Interest rates around the world are today set by central banks, by committee. Is this the best way to do it? This depends on what interest rates are. Are they variables we can tinker with to provide the best economic output? Perhaps they are like the amount of fuel given to a car engine via the accelerator, speeding up or slowing down depending on the road ahead.
But what if there is a “natural” rate of interest, that while not constant, represents the economic reality at any given time. If this is true, what does this “natural” rate represent?
Interest rates are all about time. Borrowers want money now, rather than waiting to save first, and hence are willing to pay a premium to receive the money now. Lenders on the other hand, are giving up money now for a promise of repayment in future. If given a choice between £100 now, and £100 in a year, most people would take the money now. Even if we ignore risk, and assume the future money is 100% guaranteed, none of us would pay £100 to get £100 in a years time. This waiting period is why the lender demands that the money is returned with interest, to compensate for the loss of purchasing power in the meantime. Future money is discounted compared to current money – it is worth less since we can’t use it right now. (For the sake of simplicity, we are ignoring inflation as well as risk in these discussions.)
Each of us has a different time preference – some are willing to wait months or years before consuming, and save their money accordingly. Others consume everything they earn, and save nothing. The overall time preference across the economy is what drives the natural interest rate. Those who save money provide a supply of loanable funds. Those who consume demand loanable funds. (Of course, many individuals are both saving and borrowing at the same time). The meeting of this overall supply and demand is the interest rate.
It is quite valid to describe the interest rate as the price of money, but it is important to go beyond that to see that the supply and demand for money is driven by individuals’ time preference.
When central banks alter the interest rate, they are changing the price of money. But do individuals’ time preferences change as well? If not, then changing the interest rate is as misleading and as foolish as any other form of price controls, which hide the true nature of the economy. On the other hand, if time preference does change, then changing the interest rate may actually reflect reality, as people change their spending habits accordingly.
The only problem is that artificial changes in the interest rate actually change people’s behaviour in the opposite way to what the change in the interest rate suggests. A lower interest rate suggests that there is more capital available for lending, a higher interest rate suggests that capital is scarce. When a central bank lowers its rate, it is does so with the express goal of encouraging people to spend rather than save, and on the margin, this is what happens. So while the bank lowers its rate, suggesting more capital is available, consumers will save less, therefore providing less capital! (Note this is different to a free market lowering rates – in a free market, rates will be lowered when more capital is available, which may cause some to spend more and save less, but rates will adjust accordingly, in the same way that all prices react to supply and demand. The central bank on the other hand, is not lowering rates because more capital is available, and will not necessarily raise them as capital becomes marginally scarcer as a result.)
We can apply to this to the business cycle. At the start of the cycle, a central bank lowers its rates. This encourages business to invest in longer term projects as the signal is that more capital is available. However, time preference has not changed in the direction of long term projects – if anything, it reacts to become more present focused. There is a disharmony between consumption and investment. To invest more, you have to consume less. The central bank signal is a contradiction – invest more, and spend more! By the time these longer term projects are completed, and the investment now requires consumers to make purchases, there is no money to buy them – we get the bust.
Think of the housing boom. House builders are encouraged by the low rates to build more houses, but consumers are not saving any more in order to buy houses. When these houses are completed, consumers do not have sufficient saved funds in order to buy them, and house prices collapse.