Zaphodinomics
Yesterday I was talking economics with Greg and that prompted some research and thinking into the subject of just what effect things like the Federal Reserve’s interest rate adjustments really have. So, in an effort to show the world how ignorant I really am, I’m going to write up some of what I think I might know about this. 
From what I gather, when the Fed adjusts that number you always hear about in the news, they are effectively controlling the value of money itself. The rate they usually adjust is the cost for a bank to borrow money from the Fed. The reason this is important is because that indirectly affects all the usual rates of interest you’re used to hearing about - like credit cards, some mortgages, car loans, etc. If the Fed rate is high when you get a loan, your interest rate will be similarly high and vice versa.
The interest rate the Fed charges cuts into the profits the bank can make by loaning more money, so in order for the bank to make a profit, they have to charge their customers more to use the money they borrowed themselves in order to lend out again. Borrowers are the real customers of banks - this is why they are always so eager to loan money.
Banks pay interest on savings accounts because they are using the deposited money and loaning it out to others. The saver gets paid for that service because the money is actually a commodity they are consuming in order to do business with the people who want more money than they have. When interest rates go up, banks start wanting more people to save with them and so they start offering CDs and other savings vehicles with higher interest rates. Why? Because it becomes cheaper to get money from the public than it is to go to the Fed!
It’s not to say that a person with money wants higher interest rates, though. It’s much more complex than that because the rates paid by banks are much lower than other investment types - such as the stock market. Since companies use money too, they are affected by the cost of it in ways similar to banks. The difference for them is that higher interest rates may mean they cannot afford to borrow as much which means they may not be able to grow as quickly as they’d like. This naturally results in a decrease in profits and/or growth which affects their stock prices which in turn adversely affects how much an investor in that company’s stock can ultimately make over time.
Often the news will report that the Fed is cutting interest rates in order to fight inflation. Inflation is bad, of course, because it means that $1 yesterday was worth more than $1 today. Obviously it is in everyone’s interest to avoid inflation. So what is inflation, exactly? I understand there are several schools of thought, but the one that seems to make sense to me is that inflation is something like the absolute value of the difference between goods people want to buy and money available to buy it. What this means if that if there’s more money than there are things people and companies want to buy, prices go up because companies see this surplus of money and start increasing their profits by taking more of the customer’s money. On the other hand, if there’s not enough goods to meet the demand (think oil), the prices go up because it’s harder/more expensive to get and therefore worth more to the buyer. In order for this to make sense, you have to think of money itself as a commodity that also takes part in the supply and demand equation.
So from what I can tell, for the last year or two the Fed has been operating under the assumption that the problem in our economy was being caused by a lack of goods and so they cut interest rates in order to promote people to buy more, companies to make more, etc. The theory would be that if there’s more stuff to buy, then inflation will go down and the economy will get moving again. But it hasn’t been working. So they have two options now: 1) raise the interest rates, or 2) leave them alone.
Raising interest rates means the cost of money goes up and production would likely drop. If this is what the Fed does, then it is my theory that they are suggesting that the system has too much money available rather than too many goods and services. Increasing interest rates should cause people and companies to borrow less and thus reduce the amount of money available for purchases in the system. It should also encourage people and companies in debt to repay those loans before the rates go up even higher. My theory is that this is the action we need to fix the current mess - as unpopular as that may be.
If they choose to leave the rate the same, then I think that suggests they are either playing political games (raising interest rates always seems “bad” in the public’s eye), or that they aren’t sure themselves and they want to play a wait-and-see game (which is a copout, IMO). I think the only way this could turn out well is if the ratio of money vs. goods isn’t teetering on the edge of balance that it appears to be.
My guess is that we’re on the verge of entering a time of stagflation - which is when inflation goes up, but there’s very little economic growth to show for it. Historically, they are apparently rather difficult to break because they are a bit like a self-sufficient cycle. Inflation causes prices to rise, and rising prices means it becomes too expensive to grow the economy, but since companies have to make a profit, they raise prices. Rinse and repeat. The only way out is to disrupt the balance or stop trying to grow. Since public companies have what amounts to a legal imperative to generate a profit, they have no choice but to keep trying to grow. This means something needs to change or else their attempts at growth will drive inflation to insane heights as they spin their wheels in the mud.
The Fed appears to be very conservative, so I suspect that at their next meeting they won’t change a thing. That means it’ll be another several months before anything changes unless they get lucky in their inaction and the market corrects itself. How could it correct? Well, one way is technological advance. Doing something old in a new, cheaper way is one way to create a profit without really growing. A genuine profit is created because you are simply using less money to do the same thing but you need not raise the price! Another method might be a decrease in the price of oil since it’s such a huge economic driver (which we may see soon, especially with the help of China’s recent elimination of internal price fixing). Another possibility is a reduction in the lifestyle of Americas which would mean less spending on luxuries which frees up money for essentials thus driving the cost of luxuries down and the money spent on producing luxuries drops and that causes a disruption to the balance just enough to kick start the growth again. (Seems like an unlikely scenario, though.)
Hopefully this isn’t too inaccurate. As written, it passes my “gut” test which means it feels somewhat right, anyway. I’m sure someone will tell me what I’ve got wrong eventually, though.
June 19th, 2008 at 11:07 pm
Oh wow Sean. Don’t go down this path, it’ll consume your life and eventually have you wearing a tinfoil hat.
So, some more fun stuff to research. My wife likes to call this the magic money system.
/me adusts tinfoil hat, and finds a laser pointer.
K, some basics. To you, a savings account is an asset, to a bank a savings account is a liability (a loan), you depositing money is you *lending* money to the bank. To you a car loan, house loan, credit card (with something charged on it) is a liability (a loan) to a bank it’s an asset (they loaned you money).
Our banking system is based on a system called ‘fractional reserve banking.’ What this means simply is: cannot loan out more then X% of their deposits. Usually X is ~90%, meaning they have a 10% reserve. The Federal Reserve (the central bank) is the authority in the US that determines the reserve levels.
The Federal reserve is also the entity that decides what kind of bank assets can qualify for that 10%. The Fed Reserve says qualifying assets are: cash in your vault, or funds your bank has placed into it’s savings account (non-interest bearing) here at the Federal reserve.
What happens if one day your accountants are going through your books, and you find out that you’re below the reserve requirement? What is frequently done is they go to another bank, who is over their reserve limit (has extra cash) and borrow it. Yes, that works… Think of it as the bank coming to you and asking you to deposit more money into your savings account. Does it matter if that other you is another bank? Not in the magic money system.
Now, this ’suddenly wake up’ thing can happen more often then your realize. See…all their assets (your loans) have ‘valuations’ that are necessarily the actual amount of the loan that is their ‘booked’ asset value. Examples would be: ever been upside down on your car loan? Yea…so, in the banks asset column should they be using the balance of the car loan, or what they would get for the car should you default? Valuations, for simplicity, tend to be somewhere in-between. But, you can see how determining your asset value is sometimes tricky for a bank.
Especially ones that loaded up lots of home loan assets…that are dropping like a rock.
So, when you’re in a lurch, and under your reserve requirement, you call up your competition and get them to loan you some money. But, being that they are banker’s, they aren’t going to be ok with some simple passbook savings account, they are going to want something special. This is the federal funds rate. And actually, the fed doesn’t *set* it, they recommend it. Kinda funky, they make it sound so solid on the news, don’t they? Nope…it’s just a recommendation for bank to bank lending. Usually the rate for interbank lending is pretty close to the ‘federal funds rate.’
Now, if you want to borrow *directly* from the fed reserve to restore your reserve buffer, you can. This is called the ‘discount window,’ it’s usually a few points higher then the federal funds rate, as the fed reserve is supposed to encourage the banks to borrow from each other first.
Now, if you harken back to the days of yester…well…december-januaray you’ll remember that the ‘discount window’ was in the news quite a lot. What was going on was: the banks didn’t trust each other. Home loans were being devalued *so* quickly, any bank that came knocking on the door needing a short loan to hit their reserve requirements *must* be in trouble. Why would I loan money to them. So, the actual rate that the banks were negotiating was way *way* above the federal funds rate. Actually…a lot of banks weren’t lending to each other period.
So, the fed reserve stepped in, and dropped their ‘discount window’ rate … really low, for a while to help out the banks that couldn’t get anybody to lend them money.
So…what does any of this have to do with inflation.
Magic money.
Let’s imagine a little tiny island country, totally isolated with only one bank. And, let’s say that bank runs on a fractional reserve banking system, with their reserve rate set at 10%. Let’s say I live on this island, and I go buy a car…or really I got get a car loan to buy the car. So, I borrow $10,000 to buy this car. The car dealer is totally stinkin rich, and just takes my $10,000 to buy the car (remember, we’re thinking simple examples here) and deposits at the bank. Guess what, the bank has another 10,000 * (1 - 0.10) = $9,000 to lend out. That’s just one loop of the money around the system.
Now, scale this to the size of the US and global economy.
And you thought it took a printing press to print money. Nope, all it takes is a credit card. Pretty amazing eh?
These figures are actually tracked:
M0: Physical printed money and coins
M1: M0 + ‘demand despots’ (your checking account)
M2: M1 + savings accounts, some money market funds
M3: M2 + larger more complex security arrangements and loans
This is a pretty picture:
http://upload.wikimedia.org/wikipedia/en/9/95/Components_of_the_United_States_money_supply2.svg
Oh…M3 didn’t disappear. The fed reserve decided that it was ‘too expensive’ to track. Oddly about the same time that they had the rate really low a few years back, and the whole housing bubble thing was building up. The money generated by home loans: M3.
So yea, lower interest rates == more borrowing. More borrowing == more M3. More M3 == all the dollars are worth less. The dollar gets worth less…people start demanding more of them for the same stuff. And…pow! Inflation.
You wanna turn it around. Raise the interest rates. Make people pay off their loans, some of the magic money disappears. Fewer dollars mean the ones that remain are worth more.
K, yea…go do something else now.
June 20th, 2008 at 7:15 am
Fun..
Yeah, I know about the fractional part of the banking system. In fact, I distinctly remember the day a year or so ago when I explained it all to my own wife in a conversation about where money actually comes from. 
It’s fun when you realize that *currency* has nothing to do with *money* in our system. (Although I guess you could argue that the act of making currency costs money and so therefore actually creating the stuff most people associate as being “money” is, in fact, a money drain…)
The point I was try to make was that I think raising interest rates is a good idea right now and how that change is thought to ripple through the system - at least at a high level. Of course I’m generally in favor of anything that gets people to use less credit and actually save more money, too. Plus I’d love it if I could earn more in my supposedly high interest money market accounts, dammit! Stupid low interest rates….
June 21st, 2008 at 12:29 pm
Totally 100% agree. The interest rates need to come up very soon.
June 23rd, 2008 at 3:40 am
Sorry for being off topic (feel free to delete my comment later on), but I could use some help and I think you are the right person to ask. I’ve downloaded your Pedometer app to install it on my iPhone, and I’m using DiskAid to access the phone through my Macbook Pro (10.5.3) in order to copy the files (and, yes, I know you removed it from the installer long time ago), however I’m not quite sure where to put the “PACKAGE-NOTES” unix executable file (I’ve copy/paste everything else) or even if it would eventually work on 1.1.4 (jailbroken with iLiberty+), so any suggestion would be really appreciated. I need this app and I’m not aware of any other Pedometer developed so far. Thanks in advance.
PS. Please don’t send me an email with your reply, cause I rarely check my mail.
June 29th, 2008 at 4:00 pm
I can see your new post, but I can’t see any reply to my kind request for a little help. Since I don’t have a Twitter account, shall I assume that you don’t intend to assist me? Anyway, sorry for asking.
July 4th, 2008 at 9:37 am
@alex: I haven’t developed on pedometer in a long time. I can’t even remember where everything goes - but I do know that PACKAGE-NOTES is not an executable, it’s just a text file with some notes in it. Pedometer never worked terribly reliably anyway, which is why I stopped working on it in the first place.
July 11th, 2008 at 3:20 pm
People who can afford iPhones and MacBook Pros can also afford $10 pedometers. Especially if they “need” them.
Sweet blog, Sean.