Interest rates simply reflect the truth; and it is a very sad day when telling the truth can foster such ill will.
image: Pixabay
It is often said, “Don’t kill the messenger,” but that is precisely what everyone seems to want to do in my case. I’m not sure why because the news I bring is neither good nor bad. It is simply the truth; and it is a very sad day when telling the truth can foster such ill will. There are some who go so far as to declare my very existence wicked simply for providing information people use to engage in a specific type of voluntary exchange that, although of immense benefit to society, has somehow acquired an unsavory reputation.
As you may have surmised, I am the rate of interest, the price difference between present goods and future goods. Now, many economists mistakenly identify me merely as the price of borrowing money over time, but that is only one of the many messages I carry. I also represent the price spread in the various stages of production, where capitalists purchase present goods in the form of factors of production in the hopes of selling what is produced by those factors for a higher price than what they spent. I am also this difference in price.
Nobody but me can gather the information I gather, for my message is determined by billions of individual transactions occurring simultaneously all over the economy. I consider the individual supply and demand schedules of hundreds of millions, sometimes billions of individual consumers and producers, along with the uncertainty involved in every time transaction, to determine the current price levels for transactions that involve time at any given moment.
In the case of individual borrowers, the uncertainty I mentioned includes that borrower’s previous behavior, which is generally called a “credit rating.”
The Usury Slander
While it is only one of the many prices I make available to the market, an inordinate amount of attention is paid to the price of borrowing money. That is likely for two reasons. One, as I said, is that most people erroneously believe it is the only information I impart. Two, people seem to be borrowing a lot more than they did previously in history for reasons I will explain shortly. As a result, it is regarding the price of borrowing money where I am most slandered and abused.
Because this price of borrowing is above zero, there are some who consider my existence alone as evil. They say I’m a party to a crime they call “usury,” which is a very strange concept. When everyone is acting honestly, money is a scarce commodity, so any loan by Person A to Person B requires a sacrifice on the part of A. Person A must forego consumption in the present in order to lend to B.
It is no different than if A were saving for a new car or some other expensive item for himself. He must forego eating out as much, or buying new clothes, or going on vacation this year in order to put aside money to buy the expensive item next year.
By loaning money to B, A is allowing B to skip this sacrifice and purchase the expensive item now. It seems a very peculiar notion that A should forego spending his own money on himself only to let B use it for free when needed. How did this obligation to serve B free of charge come about? Aren’t all men created equal?
Now, there are those who say it is not merely loaning money at interest but also charging exorbitantly high rates that constitutes usury. This makes no more sense than the previous definition. Is not the lender in every case charging a lower interest rate than any other willing lender is willing to accept for the given borrower? If that weren’t true, the borrower would simply borrow from the lender offering the lower rate.
In fact, this so-called “usurer” may be the only lender willing to deal with the borrower in question at all. How can this make him a criminal or a sinner, while the rest who would charge higher rates or not loan the needed money at all are considered virtuous? This version of the usury slander is as illogical as the first.
Regardless, it is not I who collect money from B or even impose any obligation on B to pay A for the service. I am merely the messenger to both parties on what rate should be charged based on a plethora of information neither could possibly gather on his own.
Nobody Likes the Truth
Even many of those who don’t believe charging interest is a crime are hostile to me. To them, I am like a friend who tells you the truth rather than what you want to hear but is not appreciated for doing so. Everyone wants me to proclaim a much lower rate than the conditions warrant.
Well, not everyone. Savers like higher interest rates. Borrowers like lower ones. There just seems to be more of the latter than the former these days, and they’re a lot louder. So, forgive me if I sometimes think the borrowers represent everyone.
Borrowers are a diverse group. They include entrepreneurs seeking to expand production, consumers, and, of course, governments. This last group has two reasons for wanting me to lie.
First, they generally have borrowed large amounts of money in the past, resulting in an accumulated debt they cannot service at higher interest rates. Second, lower interest rates allow more borrowing by entrepreneurs to expand production. Expansion of production creates jobs, lowers unemployment, and makes society in general wealthier. Politicians generally take credit for the higher standard of living, dubious as those claims generally are.
Unfortunately for them, I am incapable of lying directly. Current economic conditions at any given moment compel me to say what I say. I can no more change my message than any of you can cease being a human being. The politician, therefore, has developed a scheme to make me mislead market actors indirectly.
I said before that Person B’s borrowing requires Person A’s previous saving when everyone is acting honestly and money is scarce. Let me first explain how things work under these conditions.
When there are relatively higher savings rates over the entire economy, meaning there is a decrease in consumption, the demand for goods and services is lower related to supply, and consumer prices fall. Inventories of tangible goods are temporarily accumulated. Profits for producers at the lowest stage of production decrease or they incur losses, giving them an incentive to switch investment from lower stages and seek greater returns on investments in higher stages of production.
This series of cause-effect relationships makes expanding the productive structure self-sustaining. The accumulated inventories and lower prices help sustain consumers while the supply of consumer goods being delivered is temporarily decreased. The accumulated savings help entrepreneurs complete the expansion of existing production and new projects they have launched. When these undertakings are completed, the productive structure is permanently larger, meaning more consumer goods per capita are produced. With more products produced, lower prices become permanent, and real wages rise. All of society is rendered richer.
How Central Banks Try to Make Me Lie
One would think it a perfectly reasonable proposition that consumption must decrease for production to expand. But for governments this is untenable. First, they seem completely incapable of decreasing their own consumption, no matter how large their deficits become. In addition, they have at least two reasons for not wanting their constituents to save.
One is they subscribe to a rather bizarre economic theory advanced by a school of economists who generally tell governments what they want to hear rather than the truth. Under this theory, wealth is created by consumption rather than production. When consumption falls, which I’ve just shown is the first necessary step toward expanding the productive structure, these economists say the government should override those millions or billions of individual decisions and spend more to offset what the public has not spent.
It isn’t difficult to understand why proponents of this theory would be heralded not only by governments but also by all those who wish for governments to expand in size and influence. They have constructed a theory that says government intervention into the economy is not only positive but also vital to sustaining economic well being. So, governments and these economists promote each other, working together to delegitimize any dissenting views.
The second reason governments resist the natural means for expanding production is they never want their constituents to experience even temporary, voluntary austerity. Having falsely taken credit for previous expansions, they don’t want blame for temporary decreases in the supply of consumer goods even though it is necessary for long-term increases in supply. They want their constituents to believe they can “have their cake and eat it, too,” and to take credit for this apparent economic miracle.
The chief impediment to promoting this fantasy is that money is scarce, when everyone is being honest. After all, one can’t both consume a scarce commodity and retain possession of it at the same time. So, they have concocted a scheme under which money is not scarce.
At one time, every “Federal Reserve Note” was exchangeable for a defined amount of gold, the word “note” itself meaning the written record of a debt. Dollars at one time worked much like the ticket you get from the laundromat. You “deposit” one shirt, and the laundromat gives you a claim check. Later, you return the claim check and the laundromat gives you one shirt.
Dollars once operated the same way. One ounce of gold was deposited in the bank, and $20 was issued. If $20 were presented to the bank, the bank owed the bearer one ounce of gold, just as the laundromat owes you one shirt. Unlike the laundromat, however, you wouldn’t get back the exact same ounce of gold initially deposited, as gold is fungible and shirts are not. Dollars were also exchangeable in the community for other items, without the gold ever moving from the bank vault. At any time, however, the current owner of your $20 was still entitled to exchange it at the bank for one ounce of gold.
As long as a certain amount of gold could be demanded for each dollar in circulation, money remained scarce. Now, bankers would lend out more dollars than they could exchange for gold from time to time, either with or without the government’s approval, as this greatly increased their earning potential. It was essentially a fraud, as the bank was loaning the same gold to one person it was legally obligated to pay on demand to another. Calling it “fractional reserve banking” made it sound technical and thereby more legitimate, but it was no less a fraud.
Fortunately, because of the risk that too many depositors might demand their money at the same time, this expansion of the money supply beyond its gold backing was very limited.
To expand banks’ ability to engage in this monetary inflation, the government created a central bank. At first, this central bank merely backstopped the rest of the banks under the same gold standard. But eventually, the exchangeability for gold was eliminated, making the name “Federal Reserve Note” an absurdity because a piece of paper that cannot be exchanged for anything specific is no longer a “note” in financial terms. But it solved the problem of loaning the same dollar out to a borrower while making it simultaneously available for withdrawal to the depositor. Since neither could exchange it for any specific tangible item, both borrower and depositor could merrily go on pretending this arrangement was viable.
They say ignorance is bliss, although you all participate in this fraud knowingly today. So, it is more a case of believing what you want to believe.
Eliminating the gold standard allowed the central bank to create and destroy money arbitrarily for the general purpose of trying to make me lie to the public, encouraging them to make economic decisions the government wants them to make rather than decisions economic conditions deem prudent.
However, since it is impossible for me to lie, to announce a borrowing price based on anything other than current market conditions, central bankers must alter economic conditions instead. When they announce they are going to “lower interest rates,” what they really mean is they will increase the supply of money available to be lent. They accomplish this by purchasing securities, usually government bonds, from their member banks. In return for the securities, they give the member banks currency, created out of thin air.
As with an increase in available money due to savings, this monetary inflation decreases the price of borrowing, which in turn stimulates increased demand for borrowing. Governments borrow more; consumers borrow more, and entrepreneurs borrow more. This last group invests in higher order capital goods, expanding the productive structure just as they would if the increased money supply were due to savings. But it’s not.
Since the expansion is not the result of savings, none of the consequences of saving that make expansion self-sustaining occur. Consumption does not decrease, lowering the demand for consumer goods so consumer goods prices don’t fall. They either rise, stay the same, or fall less than they would have without the monetary inflation. Inventories are not built up. Overall, the lower prices, inventories, and cash on hand resulting from savings are not there to sustain the economy while entrepreneurs expand production.
Eventually, to combat the rising consumer goods prices they have stimulated by increasing the money supply, the central bank decreases the money supply. They do this by selling securities back to their member banks in exchange for money. This lowers the amount of money available to be lent out to the rest of the economy, which increases the price of borrowing.
I get all the blame when this cycle ends badly. Politicians especially claim stock market crashes and economic depressions are the results of “interest rates being raised too high or too quickly,” as if it is merely my telling the truth that causes all the economic problems.
Obviously, that’s not true. The problem isn’t what I tell markets but the bad decisions previously made by market actors based on artificially-created conditions. Entrepreneurs begin higher order production projects when the savings required to finish them are not there. They choose to start these projects under false pretenses, even if they are not consciously aware of it. While they may base their decisions purely on lower interest rates, lower rates are normally accompanied by savings, lower consumer goods prices, and inventories.
Consumers have also borrowed more based on the artificially lower rates. They took on debt burdens they would not have under natural market conditions when only their savings could have produced the lower interest rate in the first place. After all, one cannot consume more and less at the same time. And since they haven’t lowered their consumption, they don’t have the benefit of the lower consumer goods prices they would have enjoyed if expansion of production was fueled by their savings.
Not only consumer goods prices, but also the prices of all goods increase when the money supply is increased, other things being equal. The prices of stocks and houses are especially vulnerable to being bid up to artificially high levels.
In addition, capital is expended on producing capital goods for projects that won’t ultimately be profitable. When these projects are abandoned, any capital expended on capital goods that can’t be repurposed has been wasted, making society permanently poorer than it would otherwise have been.
Massive labor resources are also dedicated to these doomed projects. When the projects are abandoned, these people all lose their jobs. While they eventually can move to other projects, they are unemployed until new projects are launched and any new training they require is completed. While unemployed, they suffer personal hardship and the rest of society is rendered poorer than if they were productively employed.
Compounding the calamity is the opportunity cost of all these losses. Had labor and capital not been misdirected by artificially lower interest rates, all the misdirected resources would have been employed productively. All they would have produced during the artificial boom and subsequent bust represents another permanent loss to society.
It goes without saying that I abhor being even an involuntary party to any of this reprehensible behavior. And I must reiterate that the central bank has never made me lie outright. My price message to borrowers and lenders was perfectly accurate, based on the money supply conditions at every stage. It was the way those conditions were created by the central bank—from new fiat money creation rather than savings—that caused all the problems.
Be Honest with Me and Yourselves
As I tell my story, it seems that yet another economic calamity looms. Already, I can hear my name being dragged through the mud as a party to the scheme that caused it. Along with my alleged guilt by association, many other innocent parties will be scapegoated to direct attention away from the real culprits, the government and its central bank. Supposed “deregulation,” lower taxes, and even the free market itself will be blamed.
Blaming the free market is especially despicable given that overriding market conditions with monetary inflation, resulting in interest rates lower than what the market would have me prescribe, is what caused the bubble in the first place.
Nevertheless, after creating the disease by overriding the market, politicians and central bankers will demand it be overridden again as the market tries to administer the cure—falling asset prices, bankruptcies, abandonment of non-profitable enterprises for profitable ones, and liquidation of debt. Instead, the central bank will use monetary inflation to prop up stock and housing prices, sustain bad debt, and continue unprofitable businesses, and the cycle will start all over again.
What can be done? As always, I will tell you the truth, even if you don’t want to hear it. Fix your monetary system. I don’t particularly care if your currency is backed by gold, diamonds, or some other scarce, fungible commodity. It need only be naturally scarce, its supply not subject to anyone’s whim, no matter how public-spirited or “independent” they claim to be.
Get rid of your central bank. Your country got along fine for 90 of your 243 years without one, while your previous two central banks had a hand in creating many of the crises cited as the excuse to create your present one. After getting rid of your central bank, don’t let the remaining independent banks lend out more money than they have. That’s the real root of the problem whether a central bank is there to exacerbate it or not.
Don’t make scapegoats of the bankers, either. You know they’re operating on a fractional reserve. As much as they want to generate revenues based on loaning money they don’t really have, you want to earn interest on money you know they’ve loaned out. Please be honest with yourselves and me.
Obviously, enforcing these disciplines will necessitate much less government spending, but that shouldn’t bother anyone. The government shuts down from time to time, and nobody really notices. Certainly, no sane person would argue a government running trillion-dollar deficits can afford non-essential personnel. Those should be the first costs cut, but there are plenty more.
No matter what you decide, I will go on telling you the truth; I can do nothing else. Now that you know I merely communicate a price level based on supply, demand, and uncertainty, you know it is how those underlying economic conditions are determined—naturally or artificially—that determines your economic fate. You can go on doing the same thing you are doing now—lying to yourselves and trying to get me to do the same—but you shouldn’t expect different results. Someone once said that’s the definition of insanity.
Written by Tom Mullen for Foundation for Economic Education ~ December 31, 2018
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