Interest Rates and Inflation

[Nate Smith 0]

Yaron Brook in his recent debate at Loyola made the point that when you keep interest rates below the rate of inflation for as long as we have, a financial crisis is imminent. I don't understand this point. Would someone briefly explain this?

[Arnold 0]

Look at it this way. Inflation is the decrease in buying power of your dollar. If you lend $100 now and are repaid the $100 two years later, that later repayment just won't buy as much. It may have lost 5% or even more of it's purchasing value. You would need 5% more repaid to you to make it up. In this case, over two years that would be about $110

If you had invested (lent) that at a low interest rate of 1%, you would be loosing out, and reluctant to invest in cash. You would instead put money into tangible assets like houses, which is what people did, including those who could now afford it with the artificially low rates. In the end one has a bubble of over investment, and the first person to sell triggers an avalanche of selling, made worse by an increase in interest rates. The low interest has created a distortion than reality eventually corrects to the normal range of equilibrium.

[Nate Smith 0]

Good explanation, thanks. A couple follow-up questions.

If the interest rates are set too high, could a similar phenomenon occur where too much money funnels into the stock market creating a bubble there?

Any thoughts on what eventually causes the bubble to burst? (I realize this is the million dollar question.) How and when do people realize that the goods are overvalued? (I'm assuming only a few actually do, the rest are just reacting to a trend.)

And on a similar issue, I've heard it said that there has been an overreaction to the inflation threat and there is a bubble in gold. Is there any liklihood in that?

[Arnold 0]

High interest rates pull money out of the market because companies start to suffer from borrowing debt cost, and profits sink. Home owners can barely pay their mortgage, and reduce spending where they can. Business suffers further losses. Those with cash find far better returns in bonds and term deposits.

Bubbles always burst because they are artificially created in the first place. For example; if the government decided to subsidize solar panels, many more people would install them than normal. This would cause a demand that would cause a boom in solar panel production since they would be below market price. New companies would hire new employees. All would go well until either the subsidy ended, or the demand fell. Since the uptake would have been far more rapid than in a free market, once the demand eases, the fall is huge in comparison. There are far too many solar factories for sustained demand. They close and lay off employees.

It's not so much that people realize goods are over valued, so much as demand falling. Take the housing bubble we had. Many who should never have, bought when they could not afford it because interest was so low. When they find the interest rate has doubled from say, one, to two percent, their payments double, and they are forced to sell into a market others are also selling into. This causes a cascading drop in price of houses since more sell than buy. Those holding mortgages end up with houses worth less then the money they lent. The rest is history.

Gold has actually maintained a pretty steady buying power for centuries. It would buy so much bread, or a cow, or a suit, or rent with far less volatility than paper money. Looking at historical records, my opinion is that there is no bubble in gold.

[JohnRgt 0]

Looking at historical records, my opinion is that there is no bubble in gold.

The highest surge in the supply of gold occurred when Cortez returned to Spain/Europe from the Americas. Gold was the currency of the day (some would say the only viable currency.) It took a hundred years for prices of goods and services to double, even though Spain was bathing in the gold. That's one stable commodity/currency.

[ruveyn ben yosef 0]

Looking at historical records, my opinion is that there is no bubble in gold.

The highest surge in the supply of gold occurred when Cortez returned to Spain/Europe from the Americas. Gold was the currency of the day (some would say the only viable currency.) It took a hundred years for prices of goods and services to double, even though Spain was bathing in the gold. That's one stable commodity/currency.

But the prices did double. In those days the velocity of money was much lower than it is now. With electronic exchange the velocity of the money approximates the speed of light.

ruveyn

[Jim Austin 0]

Simple inflation, which is just massive printing of paper money, causes interest rates to rise as lenders seek to compensate for anticipaed losses in value of the principle.

Inflation by credit expansion causes interest rates to decrease as the new money enters the economy as new loans. It's a matter of supply and demand with increased supply resulting in lower prices, in this case, interests.

Interest rates ultimate results from the discount people have of future goods compared to present goods. Stock prices represent present value of expected future gains. Artifically lower interest rates causes a higher valuation on future gains, which thus results in inflated stock market prices which come crashing down when interest rates are tightened in any way.

With artificially lowered interests, banks and other lenders must do a volume business if they hope to make any money. That itself results in more loans to unqualified borrowers, which inevitably leads to more defaults.

Those wishing any kind of return on investment are forced to make increasingly risky investments. Those who would be satisfied with four percent in a savings account move on to riskier investments when banks pay less than one percent interest. Those who would be happy with six percent from mutual funds go one to more speculative investments to gain the same percentages. The process continues.

For these and other reasons, lower interest rates inevitably lead to crashes.