The Importance of the Interest Rate

The director of LvMIC asked me to write this:

Due to a request on my post regarding the recent lawsuit aimed at the Bank of Canada, I feel it’s necessary to speak on why a market dictated interest rate is necessary not only to inform market participants of relevant information but also as a shield against the boom bust cycle.

Admittedly, there are many definitions of “interest rate” out there.  The great Austrian economist Henry Hazlitt defined the interest rate as “merely the special name for the price of loaned capital.  It is a price like any other.”  Hazlitt goes on to explain why keeping the interest rate below its market-determined level necessarily creates market distortions.  After all, one look at government mandated price controls, such as that presently occurring in Greece’s pharmaceutical industry, makes it perfectly clear how intervention into the free flow of market transactions causes unintended consequences such as shortages.

The interest rate, which varies per transaction in a dynamic, unhampered market, is simply the price of present consumption paid by borrowers.  Murray Rothbard called this price a “premium” and that “since people always prefer money right now to the prospect of getting the same amount of money some time in the future, the present good always commands a premium in the market over the future.”  Such is determined solely by individual time preference; a hallmark of the Austrian school.

John Maynard Keynes on the other hand determined that interest rates were determined by individual “liquidity preference.”  In the General Theory, Keynes writes:

Thus the rate of interest at any time, being the reward for those parting with liquidity, is a measure of the unwillingness of those who posses money to part with their liquid control over it.

To this author, Keynes “liquidity preference” theory is just another way to describe time preference.  After all, when someone demands more liquidity, they demand it for the sake of consumption presently since money is ultimately employed as a unit of exchange.  If my liquidity preference is low, I am spending money and thus my time preference is high.  As Henry Hazlitt shows however, the liquidity preference theory itself is wrong from a practical sense because:

If Keynes’s theory were right, then short term interest rates would be highest precisely at the bottom of a depression, because they would have to be especially high then to overcome the individual’s reluctance to part with cash- to “reward” him for “parting with liquidity.” But it is precisely in a depression, when everything is dragging to the bottom, that short term interest rates are lowest.  And if Keynes’s liquidity preference were right, short-term interest rates would be lowest in a recovery and at the peak of a boom, because confidence would be highest then, everybody would be wishing to invest in “things” rather than in money, and liquidity or cash preference would be so low that only a very small “reward” would be necessary to overcome it. But it is precisely in a recovery at at the peak that short term interest rates are highest.

For a demonstration of what Hazlitt is speaking to, see short term interest rates in the U.S. over the past decade.  Make note that the housing bubble popped middle of 2006-early 2007 and the crisis really kicked in late 2008:

So how does all this determine the importance of interest rates?  In a free market, when the time preference of a majority of people fall, they save, add to their cash balances, and add to the supply of loanable funds when they deposit their money in a bank.  As this supply increases, the price of borrowing money drops as it does for any other commodity.  This lowers the rate of interest charged for borrowers.  At the same time, when people decide to save, they withhold present consumption.  This allows more resources, namely capital goods, to be devoted to longer term production which is also incentivized when the interest rate falls.

Such is the dynamics of an unhampered market.  When a central bank intervenes in this process and artificially lowers interest rates not in correspondence to a collective lowering of time preferences, longer term production is sought at the same time consumption patters haven’t changed.  This is unsustainable and will inevitably end in a bust. This is the crux of the Austrian Business Cycle Theory developed by Ludwig von Mises in his seminal Theory of Money and Credit.  For a detailed explanation, see Roger Garrison.

To believe that central bankers are capable of determining the correct interest rate for millions of individuals puts an extreme faith in their knowledge capabilities.  The artificial lowering of the interest rate not only causes an inflationary boom, but creates asset bubbles as the new money enters certain sectors of the economy instead of dispersing perfectly over the whole.  The solution to the central banking problem is not to change its leadership or authority but straight out abolishment.  A return to a free market in money and interest rates is the only means to achieve sustainable economic growth.  The interest rate is far too important of a price signal to be left in the control of the few.