Comments (17)

• tz

  It will have a large effect on interest rates - but the composition, not the average.

  Sort of the economist with his feet in a refrigerator and head in an oven that was feeling fine "on average".

  If China dumped T-Bonds/Notes, THAT interest rate would rise. They might buy gold or other commodities or something else, nor would it be neutral in terms of the effect of the USD v.s. everything else. Or they could buy stocks, so we can reinflate the NASDAQ bubble.

  T-Bonds are used as a benchmark, so fixed rate mortgates (and some resets) would cause forclosures, even if some other rate of return in the economy went down. The economy could slow down, yet that might not feed back to the T-Bond, and default risk premiums will go up.

  For every debtor there is a creditor. And shifting interest rates will change the returns and relationships. Perhaps one very narrow section of the market will have negative interest rates while everything else skyrockets (or defaults). Perhaps everything will become flat.

  But even if interest rates "on average" or aggregated (I remember Mises complaints against GNP/GDP and inflation aggregate calculations) don't move, the structure will cause significant changes. Another Misean/Austrian thought is that Inflation is not neutral, the first people to get the new money are the beneficiaries - there is probably an analogue with interest rates so that a shift caused by the Chinese will also be far from neutral.

  And I would think overall interest rates will rise. In one sense the argument is similar to "If we tax the rich, they will just spend less, so we can give it to the poor who will spend what the rich would have so it is perfectly neutral". Not! The rich will not act as anticipated - they may curb investment instead of consumption. Changing the interest rate mix will redistribute activity, but not in the way everyone expects.

  The current imbalance ends up as an error in the economic calculation of us all. The greater the uncertainty, the greater the premium. If people start not knowing what China will do, they will demand higher risk premiums, and hence, interest rates, on instruments for both possible outcomes whereas they are likely to demand only a premium on what they (maybe incorrectly) perceive as the unlikely outcome.
  

  Published: June 3, 2005 8:36 AM

• Stefan Karlsson

  I think China's exchange rate policies does lower U.S. interest rates. What Shostak overlooks is that if the yuan started to rise in value against the dollar, this would lower the U.S. trade deficit. A lower trade deficit means a lower level of total net capital inflow which in turn implies a higher cost of capital.

  Published: June 3, 2005 11:06 AM

• Harry Valentine

  This situation is the result of both China that the USA operating on Fiat currencies. Both economies could experience a contraction within the next 2 - 3 years if present monetary and economic policies continue. Under a free market gold standard banking system, this China - USA trade surplus debacle, China's bad bank loan epidemic and the problems caused by ultra-low US interest rates would'nt even exist.

  Harry Valentine

  Published: June 3, 2005 11:53 AM

• Jim B

  I don't get this. A shift out of bonds to goods would increase interest rates no matter WHO does it. That it is China or the U.S. is irrelevant.

  Published: June 3, 2005 1:07 PM

• Joe Cesarone

  I think Shostak is handwaving when he says "Now, if China were to decide to sell off its holdings of US t-bonds, obviously it would lead to an initial rise in yields. However, the Chinese are unlikely to sit on the dollars—they most likely will employ the dollars obtained from t-bond sales to purchase some other US assets, which in turn will push their prices up and lower their yields. In other words China's action will not have any effect on excess US money overall. Hence over time China's selling off of t-bonds will have no effect on interest rates."
  
  
  But what if China, believing the dollar has much further to fall, decides to buy up capital and real assets such as buildings, machinery, airplanes, etc.? History shows that holders of rapidly falling currencies eventually capitulate and spend them as fast as possible to avoid further losses. How will this have "no effect on interest rates"? I think Shostak is implying that the extra revenues from these sales will find their way back into treasuries, but how does he know this? Americans are borrowing and spending as fast as they can at the moment; they'll have even less money left over when everything at Walmart costs 30% more (or however much the RMB ends up rising against the dollar).
  
  
  That said, I think Shostak is absolutely correct that it is the Fed who is to blame for all this by artificially increasing the money supply; the fact that China has bought them some time by heavily investing in Treasuries in the past does not make them the culprit when they decide to sell (and at the same time stop inflating their own currency to buy dollars).

  Published: June 3, 2005 1:43 PM

• tz

  Time preference are also not constant nor stable. Prechter and his Socionomics might be one approach, but something like Elliott or Kondratieff waves happen. Or what Hyman Minsky called Ponzi finance.

  When things go well, it is assumed that they will continue to go well, so asset prices will rise, or interest rates will fall (regardless of the actual supply of money). A manic phase. No one can think of anyone defaulting, or everyone else will just do that much better. Pleasant greed abounds. Fail this year, you can make it up next year. Low time preference.

  But eventually we get things like pets.com or the million dollar micro condo. The assets go way beyond any dream of return on investment. There are no greater fools. Things start to fall and collapse. Doubt, then fear come into play. Fail this year and it might be 5-10 years, so maybe taking profits is a good idea. Prices start a downward cascade. It becomes just as self-reinforcing as the prior bubble. People worry about their retirement 30+ years and take more off the table, save what they can, and avoid any risk. We get the depressive phase, and things bottom when people won't do even sane investments in businesses.

  In sum, it appears that Time Preference oscillates - when it is low, it gets lower until it creates a bubble which pops, then when the risks are fresh in everyone's memory, it becomes high, and is reinforced to get higher until there is an anti-bubble (think Gold at $250, or when the last debt is defaulted on) and the mirror of the fundamentals wins out. And the cycle restarts.

  Published: June 3, 2005 2:15 PM

• tz

  If there is a shift out of bonds and into goods, the interest rate for the bonds will go up, but the equivalent effective interest rate for the companies or owners of the goods (e.g. bonds or stocks in such companies) shifted into will go down.

  I think his point is Time Preference only sets interest rates, but that can be affected by the money supply, but not by the specific distribution of the money supply.

  My counter is that economic or financial chaos tends to increase TP (rapidly), and economic and financial calm tends to lower TP (slowly).

  And radically changing the composition of the interest rates - even were the average to try to remain the same - would cause enough chaos to add to time preference. Or to impose a risk premium.

  I don't know where in Austrian Economics risk premiums go, but my time preference per se won't affect the difference in interest rates I might charge a diligent worker v.s. a drunkard.
  

  Published: June 3, 2005 2:23 PM

• Mark Humphrey

  Dr. Shostak once again makes an important point that had eluded me. China's decision to print yuan to get dollars doesn't increase the dollars in circulation, and its decision to buy Treasuries probably has little impact on the structure of interest rates. For the basic government intervention that distorts US interest rates is Fed money pumping.

  When the Fed boosts the money supply it sets into motion forces that tend to reduce the demand to hold dollars--at least among the early recipients. Rising supply and falling demand converge to push the price of future (capital) goods higher compared with present (consumer) goods. This narrowing of the price discount of future goods to present goods is a lowering of the interest rate that is built into the structure of production, and that is reflected in falling money market rates of interest.

  If the Bank of China had not bought dollars with which to purchase Treasuries or alternative US assets, most likely private dollar holders would deploy those dollars into the asset markets. True, private dollar holders might have devoted some portion of those same dollars to consumption, but since most economic activity concerns the production of capital or intermediate goods, most of those dollars would probably bid on producer goods. The effect on the interest rate structure would be about the same.

  Dr. Shostak's main point is that the broad sweep of cause and effect as concerns interest rate movements is the monetary policy of the domestic central bank. Perhaps we'll see long bond rates gradually climb from here until 3 months or 1 year from now, when the Fed once again begins aggresively pumping money.

  Published: June 3, 2005 7:22 PM

• Paul Edwards

  Frank Shostak's articles always provide a great basis for interesting discussion. I'm going to insert my comments in this paragraph:

  FS: Let us now examine how changes in time preferences interact with money and culminate in market interest rates. The lowering of time preferences on account of real wealth expansion will become manifest in a greater eagerness to lend money and thus the lowering of the demand for money.

  PE: Does FS mean "the lowering of the demand for BORROWED money", because i don't think changing time preferences influences the demand for cash holdings. Although, if he is suggesting that the increased supply of goods has increased money's purchasing power, and therefore the demand for cash holding is reduced, i could buy that.

  FS: This means that for a given stock of money there will be an increase in the excess supply of money.

  PE: Does FS mean "an increase in the excess supply of LENDABLE money", because people may save/lend or spend their money in a differnet proportion now, but the supply of money is what i could call the given (fixed) stock of money and therefore it is not increasing.

  FS: To get rid of the excess people will start buying various assets and in the process will raise their prices and lower their yields.

  PE: This statement gives me the most trouble because it was my understanding that an increase in the supply of goods with a fixed money supply will result in an increase in the purchasing power of money and therefore a reduction in prices of goods (assets).

  FS: In short, the increase in the pool of real wealth will be associated with a lowering in the interest rate structure. The converse will take place with a fall in real wealth.

  PE: Is FS saying this is the likely outcome, or a necessary outcome. I'm leaning toward the "likely" school of thought.

  Published: June 4, 2005 2:29 AM

• Paul Edwards

  I would also argue that the Chinese authorities, in buying large volumes of US bonds, form a significant element of the US time-preference that influences the american interest rate. If they stopped buying up the US dollars from private Chinese citizens, and let the chinese freely choose, they might en mass become more significant consumers of American goods and less of the forced savers of US dollar assets they are now. Less saving, more consumption spending in the US would result in higher US interest rates no?

  Published: June 4, 2005 3:02 AM

• Artisan

  I wonder if the old concern about chinese trade using very much design piracy and fake, that do infringe on intellectual property, doesn't somehow play a role in here too?

  Published: June 4, 2005 4:14 AM

• Harry Valentine

  China has been buying heavily into the Western Canadian resource industry (lumber, mining, oil etc) . . . . and may likely be using US dollars to do so. Without the Fed's low interest rate policies, it is unlikely that China would be investing in the Canadian resources industry to the extent that they are. Canada's economy is heavily interlinked and intertwined with the American economy, meaning that US currency being held by China would re-enter the USA via Canada.

  Harry Valentine

  Published: June 4, 2005 10:46 AM

• Jim Bradley

  Perhaps Shostak means this: If China sells US treasuries, then under the current US central bank operating regime, the Fed is forced to buy them to hold their interest rate peg. That would mean exchanging bonds for a swelling amount of cash which would be inflationary.

  But of course the Fed would be "forced" to raise rates and monetize less, as a net concerted selling of US treasuries would cause a panic unless it was stopped. So find another buyer or raise rates ...

  Published: June 4, 2005 2:19 PM

• Mark Humphrey

  Posters to Shostak's article misunderstand his central point, I suspect.

  Interest rates are built into the structure of production. When time preference rises, people place greater value on provision for present consumption and less value on provision for future consumption. Rising time preferences are consistent with rising interest rates. Rising interest rates are consistent with a widening spread in the discount of the prices of future goods--the goods people use to produce consumer goods--to present goods--the stuff people buy to consume. When time preferences rise, relative prices in the structure of production change: at each level of production, what Mises called the ordinal interest rate, or the rate of profit rises, which causes the discount in price of the goods used to produce a product to get bigger compared with the price of that product. Think of the producer goods employed at each level of production as future goods used to produce goods that are closer to the ultimate consumer.

  Time preferences rise when goods get scarcer, because people have to use more of their income to provide for their daily needs. On the other hand, when wealth increases as in Asia, time preferences in those growing regions fall, because rising incomes permit greater savings and investment.

  On the opposite side of the ledger, when a central bank pumps up the money supply, real wealth has not, of course, been increased. So the early recipients of the new money exchange nothing--money out of thin air--for something--whatever they buy. These early beneficiaries of inflating see their wealth and incomes rise greatly, which lowers their time preferences. Not only do their time preferences drop, but their rising income streams enable them to reduce their demand to hold money in reserve for emergencies. For with more income flowing in each month, and with income flowing in from various investments regularly, their need to hold cash balances as a reserve against income setbacks has diminished.

  Falling time preferences channel the excess cash these early recipients enjoy largely into investment, as opposed to consumption. Asset prices across the board tend to rise as a result, narrowing the discount of the price of future goods to more present goods at each stage of production. This means, of course, that interest rates fall.

  The greatest portion of economic activity and exchange in any modern division-of-labor economy relates, not to final consumption, but to the various stages of production. The loaf of bread on the grocer's shelf is exists as a consequence of the purchase of land and payment of commission to a land broker, purchase of fertilizer, seed, herbicides, equipment and parts, commissions to futures brokers for hedging, purchase of hail insurance, payments to custom combiners, to the grain elevator for storage, to Burlington Northern for freight, to wholesalers and jobbers for risk sharing, and so forth. The total of economic activity engaged for the purpose of various production activities dwarfs the scale of enterprise devoted to hawking consumer goods to shoppers.

  If the banks of China or Japan had not intervened in the market to buy dollars with which to buy Treasuries, then the dollars in question would have remained in the hands of private holders who would use those dollars to acquire US investments or goods. But because most exchanges relate to production activities, most of those dollars would have been used to buy producer or intermediate goods of one kind or another, with some small portion flowing directly into consumption. One can use the dollars to buy Treasuries, or raw materials to manufacture computers, and the effect is similar: interest rates go down.

  Published: June 4, 2005 7:52 PM

• Paul Edwards

  Hi Mark: You're explanation seems to me to reflect Shostak's meaning.

  A nit pick: it seems to me that your statement "...These early beneficiaries of inflating see their wealth and incomes rise greatly, which lowers their time preferences" de-emphasizes the fact that this inflation is a wealth transfer and it therefore overlooks the opposite and counter effects of those whose wealth is being stolen. On net, i don't see how we can know that time preferences have been increased decreased or unchanged.

  However, what i most have trouble buying into is your statement "...the dollars in question ... in the hands of private holders ... because most exchanges relate to production activities, most of those dollars would have been used to buy producer or intermediate goods of one kind or another, with some small portion flowing directly into consumption". Since the US economy also is involved in production activities, and yet we know the high time preferences here, I just don't see how you can predict the time preferences of private Chinese citizens. However, if your assessment is correct, then i do agree it follows that interest rates would be unaffected by the breaking of the Yuan peg.

  Published: June 4, 2005 9:56 PM

• Jim Bradley

  Mark - the question is whether the Chinese central bank is buying dollars against Yuan under, over, or at the market price. They are paying extra Yuan to hold the dollar peg, thus acquiring an excess of dollars (everyone is selling dollars to them over the market price). So the increase in demand from newly created Yuan finds itself in input prices -- the point being that the "increase in input goods prices" is an inflation that is underwritten by the Chinese central bank. That is far from Shostak's position as the Fed basically "setting" interest rates. The Fed's hands can be tied by events beyond their control (for instance the Asian meltdown).

  Published: June 6, 2005 5:10 PM

• Paul Edwards

  Frank Shostak’s article is so interesting and thought provoking, that I could not resist revisiting it to present more of my observations.

  This comment grabs my attention right away: “What will happen to interest rates on account of an increase in money supply? An increase in the supply of money, all other things being equal, means that those individuals whose money has increased are now much wealthier.�

  I don’t think Frank can really mean what he seems to be saying. It sounds like he is saying that on average, an inflation generates wealth. I am certain he does not believe this. At best it will redistribute wealth, but it will almost certainly diminish wealth overall. The rest that follows must therefore not necessarily follow:

  “This in turn lowers their cost of savings and sets in motion a lowering in time preferences. Hence, this sets in motion a greater willingness to invest and to lend real savings. The increase in lending and investment means the lowering of the demand for money by the lender and by the investor. Subsequently an increase in the supply of money coupled with a fall in the demand for money raises the excess supply of money, which in turn bids the prices of assets higher and lowers their yields.�

  Other similar statements such as “The lowering of time preferences on account of real wealth expansion will become manifest in a greater eagerness to lend money and thus the lowering of the demand for money� further suggests the author’s equating of inflation with real wealth expansion. Again, I am very dubious that Shostak truly believes what these statements imply.

  However, it is clear enough that an inflation brought about by bank credit expansion leads to lower interest rates, simply by increasing the supply of lendable money, as long as the expansion continues, so I agree with his final conclusion.

  In this statement, I would assert that there is confusion over the question of demand for US dollars, and the effect over time preference (and therefore interest rates) that China has. That is to say, the question is not how China affects the demand for US dollars, but rather, how China affects the ratio of USD consumption spending versus USD investing. “Also, China's exchange rate policy has very little effect if at all on changes in the demand for US dollars as such. Thus, when China raises exports of goods to the US the first effect of this is to raise China's demand for the US dollar. However, once the Chinese central bank invests all these dollars in US Treasuries this in fact lowers Chinese demand for US money. Hence the overall effect is no change in demand. This means that for a given supply of money the amount of excess US money remains unchanged overall—implying no effect on US interest rates.�

  Although this is correct that China’s central banks brings about no change in demand for USD, it still certainly could change USD consumer time preference. It does this by taking the USD from the hands of the Chinese people, who might consume a great deal more US products than they do under the present conditions, and also conversely they would invest a great deal less in US assets. Only the removal of the peg would answer this for sure.

  I also think the following statement needs to be given further consideration as well. “However, the Chinese are unlikely to sit on the dollars—they most likely will employ the dollars obtained from t-bond sales to purchase some other US assets, which in turn will push their prices up and lower their yields. In other words China's action will not have any effect on excess US money overall. Hence over time China's selling off of t-bonds will have no effect on interest rates.�

  The key question that is not considered here is does it matter what US assets the Chinese move to in determining if the transition will influence US interest rates. I would say emphatically yes it does. As I indicated above, if the Chinese were to shift to spending US dollars on consumption goods rather than on investments, then it would have the affect of increasing US interest rates. This is because it would have the effect of essentially increasing the overall time preference of holders of US dollars. I would think that a transition of $224.9 billion out of US treasuries and into US consumer goods over the next five or ten years would have a noticeable influence on US interest rates.

  Anyways, despite my criticisms, I truly enjoyed this article and find the subject highly fascinating!
  

  Published: July 7, 2005 2:11 AM