patrick.net

What do you think would happen to U.S. interest rates, home values, and our economy if the Asian markets decided to stop buying our bonds? Even worse, what would happen if our current foreign debt holders put all our bonds on the market? Why would any country want to give partial control of their economy over to foreigners?

EconPete says

This situation makes the U.S. look like 8 year old kids and China the adults.

You're assuming the Chinese will never stand up and demand better pay and rights. China's plan only works because the vast majority of their population allows their country to make them work for pennies. Someday they will fight back.

StoutFiles says

Someday they will fight back.

Things have not changed for them in generations and will not for generations. They don't have a shot because of their 1.3 billion population.

EconPete says

In a closed economy where investments and savings do not flow across boarders, interest rates respond to local market conditions. When the supply of savings gets low, interest rates go up.

Assuming a static quantity of money, yes.

The supply of money is shrinking because there is expansion and along with growth you get increasing asset prices, higher home values.

What?? Nothing has happened to the supply of money. Interest rates go up, which is nothing but the price for money. What has changed is both the demand for money and "time preferences". A heated economy where there is increasing demand for borrowing will naturally reduce the supply of money available to borrow at current interest rates, which will go up in order to attract lenders (e.g. CD rates) in order to restore available money at the banks, which in turn is available to to loan at higher rates.

However, this has a natural braking effect on an economy. What is possible at, say, a 5% borrowing rate, may not be possible at 7%, 9%, or 12%. What a rising interest rate does is force out less important / frivolous economic activity towards those which are most necessary. I would posit that a the housing bubble never would have taken such a turn to the stratosphere had rates been allowed to naturally rise.

Likewise, with a static money supply, while bubbles would be less likely because of the natural brake mechanism of interest rates, a rise in asset prices in one direction within those confines would necessitate a decline in asset prices elsewhere, thus negating the constant syndrome of all prices rising we have in our current system of ever-expanding money supply / credit.

Oppositely, when the money supply is excessive because nobody is building and the economy is not growing and assets are falling in value, interest rates will fall.

Money supply excessive?? Because of high rates? High rates reflect demand for money has increased and people are willing to pay higher rates. The exception is when an economy has become so badly dislocated that those with savings in money would rather hunker down until something more normalized / rational appears on the economic front so that they are willing to lend capital again. They may indicate this opinion by simply leaving cash in a vault or by lending only at super-high rates. This is a good thing if an economy starts dabbling with going full-retard since it applies an emergency brake. (Although, such a dislocation in an economy is very unnatural, and more likely the consequence of prior artificial interventions by policy makers that short-circuited the natural, more gradual braking mechanism in the first place. More on that below.)

However, in this scenario, the supply of money has not declined or increased. It is holds constant, while the preference for simply holding money is in much higher demand vs. a pledge to be paid back money at interest

Thus, in a closed economy there is a direct positive relationship between interest rates and home values due to all other influencing local variables.

No doubt home values are a function of monthly payments that the masses can afford, and are therefore interest rate sensitive.

But, I make the contravening comments above because your model is unclear as to what's going on with money supply from where it really matters: at the points of creation and destruction.

If we're talking a fractional reserve system, then - yes - money supply expands exponentially as a function of the multiplier effect. But the very nature of fractional reserve lending is that it specifically disconnects the "price of money" from both market time-preferences and natural demand, replacing that naturally contrived price with a price-fixing scheme determined by Central Planners running Central Banks and Governments.

The result is that we end up encouraging an economy beyond its natural state of affairs by pursuing a low interest rate / credit growth strategy, which can only be accomplished by expanding the money supply in order to defend a lower borrowing rates. The actual mechanism is that the "money system" fills the void of left by market lender to banks when their economic calculation determines they should demand higher interest rates to part with their money. These artificially low interest rates encourage activity that would otherwise not be possible at higher interest rates. However, this intervention is usually very politically very popular because it creates very visible economic activity that "proves the policies are effective."

Eventually, though, policy makers decide they must slow the new rate of activity they artificially stimulated. That's because the rise in money is ordinarily accompanied by more dramatic rises in the hottest asset prices, with an increase in "hot money / get rich quick" activity related thereto, and a general inflationary increase across the board. Unlike the static money supply model above, where prices must go down in other areas in order to accommodate a rise in another, the supply of money has risen across the board. While it gins up the hot area of an economy specifically, the remaining economy remains relatively static. Hence, the supply of goods and services in all but the frothing area remain constant (or even neglected in lieu of more quick profit activities in the bubbling areas), resulting in a rise in prices as the ratio of units of money to units of goods raises on the money side only. Meanwhile, in the bubble sector, units increase to meet the rapid, albeit artificial, demand. But the money supply supports higher prices as speculative forces further dislocate the market.

So when policy makers allow rates to rise, suddenly it's as if oxygen is removed from the bubble area of the economy, and activities that were previously subsidized at lower rates and the expanding $$ supply are exposed as unprofitable / unsustainable, and they begin to collapse.

As loans are written off, the money supply can theoretically contract. The same can be said for an environment where no new loans are created and old loans are paid off. This would result in a general restoration of old relationships between the supply of money and goods, with the pricing mechanism returning to the orginary amount of money in the system.

NOTE -- this is a restoration of normalcy. The unnatural and problematic activity was that which was artificially stimulated and unsustainable on its own from the word go. Such intervention sows the very seeds of its own eventual demise when the initial intervention inevitably must be reduced / retracted to ward off its negative inflationary / bubbly economic consequences. And since there is no free lunch, the adjustment back to economic normalcy is painful for those who redirected their efforts around and just downstream of the artificial parts of the economy.

HOWEVER, policy makers refuse to allow such a corrective recalibration to take place. Once an economy retracts and the mistakes are laid plain to see, they re-engage stimulative posture to encourage activity to ward off the correction to normalcy. Paying for free lunches / the pain associated with such corrections is not popular, and politicians and policy makers gain power / make their $ millions by promising all gain and no pain / "having one's cake and eating it too" as a matter of policy. And, of course, the intervention creates more activity and can freeze the correction taking place -- it appears to work. But instead of creating a healthy economy, it fossilizes highly broken assets a very wrong prices that won't clear absent the intervention, while further subsidizing a segment of the economy that is still in need of further correction -- creating, in essence, a zombie portion of the economy that must be fed / sustained with wealth carved from the functioning / wealth producing side of the economy.

Anyway, that's a lot, I know. I go into that depth, though, to make an alternative point to yours about money supply, economic activity, and prices -- and their relationship to policy intervention. Your quoted parts above lay a foundation that leaves the reader to guess a lot about what really goes on, and the rest of your piece falls back on that as a foundation.

I'll address the rest of your explanation in additional comments.

EconPete says

The U.S. is the most open economy in the world. This old way of thinking about interest rates is not relevant in today's globalized markets. If it was relevant, how is it that U.S. interest rates are declining when their savings is practically 0% of their income?

Because the broader money supply / global supply of U.S. dollars exists from past monetary interventions / expansions, and is also is implied /threatened by policy makers / Ben Bernanke to expand in order to defend such low interest rates. Hence the broader market accommodates the environment. If policy makers were to state today that they would no longer defend low interest rates / expand money supply by a dime, no longer intervene with bailouts in sovereign debt, etc., you'd see interest rates globally skyrocket to the existing supply of money, very likely over-shoot, and and level off at a natural rate.

Prior to the collapse of 2008, the mechanism was very simple. The U.S. expanded its money supply to ward off the tech bubble / stock collapse / recession. This money vented through the U.S. credit system and into 1) the housing bubble, into consumers hands via home equity capital gains and / or loans, into consumer goods made abroad / in China, where china loaned those dollars back to the U.S. credit system. Rinse. Wash. Repeat. And; 2) into the Credit Bubble system, where $billions were made by money shufflers who stimulated the economy by buying whatever it is they buy. Mercedes, BMW's?? Germans have dollars, loan back to U.S.. Whatever trickled down to the average consumer was then spent abroad, and came back as cheap loans from China. Rinse. Wash. Repeat.

NOTE: This had an effect of modern alchemy, where highly inflationary monetary policy actually translated into lower priced goods as the U.S. imported goods from abroad and exported great amounts of wealth to places like China where they invested it into factories, etc. that could produce more and more. In turn, we borrowed to finance more purchases, over and over again.

In a closed economy, that inflation would have been confined to the U.S., resulting in higher prices based on our labor structure. Instead, we took those cheap prices from abroad for granted, and used those price efficiencies from abroad to further price our own products, goods, services, out of the realm of affordability by increasing regulatory and tax complexity, which only further served to incentivize moving production abroad.

In other words, this massive monetary intervention greased the the destruction and exportation of our engines of wealth creation, while placating the masses with the distracting opiate of cheap goods from Wal Mart. e.g., Who cares if you lost your old job and now a lower wage when your standard of living remains constant thanks to China Inc.'s cheap goods? (that's not a jab on Wal Mart. They've merely shown the most efficient way of providing goods at an affordable price to their consumers IN THE CURRENT ECONOMIC SYSTEM FORCED ON THE U.S. BY CONGRESS AND THE BANKING SYSTEM.)

As a country the U.S. is not saving money in excess to push down interest rates. In fact the U.S. is spending way more, as a percentage of GDP, than any of their previous generations! This, in a closed economy, would indicate that interest rates should be going up to counteract the expansion of consumption and increasing asset prices. This is not happening. Interest rates are declining even while U.S. national savings is asymptotically approaching 0. Therefore the old, closed economy, way of thinking about interest rates shall not apply to a globalized economy because those opposing forces are not in effect

U.S. savings rates are irrelevant to lending and credit markets. Savings rates, in general, are globally irrelevant. neo-Keynesian monetarism has pursued policies for decades to make it so, and amid the crisis we currently endure, policy makers are ever more emboldened to do whatever is monetarily necessary to ward off a restoration of economic reality because so many, soup to nuts, are dependent / horribly woven into its dysfunction and stand to be summarily turned upside down by such a return to economic reality. And so their policy continually kicks the can... Only the can is getting really heavy, and they've cannibalized so much of the leg required to do the kicking (the functioning economy) that the can barely moves a few weeks down the line.

Truth's a real bitch, you know.

EconPete says

Foreigners can manipulate our interest rate market by buying our bonds and pushing down interest rates in order to discouraging investment and capital formation. This acts to reduce GDP growth at the same time. Why else would China invest in a 0.25% return?

We print dollars, we buy Made in China, China has dollars -- what to do with them?

Well, China is run by central planners who have for well over a decade now matched our money printing Yuan for Dollar to prevent their currency from gaining purchasing power, with a goal of developing their export sector. They achieved that goal. Along the way, they accumulated lots of dollars in their central bank (They printed Yuan and exchanged it for dollars earned by their exporters), which they in turn invested in U.S. Treasuries and other U.S. dollar denominated debt instruments.

This helped China achieve their short term policy goals (while longer term, it overstimulated their export sector and created a bubble in their own economy, but that's a separate discussion...), while it also helped U.S. policy makers achieve a short term goal of depressing U.S. interest rates so to encourage domestic U.S. economic activity.

This was deemed to be a policy win-win until exposed as somewhat problematic in 2008. However, the U.S. policy makers are still very glad that foreigners buy our debt, in the belief that low rates stimulate borrowing and, thus, business expansion and consumer demand.

It's not for the interest rate; it is to distort U.S. markets to encourage irresponsible consumption, high leveraging, and lack of investment (All disastrous to a healthy economy). All these countries have to do is drop all U.S. bonds on the market in a day and the U.S. will get their jobs back..... EXCEPT THE U.S. WILL BE THE ONES PRODUCING STUFFED ANIMALS FOR $2 A DAY FOR CHINA!

Perhaps. But China, or any other country, can only spend the dollars we allow into circulation, on U.S. debt or otherwise.

On the other hand, you'll find that in the last couple of years, China has been increasingly diversifying its reserves, away from U.S. Treasuries and into other assets (commodities, U.S. theater chains, etc.) Stepping into the void to suppress U.S. rates has been our very own Federal Reserve. QEII was a treasury program, extended through Operation Twist, which merely refinances short term debt coming due into the the 10-year treasury with the goal of lowering rates, especially mortgage rates (which very closely track changes in the 10-year.

More recently, the flight to U.S. debt has been risk-off safety trade. As the Euro continues to disintegrate, people are seeking the safety of the dollar and highly liquid dollar assets like Treasuries.

For now, the U.S. is comparatively safe. But at best the U.S. dollar / treasury is the healthiest horse at the glue factory.