# Interest rates ### In margin trading, a high interest rate to borrow asset X => little desire to remain exposed to X An interest rate indicates how 'unwanted' an asset is. On the supply side, loaning USD means that you must remain exposed to USD. If creditors do not want that exposure, they will demand a higher interest rate on their loans to compensate. On the demand side, more people looking to borrow dollars (in order to invest in something else) means that the suppliers of those dollars have the leverage to charge a higher interest rate on those loans. Conversely, fewer people willing to borrow dollars forces creditors to provide more competitive rates on their loans, lowering the interest rate. - USD lending as reflected in Treasury yields (i.e. lending USD to the US government): Countries want to get rid of their Treasuries => fewer entities willing to hold Treasuries at the prevailing low interest rate => the interest rate must increase to incentivize people farther down the demand curve to hold Treasuries. Which is why the Fed intervenes to buy Treasuries - by creating demand for Treasuries, the entities who were only willing to hold Treasuries at higher interest rates are priced out of the market, and interest rates become low again, which makes it feasible for the US government to service their debt. - USD during bull markets: No one wants to hold dollars; they'd rather be exposed to the market instead => the interest rate must increase in order to incentivize dollar lenders to take the other side of the trade (i.e. remain exposed to the dollar). When USD borrow costs spike up to 20% APY on margin exchanges, it's reflecting a distaste for holding dollars and a decrease in the quantity of institutions willing to lend those dollars ### Interest rates are related to liquidity The more 'unwanted' exposure to the USD is, the more that people want to get exposure to something else (e.g. equities). So that creates a lot of people who want to borrow dollars, so that they can invest those dollars into something else. A 'liquidity crunch' relates to there being way more people wanting to borrow dollars than there are people who are willing to lend them (and thus remain exposed to them). So, naturally, the interest rate must go up, but the adjustment process isn't instant - higher interest rates increases the *incentive* for creditors to loan their dollars, but that doesn't mean that they immediately will. The reason why disruptions to international trade such as the COVID-19 pandemic creates a liquidity crunch is due to the reality that countries which typically earn dollars through dollar-denominated exports suddenly are exporting way less, so they experience a sudden decrease in (positive) dollar cash flow. But they still must service (pay interest on) their debts, which are dollar denominated. In order to address their sudden shortage of dollars domestically, they have three choices: (1) borrow dollars on the open market, (2) sell their treasuries for dollars (3) sell hard assets for dollars. Let us explore what happens in each of these three cases: 1. If all these countries try to borrow dollars on the open market, there aren't enough lenders to supply all these dollars. So interest rates (the incentive) increase, but as detailed above, the adjustment process isn't instant - it takes time for more dollar lenders to come into the market. 2. If these countries try to sell their Treasuries for dollars, there must be someone willing to buy them. And more buyers of Treasuries (i.e. lenders of dollars) will come in only if the interest rate increases to compensate them. 3. If these countries try to sell their hard assets such as equities, SPX, Gold etc to get dollars, the buyers of those assets (i.e. suppliers of dollars) must be compensated by a decreased price Connecting all the dots in options 2 and 3, disruptions to international trade that create dollar liquidity crises are essentially like those countries being margin called or liquidated on the basis of their need to service their USD-denominated debts. Reduced net positive dollar cashflow obtained through trade means that they must make up for the shortage somehow - and when they have to sell their Treasuries or equities in order to do it (at the same time that everyone else is trying to sell their Treasuries or equities), it's functionally equivalent to high leverage liquidations in the crypto markets, where speculators are forced to sell off their assets at the worst possible time. A corollary of this is that you should go in heavy whenever a global dollar liquidity crunch occurs. As they say, buy the liqs, as the opportunity does not get much better. ### Federal Reserve response to a liquidity crunch The Federal Reserve's role in the course of a recession or dollar liquidity crisis is to be the "last-resort" supplier of dollars. Since they can create dollars out of thin air, the federal reserve is able to supply the global demand for dollars. They do so by 1. Buying bonds. Bonds are debt instruments that allow a large entity suffering a liquidity crisis (e.g. a government, a corporation) to take on debt (and receive dollars in return). Buying bonds most directly relieves the dollar liquidity crunch in a way that is (probably?) least painful for the entities in trouble - instead of having to liquidate a significant quantity of assets during a one-time firesale, they take on debt which can be serviced over time. 2. Buying Treasuries, which allows those countries looking to liquidate their Treasuries (into dollars) to find a buyer, instead of letting interest rates increase and waiting for new demand to come in 3. Buying up equities and other assets, which sets a floor on market prices and saves troubled entities from having to sell their assets when no one else is. If the liquidity crunch is bad enough, it is plausible that troubled entities will have to sell their assets near 0 (or simply go bankrupt, which is also not great either). ### Unanswered questions - [ ] But why does the US have to supply those dollars? Where do dollars come from, anyhow? - [ ] Well, dollars come from the Federal Reserve. But how do those dollars eventually end up at the global countries? - [ ] "Where do dollars come from" is a good Google search to at least try - hopefully not all of the answers are garbage - [ ] The creation of the money supply seems to be related to US government debt - something like the more the USG borrows (by issuing Treasuries, which when bought by the Fed (rather than eg foreign governments) creates money out of thin air). And the size of US government debt is what creates the relation to US GDP - the US debt can only grow as large as can be serviced by the national government through taxation and running a (fiscal) budget surplus. Figure out the exact relation between the creation of money and USG debt - [ ] Yet, the USG runs fiscal budget deficits, year after year. How is this system sustainable? And how has the system been able to last for so long without the USG defaulting on its debt? The answer appears to be related to (1) the petrodollar system, wherein we get other countries to finance our debts for us by coercing them to price their international trade in dollars, and (2) the growth of US GDP? Research (a) the size of the US budget surplus / deficit over time and (b) what would happen to the USG if it did NOT have the petrodollar system to artificially cause international trade to be priced in dollars. - [ ] How does US GDP relate to its ability to supply the dollars necessary to price global trade? I think it's because the quantity of dollars that other countries earn is limited by the size of the US's trade deficit. A trade surplus in a non-US country is exactly mirrored by (and thus can only be the size of) the size of the US trade deficit with said non-US country? Research in more detail - [ ] How are there any conflicting interests for (1) the federal reserve or (2) the USG in (a) its need to stimulate full employment, protect markets (b) its need to keep US government debts serviceable (c) the need to allow interest rates to rise in order to correct for something else, something something price+specie flow? (d) the USG obligation to fix the trade deficit - [ ] How exactly does the Petrodollar system help this? By pricing trade in dollars, the debt gets financed by other countries so the USG can continue to run budget deficits. By if it doesn't get financed by other countries, either the Federal Reserve must take up the slack (perpetually being unable to raise interest rates, possibly leading to hyperinflation) or the USG must return to a balanced budget (still not really solving the problem if interest rates are so high that the debt is not serviceable - so it looks like the Federal Reserve will have to continue supplying dollars (and thus continue debasing the value of the USD) in either case). The implication here really seems to be that dollars are not safe to hold.... Things to add to my international economics reading list: - Globalizing Capital (most obviously for price-specie flow and other models, etc. Basically the framework for thinking) - Globalizing Capital (for cementing what I've learned by connecting the international economics framework with development economics and other historical events) - George Selgin's book (on how central banking is really not as stable and reliable as it's purported to be) - Lyn Alden's other writing in a similar vein - References from Lyn Alden's report on the fraying of the Petrodollar system - Alex Gladstein piece on the end of super-imperialism (which is also about the global Petrodollar system) - Any possibly relevant materials from my economics classes (perhaps 100B) that detail how the Federal Reserve works - Any possibly relevant materials from my Hist 160 class (maybe the books and other materials cited in the syllabus?) The three things I can research / learn about at the same time: - North Korea: To keep pushing deep into one project with [[Flash Drives for Freedom]] - Monetary economics and the Petrodollar system: It will determine the outlines of the next international monetary order - Lightning + Musig + CoinSwap: it's something I can buird ### Interest rates in the context of [[International Economics]] ![[Gold Standard#Clarification on the role of the discount rate from the World Gold Council]] To summarize: - Suppose a country is currently suffering a trade surplus (more exports than imports, declining reserves) - A rise in the discount rate influences market interest rates (higher cost of borrowing [dollars/gold]) - Higher interest rates then draws money (gold/USD) from abroad to the country, strengthening the balance of payments in the current account. It also discourages investment, which includes investment spending (on productive physical capital and on inventories) - Another way to think of it is: yields for lending money (gold/USD) increase, which attracts money into the country, and away from investments in other countries - Under the gold standard, a net capital inflow results in a greater money supply, which raises prices and wages, causing imports to be cheaper and exports to be less competitive, restoring the balance of payments.