Saturday, 1 August 2009

Interest Rates are Prices

A while back I posted on Interest Rates and Capital using explanations of supply and demand. It was to my astonishment that I noticed an article published by a popular newspaper. Rather then heap praise on the recent lowering of interest rates and accepting at face value what the central bankers were saying, it actually challenged these concepts and the so called 'wise men'. There is no logic to having a centralised committee setting prices such as interest rates. Rather than determined by the market these prices are adjusted by these central institutions. Despite all the propaganda that central banks are now 'Independent' its still the same as when politicians have control over interest rates. They always try to keep them as low as possible for as long as possible. Creating inflationary booms is the best weapon politicians have at creating artificial prosperity. Until the public balks at the inflation or the scale of malinvestment becomes too large, then these prices are risen by the powers that be.

A good question would be, how should interest rates be set? Who would set them if Central Banks were not in control? That simple micro-economic concept called supply and demand would set it. The great Austrian economist Eugen von Bohm-Bawerk noted that the setting of interest rates is a time preference, peoples preference to get money upfront in the current time frame. Many sections of society view making money off money as immoral, historic notions of Usury, the reason why Jewish people have been casted outside society due to their role in money lending. Karl Marx in his critique of Capitalism stated that charging interest was 'exploitation' of the workers (everything he wrote was one big exploitation, his Communist Manifesto is heavy on that concept) with no inherent purpose. Of course Bohm-Bawerk's time preference explained this concept. If I saved then I have produced more than I have consumed during that time period. I may give this to a bank who I charge interest, as they may wish to make use of these savings. The bank in turn may lend it out to a business at a slightly higher rate as they may have immediate plans to hire more people to expand their business in the current time frame however they do not have sufficient capital to do so. They are therefore paying for this privilege. Time preference also applies to entrepreneurs and labor. Labor was not exploited, again as Marx falsely assumed. Labor gets paid upfront for what it does. I go to work and I don't risk my capital, my time - I get paid for what I produce, regardless of what happens in the market. Entrepreneurs don't. They risk their capital, their time and in the end they may not earn a penny. Again time preference explains this, do you want to get paid upfront for less, or potentially earn more later down the line if you succeed.

So how would interest rates fit in with the above example. Interest rates are set based on peoples time preference. If no one saved and lots of people wished to borrow for the current time frame, then interest rates would go up as a shortage of genuine capital would be evident. Similarly if there were lots of savers and few borrowers, interest rates would fall, deterring saving and spurring consumption or investment. The above is just a supply and demand concept, one that Governments always like to abuse.

Once the above is understood the whole economic crisis becomes quite simple to explain. It was the setting of these prices, outside of the markets control, that caused all sorts of industries to exist that were never sustainable in the long term. It's the reason why unemployment is on the rise, why businesses are failing in mass. Many economists are still blinded by such simplicities. BBC's Robert Preston drones on about regulatory structures, but its akin to a doctor putting a plaster on a cancer patient, its the wrong diagnosis. The free market interest rate article sums up this process:

"This illusion creates waste, because it makes people overestimate the available resources. Ventures that would have been unprofitable if interest rates were not artificially low are now embarked upon, drawing scarce resources away from better uses. According to Friedrich von Hayek and other advocates of the Austrian theory of the business cycle, it is this interference with interest rates and the money supply that causes an unsustainable combination of consumption and investment — a boom that inevitably leads to a bust."

We got into this mess because of low interest rates and expansive monetary policy. So how do we try and navigate out of the current situation? By using exactly the same policies as before. Putting another plaster over the other plaster of the cancer patient. A similar re-run of the seventies, more inflation to try and solve the previous inflation. Recession after recession.

This is of course a great magic act that Governments have. Through the inflationary boom, all the 'robust' growth is down to the Governments policies. During the bust it's suddenly the free markets fault, it peoples 'psychology', speculators and so on, but never the government. Blame the banks if you will, but the majority just play this game knowing the rules, profits in the boom, bailouts in the bust (we could also go into the practice of fractional reserve banking - again governments rules, banks just playing the game).

Bubble China

The most recent example of a Government creating an artificial inflationary boom is China as I write. Rather than causing the economy to readjust painfully due to the lack of Western or Japanese demand for their export products, the government have begun on a program of recklessly expanding the money supply, around 30% per annum. This is causing all sorts of incorrect investments may it be the stock market, real estate or certain sectors. The end game? They can't put off their depression merely buy time and make it much worse when it arrives. China's Banks are now copying the Wests - reckless lending fueled by cheap money and their economy will suffer eventually. The Communist party is scared that the depression would be so bad that its people would begin asking for democratic change like I mentioned in my Building Bridges post. We will have to see when.

As bad as the dollar is, where's the alternative? Governments are all bad, its just some are worse than others. There is nothing good I can see around the world right now. We are in a classic bear stock market rally all over the world at the moment. It doesn't matter what the news is, it just goes up. Japans Nikkei after 1990 rallied on numerous occasions, sometimes rallying as high as 70%, but where did it go? Right back down hitting new lows (its real lows we may have to watch, not the nominal price). The sign of a long term great bear market is the size of the rallies, so in my opinion this is truly a great bear market we are in. Lost decade? Only this time global?

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