Firstly, we must figure out what high interest rates are relative to.

If high interest rates are relative to rapid economic growth, in that an economy is firing on all cylinders, with rising levels of aggregate demand and the good kind of inflation, then there really isn’t that much to worry about.

High interest rates in this scenario are only “high” because they are viewed relative to what they were at some point in the past. This is simply the human anchoring bias at work, and low rates in the past offer little insight into what high rates in the future might or might not mean.

As stated above, the level of current economic growth (and related confidence) is what matters to current levels of interest rates.

Also, high interest rates are not destructive in a growing economy because they are a sign of business confidence. A natural consequence of this is that interest rates are high when growth is high, and low when growth is low.

Obviously, the mainstream perceives interest rates differently because their paradigm is central bank-centric. This causes them to view low rates as evidence of a higher money supply, and thus higher future economic growth, because of central bank action. 

Unfortunately, this way of thinking of low interest rates is a fallacy, as observed by Milton Friedman.

A simple way to see why this is so is to consider it from a borrower’s perspective . A business will borrow if they believe that they can earn returns in excess of the interest rate they are paying. Hence, high rates illustrate that borrowers are somewhat confident of higher future returns.

As such, high rates on their own are not indicative of borrowers’ being less able to service their debts.

Also, higher rates are not necessarily indicative of tighter financial conditions. If confidence is high enough to spark more borrowing, this will lead banks to charge more for loans, i.e. raise the interest rates that they charge.

In turn, this means that the banking system is making more loans, and more loans means an increasing money supply!

If access to credit is somewhat equal, then financial conditions really are not tight at all. If access to credit is not equal, then financial conditions will be tight for some, but not others. In this scenario, the lucky ones with access to capital will survive, while the unlucky ones will struggle to meet their interest payments.

The real problem comes when high interest rates are relative to stagnant or low economic growth. This is because economic conditions simply do not allow debtors to make enough money to service their debts at these higher rates.

How would such a situation arise?

Since growth is low or nonexistent, we know that rates are not high because of business confidence and expectations of higher future returns. Instead, there must be some other reason, for instance, a collapse in confidence in the country’s government and/or economic prospects.

As the word “collapse” implies, such a scenario is one where everyone runs for the exit at the same time. 

Which begs the question, how would such a collapse come about?

To be continued…