Of interest rates and central banks

The typical monetarist account of interest rate-setting gets quite a lot of things right. However, I'm becoming less certain that it quite understands the engine of what's going on, and therefore misses some aspects of the story. Let me try to explain how interest rates operate in a market economy, and how, therefore, altering them can cause problems. Be warned: this is necessarily a Long Post!

Interest rates: co-ordinating investment with consumption

In this story, we have two main players. The consumer is king, and businesses are engaged in the task of supplying consumers' desires. Now, in order ot understand how interest rates work, we need to understand that business and consumer alike can either focus on the present or the future.

Thus, current consumption is that portion of income which consumers are using now to spend on what Smith would term "the necessaries and conveniences of life." Deferred consumption is that portion which consumers are storing away to be used at some point in the future. They might not know which point in the future, but they know they don't want it just yet.

On the other side, businesses are engaged in the challenge of chasing consumption. Even when they only supply other businesses, the ultimate goal of the chain is to satisfy consumer desires. Therefore, businesses want to capture as much consumption as possible.

Changes in consumers' deferral patterns (which is to say, changes in their spending/saving ratio) will mean that sensible businessmen will change their behaviour. Since investment in a business does not pay off immediately, businessmen will only want to borrow money when there is an attractive block of deferred consumption to compete for. But how can they know that such a block of consumption exists?

Enter interest rates. As consumers defer consumption, assuming they put the money saved into a bank or other form of investment, they increase the supply of capital available. When supply increases, price decreases; therefore, the cost of capital goes down. Borrowing, as a form of capital investment, becomes less pricey, which is to say that interest rates go down.

Now turn the picture round and look at what businesses see. They don't see a block of deferred consumption, but they do see interest rates falling. As they do so, it becomes more attractive to borrow money or raise capital in order to invest. Therefore, while individual businesses rise and fall, the business world as a whole grows with the investment and grows in order to take advantage of the (unseen) pot of gold that is all that deferred consumption.

As if by magic, consumers' deferrals of consumption have given rise to business investment to supply that future consumption. This story is so remarkable that I continue to think of it as the miracle of the interest rate.

Central bankers: inflating the bubble

Of course, it's slightly unfair to blame the central bankers alone. In the UK, the UK government famously changed its definition of inflation to try and suppress interest rates; the result of this disastrous policy is now plain to see. However, central banks are responsible for monetary policy. Let's see what happens when they keep interest rates too low, which is the usual mistake.

If interest rates are kept too low, then businesses will be more future-oriented than the situation would warrant. They will borrow lots of money to invest and will spend less of their efforts in satisfying current consumption. However, consumers have more consumption now and less in the future than businesses are being led to believe. This entails two effects:

1. Since current production is less than current demand, prices will be pushed upwards. This is the boom period, when inflation takes off, employment increases and there is both consumption and investment.
2. As we approach the time when this 'future consumption' was thought to exist, production capacity will be shown to exceed consumption capacity (see, for instance, the over-capacity of the car industry). Deflation and lay-offs result. We enter the bust: a recession, perhaps even a depression if the boom was stoked for too long and too greatly.

Clearly, although increasing employment in the boom period is a good thing, it would be better to aim for growth which is sutainable: that is, growth which does not swing to shrinkage so quickly or so hard.

It is worth noting that were a central bank to have interest rates which were too high, then opposite, perhaps worse, effects would result, as businesses would be encouraged to compete harder for a smaller pot of current consumption, which would put them out of operation even more quickly.

How then should we live?

The obvious, and correct, answer is that interest rates ought not to be set by a committee, even of 'wise men'. If you try to fix the pricing mechanism for some good or another, then you inevitably cause a crisis in that market. Fixing the price of investment capital will inevitably cause a crisis in the investment market, and can there be anyone left on the planet who does not realise how dependent our entire economy is on capital investment? Messing around with the flange market might annoy some people; messing around with the capital market is likely to start starving them.

Of course, this will not stop the cycle of boom and bust. However, because market participants tend to find profitable activity in closing down holes and inefficiencies, freeing the interest rate from central control should mean that the booms never reach so high and the busts never dip so low. Isn't mitigating the economic cycle by stopping government interference a project worth undertaking?