The modern-day monetary system

In the current monetary system, central banks are charged with centrally planning interest rates. While they exert direct control only over short term rates (in the US, the federal funds and the discount rate), their actions tend to influence rates across the maturity curve – these days, with so-called 'quantitative easing' (better: debt monetization) having become a policy tool, more direct influence is exerted over longer maturities as well.


A similar policy has been pursued during World War 2 until 1951 as well, during which time the Fed was charged with holding the interest rate on treasury bonds within a certain channel in order to enable war financing and keep the government's debt service costs artificially low (massive inflation was the result, as the Fed's balance sheet grew more than 22-fold during the war period alone.

By 1946, the annual rate of change of CPI reached a lofty 20%). In addition, the Fed controls bank reserve requirements and margin requirements for securities lending. Changes in the regulations governing reserve requirements – in practice, the introduction of so-called 'sweeps' – were a fundamental factor in powering the credit bubble that went into an exponential growth phase from the second half of the 1990's onward.

The method by which the Federal Reserve goes about this planning task is what could in terms of an analogy be described as 'driving by keeping one's eyes firmly fixed on the rear-view mirror'. The FOMC (federal open market committee) board that meets on a regular basis to decide on what the 'correct' interest rate should be, largely considers economic and price data of the recent past to come to its decisions. Officially, the central bank is charged with ensuring both 'price stability' and 'full employment'.

These at times contradictory mandates can not possibly be achieved in practice by influencing short term interest rates, but that didn't keep the mandates from being instituted. We concede that the 'price stability' policy ('price stability' in the view of the central bank is equal to 'a small, but persistent increase in the aggregate price level') can to some extent be pursued successfully, but contrary to the mainstream view, we think it is a thoroughly flawed, in fact an economically extremely dangerous concept, one that has been instrumental in creating some of the greatest economic crises in history, including the Great Depression of the 1930's and the bust of 2008 (which is still ongoing).

In spite of the long and storied history of utter failure that attends attempts at central economic planning, regardless of their particulars (most recently thrown into stark relief once again in countries like Zimbabwe and Venezuela), most economists nowadays appear to regard the central planning of interest rates (and with it, the planning of money supply growth) as a 'given' not worthy of further debate. Instead, what debate there is centers mostly on what supposedly the 'correct' way of this central planning of interest rates and money supply growth should be.

As mentioned in a previous article (in the post scriptum to 'Monetary conditions in the US'), where we linked to some comments Friedrich Hayek made regarding Milton Friedman's views on the topic, the monetarist school is a fairly recent and prominent proponent of this idea of a 'better plan'. It is a kind of 'Keynesianism in drag' if you will. Friedman and his acolytes accept that free market capitalism is the best form of economic organization and that the government should be kept out of the economy as much as is possible, but they stop short of extending the same line of thought to money.

When it comes to money, they also accept central planning as a 'given' and are themselves proposing ideas as to how to improve on the existing planning procedures. At this point, allow us to add a clarification to what we last wrote on the subject. We mentioned that 'money is an economic good subject to the same laws as other economic goods', a comment that may be prone to misunderstanding without further clarification.

Our point was merely that a preexisting, useful economic good would be selected by the market as the money commodity, i.e. as the medium of exchange. As such, the money commodity is of course subject to the laws of supply and demand, similar to other goods. There is however one way in which money is unique, and differs from all other economic goods: an increase in its supply confers no benefit to society at large.

The central planning of interest rates today is largely designed to keep interest rates as low as possible without materially increasing 'inflation expectations'. The idea that interest rates should be kept artificially low stems from the Keynesian notion that the scarcity of capital can somehow be 'commanded' to disappear by means of monetary policy. As Roger Garrison puts it in his article 'Keynes was a Keynesian' (quoting from Keynes' The General Theory of Employment, Interest, and Money):


“The inherent uncertainty of the future, in his view, gave centralized decision making a clear advantage over the decentralization that characterizes market economies. Keynes advocated the "socialization of investment" and the "euthanasia of the rentier." The rate of interest, which "rewards no genuine sacrifice," could and should be driven to zero, at which point capital would cease to be scarce and the distribution of income would be more equitable. In a matter of two generations, the economic problem of scarcity can be solved, such that our grandchildren can occupy themselves with questions of aesthetics rather than questions of economics.”


Unfortunately the central bank can only print 'money', it can not print capital. Thus this Utopian idea is fated to fail, and it is rather shocking that this nonsense informs both economic policy and a large part of economic theorizing to this day.


What is interest?

Some people and cultures regard interest rates as somehow 'evil' and even forbid the charging of interest rates on loans (for instance, banks in the Islamic world have to go through all sorts of contortions so as to be able to lend money at interest; according to sharia law, they are simply not allowed to charge interest on their lending). What is interest, and how does it come about? Most people are aware that interest is the rate at which the present value of future goods is discounted, but there is a key point that needs to be understood.

The originary, or 'natural' rate of interest is an expression of the time preferences of individual actors in the economy – it is nothing else. In other words, the originary interest rate expresses to what extent people are prepared to forgo consumption (or as Mises puts it, satisfaction of wants) in the present as against consumption in the future. A present good will always be more valuable than a future good – the apple I can eat right now is worth more to me than the promise of an apple that I can consume a year from now. The discounting of this difference in evaluation between the present and the future good is expressed as the interest rate.

It follows from this that a natural interest rate exists whether forbidden by religious (or other) edicts or not. The fact that individuals regard present goods as more valuable than future goods is an a priori economic law that can not be repealed by edict – one might as well attempt to repeal the law of gravity.

In a free market, the interest charged in the loanable funds market would consist of this natural rate as implied by the mutual time preferences of individual actors in the economy, plus, on a case by case basis, a risk premium (depending on things like the perceived creditworthiness of a putative borrower). The natural interest rate – this is to say the ratio of the value assigned to a good in the remote future vs. the value of a good in the immediate future or present – is solely determined by time preferences. Thus, as Ludwig von Mises explains in chapter 19/2 of Human Action (The rate of Interest):


“ Originary interest is not a price determined on the market by the interplay of the demand for and the supply of capital or capital goods. Its height does not depend on the extent of this demand and supply. It is rather the rate of originary interest that determines both the demand for and the supply of capital and capital goods. It determines how much of the available supply of goods is to be devoted to consumption in the immediate future and how much to provision for remoter periods of the future. People do not save and accumulate capital because there is interest. Interest is neither the impetus to saving nor the reward or the compensation granted for abstaining from immediate consumption. It is the ratio in the mutual valuation of present goods as against future goods. The loan market does not determine the rate of interest. It adjusts the rate of interest on loans to the rate of originary interest as manifested in the discount of future goods. Originary interest is a category of human action. It is operative in any valuation of external things and can never disappear.”


The effect of interest on investment and production

Due to the nature of interest, the natural free market interest rate conveys important information to entrepreneurs. As Ludwig von Mises stresses, it is solely time preference which determines the natural interest rate – however, once it is determined, a chain of effects and feedback loops comes into play. The purpose of productive saving (there are essentially two types of saving: productive saving and saving for provision, whereby the latter is engaged in to insure against an uncertain future) is to enable more consumption in the future, by providing the funding for investment in additional production processes. In essence, the amount of available savings is the decisive factor allowing entrepreneurs to determine the extent to which the production structure can be lengthened, and thus be made more productive.

Entrepreneurs are in the position of a master builder who has to determine what kind of building he can erect by means of the totality of building materials and other factors needed in its construction that are available to him. The more the production structure is lengthened, the more productive it will become (this is to say, the more goods will be produced with the same factor inputs), but at the same time, this means that the production process will become more time consuming.

This factor of time is very important, since the production activities must be funded – unless the pool of real funding – this is to say the pool of unconsumed, saved production – is large enough to allow for a lengthening of the production structure, it simply can not be done.

A low natural interest rate in essence balances production and consumption in a new way – longer production processes become profitable, as funding for them has now become available and as a result more consumption will be possible in a more remote future. It is important to remember here that it is not simply 'more money' that enables these investments in additional production processes – to help envisage this, consider that for instance the workers engaged in building a new mine need to be fed, housed, clothed and so forth, until the mine's output is effectively produced and can be sold. They can not eat money, they need to eat real food.

Unless this food has been produced and saved, they can not be fed. Similarly, the various materials and capital goods needed to build the mine (steel girders, timber, bulldozers, drills, and so forth…) need to be produced beforehand and exist in physical form.

The more savings there are, the more it becomes thus possible to invest in processes that are increasingly remote from the final goods produced for consumption. It follows from this that if an agency like a central bank artificially lowers interest rates, investments will be undertaken under the erroneous assumption that consumer time preferences are lower than they really are. Entrepreneurs will be bound to misjudge the amount of savings and resources actually available to complete their investments in temporally more remote parts of the capital structure.

However, by setting these investments in motion, an artificial lowering of interest rates will induce an economic boom. The boom is an illusion of prosperity, brought on by the misdirection and consumption of scarce capital. As Ludwig von Mises explains in chapter 20/5 of Human Action (Interest, credit expansion and the trade cycle):


“A lowering of the gross market rate of interest as brought about by credit expansion always has the effect of making some projects appear profitable which did not appear so before.… It necessarily brings about a structure of investment and production activities which is at variance with the real supply of capital goods and must finally collapse. That sometimes the price changes involved are laid against a background of a general tendency toward a rise in purchasing power and do not convert this tendency into its manifest opposite but only into something which may by and large be called price stability, modifies merely some accessories of the process. However conditions may be, it is certain that no manipulations of the banks can provide the economic system with capital goods. What is needed for a sound expansion of production is additional capital goods, not money or fiduciary media. The boom is built on the sands of banknotes and deposits. It must collapse. The breakdown appears as soon as the banks become frightened by the accelerated pace of the boom and begin to abstain from further expansion of credit. The boom could continue only as long as the banks were ready to grant freely all those credits which business needed for the execution of its excessive projects, utterly disagreeing with the real state of the supply of factors of production and the valuations of the consumers. These illusory plans, suggested by the falsification of business calculation as brought about by the cheap money policy, can be pushed forward only if new credits can be obtained at gross market rates which are artificially lowered below the height they would reach at an unhampered loan market. It is this margin that gives them the deceptive appearance of profitability. The change in the banks' conduct does not create the crisis. It merely makes visible the havoc spread by the faults which business has committed in the boom period.”


We can deduce from this that contrary to Ben Bernanke's assertion that the Fed was 'not responsible for the housing bubble' (a declaration based on his finding that not every historical instance of the Fed holding interest rates artificially low has led to a housing bubble – a finding that ignores the fact that in these past instances booms have simply been centered on other sectors of the economy) and by implication, can be held neither responsible for the boom nor the bust, it is in reality very much the agency behind these developments.

If not for the Fed's enforcement of a too low 'target rate', adding to bank reserves by means of printing money from thin air every time the rate threatened to rise above this target and thereby backstopping a massive increase in the supply of money and credit, the malinvestment characterizing the boom would not have occurred. There is no way for a central planning agency like the Fed to determine what the natural interest is, and what therefore the optimal 'administered rate' should be, or what the optimal size of the money supply for the economy should be.

It faces the same problem that every other central economic planning agency faces: it can not amalgamate the widely dispersed information from myriad individual actors in the economy – it can not 'outguess' their time preferences and provide a rate of interest that is 'better' for the economy than that suggested by time preferences. It does not matter whether the monetary bureaucracy is well-intentioned or merely acts as an instrument for enacting the 'invisible inflation tax' to the government's benefit.

The result of its planning decisions will always be a distortion of market signals leading investors and entrepreneurs astray, and thereby creating the boom-bust cycle. In essence, what the central bank attempts to do is to circumvent ironclad economic laws – it embodies the Utopian Keynesian idea that the scarcity of capital can be suspended by bureaucratic fiat.

It is high time that economists once again debate the fundamental issue of money, and the problem posed by its administration by a central planning agency that can 'print' unlimited amounts of it. The production and distribution of money should be left to the free market – it is the only way to ensure that the boom-bust phenomenon ceases to bedevil the economy. The debate is all the more urgent given the fact that in reaction to the current economic bust the Fed has once again resorted to driving interest rates down – this time all the way to zero – and 'monetizing' large quantities of debt.




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2 Responses to “Interest Rates, Investment and Production – why central planning of interest rates doesn’t work”

  • guidoamm:

    Good to have you back Pater,

    “[…] in practice, the introduction of so-called ‘sweeps’ – were a fundamental factor in powering the credit bubble that went into an exponential growth phase from the second half of the 1990’s onward.”

    Is it not correct to say that by deliberately (arbitrarily and unilaterally) opting for a fiat monetary system, the state implicitly reserves the right to push inflation faster than underlying economic growth. Thus, inflation is a deliberate policy of state and the conditio sine qua non of the existence of the monetary system thus the state.

    Given that inflation is exponential in character, if the above is true, then it follows that enshrined in the fiat logic the state progressively and necessarily becomes the largest actor in the economy.

    If you agree with the above, then would it be correct to say that state action, blatantly illegal as it is, is par for the course thus expected in our economic/political context.

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