Monday, July 9, 2012

The Importance of Interest Rates

I have discussed before (here and here) the Federal Reserve's policy of "Operation Twist".  This is the Fed's policy to buy long-term government debt in favor of short-term debt.  Its main purpose is to lower long-term interest rates.

I already discussed some of the reasons that the Fed might want to do this, as well as some of the possible unintended bad consequences.  For today's post, I want to discuss another bad side effect of this policy of setting interest rates below where the market would set them.

Interest rates tell us the price of money.  Almost everyone would prefer to have one dollar in their pocket today than have it a year from now, even if their intention is to save it.  If someone is going to defer getting paid a dollar today and instead get paid a dollar one year from now, then this person would expect some additional reward.  This extra amount is the interest rate.

The interest rate serves as a price.  Since it is essentially a price, it also serves as a signal to the market.  If interest rates are really high, then that means the market is signaling that savings are too low.  People are consuming too much and not saving enough for the future.  The high interest rate provides an incentive.  It is an incentive for people to save more, as they will get rewarded with a higher interest rate for their savings.  It is also an incentive for people to borrow less, since their borrowing costs will be so high.

There is a saying that the solution to high prices is high prices.  The same goes for interest rates.  The solution to high interest rates is high interest rates.

The same goes for low interest rates.  This is a signal that savings are high.  It actually gives incentive for people to borrow more due to the low rates.

It should be mentioned that interest rates also reflect expected inflation and risk.  If there is a big risk that the lender won't be able to pay off the loan or if there is an expectation that there will be high inflation, then the interest rate will reflect these things.  But it is important to know that these are only two factors and we should not forget that interest rates are also an indication of the time value of money as discussed above.

If the federal government manipulates the price of oil or tampers with the production of corn, it mostly just affects these things and the other products that rely on them.  However, when the government/ Fed tampers with the interest rate, they are tampering with the price of money.  Money is used on one side of a trade in almost all transactions, unless you count barter (which is not much in a high division of labor economy).  So when the Fed tampers with the interest rates, it is really distorting the entire marketplace.

While it is impossible to say what interest rates would be exactly in a free market economy, there can be little doubt that they are artificially low right now, if anything.  This is a problem because it distorts the need for savings.  It is telling the market that interest rates are really low because savings are so high.  The problem is that this may not be the case.

Fortunately, despite the government's profligate spending, many Americans are actually trying to save more, spend less, and pay down debt.  Unfortunately, it is still not enough to offset all of the bad that the government is doing.  If the Fed would stop buying government debt, then interest rates would eventually rise and Washington DC would be forced to cut back.  It would raise the rates on long-term bonds and it would also send a signal to people to save more.

Interest rates are low because of the bad economy and the fear that goes with it.  But the Fed is not helping in continuing to buy government debt with all of its schemes.  Of course, the Fed and the governments are also the cause of the bad economy in the first place.

In some ways, it might be better if the Fed were to create money out of thin air by directly handing it over to the government to spend, instead of buying its debt.  It would still be counterfeiting, but at least it would be more transparent.  It would also have less of an effect on interest rates.

We should demand an end to price controls, starting with the controlling of interest rates.  The free market should determine rates, which would allocate capital in the most efficient way.  This would mean more prosperity and a higher standard of living in the long run.

2 comments:

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