Pluralistic: Higher interest rates increase both the monetary supply and inflation (04 Feb 2023)

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A portrait of Milton Friedman looking pensive, his chin in his hands. In his skull is a superimposed thought-balloon, and within it is a silhouette of a proud-looking horse. In the background is a three dimensional 'line-goes-up' red line, with an arrow on its rightmost, sky-seeking tip. The arrow has a gold dollar-sign within it.

Higher interest rates increase both the monetary supply and inflation (permalink)

Here's the theory: first, hike interest rates, which makes borrowing more expensive and reduces the supply of money in circulation. With less borrowing, there's less expansion, which leads to layoffs that lower the spending power of workers, which means that there are fewer dollars chasing the same goods, which means that prices go down. Q.E.D.

This orthodoxy comes to us from Milton Friedman, the father of neoliberal economics, who believed that every economic problem was down to a mismanagement of the money supply. As economist Robert Solow quipped: "Everything reminds Milton of the money supply. Well, everything reminds me of sex, but I keep it out of the paper."

Friedman's orthodoxy – monetarism – has reigned supreme for decades, which is ironic, given that Friedman and his colleagues at the Chicago School of Economics claimed that they had elevated economics into an empirical, quantitative science, a kind of physics of human action, not like those squishy, social sciences.

You'd think that a self-styled physicist of human behavior would avail themselves of the underlying methodology of the "hard" sciences, which is to say, forming falsifiable hypotheses and then checking to see whether they were borne out by real-world outcomes.

But that's not how the neoclassicals roll – they function like the caricature of the physicist whose every inquiry begins with "imagine a perfectly spherical cow of uniform density on a frictionless plane." Or, as Ely Devons famously quipped, "If economists wished to study the horse, they wouldn’t go and look at horses. They’d sit in their studies and say to themselves, 'What would I do if I were a horse?'"

(This is why the most heralded revolution in economics for generations is "behavioral economics," which is a fancy way of saying, "Doing economics but checking to see if our assumptions about human behavior are actually right.")

The evidence for monetarism and its interest-rate prescription for reducing the monetary supply and taming inflation is…not good. In a post called "Do High Interest Rates Reduce Inflation? A Test of Monetary Faith," Blair Fix brings out some empirical big guns to test the Friedman method, and finds it sorely in want of a practical basis:

Figure 3: Interest rates and the growth of the money supply — the pattern across countries. Looking at international data, this figure compares national lending interest rates with the annual growth of the local money supply within each country. To measure the average trend, I put interest rates into size bins. Each blue point indicates the midpoint of a bin. Within each interest-rate bin, I then measure the range of monetary growth. The blue line indicates the median growth rate within each bin. The shaded region shows the middle 50% of the growth-rate data (the 25th to 75th to percentiles). Note that both axes use a logarithmic scale. [Sources and methods]

Fix pulls data from the World Bank to investigate the link between interest rates, monetary supply and inflation. He finds that even extremely high interest rates (e.g. Nicaragua's 1992 interest rates of 450%) correlate with an increase in the monetary supply – this is likewise true for single- and double-digit interest rates.

Fix measures this in several ways to validate his conclusion, and finds it robust. A few countries have sometimes experienced a modest contraction in monetary supply when interest rates rose, but they are outliers: most of the time, rises in interest rates correspond with increases in the monetary supply.

Figure 5: Interest rates and the annual rate of inflation — the pattern across countries. This figure analyzes the international relation between the inflation rate (within countries) and the lending rate of interest. To show the average trend, I put inflation rates into bins, plotted on the horizontal axis. The blue point indicates the midpoint of the bin. On the vertical axis, I then plot the range of inflation rates (within each bin). The blue line shows the median inflation rate. The shaded region indicates the middle 50% of the inflation data. Note that both axes use a logarithmic scale. [Sources and methods]

OK, so hiking rates doesn't reduce the monetary supply. But does it tame inflation? Once again, our uniform spherical cow on a frictionless surface nevertheless skids to a painful halt: "As interest rates grow, it seem that inflation responds by … increasing."

This is another robust finding, one that persists whether we measure inflation between countries or within a single country over time: "For the vast majority of countries — about 82% — the interest-rate-inflation correlation is positive. In other words, when interest rates get hiked, the norm is for inflation to increase."

So what's going on here? Fix turns to a 2022 paper by Tim Di Muzio called "Do Interest Rate Hikes Worsen Inflation?" in which Di Muzio injects some much-needed political economy realism into the thought-experiment dreamland of the Friedmanites:

Di Muzio observes that when interest rates go up, businesses don't reduce their borrowing, as the neoclassicals would predict. Why not? Because businesses in our real world enjoy pricing power, which means that when their costs of borrowing go up, they pass those increases on to their customers (economists call this "cost-plus pricing").

Which is to say that because interest rates increase the costs for businesses who enjoy monopolistic market power, interest rate increases also cause price increases. And not to put too fine a point on it, the economists' term of art for "a sustained rise in the price level" is…inflation.

Fix says that at best, monetary policy – raising interest rates – simply fails to mitigate inflation. But at worst, it actually increases inflation. Here he echoes Joseph Stiglitz and Regmi Ira, who compare interest rate hikes to bloodletting. If the patient gets worse, you're not bleeding them enough. If they get better, the bloodletting clearly saved them. If they die, well, some diseases are simply incurable:

For Stiglitz and Ira, interest rate hikes don't address inflation because inflation isn't caused by too much money. Rather, it's caused by things like wars and pandemics (which reduce the supply of key inputs and goods), mass deaths (which reduce the workforce), lack of daycare and other policies (which reduce it further), and more:

For Fix, the interest rate/inflation superstition is a tragicomedy: tragic because it worsens the problem it seeks to solve, and comic, because of the absurd motivated reasoning that Friedman-pilled economists indulge in when they are confronted with the overwhelming evidence against their ideological certainty.

Fix describes how, if a neoclassical is argued into a corner by empirical evidence that disconfirms their hypothesis, they will turn, at last, to the idea of distortion: the economy should work the way my model predicts, and if it doesn't, it's because the gubmint has "distorted" the economy by "intervening."

This magical thinking insists that we just need to bleed the patient a little more, remove a few more guardrails and give a little more control to shareholder-worshipping financiers and a little less to democratically accountable regulators, and the map will become the territory.

"Hurry, bring more leeches, the patient is dying!"

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