large portfolios, makes any direct comparison of yields unreasonable. This is also true of living organisms, larger organisms tend to grow more slowly and have a longer reproductive lifecycle period(doubling time).

Wealth Storage and Marginal Returns (plus time horizons)

Simplified models, even if unrealistic, can provide insight and help us learn principles. It is possible to describe the premise of investment, saving, and financial returns, even in the context of lone person stranded on a deserted island. A yield is simply an asset which is more valuable in the future, than it is today. In the context of individual use value, this issue collides with marginal utility and indifference curves.

As you accumulate more wealth, you have to anticipate a longer time horizon. You will likely become increasing willing to stack assets with smaller returns. Such is the dilemma of "free time". Thus the greater total wealth, the smaller marginal returns tend to be.

Far future discounting is difficult, and more difficult for some assets than others

When you play chess, there is a knowledge horizon, beyond which it becomes very difficult to analyze the minimax tree of potential outcomes. The world of finance is no different. The further into the future you are trying to store wealth, the more difficult it is to anticipate what and how you should store it.

While this is true for all assets, it is more true of some assets than others. Stocks and commodities are difficult to predict over long time horizons. But some assets tend to be more predictable. In particular, treasury bonds and fiat currency, which can be described as "tax credit accounts", may present long term stability, due to the longer lifecycles of countries and the certainty of the need to pay taxes.

The simple nature of wealth, means that the more you have stacked, the longer the relevant time horizon. This tends to push people in more long term stable assets, like treasury bonds(tax credits).

In general, wealthier people tend to also favor assets they can influence or control, for this reason as well.

Prices And Yields are Relative

Inherently, any yield is the relative devaluation of the currency or unit of account. If a bond yields 10%, that means the currency depreciates 10%, compared to the bond.

Bond Yield Targeting

Instead of using interest rates to try to control the change in value of a currency, it makes more sense to try to control the CPI adjusted yields of treasury bonds. This is best when allowed to float within a range.

While some experimentation may be needed to determine the best yield ranges, one could start with +3%/-2%. If inflation adjusted yields of tsy bonds drop below -2%, then rates can be increased. If these yields rise above 3%, then rates can be lowered.

For more persistent inflation(over 3-4 years), the range may need to be relaxed, with a larger potential upside or downside, for example, +5%/-3%,

Why Inflation Adjusted Securities are Unstable

Inflation adjusted financial assets have the same issue as fixed exchange or pegged currencies. Instead of graceful/gradual failure like equity, it makes the system unstable.

Adjusting rates upward to delay inflation, to stretch it out over a longer time frame, is a reasonable monetarist practice, however, as discussed, targeting inflation, instead of the real yield, also creates instability.

If the policy rate is elevated, then bonds can achieve a positive real yield, even with a high rate of inflation. For example, if the policy rate is 8%, and inflation is 7%, then bonds have a real yield of 1%, which could be considered acceptable. If inflation unexpectedly falls, then the real yield could be as high as 8%, if inflation falls to 0.

Counter-Cyclical Fiscal Space, and a k-percent debt model(modified friedman)

Conventional wisdom would dictate that countries with low debts can spend more money, and countries with high debts can spend less.

However this conventional wisdom runs counter to basic financial strategy. A private company, for example, will want to raise more capital when their share price and total valuation is high, and limit share issue when they have a low share price, to prevent further devaluation. Strong currencies and high debt levels are often associated, because when currencies inflate, the associated debt shrinks, and such countries have difficulty issuing more debt.

A great example or model of this, would be a modification of Milton Friedman's famous "k-percent" rule.

Milton Friedman suggested increasing the money supply by a fixed "k-percent" each year.

One might contend, that national debts are a more indicative measure of the amount of currency issued, rather than monetary aggregates, like M1, M2, and others. Monetary aggregates include different kinds of currency denominated assets issued by diverse financial institutions, whereas national debts are currency denominated assets issued exclusively by the associated sovereign country.

It can be contended that the aggregate valuation of national debts, and the unit valuation of currency, is inherently linked. Thus, debt valuation may be a better indication of financial outlook, than conventional monetary aggregates.

Limiting fiscal deficits to k-percent of outstanding debt, means that countries can spend MORE, when the value of their currency and debts is high.

This also naturally leads countries and sovereign governments to perform a much needed counter-cyclical financial role. When the rest of the market does poorly, the relative value of currency and public debt increases in proportion, leading to more fiscal space.

Compared to a more conventional debt metric, such as managing Debt-to-GDP ratios, a k-percent debt rule facilitates counter-cyclical spending: spending more when the rest of the economy does poorly, and less in relative terms when the private sector is strong, which allows fiscal spending to play a stabilizing role against market fluctuations and volatility.

Duration: Mechanical Effects of Temporally Anchored Money

When you purchase a security, you are buying a temporal monetary anchor. It pays out a specific amount of money at a specific date.

Entities that don't issue Equity

Equity is a flexible, but costly financing tool. It is flexible in the sense that its value adjusts dynamically, and cannot create insolvency. It is costly in the sense that equity holders retain all the residual value, there is an unlimited upside for equity holders. While pro-active measures can help the different participants in a business to benefit comparably from business success, the design of equity makes the shareholder profit the lowest priority in disbursing payouts in the short-term, but the highest priority in terms of decision making and future gains.

Equity benefits are paid out after all debts, which include wages and other obligations, thus in a procedural sense, equity claims have the lowest priority. But in term of governance and decision making, equity claims are treated as the highest priorities.

There are many financial entities that don't issue equity shares. For many of these, the reason is simply size and complexity.

Debt Valuation

Money without debt has no fundamental value or cost, so the price level is arbitrary.

But once you attach debt to money, then the price level determines the valuation of said debt.

Mosler's Unique Theory of the Price Level: Price Anchoring

Warren Mosler has provided an effective critique of conventional rate policy, and an alternative framework for analysis of the price level:

The price level is a function of prices paid 
by government when it spends, or collateral
demanded when it lends.

This means that whenever the government spends or lends money, it must necessarily do so at a specific price level

It may not be immediately obvious, but this statement also can be applied to interest spending. As discussed interest is an exchange rate for money, in the own unit of account, between two parties at two points in time. As such, when a government, or any entity, sells a greater amount in the future, for a lesser amount today, they devalue the unit of accout.

The government instigating such a trade is uniquely determining, as they are the monopoly issuer, and can do so at any scale.

The concept of price anchoring can be applied either descriptively to analyze price dynamics, or prescriptively in shaping fiscal and monetary policies.

Descriptive Price Anchoring

This is merely analyzing or researching how the governments bids with fiscal spending, or its collateral appraisals for the banking system, drive the price level over time, if at all.

Prescriptive Price Anchoring

Prescriptive price anchoring, is recommending specific policies designed to help manage the price level. In this case, the typical proposal is a permanent zero interest policy, and a Job Guarantee.

Zirp Plus Job Guarantee

While this is the broadest and most universal example of price anchoring, and therefore useful for thinking about an economy where price anchoring is the primary or only tool for price management, it does present the issue of differing significantly from conventional practiced monetarist and fiscal programs, and requiring tremendous transformative policy changes.

While this has the potential to be good, and it also establishes what makes this perspective unique, it is difficult to analyze the impact of such a transformative shift.

A Price Anchor is Like One-Sided Currency Peg

The most helpful way I have to explain a price anchor, is that it is similar to a currency peg or fixed exchange rate, but it only applies in one direction.

For example, a currency pegged to gold, involves a commitment to buy and sell gold at a fixed price. If you think about this from a trading perspective, it necessarily guarantees no profitable trading, because to profit from a trade, you must sell it at a higher price than you bought it.

A currency which is instead "anchored" to the price of gold, is one in which the issuer guarantees to buy all gold at a fixed price, but not necessarily sell it. So, a dollar currency issuer could buy gold at $1,000 per, oz, but hold it and only sell when the price reached $2,000 per ounce.

In other words, a price anchor allows reserve or exchange assets to be used profitably and discretionally according to the issuers judgement or strategy.

The "Anchoring" Function Refers to Balance Sheet Impact

Conventionally, a comment to always buy an asset or commodity, is a support level for that asset or commodity, and thus technically would be a resistance level for the other asset involved in the trade, specifically the issued currency.

From this perspective, a price anchor appears like it would not keep the price level down, but rather prop it up.

However, there is a level of nuance, where an issued asset reflects the financial state of the issuer, whether that asset happens, to be currency, debt, or equity.

In this case, as price anchoring allows issuers to benefit from price fluctuations, ie swap reserve or exchange assets profitably from a trading perspective, the goal or expectation is that it would in fact promote the valuation of issued assets over the long run.

The Price Level is not the Price of Everything, it is only the Valuation of Currency

Because price levels are measured using commodity indexes or other aggregate measures, it may appear like managing the price level involves manipulating or controlling all the prices in an economy.

While there may be benefits in promoting general economic fairness, the price level is really only about the price level of one thing: the currency itself. But because a currency is used as the unit of account for measuring all other prices, it is easy to misinterpret it as an aggregate of all prices and the total economic system, rather than simply a way to measure the unit of account itself.

I think this is a common misinterpretation, because we have become accustomed to very stable currencies or unit of accounts, compared to historical patterns.

Price Anchors allow you to link a currency to consumables like labor or energy

Because a reserve peg requires bi-directional price control, it requires assets or commodities that are easy to both buy and sell. We can call such assets reserve assets.

But price anchoring can applied to assets that are not easy to store or resell, like labor or energy. This makes it potentially more useful and flexible, compared to a pegged currency.

We can call any such asset an "exchange asset", in contrast to reserve assets used for a peg.

Other Price Anchoring Possibilities

We have so far presented 3 different price anchors:

1. A Job Guarantee (always buy labor at minimum wage)
2. A Permanent Zero Interest Rate Policy (never sell future money at a discount)
3. A Gold or Reserve Commodity Price Anchor (always buy at minimum price)

Technically, a permanent zero interest rate differs from these other two. It is a commitment to never sell future money at a discount, it is not a guarantee to always buy(ie extend credit) at a minimum price.

But a permanent zero interest rate and the other two price anchoring policies are similar, in that you would avoid selling below the minimum price. So with a reserve commodity, you would avoid selling that reserve commodity

below the price you bought it,

and with a permanent zero rate, you would never sell future money at a discount, in other words, you would never borrow your own currency at interest, that you can simply issue yourself.

Other than these 3 price anchoring policies, you could also limit public service pay increases, or create commodity buffer stocks for specific critical or strategic resources.

A housing buffer stock could lower housing rents

A housing buffer stock would simply involve paying landlords to keep housing empty. This would create less volatility, and lead to a reduced supply curve for housing, by supporting the creation of a slight excess of housing inventory, which would reduce price shocks.

While such a policy would have to be limited, and preferably encourage inventory rotation(capping the vacancy time for a particular unit, say at 2 or 3 years), it could potentially dramatically improve housing markets for renters and nimby attitudes.

A housing buffer stock policy, therefore becomes a highly targeted price anchoring tool.

While this is a more direct form of market manipulation, it should be noted that reserve commodity pegs, like a gold standard, also manipulate market prices to a high degree.

Many similar targeted or strategic price anchoring policies are possible.

Rate Disparity: why returns and growth rates differ

In ecological systems, rates of growth vary widely. Doubling time for most bacteria varies on a distribution between minutes and days, according to this study:

https://pubmed.ncbi.nlm.nih.gov/29899074/

Other living things have a rate of growth, as they increase in size and mass, and a reproductive rate, as they create more copies of themselves.

The world of finance has many parallels to such ecological systems. Companies spin off other companies and ventures, capital is raised, or shares bought back. There are many both physical and political boundaries that affect how investments and financial returns flow.

Rather than simply describing any unanticipated return difference as "risk", and anticipated differences as "friction" it is helpful to think of economy as a dynamic living system.

Interest rates vary for many reasons, including the incentives and interests of investors, and their relationship and role in the overall system.

Thinking about finance as a total system, is something I hope to see more people adopt, and I hope that I can help contribute to this, in an accurate and rigorous way.