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Milton Friedman’s Interest Rate Fallacy
- adolph 5y agoThis is an interesting read: In summary, Friedman’s fallacy is derived from two fundamental, yet counterintuitive, observations of economic history. One, when the economy is rapidly and robustly growing, and there are plenty of profitable investment opportunities, interest rates tend to increase, as both financial and non-financial institutions bid for funding/financing to take advantage of the differential between the current interest rates and the future returns on invested capital. Two, rather than differentiate between good or bad credit based only on price (via higher or lower interest rates), banks and institutional investors also differentiate between good or bad credit based on access, so that uncreditworthy businesses are altogether excluded from global debt markets, counterintuitively causing falling, rather than rising, interest rates as credit is contracting.
- WalterBright 5y agoMore succinctly, interest rates (i.e. the price of money) are based on supply & demand (in a free market).
- jbay808 5y agoIs the market for credit a free market, even approximately?
- WalterBright 5y agoUnder a free banking system, yes. The Fed's operations, however, are not free banking, but bureaucratic banking.
- jbay808 5y agoI suppose I should have clarified that I was asking about the system that currently exists :)
- danans 5y agoI'm not an economist, but a simpler explanation is that the credit volume change lags the interest rate changes, because it takes a while for inertia in the system to play out, because a lot of credit might be at fixed rates and terms. Therefore the decrease in volume follows a period of sustained higher rates, and vice versa, as investors and borrowers adjust to the changed rates. I've never seen a large real world system that has instantaneous response in any field. It always trails the stimulus by some time. That said, I'd like to hear from someone who has thought about it more why they simpler explanation doesn't work.
- danans 5y agoWell it looks like I triggered a debate about Friedman's MO, which is fun, but not necessarily what I was after. So asking again: why is the mismatch between interest rates and credit volume not just explained by the delayed system response to the interest rate change, versus the extremely complicated supply-side explanation in the blog post?
- lisper 5y agoYou have it exactly right, but you left out two important factors. First, not everyone has equal access to financial markets. A retail consumer can't go to the Fed and take out a loan at the discount rate to finance the purchase of a house. They have to access that credit through a middleman -- a bank, and banks are a good-old-boy network. That complicates the system response tremendously because it brings lots of human interpersonal dynamics into the mix. The idea that the economy is a distributed system of rational actors is just wrong. And second, everything Milton Friedman says has to be viewed through the lens of his political agenda, which was radical libertarian. So whenever Friedman says anything you always have to ask yourself: is he saying this because it is actually correct and there is actually data to prove it, or is he saying it because this conclusion is necessary in order to bolster the case for abolishing government? Just like the economy, the dynamics of economists is much more complicated than intellectually honest scholars seeking truth.
- klabb3 5y agoI agree that Friedman was ideologically opposed to government intervention, to some extent. That said, if you read him or watch his show he demonstrates an intellectual honesty and willingness to debate with anyone. The great tragedy with Friedman was that politicians, especially right wing, used his rhetoric selectively — which was very effective but dishonest. The world absolutely did NOT move in the direction of fiscal conservatism and small market-regulating governments, but quite the opposite. Yet people still act as if he was the puppet master of the corporatist kleptocracy we find ourselves in. It's a shame he died before the 2008 crisis, he probably turned in his grave when the bailouts happened.
- refurb 5y agoBut this somewhat makes intuitive sense? It's like saying "Insulin reduces blood sugar, but our data shows that blood sugar is highest when insulin is administered." The fed's control over interest rates is complete, but not the market's response to rates. And when do you increase interest rates? When the market is offering credit at a pace faster than you want. So it seems intuitive that lending is highest during high interest rates (or at least significantly overlap)?
- initplus 5y agoThat's a great analogy.
- jbay808 5y agoI agree. Central bank policy should be analyzed the same way as other feedback contollers. It's popularly believed that furnaces provide heat, but in fact, furnace activity closely correlates with low temperatures, and indeed furnaces are actually off entirely during the hottest times of the year.
- ajuc 5y agoMy teacher explained it as such: imagine you look at a correlation between the position of the gas pedal and the car speed while driving normally (so - at the speed limit) on a hilly road. You'd conclude gas pedal and car speed are completely independent.
- andrepd 5y ago
- rossdavidh 5y agoMight want to read the article again; it's a fallacy identified by Friedman, not something Friedman is alleged to have said that is false.
- jmeister 5y ago[flagged]
- the_only_law 5y ago> Conservatives would never write off anyone just based on their ideological affiliations Is this satire? If so, it’s pretty good.
- mhh__ 5y agoI remember showing someone who absolutely loves fallout New Vegas a video about how terrible fallout 3 is in comparison, and he said he didn't want to watch it because the narrator was too left wing. That was strange
- trentnix 5y agoWhile there are plenty of close-minded conservatives, in contrast Milton Friedman was genuine, engaging, and patient with all interlocuters. There are hundreds of hours of video available showing how not only was he gracious and humble, he was an excellent listener as well. But despite this track record of affable behavior, he's demonized. But he's demonized not because he was a polemic, but rather because he was effective. And that's the unfortunate reality of today's political discourse. For those who don't know about Milton Friedman, I highly encourage you to watch one of the many Youtube videos where he's being interviewed (such as when he was interviewed on the Phil Donahue show). You can judge for yourself.
- rossdavidh 5y agoSo it would have been interesting to read this person's analysis of Turkey's current interest rate policy?
- Supermancho 5y ago> This is because almost everyone is thinking about and taking into account only the demand side – most people would love to borrow at low interest rates, ...low interest rates must mean that credit is both cheap and plentiful. However, not thinking about and taking into account the supply side of the picture I'm not sure this is any kind of explanation to the contrary. Credit issuance means someone took advantage of credit offered, not a total of the available credit (offered). I got a home mortgage 2.75%@30yrFxd with 7%! down for hundreds of thousands of dollars this year. I have a friend who has almost 100k in debt, which she cannot service, and a credit score of just over 640 (by gaming the score during the pandemic from 500s) and has credit cards with 10k limits coming in the mail. Credit IS cheap and plentiful and the same mistakes of 2007 have been amplified by the banking system (Fed + too big to fail cronies).
- WillPostForFood 5y agoCredit IS cheap and plentiful That's the fallacy, right? One would think it is plentiful given the low rates, you have an anecdote that it is, but look at the data. Lending is fraction of what it was in 2007. https://cdn.substack.com/image/fetch/f_auto,q_auto:good,fl_progressive:steep/https%3A%2F%2Fbucketeer-e05bbc84-baa3-437e-9518-adb32be77984.s3.amazonaws.com%2Fpublic%2Fimages%2F1d4895dc-9903-4a63-b0d2-f16a5b2d1e20_1833x1101.png https://cdn.substack.com/image/fetch/f_auto,q_auto:good,fl_p...
- Supermancho 5y agoAgain, that's because people aren't taking out copious credit, not that they aren't being offered. There's no data on what's offered, only what's contracted.
- SilasX 5y agoYep, and all throughout the 2008 crisis, I never stopped receiving credit card offers.
- Supermancho 5y ago
- dools 5y agoCentral banks of nations who issue their own currency on a floating exchange rate have complete control of the cash rate. The natural rate of interest is zero so if the central bank didn’t interfere that’s where it would tend towards.
- canjobear 5y agoSee also the Lucas critique: https://en.wikipedia.org/wiki/Lucas_critique https://en.wikipedia.org/wiki/Lucas_critique
- galaxyLogic 5y agohttps://www.forbes.com/sites/stevedenning/2013/06/26/the-origin-of-the-worlds-dumbest-idea-milton-friedman/?sh=5ca91455870e https://www.forbes.com/sites/stevedenning/2013/06/26/the-ori... "The success of the article was not because the arguments were sound or powerful, but rather because people desperately wanted to believe."
- carlivar 5y agoWhat does this have to do with the interest rate fallacy?
- tengbretson 5y ago> If credit was really as cheap and widely available/accessible as it is often claimed to be, then why have annual small business loan originations still not recovered and reached levels seen in the early 2000s? The fact that the cohort of people that would be taking on these business loans today are already strapped with 6 figures of college debt might have something to do with it
- Icko 5y agocollege is voluntary
- mellavora 5y agobut debt is not
- uoaei 5y agoWould have loved to know that before being pressured by the entire school system around me to pick the high school with the best feeder stats and the highest graduation rate. Before spending literally the last two years of high school mostly just working on getting into college. Does it not once occur to people who play the incredibly tired libertarian lines that in fact we do live in a society that exerts constant coercion on how we lead our lives? As unhelpful as this rhetorical frame is, taxes aren't the only thing that is being stolen... so is agency.
- throwaway2048 5y ago[flagged]
- spaetzleesser 5y agoModern society is pretty much designed to give people with college degrees an advantage. Yes, you can have a good career in the trades but a college degree is the safest bet. Life is much harder without.
- nonameiguess 5y ago
- hamilyon2 5y agoI would like to see more analysis. First of all, and most obvious, fed rate is controlled variable which regulator can change in response to what is happening to economic metrics. The article somehow glosses over the fact. I think, FRS changes base rate at least partially in response to amount of credit issued and total amount of money in circulation. It takes in account many other variables, of course, but still. I think it is possible that fed will raise base rate immediately following rapid expansion of credit to prevent overheating and inflation. On the other side, when lending is insufficient, FRS might consider lowering rates. There is no surprise in that. It will lead to somewhat correlated graphs of credit issued and rates. I would like to see if graphs and their derivatives could be predicted from one another.
- fuoqi 5y agoIn the Princess of the Yen book it was shown that in the post-war Japan BoJ was primarily controlling amount of credit creation (in addition to selecting sectors which got it) and that interest rate was a just secondary tool. If a central bank does not have such degree of control over its domestic banks, then it has to use the rate policy, but it's a quite blunt instrument with significantly lagging response (since you can not easily cure systematic risk-aversion, even if loans are dirt cheap). But there is another tool which can be used by colluding with domestic government: debt monetization (a.k.a. "money printing"). It results in the financial system being flushed with newly created base money, thus reducing the need for additional credit. As noted in other comments: many have option to leverage, but prefer not to. Not only because future looks too uncertain, but also because today they have enough cash to get by.
- zhte415 5y agoIt would be well worth reading regular reports that come out of central banks, which do address what the article mentions. Some can be a bit estoric and there only if you really know what you're looking for stuff. I'll take the UK for example, as I'm most familiar with that: The Bank of England publish their Inflation Report [1] every quarter. There's quite a lot of interesting information in there. Credit conditions are mentioned in the linked article, which there's a specific report for, called Credit Conditions Survey [2] Lots of people know what money is. Sort of. The article also mentions volumes of lending. This comes in monetary statistics too, but you have to dig for it. [3], from the URL the phrase 'need to know what you're looking for' - this is what the author may be looking for in terms of interest rates and volumes of lending. Money, as an economic concept, has been out of fashion for several decades, ever since velocity of M0 started doing funky things that should have been well understood and anticipated and never used as a monetary target under those conditions. It remain no less relevant however. To make sense of it does takes some analysis. [1] https://www.bankofengland.co.uk/inflation-report/inflation-reports https://www.bankofengland.co.uk/inflation-report/inflation-r... [2] https://www.bankofengland.co.uk/credit-conditions-survey/2019/2019-q2 https://www.bankofengland.co.uk/credit-conditions-survey/201... [3] https://www.bankofengland.co.uk/boeapps/database/FromShowColumns.asp?searchText=private+non+financial&Travel= https://www.bankofengland.co.uk/boeapps/database/FromShowCol... Other central banks do have, and most provide, similar data. The format's a bit different. ECB and Eurostat for the Euro area, various FEDs for the US, etc. I suppose > Modern economists and financial analysts may find the above useful if they with to become less 'average' as the article mentions. I assumed the average economist would be aware of these. Disclaimer: I am not an economist, just someone that takes an interest.
- notahacker 5y agoThis article seems to miss both the actual point Friedman made and what modern economists and central bankers actually believe. Modern economists talking about "interest rates" are talking about the base interest rate which is the cost of bank borrowing which creates new money. Friedman was also interested in regulating the supply of new money but wanted to try to fix the quantity of a monetary aggregate, which could be achieved by.... tweaking base interest rates. The modern central banking approach is to fix the base interest rate (essentially the price of creating money) for a fixed period and be more cautious about adjusting it rather than try to directly fix the quantity of money. Central bankers tried Friedman's approach of fixing the quantity of [a particular aggregate of] money in the early 1980s, it was extremely unstable with wild interest rate lurches needed to fix the quantity of the monetary base (and the monetary aggregates the bank wasn't targeting still wildly fluctuated in volume) and even Friedman conceded that with hindsight he might have made different recommendations. So they switched to fixing the price of credit rather than the quantity instead The modern policy is consistent with what both Friedman and central bankers wanted to achieve (a relatively low and predictable rate of inflation). They raise base rates because the economy is growing and the level of borrowing with it. But they're not interested in raising interest rates so rapidly that firms end up with the same low level of borrowing as before, merely in stopping credit expansions from growing too fast and creating price inflation (and conversely, making it cheaper and easier to borrow when lending drops) so the interest rate rises tend to track rather than halt the natural rise in lending.
- ethn 5y agoThe author should consider A Monetary History of the United States by Friedman. The EFFR is exactly incrementally increased in a way to not immediately perturb markets, to slowly approach its target. It is also well known that there is delay expected between prices of all assets (including credit) to react to monetary conditions.
- TheOtherHobbes 5y agoI've yet to find anyone who can explain to me how interest rate woo is supposed to fix the cost of essential imports like energy - which historically is one of the most obvious and direct causes of inflation. The inflation of the 70s wasn't caused by the cost/availability of credit, it was caused by the fact that oil prices jumped from an average of $4 in 1973 to $13 in 1974. For some reason we're supposed to pretend this had no significant effect on prices in an economy largely powered by oil. It's baffling that educated adults can still take this seriously.
- guillermin 5y agoThis is why central banks tend to look at measures other than CPI when they make their decisions. For example, "core" inflation does not include energy, which is highly volatile and doesn't directly represent the loss of value of the currency.
- throw0101a 5y ago> The inflation of the 70s wasn't caused by the cost/availability of credit, it was caused by the fact that oil prices jumped from an average of $4 in 1973 to $13 in 1974. > For some reason we're supposed to pretend this had no significant effect on prices in an economy largely powered by oil. Because there are different types, or sources, of inflation: * https://en.wikipedia.org/wiki/Demand-pull_inflation https://en.wikipedia.org/wiki/Demand-pull_inflation * https://en.wikipedia.org/wiki/Cost-push_inflation https://en.wikipedia.org/wiki/Cost-push_inflation * https://en.wikipedia.org/wiki/Built-in_inflation https://en.wikipedia.org/wiki/Built-in_inflation * https://en.wikipedia.org/wiki/Inflation#Keynesian_view https://en.wikipedia.org/wiki/Inflation#Keynesian_view And not all of them are caused interest rates and the availability of credit. > It's baffling that educated adults can still take this seriously. Perhaps the adults who take this seriously have better educated themselves on the topic. If the experts in a field hold a different view than you, it is often prudent to examine whether you're missing something.
- tagoregrtst 5y agoBecause foreigners don't want pieces of green cotton for their goods, they want things. If interest rates are low, money is cheap for Americans and they can buy real things with something that is worth less (not worthless) that it was. Its worth less because Americans didnt have to produce to make that dollar. On top of that, since the dollar is the reserve currency, all the price inflation is effectively diluted among all countries. So America gets to print its budget deficit and not even suffer as great an inflation. But the price inflation pressure is there, it must be there. Its what the French called “America’s exorbitant privilege” As to the oil shock, of course that affected prices. But the embargo only lasted 6 months, didn't cover Europe and oil is fungible (ie Americans can buy Norwegian oil destined to Ireland at a small premium and the Irish buy oil from the Arabs [1]) [1] this is an illustrative example. I don't know or care where the Irish buy oil
- ngcc_hk 5y agoI were taught if one has to do the non-existing macroeconomics, one can only do money supply. Then the details are how, via interest somehow … That is all. Only micro existed in Chicago school in those day I thought.
- sleepysysadmin 5y ago>In conclusion, one can theorize that falling interest rates can be indicative of tight monetary conditions in the economy in the sense that demand for credit is falling (due to explanation one) and/or access to debt funding/financing is limited to just the largest and most creditworthy businesses (due to explanation two).2 Boomers are retiring or getting damn close. They are moving their investments to 'safe' options like bonds. In reverse the system has to match up those bonds with someone issuing a bond. This is typically cars and houses. So for a boomer to invest in a bond, someone had to have bought a house. If interest rates were high, then people wouldnt be buying houses. So interest rates must drop so that the investments can happen. Furthermore, it's also those same boomers who are selling their large house to 'downsize' or whatever. They cant sell unless someone is buying. The even crazier thing, the real yields on bonds are negative right now. Interest rate is 0.25% in Canada while inflation is at 4.7%. So retirement funds are effectively losing the difference. The boomers thought they could retire because they have some nice big numbers but it's double edged. They might have a big number but it doesnt grow much at 0.25% and their costs to buy things is 4.7% higher. So in a few years many boomers who retired may find out they cant afford to be retired anymore.
- mym1990 5y agoIt makes sense to me because banks make more money on loans when the interest rate is higher, so they would be more willing to give loans out. Under 0% Fed fund rate conditions, if inflation hits any kind of stride, it can be disastrous for lenders who now hold diminishing assets.