The real interest rate on your ING account

If you're an ING customer like me, chances are that you were first drawn to the bank by their absurdly high savings account interest rates (upwards of 4%), but are now disappointed with the paltry 1.3% now being offered.

However, it's good to remember that in order to arrive at the true interest rate, you have to remember to subtract inflation. For example, if you are getting an interest rate of 4% but inflation is also at 4%, then you're really just breaking even--your pile of cash is maintaining the same value over time.

Currently, we're in a period of negative inflation, or deflation, which this month is in October was -0.18%, which means that the true returns on the ING savings account is was 1.3-(-.18)=1.48%. Indeed, if ING's rate were still up around 4%, you would be getting a ridiculous no-risk return of like 5.5%.

Of course, remember that inflation is a rough estimate: it's just an index that tracks a basket of consumer goods. So mileage will vary depending on what you spend your money on. But still, it's worth taking into account when frowning at ING's latest low savings account interest rate.

Fast, slow

You hear a lot of metaphors in talk about the economy, and one of them is talk about it in terms of speed, as if it's a vehicle of some sort chugging along--so you get an economy that is in a slowdown, or that is in danger of overheating, or that is humming along nicely. But I never really grasped in what sense an economy could be like a vehicle like this.

Maybe it's something like this: in America you have a bunch of stuff--natural resources and factories and the like--and you have a couple of hundred million people standing around doing nothing. It's also the case that most of those people would like to have more stuff for themselves (including things which they, as human beings, definitely need, like food and shelter). And so a bunch of them get to work, using their individual time and energy to take the stuff that's there and work it into other stuff, which they can then trade for stuff that they want.

So the important things to keep track of here are two different rates: the first is the rate at which people make new stuff out of the stuff that's there, and the second is the rate at which they trade that stuff for other stuff. And, of course, the two rates are related: for example, if people are very willing to trade stuff they have for other stuff, then there's going to be a lot of demand for people to step up to the plate and start making that other stuff; contrarywise, if people are very reticent in their trading for other stuff, then the makers of this other stuff will soon find themselves without a trading partner, and will once again go idle.

Now, this relation between the two rates creates the potential for a vicious circle, because if lots of individuals decide to lower the rate at which they trade their stuff for other stuff, and makers of this other stuff go idle as a result, then these makers must lower the rate at which they trade their stuff for other stuff. And everybody else is watching this chain reaction slowly build, and so--since they as makers figure they may well go idle soon--they all decide to conserve the stuff they have by lowering the rate at which they trade it for other stuff. And so the rate of trading lowers across the board, causing there to be less of a need for making stuff to be traded, causing the rate at which stuff is made to go down. And so you have this suboptimal arrangement, where far more of those hundreds of millions of people are standing idle than need be.

So that is, I think, the way in which an economy could be said to be going "faster" or "slower". If it's faster, then that means the rate of making stuff and trading stuff is really high, and all those hundreds of millions of people are busy as bees, making stuff for the first half of the day and then trading that stuff for other stuff for the second half of the day (and on weekends, trading all day). But if the economy is "slow", then that means that the rates of making and trading stuff is low, and that--while lots of people are still busy as bees--there are also lots of people just standing around idle, not making any stuff and trying to keep their trading of stuff they have to an absolute minimum.

So that's the metaphor, I think. It is worth adding that the government, via a central banking system, can take steps to control the speed of the economy to interrupt the positive-feedback loops that occur, where increasing speed begets increasing speed and decreasing speed begets decreasing speed. If I understand it correctly, it does this in a very tricky way. Above, when I say that people exert time and effort to work stuff that's there into other stuff, which they then trade for stuff they want--well, as you have probably noticed, people tend not to directly barter, but to trade their stuff for an intermediary thing--dollar bills--which serve no other function besides being containers of value. So when there is a slowdown in the rate that people trade their stuff--their dollar bills--for other stuff, this rate can be effectively raised simply by increasing the overall number of dollar bills. The government does this by allowing banks to borrow into existence dollar bills, and charging the banks interest on those newly created bills. When the government lowers the interest rate, the banks borrow more, and thus they are able to spend more--that is, the banks are able to trade more of their stuff for other stuff, and all that extra trading propagates through the economy. If the economy is moving really fast, the government can slow it down by raising that interest rate, and thereby reducing the rate at which the banks trade their stuff (their dollar bills) for other stuff. Of course, by constantly creating dollar bills out of thin air, and thereby increasing the total number of dollar bills in existence, eventually prices start to go up, because everybody has more dollar bills in their pocket, and so everybody bids up the price of everything. This is inflation.

What's happening now--and the reason why people like Paul Krugman are saying that the federal government should run deficits of many hundreds of billions of dollars to get the economy sped up--is that we're in a so-called "liquidity trap". This just means that the usual mechanism for speeding up the economy--cutting that interest rate, thereby allowing banks to borrow into existence more dollar bills--doesn't work anymore, because that rate has already been cut to (virtually) 0%. Moreover, even when the big banks do borrow a bunch of dollar bills into existence, it doesn't help increase the rate of trading, because the banks are hoarding the dollar bills rather than using them to trade for stuff (first off, the banks are worried that the assets on their books will plummet in value, causing them to fail; second, they don't want to lend to anyone because they're afraid they won't get paid back). And so the only way now to increase the rate of trading is to have the government itself actually start doing a whole bunch of trading (i.e., trading dollar bills for things like subway systems, improved roads, etc., or just straight up giving dollar bills to people who will surely spend them, like the unemployed). This is called "stimulating the economy".

The last time there was a massive slowdown in the economy like this was the Great Depression. The thing that eventually got the economy back up to speed again was World War II, because it required the government to singlehandedly spend absurd amounts of money on war thingys. So now it looks like it's up to the government to spend and spend and spend.

It's all so strange. I remember my grandfather once told me that, during the Depression, some communities--communities with able workers and plenty of natural resources and factories and such all around--nevertheless found themselves mysteriously idle. There were no jobs and no one could borrow money. People were starving in the streets, and yet farms were throwing away truckloads of fruits and vegetables because they couldn't find buyers for them. There was a shortage of dollar bills! So: they printed their own script. And in no time economic activity started up--people started making stuff, and trading that stuff for other stuff (using their script as the intermediary). And lo, they were busy as bees once again.

Hold your breath

Apparently we're once again moving to the brink of disaster in the credit markets. Krugman tells us not to worry about the plummeting stock market:

Panic about the credit markets instead. Interest rate on 3-month Treasuries at 0.02%; interest rate on high-yield (junk) bonds over 20%.

This is an economic emergency.

If my understanding is correct, the spread between those two numbers indicates how scared investors are that borrowers in the private market (including banks, companies, and you and me) will default. Treasuries are loans to the federal government, and are considered virtually 100% safe (since the government can always tax, borrow, or print money to repay a debt, and will basically never default). Since everyone is "flocking to safety" and loaning to the federal government, the federal government can demand to borrow at very low interest rates and still find a lender. In fact, the federal government can now borrow $100 today and only have to repay a total of $100.02 three months from now!

On the flipside, "junk" bonds--which are considered higher risks for default, and which can only find lenders by offering to borrow at very high interest rates--their interest rates are shooting through the roof. This is because nobody wants to invest in the private markets, because they are afraid that private borrowers will default.

And so a wide gap between those two interest rates indicates people are getting the hell out of the private markets and essentially stuffing their cash under the government's mattress.

Incidentally, while this is all bad news, it also illustrates why federal deficit spending is required in these situations. The government can borrow money for free; now is the time for the government to borrow lots of it and get it spent in the economy, so as to make up for the decrease in consumer spending and keep lots of businesses alive (thus preserving jobs). And of course, this should be done in a constructive way, with spending on things like increased unemployment insurance, infrastructure, financial aid to the states, and tax relief for everyone.

Anyone who talks about balanced budgets right now just doesn't know what they're talking about. Obama needs to run, like, a 500 billion dollar deficit next year.

Uh oh

Today when I left work, everything looked on track for the bailout. All sides had agreed on the principle points: $700 billion, government buys equity in the firms, oversight of the federal purchase of assets, relief for Main Street, limits on executive compensation. The consensus was that a bill would be signed by the weekend.

But after a thoroughly enjoyable evening dining with Marian and the great Harinder Chahal, I come back home to find this NYT headline staring me in the face:

Talks Implode During Day of Chaos; Fate of Bailout Plan Remains Unresolved

When the economy is on the verge of utter, Depression-level collapse, the last thing you want is some salient public event to panic everyone into thinking that everyone else is panicked, thus causing everyone to pull their money out of the system. It's a collective action problem. So words like "chaos" and "-plode" in the morning headlines do not bode particularly well.

Moreover, it is not a good sign that the level-headed authorities that are supposedly piloting us through these troubled waters are doing things like entreating House Speakers on bended knee and pleading with them not to blow things up:

In the Roosevelt Room after the session, the Treasury secretary, Henry M. Paulson Jr., literally bent down on one knee as he pleaded with Nancy Pelosi, the House Speaker, not to “blow it up” by withdrawing her party’s support for the package over what Ms. Pelosi derided as a Republican betrayal.

“I didn’t know you were Catholic,” Ms. Pelosi said, a wry reference to Mr. Paulson’s kneeling, according to someone who observed the exchange. She went on: “It’s not me blowing this up, it’s the Republicans.”

Mr. Paulson sighed. “I know. I know.”

Before tonight, I thought there was an air of cautious optimism that some kind of package--however suboptimal--would be agreed upon that would stave off financial collapse. But it seems like that has been replaced with something far more ugly, visceral, and frightening: panic. It's palpable. It's in the language people are using. "Madness", says Krugman. "This sucker could go down", says Bush. Bailout plans are in "disarray", says WSJ. And Drudge? "BREAKDOWN" (although, it should be noted that there are no siren animated GIFs--close shave there). And on top of all this, Washington Mutual failed and was bought out by JPMorgan.

Of course, all this is just one layman's gloss of the whole thing. Hopefully I'm mildly embarrassed tomorrow and nothing extraordinary happens. But I have the sinking feeling that tomorrow will soon have the word "Black" attached to the front of it.

PS: Apparently, the key figure to keep an eye on is not the stock market but the so-called "TED spread". This measures the difference between the interest on 3-month Treasury bills (T-bills) and the 3-month LIBOR. Let's see if I understand this well enough to explain it coherently:

A T-bill is a security that the federal government issues as a way of borrowing money from the general public: you pay, say, $1000 for the T-bill, and the government agrees to pay you back $1100 in three months. T-bills are considered one of the safest possible investments, because they are backed by the federal government--the government, of course, being the only player in town capable of raising funds by coercive force (taxes) or, if it comes down to it, by simply printing more money. Interestingly, the interest rate of the T-bills is determined by a regularly held auction, so that it is constantly fluctuating depending on how much demand there is for people to lend money to the government (or, put another way, how much demand there is for T-bills). If there are lots of people who want to lend to the government, then the government can command a lower interest rate for itself, because lenders will be undercutting each other at the auction with lower and lower interest rate offers. If there aren't a lot of people who want to lend to the government, it will be forced to borrow at a higher interest rate. If investors don't have confidence in private institutions, then they tend to flock to the safety of federally-backed T-bills, driving down the T-bill interest rate.

Meanwhile, in just the same way that the government borrows money from the general public (including big banks), big banks borrow from other big banks. The LIBOR is the average interest rate at which this interbank borrowing takes place.

The upshot of all this is that, when times are good and investors are very confident in the private banking system, then banks will consider loaning to other banks to be as safe a bet as loaning to the federal government--and so the interest rates will be about the same for lending to each, and the difference between the rates (the TED spread) will be small. However, if there is little confidence that banks can repay their loans, then no one will want to risk lending them money unless they get a juicy interest rate in return (e.g., I'm not gonna take the risk of lending First Shitty Bank International a billion dollars unless there's a significant upside in it for me--like, say, that First Shitty will borrow from me at high interest rate). And so the average rate at which banks lend to each other--the LIBOR--will be higher.

To put it all together: if there's high confidence that private banks can repay their loans, then these banks can demand interest rates as low as what the government demands. However, when confidence in the banks' ability to repay is at an ebb, borrowing banks cannot command a good interest rate from lending banks, and so the average interest rate of interbank loans (LIBOR) rises. Moreover, since investors are flocking to the federal government (since it's too risky to lend to private banks), the interest rate of T-bills goes down. The rising LIBOR and falling T-bill rate means a higher TED spread.

The TED spread, then, reflects the amount of credit that is available: a high TED spread means there is not that much credit around (i.e., not much money available that can be borrowed), and a low TED spread means that credit is plentiful (i.e., it is easy to get an affordable loan).

The big danger is that credit will "freeze up"--become unavailable--and that all of the parts of the economy that rely on there being credit--people being able to buy houses and cars, businesses being able to stock inventory and keep operations going during a revenue slump, financial institutions being able to pay investors who unexpectedly want their money back--will simply stop. And this will cause a negative feedback loop of investors pulling their money out of the system (i.e., liquidating their assets--i.e., selling their assets--i.e., turning their assets into cash), leading to a flooding of the market with assets, which will cause the value of the assets to plummet (too much supply, not enough demand), which will cause the financial institutions--whose net worth is tied up in the assets--to have even more losses, which will make confidence in these institutions' ability to repay their loans sink even lower, which will make interest rates even higher (and thus, credit even scarcer), and so on, until we wake up and Depression II is upon us, and a huge chunk of the economy has gone out of business, and unemployment is at 25%.

Phew! So, I'm not sure if all that is correct. It is my best understanding of the whole situation, and I am, I hasten to remind you, a layperson when it comes to this stuff. But I think the basics are there, and in any case, I recommend keeping a tab on Paul Krugman's blog tomorrow, as he will no doubt have some kind of analysis of that all-important TED spread figure.

Oh, and by the way: here is what the TED spread actually looks like. We're already way up in the 3% "credit hell" zone--let's see what tomorrow brings.