Miltion Friedman's Interest Rate Fallacy - Crucial To Understanding The Monetary Environment

Anyone who follows my articles knows that, to put it simply, most people's understanding of money and the financial system is wrong. They believe in ideas that are either not true or no longer value.

Much of this stems from economists, who live in a theoretical world, yet espoused their ideas like they work in reality. Then we have the central banks, which have their own fields of economists, putting on their dog and pony show to convince everyone they are in charge.

It is interesting how this works. In one of my recent videos I showed how Ben Bernanke, the scholar, pinpointed the problem during the Great Depression. It was non-equilibrium of money, a rather short term situation, that penetrated the banks, turning the situation into a long term mess.

This changed when Bernanke the Fed Chair showed up. Suddenly, he fell into the central banker nonsense to take credit for stuff he knew was outside his control. That is why he spoke of sub-prime mortgages when he knew very well that wasn't the issue.

In this article we are going to cover one of the most important concepts that is messed up by most.

Milton Friedman's Interest Rate Fallacy

Milton Friedman was the first one to attack the common notion about interest rates and money. He created the interest rate fallacy after looking at the way rates moved and what really was taking place.

We are conditioned to believe that low interest rates are a sign of easy money. This is not the case. In fact, it is the exact opposite.

Low interest rates mean we are in a deflationary monetary situation. We do not have too much money but rather, not enough money.

Obviously, this is contrary to what everyone is taught. It is also why Friedman stands out from most of his peers when it comes to understanding what takes place (although he wasn't always correct).

So how does this work?

Low interest rates are a sign of economic difficulties. When they are low, banks are not lending. To start, it is not profitable. This is rather evident. Another issue is what is sought. This sets the old idea on its head.

When economic conditions are tough, i.e. heading into a recession, the desire is for safe and liquid assets. On this point, interest rates are driven down. So far, the common notion holds.

The problem arises when we look at the scope of this. If safe and liquid is desired, what about the opposite. Here is where interest rates, if available, skyrocket.

For example, if the interest rate on a t-bill drops, the government can borrow on the cheap. Easy money. The same is true for Apple, who can tap into the debt markets.

But what about the restaurant seeking to open a second one? Good luck on that. The average business is not going to see access to money. This is evident in the fact that banks start to tighten their lending.

Thinking Like A CFO

The best way to look at this is like a CFO.

In this regard, interest rates mean nothing on their own. Instead, it is in relation to economic potential.

For example, a CFO will sign a 10% before a 1% in most instances. Why is this the case?

If interest rates are at 10%, the economy is strong. That means the potential return is much greater. A 10% mortgage pales in comparison to a 25% or 30% return.

When economic conditions are poor, a 1% mortgage typically means that the return is low. If the company expects to break even on the plant for 3 years before scratching out 5% annually thereafter, the CFO isn't interested.

Many want to claim the Fed kept interest rates artificially low. I don't think that is accurate because the yield curve is telling us that the Fed isn't in control of things. The market is against the Fed's actions.

Bank Lending

Interest rates as set by the central bank are not indicative of the money supply. The Fed cannot make the commercial banks lend. This is why they have to use indirect methods to try to get the response they want.

Access to money, for the average person, comes down to banks. The central bank can engage in all the tactics it wants. Ultimately, the money supply only expands if banks are lending. Without new loans, the amount of legal tender decreases due to payments on principal being made and defaults.

A thriving economy means that banks can charge more for money. It really is nothing more than supply and demand equation. CFOs and others are willing to take on debt when they feel optimistic. As economic conditions improve, the ability to repay goes up, giving banks even more confidence in lending.

Money is available for riskier ventures such as a new business as compared to the low interest rate environment where safe and liquid was desired. In such a realm, banks themselves opt for the security of safe assets, forgoing the risk of lending.

Since the Great Financial Crisis, the Eurodollar Market was deflationary. We are seeing contraction all over the place, resulting in tens of trillions in lost GDP (globally). This means there is not enough money to fund expanding global growth. This is why long term growth rates were broken and are falling below.

Without the money to expand global trade, GDP suffers. We see this across every major economic area. Yet, in spite of this, the Fed is claiming how strong things are and raising rates on weakness.

By understanding what Friedman was talking about, we know how this ends. If the economy keeps contracting, and banks slow lending which is happening, rates will come down. This is not a sign of too much money but a result of not enough.

Just another way that many get things backwards.

Posted Using LeoFinance Alpha