Inspecting the interest rate imbroglio – Part I

Daniel Gomes Luis
June 1, 2021
In the midst of the enigmas pervading the enormously important, though puzzling, study of the economy, none other causes as much perplexity as interest rates. In spite of being the ones that pop up outright in people's minds when they think of them, in reality, there is a myriad of interest rates across different asset classes and geographies.

Unsurprisingly, throughout the ages, interest rates have been the subject of immense scrutiny and discussion. However, it seems the level of understanding has not been improving. In fact, I contend it has actually regressed. The reasons for such growing mystification lies on i) the evolution of the monetary system (eurodollar), ii) academic obstinacy, iii) bureaucratic inertia and iv) reverence towards the so-called experts.
To make long story short, due to technological progress, combined with the inauguration of new banking configurations brought about by methodological advancements, the banking industry started to mutate into a wholesale deposit system, increasingly burying the traditional retail banking arrangement. Following the inception of the eurodollar regime, banks, in lieu of compensating depositors according to their time preferences, began to, on the whole, pay them interest based on the risk factors of their balance sheets’ makeup.
Owing to the developments of money and financial intermediation, credit expansion ballooned, particularly in the first few decades – Great Inflation -, regardless of the ostensible high interest rates and “missing money”. Evidently, economists became confounded by this assumed dissonance for not being attentive to changes in the monetary system, having been stuck with an ancient worldview; an era that is no more.
Overall, interest rates are determined by the participants in the financial system (predominantly banks) insofar as the economic and financial conditions forge their assessment. Moreover, credit is provided on the basis of balance sheet constraints and its various risk metrics.

To begin with, the accepted view on interest rates, the one you are taught in college, is that interest rates reflect the time preference of society, which gives us the pure interest rate as Murray Rothbard dubbed it, plus entrepreneurial risk and inflation risk – the former one accounts for all the idiosyncratic forms of risk particular to any enterprise, while the latter one is an unanticipated loss in the purchasing power of money (PPM), since the expected loss in PPM is already reflected in the time preference and, therefore, the pure interest rate.

In the classical and Austrian views, people’s time preferences are what shape the production structure. The proportion of consumption to saving on investment is determined by the degree to which people prefer present to future satisfactions. The less they prefer them in the present, the lower will their time-preference rate be, and the lower will, obviously, be the pure interest rate.

On the one hand, a lower time-preference rate will be reflected in greater proportions of investment to consumption, a lengthening of the structure of production and an accumulation of capital. On the other hand, higher time preferences will be expressed in higher pure interest rates and a lower proportion of investment to consumption.

Because of varying degrees of entrepreneurial risk, along with loss of PPM risk, a structure of interest rates is established instead of a single uniform one. Nevertheless, seeing that it is the basis for the structure of production, and being a key aspect of the Austrian business cycle theory (ABCT), the crucial ingredient is the pure interest rate.

According to the ABCT, when banks swell their credit balances to the economy, this new money pours forth on the credit market and lowers the rate of interest. Albeit this condition is not vital to the process, as Mises posited:

“If a bank does not expand circulation credit by issuing additional fiduciary media…it cannot generate a boom even if it lowers the amount of interest charged below the rate of the unhampered market….The inference to be drawn from the [Austrian] monetary cycle theory by those who want to prevent the recurrence of booms and of the subsequent depressions is not that the banks should not lower the rate of interest, but that they should abstain from credit expansion.”

– Ludwig von Mises, Human Action, p. 789n5, 1949

In summary, while banks could arbitrarily lower the interest rate on loans, this would not initiate an inflationary boom. By the same token, even though banks could leave the interest rate unchanged, they could still lend out newly-created bank reserves by lowering the criteria of credit origination, which would ignite a boom and asset price inflation.

Ergo, the concept that a low interest rate would spur credit expansion has been nebulous for a very long time. Yet, this tenuous link is still “taken for granted”, even though Milton Friedman demolished this belief as far back as 1967 with its interest rate fallacy, as Jeff Snider coined it.

“As an empirical matter, low interest rates are a sign that monetary policy has been tight – in the sense that the quantity of money has grown slowly; high interest rates are a sign that monetary policy has been easy – in the sense that the quantity of money has grown rapidly. The broadest facts of experience run in precisely the opposite direction from that which the financial community and academic economists have all generally taken for granted.”

– Milton Friedman, Presidential Address to the 80th Annual Meeting of the American Economic Association, December 1967

In order to comprehend the current predicament, our journey starts in Chicago in the late 1940’s. Although the ideas for quantification of economic factors have risen in the 19th century, technology and theoretical proficiency made way for those ideas to be expressed more coherently.

Due to turning out so revolutionary, Harry Markowitz had, to all intents and purposes, established a completely new branch of economics: portfolio theory. By applying probability theory to equity behaviour, Markowitz would unwittingly change the world. Using variance (and covariance) to measure the risk of a portfolio, an investor could select a point from the set of Pareto optimal expected returns and variances of return combinations, known as the efficient frontier.

In view of the intuition in this intellectual framework, it has been widely adopted. To the purposes of our discussion here,  this theoretical breakthrough provided the technical tools  to the overarching monetary tranfigurations that commenced in the 1950’s. Naturally. this reduced the relevance of not just prior concepts, but actual operative workings. Owing to its fractional reserve nature, risk management had always been concentrated far more so on the liability side. As a consequence of the portfolio theory, this style was adopted instead into the asset side to hopefully produce enough knowledge and foresight about the risks involved.

Basically, the rise of the eurodollar standard, besides prompting the demise of the faulty gold standard under the Bretton Woods (BW) edition, introduced a vast array of variables upon which the concept of risk would have to apply. The monetary sea change that ensued, because of the introduction of floating currencies and the parallel rise of derivative markets, led the US Securities and Exchange Commission (SEC), in 1975, to issue the Uniform Net Capital Rule (UNCR), which sought to crystallise risk management through standardised quantification, placing bank assets into twelve classes.

Before moving on chronologically, I had better clarify this further. This eurodollar system is not a proper currency system, having indeed more in common with a computer network. For the “medium of exchange” function being the most important one for global trade, money has had to satisfy this need primarily, throwing the “store of value” function to near oblivion. For instance, a company in Portugal was not – and still is not – interested in attaining US dollars for their possession per se, but only so far as dollars would mediate trade across different jurisdictions. If exporting, the Portuguese business could convert whatever currency that might be coming back easily into escudos. Vice versa, if importing, the company would exchange escudos into dollars to be further converted into whichever currency of the ultimate destination of the goods.

Seeing that it operates off-shore of the US, outside of the American regulating authorities’ purview, this eurodollar setup has been extremely advantageous. In addition to the lack of government rules and regulations, there was no need for reserves properly regarded as currency. Suitable for a Twilight Zone episode, global trade did not – and till this day does not – require payment in physical, nor digital, Federal Reserve Notes at each node of a transaction, needing exclusively the methods and systemic capacity to bridge disparate financial and currency regimes under a common standard.

By giving a blow-by-blow hypothetical, I am going to expound on how this system operates. Using that same Portuguese company as our example, though we can go forward in time to today, this business is now seeking for a loan in dollars and so it asks a local bank for one. Lacking the sufficient capacity to make that loan, this bank in Portugal gets in contact with a bank in the City of London that claims to be able to source those dollars. With no actual dollars ever exchanging hands, a claim was all that was required and everyone lived happily ever after. The end. Not quite, though. This is hardly the end.

How exactly do they perform this modern financial alchemy? Through digging deeper, we realise they put into practice the concepts of portfolio theory, building on those ideas introduced by Markowitz. For the bank in the City to extend the loan to its Portuguese counterparty, it has to overcome a series of constraints. So as to pull this off, banks and financial institutions in general came to use, essentially, Markowitz foundations to describe  mathematical properties, via probability statistics, of quantifying risk .

Among them was Value-at-Risk (VAR), which set the world on fire in the 1990’s and 2000’s, being of more limited use before then. As Darryll Hendricks detailed in his paper titled Evaluation of Value-at-Risk Models Using Historical Data, by aggregating “the several components of price risk into a single quantitative measure of the potential losses over a specified time horizon”, the VaR models “convey the market risk of the entire portfolio in one number”, making it very appealing.

Thus, the ability to make that loan is going to depend on volatility measures (variance and covarience) and loss probabilities, of which VaR is just one of them. As a result, the bank in the City will only lend balance sheet space (i.e., make the loan) to the one in Portugal if it does not disrupt internal (and external, such as regulations) balance sheet guidelines. Likewise, the Portuguese bank will have to run its share of calculations to maximise the efficiency of its balance sheet. Nowadays, these procedures, where the notions of financial risk, expected return and projected usage are respected, have become common practice and near instantaneous.

To add some complexity to the example to approximate it with the real deal, we have to add collateral to the mix. Although in the pre-GFC era there were a lot of unsecured loans being made and the resort to exotic instruments like credit default swaps was recurrent, loans secured by collateral became the almost exclusive form.

Hence, in order to make this scenario more realistic, the City bank will most likely only manage to make the loan if the bank in Portugal submits a security as collateral first. As you may have already figured out, the higher the risk of a particular deal (either with another bank or non-bank entity, whether secured or unsecured), the more balance sheet capacity it is going to consume.

Notwithstanding, there is more to it still. That collateral has presumably come from some entity who has a sizable inventory like any major US-based bank operating as dealer in global repo and interbank markets. If both of those counterparties decide to take the least amount of balance sheet space, by hedging against risk as much as possible, then the Portuguese bank will post the highest form of dollar collateral, US Treasury securities (USTs), of which the short-tenors, T-bills, are the crème de la crème, for being the most liquid (less volatile) securities.

Want more complexity? That collateral provided by the dealer is possibly being repledged. This means that the dealer has obtained the UST through its prime brokerage business, for instance, where customers allow consent for their securities to be re-used by their brokerage firms ( in this case, part of this US-based dealer), in exchange for some compensation of course. Alternatively, it can borrow from an insurance company or pension fund, or even from other dealers.

Despite this example appearing monumentally intricate, the real world makes this entanglement seem like kid’s stuff. In reality, those banks have many clients and relationships with many other banks and dealers. These latter ones being at the center of this financial web. Due to having many companies looking for dollar-denominated funding, the Portuguese bank creates a portfolio of mainly longer-term dollar loans which are sourced from arrangements with several banks worldwide, falling back on the simplest means, like our example, and also on currency swaps and other derivative instruments so as to devise the optimal liquidity strategy for the balance sheet.

On account of being naturally short-run, the Portuguese bank has to keep on rolling over these liabilities to continue to fund its portfolio without a bump in the road. Since the assets have longer maturities than the obligations, a dangerous maturity mismatch ensues. Be that as it may, this bank buys access to large pools of collateral, engendered by the dealers, by posting a small margin of collateral. Thus, the bank has now secured enough collateral to fund all its dollar needs. All in all, this is the essence of the eurodollar system or, as some would call it, shadow banking.

Bearing in mind that balance sheet capacity is governed by volatility and, consequently, judgements about risk, then anything in the world that could disturb risk perceptions will take its toll on balance sheet capacities of all the players in this system. Therefore, and remembering that those behemoths that act as dealers have a fundamental and pivotal role in all of this, were something to interfere with the collateral chains (worsening risk judgements), this house of cards would collapse, kicking off a shadow bank run.

Finally, this run does not entail that the lenders, either of “cash” or collateral, will demand the borrowers to liquidate their positions. Instead, they could get hit with more collateral calls – i.e., simply asking for more collateral or of better quality (more “pristine” ones). Considering that the less risky a security is, the less volatile it is and, ipso facto, the more liquid it is. Accordingly, the safest and most liquid securities are massively sought after during periods of financial distress, thereby precipitating a surge in their prices and a drop in their yields (interest rates).

Because of already being extensive and having still much to say about this, allow me to take a breather and we will carry on with this analysis another day. So, be patient.

Read the part II of this article here