Every time we go through a major economic upheaval the pundits appear on cue heaping scorn upon capitalism and the evil free market.  It is the greed and instability inherent in these systems, say the critics, that have caused the our current crisis.  We must prevent future instability with increased regulation and by placing shackles upon the evil free market!

This is complete nonsense.  The premise on which these critics are basing their arguments is completely wrong.  Free markets can’t be the problem since we, at a fundamental level, don’t have them.  In fact the opposite is true.  It’s precisely because we don’t have free markets that we’re living through a slow motion economic train-wreck.  Attempting to solve problems rooted in the bastardization of the free markets by further interfering with and regulating those markets is utter folly.

In my previous post I both defined free market capitalism and also showed how government interference with the price discovery mechanism necessarily leads to inefficient markets.  Today I want to apply that discussion to what’s arguably the most important price that exists in an economy (especially an economy that purports to be capitalist): Interest rates.

Interest Rates – The Price of Capital

Most non-economists don’t think of interest rates as a price.  They are.  In fact, interest rates are arguably the most fundamental price that exists in a capitalist system: The price of capital or money.

Like any other good or commodity money has a price.  That price is interest rates.  If an individual or company wants to obtain money to buy a house, invest in a new factory, etc., they need to borrow money or capital.  We all know that borrowing money is never done for free – the lender needs to be compensated both for any risk and also for forgoing access to their money for the duration of the loan.

In a free market interest rates are the quantitative expression of:

1. The premium the borrower willing to pay in the future to have access to money today.
2. The profit the lender demands in compensation for the lose of access to their money for the period of the loan (and any risk).

In a free market interest rates, just like any other good, should be set through the price discovery mechanism.  The more people save, the more supply of money exists and the lower the interest rate.  The more people spend, the lower the money supply and the higher the interest rates.  On the demand side, increasing demand yields increasing interest rates.  Referring back to the standard supply/demand chart the situation looks like this:

In this particular chart P* would represent the free market interest rate.  Any deviation from that optimal interest rate would cause either a shortage or excess of available capital (see my last post for a discussion of price fixing).  Both results, a shortage and an excess, have detrimental effects on the economy at large and, among other evils, are the primary causes of bubbles and the boom/bust cycle.

What Happens When Government Fixes Interest Rates

Let’s take it for granted that neither the government nor any other entity could possibly select prices as correctly and efficiently as the free market.  It directly follows that under our current system the government must be setting interest rates sub-optimally above or below the equilibrium price.  Let’s look at the effects of each of these cases.

Interest Rates Set Too Low

Current interests rates have clearly been set artificially low.  Indeed, the current Federal Reserve discount rate (the special rate the Fed will lend money to banks at) is less than 1%.  The Fed has also given indication that the rates will remain artificially low through 2015.

What is the impact of such a policy?  Well, apart from turning banks into gamblers (since banks can borrow money from the Fed to invest in a range of vehicles earning returns well in excess of the loan’s interest rate), the impacts of such a low rate are entirely predictable by looking at the supply/demand models: Demand soars.

For normal goods, such an artificially low price would result in shortages as suppliers would be less willing to produce at such low prices while at the same time demand would be high.  But money, especially fiat money in a fractional reserve system, is not a normal good.  I don’t want to go off on a tangent so, for the purposes of this discussion, since the Fed also controls the quantity of money in circulation, let’s assume that the Fed in conjunction with the banks will simply ensure that sufficient money supply exists in the system to satisfy demand.  Thus, the result of the artificially low interest rates is simply a surge in borrowing.

This surge in borrowing and the abundant availability of cheap capital first and foremost creates an artificial boom in the economy.  After all, people borrow money to spend it. The higher the aggregate borrowing in the economy, the higher GDP is pushed.  In the short term life is good.

But this short-term boom masks the underlying imbalances that have been created.  Depending on other policies in the economy, asset bubbles can be created.  Probably the best recent example of this is the U.S. housing bubble (which popped memorably in 2008) and the Canadian housing bubble (which is about to pop).  These bubbles where created exactly because of the availability of cheap mortgages.  This did no favour to the average person since it simply caused housing prices to shoot through the roof.  Houses doubled in price but salaries did not.  Although the low interest rates meant you could now get approved for a $500,000 mortgage due to the low interest rates, this made the outstanding debt as a percentage of income much higher than ever before for the standard person.  A whole middle class has literally become debt slaves.

So these are the first effects of artificially low interest rates: Asset bubbles and higher consumer debt.  Neither of these are healthy for the long term economy.

Another effect of low interest rates is to make people more likely to engage in suboptimal or high risk investments.  Since money is so cheap people are more willing to borrow for things that they would not have under normal (higher) free market interest rates.

Low interest rates can also delay or prevent inefficient businesses from going under.  One of the keys to the capitalist system is that the most efficient producers in any given market are selected for while less efficient producers are forced to improve or go out of business.  This leads to the best prices for consumers and the highest aggregate wealth in the economy.  Cheap and abundant credit provides less efficient producers with a way of circumventing this economic natural selection: Issue bonds, lots of bonds.  Thus, these companies can temporarily stay in business due to the over-supply of credit.

Finally low interest rates hurt savers.  Savers are supposed to be the keystone in the capitalist system since it’s their savings that are used as the basis for the economy.  People who used to be able to earn a return at or above inflation relatively risk free now must chose between returns lower than inflation (i.e. a lose in purchasing power year to year) or chasing returns in more risky investments, using precious metals etc.  The oft heard argument that the loss to savers is more than offset by the savings on interest payements for borrowers is nonsense.  As I’ve mentioned, low interest rates tend to get expressed in increased prices (so borrowers aren’t really saving and instead taking ever larger debt burdens).  At the same time pension funds and individuals are forced into riskier investments.  The end result is much higher debt for borrowers, much lower returns for investors and an increasingly risk based economy.

Interest Rates Set Too High

If the price of a good is fixed above the free market equilibrium price a surplus results. That is, there is more supply than needed to meet demand at the price.  Applied to interest rates the picture is again muddied due to central bank monetary policies.  High interest rates are often associated with tight monetary policy.  But regardless, the general result is still the same – the credit market dries up, investment opportunities dwindle and the economy slows.

In the real world it’s been a long time since we’ve seen above market interest rates.  Probably Paul Volcker’s stint as Fed Chairman in the late seventies and early eighties is the best recent example.  In order to reign in runaway inflation which had topped 13.5% in 1981, Volcker jacked interest rates north of 20%.  The plan worked but caused a spike in unemployment and slowed growth in the economy.

While I doubt we will see high interest rates at any point in the foreseeable future the lesson remains: Artificially high interest rates are also damaging to the economy.

Why Does Government Fix Interest Rates

Given the myriad of problems and inefficiencies caused by governments fixing interest rates, why do they do it?  Money.

You see, governments also undermine the free market when it comes to currency.  Legal tender laws, capital gains taxes required for any exchange of precious metals, and other laws all exist to ensure governments have a monopolies on their nations’ currencies.

While we can argue about motivations for why government has imposed such a currency monopoly on us, for the purposes of this discussion the why is irrelevant.  What is relevant is the fact that there does undeniably exist such a currency monopoly and that the value of the currency is being eroded continually by inflation.  This systematic debasement of the currency is intentional.  Central banks usually target around 2% annual inflation as being a good thing.  Using the U.S. as an example, even the official stats report the loss of over 95% in the purchasing value of the dollar since 1913.  Often inflation runs higher that the 2% target and in virtually all cases real inflation is under-reported due to the statistical games played in the way inflation is defined by the government.

Why is any of this important to a discussion about interest rates?  Simple.  You can’t have an inflationary currency and free-market interest rates without very quickly breaking the economy.

It all comes back to the definition of interest rates being the price of currency.  Assume there’s a free market in which there’s no currency depreciation and where interest rates, through the price discovery mechanism, are running at 5%.  Now introduce an expected 3% currency devaluation into this economy.  In a free market lenders would demand to be compensated the additional 3% in order to make a loan.  The lender understands that being paid back in devalued currency cuts into the premium they demand in compensation for risk and deferred payment on their loans.  The entire supply curve shifts up by 3% and interest rates in such a system rise to 8%.  At the new 8% interest rate there is less demand for borrowing and the economy slows.

This scenario shows that, in a true free market, currency inflation will slow the economy as lenders attempt to shift the burden of inflation onto borrowers.

The only way governments can reap the benefits of inflation without the detrimental impacts of such a policy being immediately visible in the economy is if the government also seizes control of interest rates.  Thus, currency and interest rates are the two necessary prerequisites to enable currency debasement.

Conclusion

Were governments to raise all funding through taxes the people would revolt.  Inflation provides a mechanism whereby people can be taxed without their knowledge or understanding.  This enables government to grow ever larger while the people, confused, grow ever poorer.  Conveniently, government also controls the education system and sees to it that a basic, common sense understanding of economics is not part of the curriculum; Instead we learn about magic multipliers, benefits of omnipotent government price regulation and the like.

But this currency debasement is only made possible due to the control of interest rates and the extent to which this is able to distort, obfuscate and manipulate the economy.  In the process a never ending cycle of booms and busts, crises and panics are created.  This is the inevitable result of a managed economy – an increasingly chaotic system that eventually implodes.  Just ask the Soviets.

And that, ultimately, is where our managed economies are heading – ruin and collapse.  We have allowed the State to eliminate the free market for the most important price that exists in a capitalist system: The price of money – interest rates.  In so doing we consigned ourselves to a permanently sub-optimal economy.

No, we don’t have free market capitalism.  Not even close.  Welcome to the managed economy.