Cities, Interest Rates, and the US Dollar

“The Interest Rate” features prominently in much discussion of economic performance. Currently, the Federal Reserve is holding the interest rate at 0%, or as close as they can get to that (technically the Federal Funds Rate, or FFR, the rate at which banks lend money to one another–which is thus closely tied to the rate at which banks lend money to businesses and people). The FFR is the chief means that the Fed uses to impact the economy. When the economy is doing well, they tend to raise the rates, and they tend to lower it when the economy is doing poorly. The European Central Bank does the same thing for Europe. However, as has been greatly in the news, the economies of some Euro-zone countries are doing quite poorly (periphery countries like Greece and Portugal) while others are doing quite well (Germany and the Netherlands). So, how does the ECB set interest rates? A recent Fed note provided evidence that the rate mirrors conditions in the center, with negative implications for those on the periphery–creating intriguing questions about the United States.

Before delving into that, though, a quick primer on the logic of interest rates. In a growing economy, most firms are selling well, and tend to see room for expansion. Oftentimes, this means borrowing money to fund that expansion–setting up new plants, performing more R&D, etc. Further, entrepreneurs tend to see new opportunities as well–perhaps the growing economy has opened up new markets. In any event, there will tend to be a greater demand for borrowing money. In the face of this increased demand, banks and other lenders (I’ll just say “banks” for shorthand) with finite lending capacity will not lend to everyone–that is, there will be more demand for loans than supply of them. This will tend to increase the price of a loan–that is, the interest rate.

On the other hand, in a struggling economy, few firms will be looking to expand, and few individuals will be looking to make new investments like a home mortgage–meaning lower demand for loans. This will tend to have lower interest rates, as banks will find no takers if they don’t lower rates.

So, one of the nice things about having your own currency is that you have some measure of control over interest rates. The Federal Reserve can buy and sell bank assets with new currency, increasing or decreasing banks’ willingness to lend. By tightly controlling this process, the Fed can keep the interest rate at their desired level. In turn, they determine their “desired level” by judging a number of variables. In particular, the Fed tend to follow a fairly simple rule (called a Taylor Rule) that attempts balance between inflation and unemployment: higher interest rates are associated with low inflation (generally good) and high unemployment (bad), while lower interest rates are generally associated with high inflation (generally bad) and low unemployment (good). For example, a simple Taylor rule could be:


In fact, this rule seems to be a pretty good approximation of Fed policy:

The largest departure from the predict path occurs in the early-to-mid oughts. Many commentators have attributed some portion of the housing bubble that occurred during this time to the too-low interest rates: with interest rates so low, banks lent to a large number of borrowers, and many of these investments turned out to be unprofitable. Had interest rates been higher, perhaps fewer of these borrowers would have sought mortgages, and the later crash wouldn’t have been so bad (so the story goes).

In any event, I thought it would be interesting to try to replicate the analysis of the European interest rates with a similar analysis looking at US cities. By “city”, I mean here “large metropolitan area” (technically, most are Combined Statistical Areas, as defined by the Census Bureau). For an example of the scale, the broadly-defined New York CSA (population: 22 million) abuts the Philadelphia CSA (6.5 million), which abuts the Washington-Baltimore CSA (8.6 million), which stretches to West Virginia. All told, they sum to 116 million people, or over 35% of the US population. Considering that the New York CSA has roughly the same population as Greece and Portugal combined, it seems like a worthwhile exercise. And indeed, replicating the above Taylor rule for 14 large American metropolises shows that the common Rule above masks huge diversity:

Now this is a much different picture. While the Fed may have done a good job of setting the interest rate for the entire economy, it was helpless to respond to the unique circumstances of all of these places individually. Here’s a narrower view with everyone’s favorite failed city: Detroit.

Despite being too low for the US as a whole, interest rates in the middle of the decade were too high for Detroit as a whole. While not a panacea, this certainly did nothing to assist the Motor City in grappling with its many woes. The last couple years in particular look astonishingly like the Greek story–a stark need for a “competitive devaluation”, and no ability to do so due to the common currency. Perhaps unsuprisingly, both Detroit and Greece are places up for discussion for massive fiscal transfers from elsewhere in their currency areas–Detroit in the form of bailouts for the auto industry, Greece in the form of below-market borrowing and potential loan forgiveness.

One final case I’d like to highlight. In the last 20 years, there have been two large “bubbles”: the dotcom bubble of the late 1990s, and the housing bubble of the early/mid 2000s. Conveniently for our purposes, both were associated with particular geographical areas: the epicenter of the dotcom bubble was Silicon Valley, while the housing bubble was felt particularly strongest in places like Las Vegas, many places in Florida, and cities in California like Riverside. Silicon Valley lies in the San Francisco CSA, while Riverside is in the Los Angeles CSA. Charting the Taylor Rules for these cities proves illustrative:

From 1996 until after the dotcom crash, economic conditions in San Francisco called for higher interest rates than the US as a whole. If San Francisco were able to set its own interest rates, it could have raised them in response to the sustained economic growth. This would have had the effect of slowing borrowing, and limiting the number of ill-planned startups that quickly went bust. During the 2000s, the Los Angeles area would also have preferred higher interest rates, which might have slowed the growth in mortgage lending to people buying over-large houses in massive exurbs, far from jobs and sustainability.

However, neither San Francisco nor Los Angeles can set their own interest rates, as they do not have their own currencies. Instead, the interest rate is set nationally. Because there is fairly free mobility of capital across the country, savers in New York can be matched with borrowers in California. This means that rapidly expanding places–San Francisco in the 1990s or LA in the 2000s–experienced no checks on their growth, as the borrowing of firms and households of local households fails to drive up interest rates. Unfortunately, this meant that just about anyone with a dotcom in their business plan was able to borrow at unreasonably low rates through the 1990s–despite the fact that many were clearly terrible investments.

But those terrible investments were eventually revealed as what they were, and in response to the busts in San Francisco and many other cities (though not Los Angeles, judging by blue prescribed interest rate), the Fed lowered the interest rate. While this was beneficial for San Francisco and other places, the interest rate was then too low for Los Angeles, leading to similar capital inflows from elsewhere. Unlike San Francisco, much of it was channeled into housing construction in far-flung and unsustainable areas. As before, however, there was a crash–this one far worse both for Los Angeles and nationally.

I’m not sure where this leads–metropolitan areas issuing their own currencies is, while, a bit of a political nonstarter. Nevertheless, I think the analysis is useful. Looking back at the first graph, one can see a a city with small tail of positive growth on the far right. That belongs to the Washington D.C.-Baltimore CSA. The interest rate remains at 0%, while that area calls for a rate closer to 5%. I for one am curious where those massive capital inflows are going, and what consequences we can expect in a few years, when many of those investments inevitably come up dry.

5 thoughts on “Cities, Interest Rates, and the US Dollar

  1. So, a question (which you may have pointed out and I missed) and an idea:

    First, how does the EU set interest rates? Each country their own or not? I’m a bit unclear on that.

    And second, your idea is interesting, but I wonder what the negatives are of having each area set their interest rates–nationally and comparatively. But perchance, there are only benefits? I wonder if you can find historical examples of similar situations (you may have to go back a long, long ways). Perhaps some early American economic history examples (colonies, regions, etc.).

  2. The European Central Bank sets the interest rate; individual countries have no ability. The basic idea is, one interest rate per currency.

    One drawback is the cost of doing transactions in other places; you have to convert dollars to Canadian dollars or what have you. Credit cards and other electronic payment forms minimize this, however. Preventing inflationary policies, political integration, and price predictability are other reasons.

    As for the historical record, state-licensed banks issued drafts (much as the Fed does today) that operated more or less as regional currencies until 1908. These were used in inter-regional trade and the exchange rates were able to fluctuate over time. One impetus for abolishing such trade was that these fluctuations were seen as exacerbating economic downturns. Wide-scale cyclic downturns being a poorly understood phenomenon at the time (and some would say still), this theory was not subjected to much testing. Recent studies have concluded that my 19th century forebears had it wrong: exchange rate movements were symptoms rather than causes of regional economic growth and decline.

  3. Thanks for the link. I’ll be checking it our shortly.

    So, overall then, based on what I’ve read, it seems like you think the pluses definitely outweigh the drawbacks of breaking up the currency? Would there still be, theoretically thinking, a “US Dollar” that all these regional US currencies go into for the world stage/trade?

  4. I think that cities are probably the best level for currencies to be issued. But these posts have been more about thinking through a what-if, rather than pushing a viable present alternative. The huge political/institutional/historical factors involved, that I really haven’t thought through to any great extent, mean that even if it would have been better for us to have more local/regional currencies instead of a national one, that jumping ship now might not be such a good plan.

    Although the pending potential break-up of the euro might provide some evidence on that front..

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