Why do we care about the nominal interest rate?

What is the best currency to use in Yap?

Dave Bradley
Investment Manager (Financial Advisor) in North Charleston, SC

Why do we care about the nominal interest rate?
May 11, 2016

Are those stones worth more in the bank or on the island of Yap? Many of our financial gurus are bull-horning from their ivory towers about ZIRP (zero interest), NIRP (negative interest), HIRP (high interest), and my favorite TSIF (the sky is falling).Mercy, mercy, combined with NINJA (no income, no job, and no assets) we are all just ….!

As the picture implies, Yap is known for its stone money, called Rai, because that’s where the money is. True, Rai are only valid on Yap which is located in the Caroline Islands of the western Pacific Ocean whichis a part of the Federated States of Micronesia. Unlike most places, money theft was never an issue on Yap. Of course, the stones vary widely in size; the largest are 3.6 meters (12 ft) in diameter, 0.5 meters (1.5 ft) thick and weigh 4 metric tons (8,800 lb). The natives even say; One day during a strong storm a Rai fell off their canoe into the bottom of the ocean. Don’t despair; Rai is everywhere declared the wise council.Rai has value wherever it is.Even at the bottom of the ocean-we know it’s there (nobody steals a Rai). So, unlike what may or may not be in Fort Knox, a Rai hold its value during good times and bad. All Hail Rai wherever you are.

In Economics, Greg Mankiv's books teach us about generating equity capital (value). We all want the benefits of money (your choice of which). The confusion lies (typo?) in the interpretation of macro and micro.

Some call this the “money illusion” which is the tendency to think in normal terms rather than real terms. Kind of like that 1% raise you are getting while inflation is 3%.Hello, you’re not making any money.

Here are 3 arguments for inflation:

  1. Inflation is just economic lubrication- meaning it has no real benefit
  2. Low but positive inflation can protect us against deflation particularly during economic weakness.
  3. Modest inflation can give our central bank more room to lower rates before hitting zero.

To summarize; inflation is bad, deflation is worse and hyperinflation is the worst.

In reality, never forget that: Nominal interest rates can’t go below zero. What fool would loan you money and also pay you for using it?

For those inspiring Economists among us, a fellow named Walter Bagehot (the one associated with The Economist magazine) had a simple policy for lending:

  • Lend freely against all good collateral at a punitive rate.
  • Lend as much as you need to solve the liquidity problem, recognizing that having access to liquidity makes the problem less likely to occur.
  • Demand sufficient collateral to cover the loan if it defaults, recognizing that the asset may be valuable but illiquid (like a bank building).
  • Charge a rate of interest high enough to discourage unnecessary borrowing, but not too high as to cause a panic, recognizing that you should discourage those needing funds from acting irresponsibly by thinking they are entitled to have whatever they want.

Here is an updated version on fiscal responsibility in our modern banking system.

  • No matter how reckless our financiers behave, our government should protect the innocents who might otherwise get burned because of others greed.
  • Modest interventions like insuring bank deposits or lender of last resort can have an oversized impact.It is sensible to use public resources to prevent or stop a small barn fire before it spreads into a national wildfire.
  • Government can’t credibly commit to stand idly buy in a crisis no matter what politicians say before the fact.So, why not try to prevent it!

OK, who’s ready to go to Yap?No worries about not having enough to get there.Contact us directly to discuss where you need to be financially and to keep you there. You just concentrate on enjoying your lifestyle. It’s a long boat/plane ride from the states but well worth the trip. Just invest your money efficiently (feel free to ask us about Rule #1 investing) and enjoy your lifestyle.

It’s not what you make, It’s what you keep that determines your lifestyle.

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