Thursday, May 20, 2010

Credit Cycles

Regarding my Prices and the Rate of Interest graph,

Jerry writes:
I think what you are saying is that the money supply is mostly controlled by lending, and so inflation is mostly controlled by lending.

If that were true, wouldn't you expect that the periods of low interest rates would spur MORE borrowing, and there would be MORE inflation? that is, isn't the graph sort of upside-down from where it should be? they shouldn't be a glove-like-fit, but rather a mirror-like-reflection.

Well yes, Jer -- Low interest rates DO spur more borrowing, leading to more inflation. But it's not instantaneous, so my graph doesn't show a "mirror-like reflection."

There is a lag between when rates start to fall and when borrowing begins to increase. That interval of time is when recession occurs. If your "mirror" idea was correct, there would be no recession.

The glove-like fit on my graph above comes from interest rates and inflation moving up together in the "good" years, and down together in the "bad" years. The mirror-like movements occur near peaks and troughs of the cycle, where interest rates continue to rise while inflation begins to fall, or the reverse.

The mirror-like movements occur fleetingly and only at particular points of the business cycle.

Recession, Growth, Interest Rates, and Time Lags

Interest rates rise during the good years, reach a peak, and fall through the bad years. This graph from the St. Louis Fed shows the pattern.

As you can see on this graph, interest rates generally don't "break" and start to fall until growth is giving way to recession. And once recession starts, it feeds on itself. So there's less borrowing and less growth and less inflation even while interest rates are falling. Glove-like.

After a time confidence returns, low interest rates spur more borrowing (as you say), the recession ends, and economic growth resumes. But again, it is not instantaneous. Coming out of recession, borrowing begins to increase only gradually. This subtle change in borrowing will lead to a rise in interest rates, but not until the growth of credit-use regains momentum.

As the economy grows, demand picks up more and more. Increasing demand for loans begins to pull interest rates up. Increasing demand for goods and services leads to increasing inflation. Then we see more borrowing and more growth even while interest rates are rising. Interest rates and inflation move up together, glove-like, until a sudden drop in borrowing allows interest rates to break again.

So Jerry, your critique of my graph is correct except you overlook the time lags. Low interest rates do spur borrowing, but only when people are ready.

A Larger View

The St. Louis Fed graph clearly shows interest rates responding to the business cycle. Like a heart monitor in ICU, a canary in a coal mine, interest rates provide significant feedback.

But underlying the vigorous up-and-down pattern of that graph is a carrier wave, a long-term trend that shows increase from the mid-'50s to around 1980, and then decrease. This is a different kind of business cycle, a much longer cycle, perhaps a Kondratieff wave.

The Kondratieff is a business cycle fifty years or more in length. Wikipedia points out that "Kondratieff ... made observations focusing ... on prices, inflation and interest rates." Prices, inflation and interest rates. We have the same focus.

Oh, and speaking of big cycles... Have a gander at some of the charts in Sidney Homer & Richard Sylla's A History of Interest Rates. Scans from my copy:

Homer and Sylla write:

Chart 1 provided a very rough sketch of the trends of minimum ancient Greek and Roman interest rates... A saucer-shaped pattern was followed by interest rates during the history of each ancient civilization... Chart 78, which is based on long-term interest rates in those nations forming what is often called Western civilization, reveals what could be the first part of a similar saucer.

Arnold Toynbee showed that civilizations rise and fall in a recognizable pattern. Homer and Sylla show that interest rates are intimately involved in the process. And Keynes identified the interest-rate trough in the cycle of civilization as "the greatest age of the inducement to invest." He called it "a limiting point" ... "a period of almost one hundred and fifty years."

Are we late in the saucer-shaped pattern? Are interest rates on the rise in our era? I would say yes, and yes; but I don't make predictions. Still, there is an urgency to this matter that demands our attention.

All these business cycles, of various duration, are based on, or exposed by, or closely related to the pattern of interest rates. No, I don' think we could solve our problems by passing a law to limit the rate of interest. But interest rates are the canary in the coal mine of civilization. They are an early-warning system we must not ignore.


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