Controlling Interest Rates

During the middle ages, the church attempt to set the just price for bread. Their efforts failed, because they either set the price too high and created a glut or set it too low and created shortages. They eventually gave up.

Governments used to control prices from time to time, but have now given up for the same reason. The last bastion of price control is the interest rate. Most governments still attempt to control the interest rate.

The interest rate is the most important price in the economy. It is the price of the future. It should reflect the value that people place on the future. If people have confidence in the future, they will not need much compensation for saving, so interest rates will be low. On the other hand, if people have no hope for the future, the interest rates will be high. A future orientation will reduce interest rates; a present orientation will cause high interest rates.

Giving central banker’s control of this important price is a mistake. One problem is that they do not have enough information to get the price right. Most of the time, they set it too high or too low.

The other problem is that controlling the interest rate is a very blunt instrument. When using interest rates to slow the economy, central bankers hurt all businesses, not just those that are least efficient. Higher interest rates prevent efficient businesses from expanding and may cause some to shift overseas. Exporters are often hurt by the consequential rise in the currency. On the other hand, reducing interest rates to speed up the economy encourages all businesses to expand, when it would be better if only the more efficient ones grew. Worse still, the low interest rates can cause distortions in the economy, by encouraging speculation in fashionable assets.

Most of the time, central bankers are taking actions to fix up problems caused by their own mistakes. Allowing them to slow the entire the economy to eliminate a problem they have caused is like giving the key of your house to the pickpocket who stole your watch.

Artificially lower interest rates cause distortion in the economy. The housing boom was caused by central bankers setting the interest rate too low. A housing boom cannot cause inflation. If people become obsessed with owning houses, the price of houses will go up. However, those who are spending their money on houses will have to stop buying other things, so the demand for those things will fall. If the person buying the house borrows the money, the person that they borrow from has stopped buying something. A housing boom can only turn into inflation, if the government supports it by increasing the money in circulation. By setting interest rates very low after the Dotcom crash, the US Federal Reserve fed the property boom, turning it into a bubble that caused the Global Financial Crisis.