The Hidden State Of Money

Correctly interpreting the bond market is more than just how and when to invest your money in UST’s. Not that it isn’t useful in such a money management capacity, but interest rates starting at the risk-free tell us a lot about what is wholly unseen. There is simply no way to directly observe inside an economy what is taking place at all levels and in all transactions. We try to estimate as best we can in the aggregate, but the real economy works itself out far over the horizon.

The closest we might get to a more accurate description is provided by market prices. Though incomplete by themselves, they are derived of the same dispersed knowledge of actual conditions. The bond market by its nature and its history is one of the best sources of information.

The specific issue is, as always, opportunity. An economy’s monetary circumstances will always be described first in those terms. As Keynes proposed for consumers, it is opportunity that dictates liquidity preferences; without it, economic and even financial agents will hoard money, near-money substitutes, as well as highly liquid instruments like UST’s.

This relationship between interest rates and the hidden economic money condition was first stated by Knut Wicksell in his theorizing about a natural interest rate.

In good times, when trade is brisk, the rate of profit is high, and, what is of great consequence, is generally expected to remain high; in periods of depression it is low, and expected to remain low. The rate of interest on money follows, no doubt, the same course.

Milton Friedman much later stated it plainly as the interest rate fallacy. You can have all the central bank statistics you want claiming that money supply is “loose”, but if interest rates behave as Wicksell and Friedman ably described then in actuality the unobservable monetary condition in the real economy must be contrary to those numbers.

In the 21st century this may seem instead a settled affair. The Federal Reserve dictates dollars, full stop. In truth, however, the Fed does nothing of the kind. The textbook all say that open market operations are the key to money stock, but it just hasn’t been the case if a very, very long time. This is a condition which past officials have from time to time fully admitted. Most people never much paid attention to what were and are treated as at most philosophical digressions.