An Interesting Theory -Why Interest Rates are Important but not for the Reasons Commonly Assumed

An Interesting Theory

Why Interest Rates are Important- but not for the Reasons Commonly Assumed

By Artie Lees

Copyright 2015 Artie Lees

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Table of Contents

List of Figures

Introduction

Chapter 1-Money supply

An alternative explanation for the growth in the money supply

Pegged Currency's and the Gold Standard

Money supply in practice

Chapter 2 - Growth and Inflation

Growth and Inflation

The apparent success of the Monetary Exchange Mechanism

Inflation -Disease or Symptom

Chapter 3- The economic consequences in a changing world

The Form of Money

Price or Asset Inflation

Housing Bubbles and Unstainable Lending

Sustainable Lending and Growth

Summary and Conclusions

Footnotes

Appendix

Data source for charts

Hyperinflation

About the Author

List of Figures

Fig 1.1 M4 and money supply growth by interest payments

Fig 1.2 Pound Sterling M4 compared to total accumulated interest

Fig 1.3 US Dollar M2 compared to total accumulated interest

Fig 1.4 Euro zone M1 compared to total accumulated interest

Fig 1.5 UK Money 1870-1914 and accumulated interest

Fig 2.1 Comparison of annualised UK GDP excluding inflationary effects and money in the real Economy

Fig 2.2 Comparison of UK quarterly GDP excluding inflationary effects and money in the real economy

Fig 2.3 Comparison of UK quarterly GDP and money in the real economy

Fig 2.4 Comparison of UK Change to money in the real economy and changes to government spending

Fig 2.5 Comparison of UK Change to money in the real economy and changes to saving and interest created money

Fig 2.6 UK money supply growth and GDP (Annual change)

Fig 2.7 Comparison of UK Inflation with the Nominal Lending Interest rate

Fig 2.8 Comparison of UK Inflation with the percentage change interest repayments on secured lending

Fig 2.9 Comparison of non-property lending with the Real Interest Rate

Fig 2.10 Comparison of UK Inflation with the sum of inflation components

Fig 2.11 Comparison of UK Inflation with real Interest Rate

Fig 3.1 Comparison of UK Inflation with the sum of inflation components and house price inflation

Fig 3.2 Comparison of US Inflation with S&P500 P/E ratio

Introduction

The principals of today's economic theory have been developed over a number of years and draws from a number of traditions. However at its core is the notion of balancing growth and inflation through the cost of money. This theory seems to work well enough when economies are in good health but has proved unreliable in the years following the 2008 crash. Some put this breakdown to an anomaly but as the same circumstances arose following Japan's crash some two decades earlier it would suggest that there are more fundamental issues at play. This appears to be a total misunderstanding of the role of interest rates in a modern economy. This should not be too much of a surprise when even central bankers confess that they do not fully understand the process as the former Governor of the Bank of England, Mervyn King, has admitted as much¹.

At the heart of this misunderstanding is how fiat money is created. Traditionally it has been supposed that it was purely down to public demand for borrowing from high street banks that in turn could facilitate them from the central bank which can ultimately draw from an endless stock of government bonds. Whilst this may remain a mechanism during periods of exuberance or hyperinflation further analysis of the data suggests that in more normal times the banks' lending decisions are much more conservative. That they limit any increase in lending to an increase in deposits which grow at a rate similar to the interest charged.

This in itself offers an explanation as to why the low interest policies recently deployed have not led to the expected growth but it does not explain the corundum of inflation. Previous theorisers may be forgiven for thinking that raising interest rates does reduce inflation because it does but the effects are relatively short term and have remained hidden as governments or central bankers have tried to micro manage the economy. Nevertheless recognition of the relationship between interest rates and inflation goes back to 1930 when Irving Fisher developed the equation that linked nominal interest with real interest and inflation. Fisher and those that followed him drew the conclusion that interest rates somehow predicted inflation rather than the cause it. This is again is understandable because at that time the world was on the Gold Standard when the quantity of money was supposedly fixed. Once more an analysis of more recent data suggests otherwise. This shows that the ratio of inflation to growth is very similar to the ratio of lending on property to the whole suggesting that mortgages are the root cause of underlying inflation.

This book presents the evidence for both of these observations and suggests mechanisms to explain them. From this starting point comes a new understanding of macroeconomics that not only explains some of the forms of inflation,