Who Should Set Interest Rates?

Column 2019-6 (2/11/19) 

I have debated with myself about writing this column. It covers an important point that is generally ignored. My concern is, Will it put everyone to sleep? If it does, perhaps you should clip it out and put it in your medicine cabinet.

In free markets buyers and sellers interact to determine prices. When there is a surplus of hammers the price decreases. Producers make fewer hammers. Because of the lower price buyers purchase more hammers. The price moves toward the point where supply will equal demand. That “perfect price” is a moving target, not a fixed number. Nevertheless, supply and demand stay close to being balanced most of the time.

If government imposes price controls, shortages and surpluses are inevitable. Producers will only make things they can sell at a profit. Price controls caused the natural gas shortage during the 1960s and 1970s. The price was set so low that drillers stopped drilling. The waiting lines at gas stations in the 1970s were also caused by price controls. Gasoline prices could not rise to where supply equaled demand.

Half of most sales is money. Even if the buyer doesn’t pay with money, the prices are usually expressed in units of money. In the US most prices are expressed in US dollars. How can we have free markets when the quantity of money and the rental price (interest rate) are determined by the government?

Government doesn't set interest rates. The Federal Reserve (Fed) increases or decreases the amount of money until lenders and borrowers agree on the rate the Fed wants. It is like determining the price of hammers by manipulating the supply of hammers.

Almost all economists recognize that price controls for goods and services create shortages and surpluses which can cause serious problems. At the same time most economists accept and encourage price controls on the rental price for money.

Government can’t create hammers, natural gas, and gasoline out of thin air. So, when the shortages occur people are left on their own to deal with the problems as best they can. The Fed and fractional reserve banks can create an unlimited amount of money out of thin air. Thus, even with artificially low interest rates borrowers can still find money to borrow.

So, what is the problem? The problems occur when the borrowers start spending the new money. The supply of things to buy didn’t increase when the money supply increased. Prices rise, soon, even with the new money the borrowers can’t afford to buy. They cancel their buying plans that were based on more money and the same old prices.

The shock waves disrupt the entire economy. The recession that follows is the price we pay for government’s manipulation of the rental price of money.

If the money supply wasn't manipulated by government, only savers could lend. The saver would transfer his right to his savings to the borrower. The borrower spends the money the lender didn’t. The money supply remains unchanged. Borrowing has minimal affect on prices.

Interest rates will endlessly seek the point where the demand for loans equals the savings offered for borrowing. If borrowers want to borrow more they will have to offer to pay higher interest. This offer will encourage more savings.

No one will have to worry about finding the right interest rate. Interest rates will be determined by lenders and borrowers interacting in the marketplace. This will eliminate the problem of artificially low interest rates over heating the economy which then crashes into a recession.

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Copyright 2019

Albert D. McCallum