Thursday, June 25, 2009

Quiz About Interest Rates & Economic Imbalances

This post will be somewhat unusual, as it will present you with a quiz to think about. Whether or not I will continue with more posts of that kind is not clear at this point and will depend on the responses to this post as well as if I can come up with appropriate questions in the future.

In his book about the financial crisis, A Perfect Storm (I reviewed it in Swedish here), Swedish libertarian writer Johan Norberg on the one hand argues that the Fed’s low interest rate policy was a contributing factor behind the U.S. housing bubble. Later in the book, he attributes Iceland’s imbalances on excessively high interest rates, as it caused the Icelandic krona to be overvalued, which in turn made imports too cheap and exports too expensive.

At first glance, that would appear to be a contradiction. After all, economic laws should be the same in all countries, and if there was something about low interest rates that created imbalances then surely high interest rates should have the opposite effect and prevented imbalances. And if high interest rates through the effect on exchange rates in Iceland created imbalances there, shouldn’t the depressing effect on exchange rates from low interest rates in America have prevented imbalances in America?

The apparent contradiction gets even worse if you adhere to a Keynesian analysis, according to which currency appreciation will reduce cyclical excesses, which would make the Icelandic bubble even more incomprehensible.

There are however good reasons to think that no contradiction exists here, and that it at the same time can be true that low interest rates created imbalances in America and that high interest rates could have created the imbalances in Iceland. This also further illustrates the fallacy of Keynesianism.

So the quiz challenge for you is to try to figure out why this is not a contradiction, despite the fact that it might appear so at first glance. A hint is provided through the mechanisms described, but there is a lot more to it than that. Some further hints can be found in certain previous posts from me related to the subject, but I won't tell you which. I know the answer, but before I present it I will give you the chance of trying to figure it out for yourself. And for those of you who have Norberg’s book, the answer can’t be found in there, as the apparent contradiction isn’t noted there. The reason why it's not there is probably that he hasn't thought about the issue, but if he reads this he is of course very welcome to tell us what he thinks the solution is.

Note also that there might be alternative solutions to this riddle unrelated to the one I had in mind and have hinted here which you might suggest. Just remember that it must explain why what applied to America didn't apply to Iceland, and vice versa.

You can think about this until Saturday (27/6) evening (Swedish time), after that I’ll present the answer. No comments on this post will be posted until then however, so as to prevent you from copying each other.


Blogger Damo Mackerel said...

Is it because america is a consumerist and real estate market. To keep americans consuming and building houses the Fed deliberately kept interests down so credit would be cheap.

Iceland is an exporting country. Their thriving export markets brought in a lot of cash. To stop inflation, the Icelandic goverment increased interest rates agressively. This high interest rate made the Icelandic Krona very attractive to foreign investors, who opened accounts in Icelandic banks to capitalise on the high interest rates offered.

I'm not an economist, I just thought I take a stab at it.

2:32 PM  
Blogger Aki_Izayoi said...

Maybe the krona was overvalued due to capital inflows and Iceland misallocated its resources by putting it in finance causing a cycle of "malinvestments?"

10:17 PM  
Blogger Metin said...

One explanation seems to be that high interest rates encouraged locals to borrow abroad at lower rates and the foreigners to invest in local currency for the extra yield, thereby leading to excessive money supply situation. The bubble seems to have been exacerbated given the puny size of the local economy.

12:36 AM  
Blogger Libertyfirst said...

Nice idea. Let me try. Easy money in the US implies the creation of credit in excess of real savings, which results in an unsustainable boom. So far, thus, we know that there is at least one country where tons of paper credit have been created and are affecting the path of production, consumption, investments and savings.

The US boom was mainly funded by third world savings which have kept the US price inflation at bay thus enabling the Fed to perpetuate the unsustainable boom, till recently. This resulted in a massive trade deficit despite the low US interest rates.

Iceland is a tiny open economy. It has high interest rates, thus promoting carry trade in its favor. Excess US credit has poured in the icelanding economy, creating the conditions for an enormous increase in the monetary base despite the high interest rates. This resulted in a high trade deficit. This credit, created elsewhere, has created a boom in Iceland.

Two questions naturally arise. The former is why this mechanism wasn't compensated by the high interest rates. The latter is why the Icelandic currency didn't depreciate so fast to curb carry trade by reestablishing the interest rate parity condition.

Capital inflows should reduce interest rates, or result in price inflation, devaluating the currency. This is the equilibrium story. However, when interest rates are fixed by the central bank, the burden is on the price level, which may require a lot of time to be in equilibrium, especially because booms first affect asset prices and then final prices.

Besides, I would add that Iceland's financial position was fragile because most capital inflows were "hot" (short term), and because banks were too big for the national GDP.

1:27 PM  
Blogger Reginald said...

"Later in the book, he attributes Iceland’s imbalances on excessively high interest rates, as it caused the Icelandic krona to be overvalued, which in turn made imports too cheap and exports too expensive."

An increase in interest rates is accomplished via the central bank decreasing the money supply. All else being equal, the exchange value of that money will increase relative to foreign monies. A stronger domestic money decreases the price of imports, and increases the price of exports.

Thus the volume of imports increases, and the volume of exports decreases.

3:35 PM  
Blogger Aki_Izayoi said...

Also couldn't their high interest rates draw capital into the country because people were engaging in carry trades (selling dollars/yen etc.) to buy high yielding krona. Didn't that give banks a lot of capital to malinvest?

5:06 PM  
OpenID tmprandom said...

My take:
If the interest rate is set to a different rate than market time preference (which is changing and not easily discoverable), entrepreneurs might erroneously commit to projects with profitability calculated based on incorrect assumptions. Erroneous decisions accumulate, market and market coordination becomes distorted. Expansion or contraction of credit changes relative prices. Completion of started projects becomes impossible. Completed projects are discovered unprofitable. Real wealth is lost. Corrective depression occurs.

As for (officially or effectively) pegged currencies with the interest rate set higher than then the interest rate of the peg (a single currency or a basket of currencies), like LVL, ISK, UKH, PLZ – they are just tools of looting on enormous scale by high-level bureaucrats (riskless carry-trade, financed by the local population).

1:11 PM  
Blogger Flavian said...

I think that it might be the case that the exceptionally overvalued icelandic crown masked a high domestic inflation rate, whereas the far more liquid US dollar can't get so heavily overvalued and that in reality Icelandic real interest rates were even lower than those in the US.

2:50 AM  

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