Southern Bread

This is a rhetorical question that Bob Murphy recently asked during one of his lectures at this year’s Mises University. He was posing it rhetorically, since the answer is that it’s a completely fake number. Setting interest rates to zero is absurd precisely because it would never arise naturally from the market. It’s a meaningless number. But, in order to understand this, we need to go over what interest rates really are. Let’s get into it.

At it’s core, interest is the cost of renting money. Since money acts conjointly as a medium of exchange and as a commodity, we rent capital(i.e. money for investment or spending) in the same way we rent any other good or service. If you rent a car, you expect to pay it’s owner a fee for it’s use. In the same way, if you rent money by taking a loan, you will pay an interest charge to the money’s owner. This may seem straightforward, but in the past, this practice has been challenged on a regular basis. Especially by those in the church. They called the practice of charging interest on loans “usury,” and it was hotly debated.

But, if interest is just the cost of renting money, then how is the interest rate determined. Is it just a random figure? No, it arises as a market price, the same way the price of any other good is determined. If there are five lenders on the street and 2 of them lower their rates, the other three will have to follow suit or lose business. Likewise, if the current market conditions become very risky, lenders will raise their rates to cover the new risk. Those that don’t risk serious defaults on their loans. This is the same way that any other price is determined. But, there is another factor about interest rates that is often overlooked by non-austrians, and that’s the effect of “time preference.”

Time preference is the idea that people almost always prefer having a good now to having a good later. The strength of this preference per individual is said to either be high or low. A person with a high time preference is somebody that strongly wants a certain good right now. Conversely, someone with a low time preference is less concerned with the immediate acquisition of a good. Time preference is a major influence on interest rates since a low time preference would drive rates down in order to entice borrowers. Likewise, a high time preference will raise rates since more pressure is being placed on the supply of lendable funds.

So, with those ideas in place, we can now look at the Fed and it’s manipulation of interest rates for what it really is: price controls. Just like Nixon putting price controls on things like meat, having a central bank “set” the interest rate to a certain level is a price control on the loan market. And we all know what happens when price controls are enforced. First, market players will come up with loopholes to get around the price controls. We saw this en’ masse during the housing boom with the popularity of so-called “exotic” financial instruments. And secondly, when price controls are applied to a sector of the economy, you always see a “black market” pop up. Again, we see this right now with the derivatives market. All the politicians are screaming about how bad the derivatives market is since it’s unregulated. It’s a black market. Which is to say, it’s the real market trying to work.

And, hopefully, now you can see pretty easily why the Fed setting the interest rate to 0% is so hazardous. The Fed’s rate setting places an artificial cap on the market price of borrowing money. It’s equivalent to passing a price control law that sets the wholesale cost of beef to zero. That means that the local grocery store would be getting it’s beef stock for free and selling it at 100% profit for an artificially low price. Of course, this would never work with beef since producers wouldn’t raise cattle for free, but it does work with banking since the central bank is creating money out of thin air at zero cost. Obviously, the ramifications of this type of price control are bad.

Given our beef scenario, what do you think will happen if all of the sudden steaks were .10 cents per pound? That’s right, people would be buying beef like mad. In the same way, artificially low interest rates entice people to borrow money when they otherwise wouldn’t in a free market. Just like increasing the price for any other good is a check on the overconsumption of that good, increases in the market interest rate are a check on the overconsumption of borrowed money. As more and more people are borrowing money, the interest rate would naturally rise and detract more borrowers. But, when the central bank sets the rate at some arbitrary amount, it negates this natural market check and balance system and creates the boom and bust cycle.

We can’t know what exact effect a zero percent interest rate will have in the short term(although Japan offers up some decent examples), but in the long term the effect is clear. There will be another huge boom. Let’s just hope it isn’t the so-called crackup boom. We’ll talk about that next time.