Let’s look more closely at the role of interest rates

Money is one of many forms in which wealth may be held, but money and wealth are not synonymous. Wealth is the accumulation of savings. Savings, in a business, are what is left after meeting all its direct and indirect costs, depreciation, distributions to the factors of production (rent, wages, interest on loans and dividends to shareholders) and taxation.

The entrepreneur must now choose what to do with those savings. He may choose to “plough them back” in the business, by, say, incurring the cost of creating new product lines, or acquiring another business – the possibilities are endless.  Or he may simply choose to lend his savings in return for interest.

But at what rate of interest? Determination of interest rates is a behavioural phenomenon, depending on the borrower’s and lender’s respective time preferences for money.

Interest rates therefore arise out of our very nature as human beings.

 

People will generally prefer to have desires 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, with £10,000 repayable in 10 years’ time. Interest of £2,000 is therefore “implied in the logic of human action.”

The “time preference” of the borrower manifests itself in the interest rate. The greater the time preference (the more urgently the borrower needs the money) the higher the rate applicable. It is therefore the natural law of human interaction, via the market, that determines the interest charge – not a central bank!

Central banks’ attempts to annihilate interest are therefore a huge economic error. Credit markets have the crucial function of channeling resources from savers to investors, establishing equilibrium between them and enabling both to contribute to wealth creation in the community.

Since the last financial bust in 2008 governments all over the world, via their central banks, have forced interest rates lower and lower. The idea of freedom from the bondage of having to pay interest is, of course, sheer nonsense – a fool’s paradise. Indeed, it is amazing how long central bankers can drag out the agony: an “official bank rate” of, say, 2%, may be dropped to 1.5%, then 0.5% (where it got stuck for years in the UK) only to be followed by 0.25%!

But why stop there? The Bank of Japan even ventured into negative territory, charging depositors for the service of “looking after your money”. If you have £1,000 you can deposit it with a Japanese bank and it will promise to give you £950 in a year’s time, a practice that turns the rules of borrowing and lending upside down. No wonder the sale of domestic safes is now a booming business in Japan!

 

Yet none of this Keynesian demand-stoking has ever been effective

 

Yet none of this Keynesian demand-stoking has ever been effective beyond the expediency of short-term crisis management – when the crisis itself is a result of the very policies now being touted as a cure! Feeding demand achieves nothing on its own.

There can never be a shortage of demand if there are people. While that is a statement of the obvious, production is not obvious. It requires human endeavour; it must be created.

After all, if stimulating demand could magically generate the production needed to satisfy it, Venezuela, Zimbabwe and the Democratic Republic of the Congo would be among the most prosperous countries on earth!

[Let’s be clear: the contrived suppression of interest rates is unsustainable and cannot last indefinitely. Investors, savers and pension fund managers have been giving vent to their frustration with the central bank’s idiotic interest rate suppression, and they no longer swallow the Chancellor’s putative rationale. He has been compelled by public pressure to ease rates at last, in an upward direction.

When interest rates are suppressed businesses like Carillion are tempted to initiate long-term investment projects “on the cheap”. Since these projects cannot be subjected to normal economic criteria for testing their viability, they will never turn a profit, and will eventually have to be abandoned. This is the very essence of malinvestment, causing destruction of capital that can never be recovered. Meanwhile real satisfactions go unmet. But people don’t know about it for the very reason that an unmet satisfaction is not seen!]

 

Did these people imagine that free credit would last?

 

The fatalities are evident everywhere, with new ones added every week. Multiyork, Maplin, Palmer & Harvey, Carpetright, Toys-R-Us, and Mothercare have gone, and there are threats of wholesale closure of stores and branches owned by M & S, Tesco, House of Fraser, Waitrose (part of John Lewis), Prezzo, and many others, that are being forced to face the rising cost of servicing debts racked up when money was so cheap. Did these people imagine that free credit would last?
© Emile Woolf May 2018 (website)