Sunday, June 28, 2009

Interest Rate Quiz Solved

I recently challenged readers to figure out how it could be true at the same time that low interest rates created economic imbalances (excessive borrowing and consumption/malinvestments) in America and high interest rates created economic imbalances in Iceland. Some of the answers were on the right track, but didn't really solve the mystery.

The most common answer was that high interest rate created massive capital inflows into Iceland, which in turn meant that capital were more available and so created the economic imbalances. That is not entirely inaccurate, but it doesn't really explain how it encouraged borrowing. The implicit assumption seems to be that this is related to the terms of credit. But in order to encourage borrowing you would need to lower interest rates, and since the premise was that interest rates were high, it really can't explain it.

Another answer was that high nominal interest rates could simply reflect high inflation and not high real interest rates. But while that could explain while imbalances could arise despite high nominal interest rates, it doesn't explain why the high interest rates could be the causal factor. This would rather implicate high inflation as the causal factor.

Another answer was that high interest rates encouraged Icelanders to borrow in foreign currencies (such as U.S. dollars, euros, francs). But while that can explain why the relative proportion of foreign currency loans increases, it can't explain why total borrowing increases. High Icelandic interest rates doesn't make it more profitable to borrow is dollars or euros, it only makes it less profitable to borrow in Icelandic kronors. Or in other words, the amount of domestic currency debt should be reduced while the amount of foreign currency debt should be unaffected.

Also, to the limited extent the uncovered interest parity condition holds, not even that part about relative profitability holds.

And moreover, none of these explanations really explain why this didn't lead to reduced imbalances in America.

The solution lies instead in the hint I gave about the difference between the United States and Iceland. There are many differences between these two countries, of course, but one of the most important is the size of the population. America has slightly above 300 million people, while Iceland has slightly more than 300 thousand people. America is in other words almost exactly 1,000 times bigger.

What does that have to do with this issue? Well, remember what I wrote about how a currency appreciation caused by the capital inflows caused by high interest rates will makes imports cheaper and therefore induce people to demand more of it (And at the same time it will make exports more expensive to foreigners and therefore reduce exports). Currency appreciation will, other things (like interest rates) being equal, increase net borrowing from abroad.

As currency appreciation often results from higher interest rates, this effect will to some extent cancel out the borrowing reducing effect from higher interest rates.

But since foreign trade is a lot more important in tiny countries like Iceland than in giant countries like the United States, this imbalance enhancing effect from exchange rate movements will be a lot greater in small countries than in large countries.

At the same time, the interest rate effect on borrowing will be at least as large in large countries as in small countries. Indeed, it will probably be a lor larger in large countries as the use of foreign currency financing is more accepted in small countries with small and illiquid currencies like the Icelandic Krona than in countries with a widely accepted and higly liquid currency like the U.S. dollar.

And so, while low interest rates in America had a great impact on the capital market side of the economy while the indirect effect on goods markets (through currency depreciation) was limited , the opposite held true for Iceland. The capital inflows that some of the commentators focused on in the case of Iceland did cause this, but not through the effect on interest rates, but through the effect on exchange rates.

One obvious conclusion here is that the value of "independent monetary policy" to stabilize the economy is dependant on the size of the country/currency area. Even if done right, small central banks have little or no chance of stabilizing their economy. If other central banks pursue inflationary policies then any attempt to counteract that will cause excessive currency appreciation which will create the kind of imbalances that the independent policy was supposed to prevent. By contrast, larger central banks like the Fed and the ECB can choose whether or not they want to create bubbles.


Blogger Flavian said...

The Icelandic CPI has fallen approximately two thirds in terms of gold since 2005.

The answer to Iceland's problems is free trade and monetary internationalism.

If one takes a look at other tiny economies Saint Helena is interesting. Saint Helena has 8.000 inhabitants, largely free trade, a truly fixed exchange rate and no deposit insurance.

Yes, Saint Helena is poor and dependant on Britain, but still suffers no major macroeconomic disequilibrium. Any country adopting the principles of monetary internationalism and free trade can have a larger domestic economy than the US; the whole world!

Icelands major problems are its floating micro-currency, the deposit insurance and farm protectionism. Without farm protection and with a fixed exchange rate a rising real exchange rate would lower farm production, create a large deficit in the balance of payments and thus, via the fixed exchange rate, send short term interest rates in the sky and stop the boom.

Floating exchange rates do actually prevent the world market from sending price signals into the domestic market.

12:09 PM  
Blogger Flavian said...

One could even push this argument one step further.

Countries with large domestic economies are not made aware of the unhappy consequences of floating exchange rates due to the fact that they within themselves form such large currency areas that these can be understood as a kind of monetary unions.

The North of Sweden is monetary union with the South of Sweden and within this currency zone there are about nine million people which makes this currency zone far more liquid and thus more well-functioning than the monetary union between the north and the south of Iceland since that monetary union only has about 300.000 inhabitants.

I do not think that it will ever happen and if it would happen it would of course be turned into a poltical football, but if there were a global paper currency issued by a global central bank and this central bank would pursue very strict non-inflationary monetary policies that would probably work almost as well as an international gold standard.

11:33 PM  

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