The importance of interest rates

I have written many times of the persistent but forlorn attempts by central bankers to “stimulate” growth in their countries’ flagging economies by applying the twin practices of quantitative easing (QE) and lowering interest rates.

It has been clear for years that these policies simply do not work. The only surprise is that, despite all the evidence, their perpetrators persist with them, and do not give up.

The underlying rationale of these policies is as follows:

If the central bank creates (prints) bonds for the Treasury to buy, press a computer key and ‘monetise’ them into circulation, the commercial banks will be encouraged to lend the new money; citizens will be encouraged to borrow and spend; new businesses will spring up; and existing businesses will grow and be encouraged to expand their operations.

The fact that it doesn’t work, has never worked, and will never work — anywhere — has not deterred mainstream economists from trying it, over and over again.

No one, apart from the benighted central bank and its partner-in-crime, the Treasury, still swallows this fairy tale. The problem has therefore become one of lost credibility. The panoply of economic manipulators are so palpably inept that what may still make sense to them, principally the Treasury and the central bank, is no longer believed by the people.

The people have lost what little trust they ever had in their economic guides — even though they may lack a technical grasp of the mechanics of what these wizards are trying to pull off. This lack of public trust has now morphed into a widespread emotional rejection of policies that may well seem rational, but in reality are seen to make matters visibly worse. Society having now reached the stage of disbelief, there can be no going back, and the inexorable unwinding will simply run its course. Let’s look at it more closely.

Impossibility of economic calculation

As a businessperson, you may at first be taken in by the lure of cheap credit as the answer to a maiden’s prayer. But what are you going to do with it? Your problem is that you can’t even begin to prepare the projections you need to justify even a modest business expansion if you don’t trust the government’s monetary policy. If you base your forecasts on the availability of cheap borrowings, can you rely on it remaining cheap? If your business plan requires the import of raw materials or capital goods will the volatility of the currency leave you with higher repayment costs? Will you commit to large-scale capital expenditure? No. You will watch and wait, maybe — but you certainly will not commit to spending on anything that promises a commercial return in months or years.

This is evident all around you: just look at your suburban High Street — cafes galore, sandwich bars, fruiterers, mobile phone outlets, hairdressers, cheap motor accessory shops, betting shops, cut-price clothes shops, pound shops — and branches of banks, banks, banks. Yet there is virtually nothing involving a demand for a major outlay and months before you can sell it to see a return. Uncertainty stalks the cities and is the enemy of trade and commerce.

So that is one clue on why money creation, as a means of stimulating the economy, does not work. Only today we read that the Bank of Japan has disappointed the markets with only a “modest” increase in “monetary stimulus” by doubling its annual spending on corporate bonds. As one securities firm put it, “the BoJ won’t admit it, but it has now reached the limits of QE and negative rates”. It and other central banks have run out of both ideas and options. The astonishing aim of all these banks is to achieve a 2% “inflation rate”, again thinking that contrived inflation will cause people and business to spend now because of the fear of rising prices.

Interest rate suppression

What about QE’s partner-in-crime, the deliberate, systematic and relentlessly contrived suppression of interest rates? Like a troupe of underworld ghouls, Messrs Yellen, Draghi, Carney, Kuroda, et al, just keep dragging out the agony: starting from an interest rate of 2% they then tried 1.5%, then 1.25%, then 1%, then 0.5% (where in this country it stuck for years) and now, lo and behold, the UK’s financial mandarins are betting on a drop this week to 0.25%. How original! Amazing how many gradations they can find in the interstices between adjacent decimal points!

But why stop there? Why not go into negative territory, as in Japan, and charge depositors for the privilege of allowing the bank to “look after their money”? If you have £1,000 you can deposit it in your bank, which will promise to give you £950 in a year’s time. Wow! The banks’ game of ‘follow-my-leader’ is far more like ‘blind-man’s-buff’, because — please believe it — they really do not have a clue what they are doing. When it all blows up they will mumble “well, it seemed like good idea at the time”.

Again, the origin of this insane ploy is the threat that if we, the monetary authorities, put money in your pockets and you don’t spend it.…we’ll just take it away from you! After all, with negative interest rates, over a long enough period the sum you deposited will disappear altogether. No surprise that it’s boom-time for sales of domestic safes in Europe!

For Keynes, ‘Demand’ is god. If there is enough demand, somehow the workings of the economy will ensure that the demand is satisfied. But since people are evidently far too stupid to see this, the state has to take over and determine the size of the money supply — and the rate of interest. Thus did the rot set in.

Good economics (Say’s Law) tells us that production is needed in order to satisfy demand. Demand, after all, is everywhere. There can never be a shortage of demand if there are people. That is a statement of the obvious. But production is not obvious. It requires human endeavour; marshalling, combining and synthesising the factors of production are needed in order to create it.

Savings — the key

Again, money and wealth are not synonymous. Wealth is the accumulation of savings, and savings are what is left after wages, overheads and direct costs of production have been settled. Therefore sound business start-up capital comes from savings: not necessarily yours — in which case it will represent borrowings — and there is nothing wrong with that. But at what rate of interest?

All over the world interest rates have been forced lower and lower. The idea of freedom from the bondage of having to pay interest is sheer nonsense — a fool’s paradise. Interest rates arise out of our very nature as human beings. Determination of interest rates is thus a behavioural phenomenon. People may well prefer their desires to be met sooner rather than later. I might offer to let you have a loan of £10,000 in 10 years’ time, but if you want it now you may have to accept a discount and settle for £8,000. Interest is therefore “implied in the logic of human action”, as an Austrian economist might put it.

The “time preference”, the desire to consume sooner rather than later, manifests itself in the interest rate. The greater the time preference (the more urgently I need the money) the higher the rate of discount applicable.

The central banks’ attempt to annihilate interest is therefore a huge economic error: credit markets have the crucial function of channelling resources from savers to investors, and hence establishing equilibrium between them and enabling both to contribute to wealth creation in the community.

That’s natural.


Emile Woolf is a Renegade Inc. correspondent