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Austrian Economics Interest Rates Inflation

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The International Flow

Internationally speaking, money flows from low Interest Rate countries to High Interest Rate countries. This is common sense.  People want to get a higher profit.

When this happens, money (credit) becomes more scarce where Interest Rates are lower, therefore it’s price rises, therefore Interest Rates rise until they match the high Interest Rate of the country they were flowing into, to begin with.  This is a healthy mechanism because it tends to level the playing field for manufacturers and consumers. It plays against games politicians play when trying to manipulate money in each separate country. Politicians don’t like this.

In other words, at an international level, Interest Rates tend to equalize over a long term. Back then, when we had the Gold standard, this process was easy. Gold left country A and entered country B until Interest Rates were the same. Instant balance!

However, nowadays with funny money, the situation is vastly different.

Take, for example, a country with a negative balance of trade and a large external debt. This is, they buy from other countries more than they export, and they have a huge national debt with other countries. A situation such as this describes pretty much any country in the world, with the exception of a few selected ones such as China.

People in this country, let’s call it Fiatland, needs to:

  1. Make debt payments to other countries in their own currency. They need to exchange their money for their money to do so.
  2. Purchase goods from other countries in their own currency. They need to exchange their money for their money to do so.

Therefore, the exchange rate between, let’s call it the Fiat dollar and other currencies matter. This is so because if there is inflation, Fiatland will need more Fiat dollars all the time to buy Euros and Bolivars and any other currency. This is so because people taking Fiat dollars are not stupid. They realize that there is Fiat dollar inflation and they automatically rise the prices of other harder currencies. Think of these harder currencies as just a product or a commodity.

The politicians in Fiatland now have a problem. They don’t have enough Fiat dollars to buy enough of other currencies to pay debt obligations and goods and services from abroad. If they print more Fiat dollars, the situation becomes only worse. So, what is the solution? The solution is to fix exchange rates.

 

Fix The Exchange Rate!

By decree, Fiatland politicians determine that one Fiat dollar can only be exchanged by X Euros or Y Bolivars. Any other transaction price is forbidden by law.

In this manner, they can keep printing Fiat dollars but the exchange rate does not change. At least theoretically.

The problem with this method is again, that people are not stupid. If they see that they cannot exchange their worthless Fiat dollars inside Fiatland, they will do one of two things. They will either:

  1. Demand much higher Interest Rates for Fiat dollars or
  2. Take their money out of Fiatland and exchange their Fiat dollars for harder currency outside Fiatland.

If they demand much higher Interest Rates, Fiatland economy eventually goes into deep crises as we have seen in Part 1 of this lesson. That’s not good.

If people take their money and run, Fiatland suddenly has a big problem. All the capital is leaving. Without capital economies can’t work. With a constantly crippling economy, Fiatland goes into economic crisis.

In other words, you are doomed if you do and you are doomed if you don’t.  Fixing exchange rates is not a solution; it is actually a shortcut to economic crises.

Of course, this fact does not stop governments from doing it all the time. As we explained in our lesson Argentina is the future, we look forward to this country as a gloomy guiding light in terms of political stupidity. As we type today, Argentina has had exchange controls for over 2 years. The consequences? Very high Interest Rates, very high Inflation, de-capitalization and economic crises.  

This may seem like theoretical to you, but it is not. Without going so far as to Argentina, consider that the mighty US took the very same steps in 1987 with the exact same consequences. How long until your country does the same? It is only a matter of time. Yes, political stupidity is prevalent worldwide.

So, what do CB’s do then? Simple. They eventually abandon fixed exchange rates because either:

  1. The economy is about to implode and the political situation is unsustainable, forcing them to do so
  2. The economy implodes forcing them to do so because the political situation is unsustainable

Again, this is exactly what happens in Argentina today. They go through these implosions on a regular basis because this is exactly what they do on regular basis!

 

Don’t Fix The Exchange Rate!

No, we are not done yet. Then, the geniuses at the top of the CB’s decide that if fixing exchange rates does not work because it skyrockets Interest Rates, then, the opposite must be true!

Get rid of fixed exchange rates, let Interest Rates resume their normal upward movement, and then inflate. At this stage, the injection of funny money will bring down interest rates simply because there is more supply of credit. However, as we have seen in Part 1 of this lesson, this lowering of interest rates is only temporary and soon enough Interest Rates resume their march upwards.

 

The Trap

The situation is now yet again one where CB’s are doomed if they do and are doomed if they don’t. The problem is, they can keep inflating into oblivion, whereby you cannot live with such inflation because the economy collapses.

Once CB’s get into this trend of inflating, they are trapped. As we have seen before, they can’t fix exchange rates and so they print, print, print and then they print some more. The goal is to keep Interest Rates low and we have see that this only works for some time.

The problem is that external investors want to have real profits in Fiat dollars. This means, they will ask for Interest Rates above the rate of inflation. We have seen in Part 1 of this lesson, that these Interest Rates will be quite high because they are anticipating inflation.  As such, Interest Rates in Fiatland  are now controlled by the owners of the capital. Either they get higher Interest Rates or they de-capitalize Fiatland with the inevitable economic collapse. So, much that Fiatland’s CB tries to lower Interest Rates by printing, it is a futile effort because although there is more supply of money, capital owners have wised-up and demand higher profits!

So the CB prints, prints, prints and then prints some more in a futile attempt to lower Interest Rates. The only thing they achieve is to reach some sort of equilibrium where Interest Rates keep climbing, but not too fast.

If CBs stop printing, the economy collapses because it is now fully dependent of “cheap” money. If the CBs continue to print, the economy collapses because of impossibly high Interest Rates.

Doomed if you do and doomed if you don’t. Indeed!

Don’t miss the third part of this series, where we will discuss current “magical” situation of high credit and low Interest Rates.

Note: please see the Glossary if you are unfamiliar with certain words.

Continue to Senseless Inflation and Interest Rates - Part 3