Friday, 24 May 2013

Interest Rates

In the near future I will be producing a more detailed blog post on interest rates, covering why they have been low, and why they are set to rise. Here I just want to try to briefly explain why the cause for low interest rates is not money printing, as commonly believed.

According to Marx, interest rates are determined by the supply and demand for money-capital. On that basis, its clear that for Marx, simply printing money token cannot be a means of reducing or raising interest rates, because whilst central banks can print those money tokens, and credit, they cannot print capital. But, just because Marx said it does not mean it is right. So, let me try to show that what he says is right.

Let us start by assuming two firms, which represent the two sector model that Marx sets out in Volume II of Capital. 

1) C 4,000 + V 1,000 + S 1,000 = E 6,000

2) C 2,000 + V 500 + S 500 = E 3,000

Here firm 1 produces means of production to a value of £6,000, which is equal to C for 1 & 2, i.e. £4,000 + £2,000.

Firm 2 produces means of consumption = £3,000. That is equal to the consumption of workers and capitalists in both firms, i.e. £1,000 + £1,000 (firm 1) and £500 + £500 (firm 2). This is the situation under simple reproduction, where the surplus value is all consumed unproductively by the capitalists rather than accumulated. 

Both firms sell their commodities in the market, and receive payment in the form of £1 gold coins.

Assume that firm 1 wants to consume unproductively their surplus value, but also wants to invest an additional £500. Firm 2, by contrast, does not wish to consume their surplus value at all. That could be because they need to have £2,500 of capital, before they can actually expand their production, for instance. So, its obvious that under these conditions firm 2 could lend their surplus value to firm 1, so that they could invest the additional £500.

So, in the next cycle we would have:

1) C 4,250 + V 1,250 + S 1,250 = E 6,750

2) C 2,000 + V 500 + S 500 = E 3,000

There appears to be an imbalance of £500, because the value of output of firm 1 is £6,750, whereas the value of demand is only £6,250 but that is only because £500 of surplus value from firm 2 that would have bought means of consumption, was lent to firm 1, to fund additional means of production. So, firm 2's output of £3,000 is consumed £1,250 + £1,250 (Firm 1) plus £500 (V from firm 2). Firm 1's output of £6,750 is consumed £4,250 (Firm 1) + £2,000 (Firm 2) + £500 (Firm 1, lent from firm 2).

However, firm 2 will not lend this money to firm 1 for nothing. They will expect to receive interest.

Suppose, on this level of supply and demand for capital, firm 2 will lend £500 to firm 1 for 5%, and firm 1 is happy to pay it. In that case, in future years, firm 1 will pay £25 a year interest out of its surplus value to firm 2, making a transfer of surplus value in the opposite direction, and will repay the £500 capital sum, at the end of the period of the loan.

But, in reality, both firm 1 and 2 will pay the proceeds of their sales into the bank, as will the workers with their wages, and will draw them out again as payments to the sellers of commodities. So, the loan from firm 2 will not be made directly to firm 1, but will actually appear as a loan from the bank.

Now, however, assume that the central bank in order to stimulate investment, reduces interest rates by printing money. They do this by agreeing to provide the bank with paper money tokens, which they may do by simply lending these tokens to the bank, on the basis of the bank's assets, or they may even exchange some of these money tokens for gold coins. If 1 money token exchanges for 1 coin normally, the bank may agree to exchange 2 tokens for each coin, loaning the bank the difference. On this basis, the bank may feel that because they now have £1,000 rather than £500 to offer to lend they can and need to offer this money at a lower rate of interest.

Two things can happen. Either, firm 1 may decide it wishes still only to borrow £500, in which case the bank will be left with £500 sitting as a money hoard in its vaults on which it is paying interest but receiving no interest, or it will be able to lend the £1,000 out, either all of it to firm 1, or some to both firm 1 and 2. In the first instance, there is no reason for the bank to borrow this money, or to offer a loan to firm 1 at a reduced rate.

If, however, firm 1 decides it will borrow now £1,000 instead of £500, the bank may do this, lending it at a rate of say 3% to firm 1. The bank then earns interest of £30, instead of £25. However, this additional £500 put into circulation has not resulted in any additional value being created. Its possible that if there are unused and unemployed resources, the borrowing by firm 1 might bring them into use, and create £500 of additional value in the economy as an equivalent of the additional money put into circulation. But, there is no guarantee this is the case.

Consequently, we now have from the first cycle £9,000 of value to be circulated, and £9500 of money and money tokens in circulation (£9,000 in coins £500 in notes). The result is that the money is depreciated i.e. inflation. Although the value of all production remains the same, the money prices rise. The increase is equal to 9500/9000 = 1.055. So, the money prices of the values in cycle 1 would be

1) C 4222 + V 1,055 + S 1,055 = E 6332

2) C 2111 + V 523 + S 523 = E 3157

In other words, in nominal money terms capitalists 1 and 2 will now demand additional money capital to cover these higher nominal money prices. The additional £500 of money put into circulation, therefore causes a rise in the demand for money-capital of an equal amount, not to expand production, but merely to account for the rise in nominal money prices. The end result is that there is no real change in the supply and demand for capital in constant money terms, and so there is no basis for any reduction in interest rates.

Put another way, when firm 1 throws their additional £500 of money-capital into the market, it finds no increased value as its counterpart. Monetary demand rises, but with no increase in supply able to meet it, money prices rise.

In fact, in the real economy, such a situation may result in interest rates rising above where they were prior to the injection of additional money tokens. That is because, holders of money-capital who decide to invest it in Government, or commercial bonds, may decide that such inflation, will be persistent. The consequence of that is that the real value of their bonds will fall over time. Consequently, the real rate of return on those bonds will fall. Bond buyers will then offer correspondingly lower prices for bonds, increasing their yield, which then means that the interest rate offered on all newly issued bonds will have to rise.  An indication of this, and of the problems central banks will face is what has happened in Japan.  There the central bank has committed itself to creating inflation, to end the 20 year deflation the country has been suffering.  It has committed itself to doubling Japanese money supply.  In the last month, rather than falling Japanese interest rates have tripled!!!  On Thursday, Japanese JGB's rose to over 1% for the first time in more than a year.  That was part of the reason that on the same day, the Japanese stock market crashed by more than 7%!!

In my future blog post, I will show how the low interest rates, and the secular down trend in interest rates of the last 30 years, is actually the result of a rising rate and volume of profit, increasing the supply relative to the demand for capital. The money printing that has occurred has in fact, been another consequence of the factors which led to that.

The reversal of those factors will now lead to a rise in interest rates whether or not central banks continue to print money tokens and credit. Instead, continuation of those actions will simply lead to a rise in inflation.  

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