Saturday, 8 October 2016

Are interest rates artificially low?

Summary.    Contrary to popular perception, rates are not artificially low because of central banks’ low interest rate policies of recent years. The reality is that rates were artificially BOOSTED by central banks in the years prior to the crisis. On the other hand there are other factors which interfere with the free market rate of interest and the net effect of all those factors is near impossible to determine. The other factors are fractional reserve banking, which artificially reduces the rate, and government borrowing which artificially raises interest rates in all probability.


When a big change occurs, it’s normal to assume there must be something odd or artificial about the new order, i.e. that the old order represented the NATURAL state of affairs. Thus people tend to assume there must be something ARTIFICIAL about the low interest rates of recent years. I.e. it’s commonly assumed, that the free market rate of interest must be above its current level.

Prof Stephanie Kelton (a leading MMTer) hinted at the flaw in that idea in these tweets recently.

So in what scenario would a genuine free market rate of interest obtain? Let’s answer that by starting with the simplest possible economy, and then add the complexities of the real world. (Incidentally I’m not suggesting Kelton would necessarily agree with the paragraphs below)

Assume the following:

1. A barter economy where the people democratically vote to create a form of money with a view to circumventing the inefficiencies of barter.

2. The new form of money will be issued by a newly formed “central bank” (CB).

3. Initially the only form of money is CB issued money (i.e. base money). That is, money creation by private banks is not allowed: in fact there ARE NO private banks – everyone just has an account at the CB (an innovation that CBs are actively considering right now, as it happens). As to whether the base money takes the form of some rare metal like gold or comes in fiat form doesn’t matter.

4. As to lending and borrowing, that takes place direct person to person (or person to firm etc) rather than via commercial banks.

5. There is no government borrowing.

Now what’s the optimum amount of money to issue? Well the larger each person’s stock of money, the more they’ll tend to spend all else equal. So as the stock of money rises, demand rises. And it will rise to the point where inflation becomes excessive. So the optimum amount of money to issue is the amount that induces the population to spend at a rate that maximises employment while keeping inflation at acceptable levels (NAIRU if you like).

As to the rate of interest, obviously that will settle down to some genuine free market level as long as the CB does not deliberately interfere with it – or in the words of Kelton, as long as the CB does not offer interest on reserves (IOR). (Reserves are not held by INDIVIDUAL PEOPLE in the real world of course, but in our hypothetical economy, since individual people have accounts at the CB, that money amounts to reserves.)

Notice that demand is regulated in our economy by a mix of fiscal and monetary means: i.e. given inadequate demand, government just creates more base money and spends it into the economy (and/or cuts taxes). That spending falls into the “fiscal” category, while the resulting rise in the stock of money falls into the “monetary” category. That is, demand is not regulated by adjusting interest rates.

How about interest rate adjustments?

But suppose it was decided that adjusting interest rates was a good idea, how would government and CB do it? Well the only way of artificially cutting rates would be for the CB to offer cut price loans to all and sundry. But that would involve the CB engaging in COMMERCE, i.e. that would involve exposing the CB to the possibility of losing money. And that in all probability wouldn’t be acceptable in the hypothetical economy just as it is regarded with suspicion in the real world.

So an alternative would be for government to spend an EXCESSIVE amount of money into the economy, and then, with a view to damping down demand, artificially raise interest rates by offering interest on reserves. Alternatively government could borrow by issuing bonds. But that would quite clearly result in an artificially high rate of interest.

Having issued that excess stock of money, the CB is then in a position to adjust interest rates by for example altering interest on reserves.

And that, lo and behold, is what happens in the real world, as intimated in Stephanie Kelton’s tweets.

To summarise, if demand is going to be adjusted by altering interest rates, interest rates have to be maintained at an above free market level – at least in our simple hypothetical economy. So the next question is: does that also apply to the real world once we’ve added the complexities of the real world?

Government borrows.

With a view to making our economy more realistic, let’s now assume that government borrows so as to fund infrastructure investments etc rather than to artificially raise interest rates.

Does that infrastructure borrowing artificially raise rates? Well it’s hard to say because it’s not clear whether government ought to borrow for that purpose or not.

Certainly the conventional wisdom is that the latter borrowing is justified. On the other hand Milton Friedman advocated a zero government borrowing regime as does Warren Mosler. I also set out several of the flaws in the latter conventional idea here.

(For Friedman, see his American Economic Review paper "A monetary and fiscal framework…”, para starting “Under the proposal…”. For Mosler, see his Huffington article “Proposals for the banking system”, 2nd last paragraph.)

At any rate, if infrastructure borrowing is NOT JUSTIFIED then by definition, the effect of government borrowing will be to artificially raise interest rates.

Alternatively, if such borrow IS JUSTIFIED, then the effect of government borrowing will be to artificially raise interest rates.

Fractional reserve banking.

Having said that in the hypothetical economy private banks are not allowed, what happens if they ARE allowed? Well fractional reserve banking tends to reduce interest rates and for reasons set out by Joseph Huber in his work “Creating New Money”. See passage starting “Allowing banks to create new money…”


In order to use interest rates to adjust demand, interest rates first have to be artificially raised, which is a flaw in the whole interest rate adjusting idea. However there are other factors which interfere or may interfere with the rate of interest, in particular fractional reserve banking and government borrowing. As to what the overall or net effect of all those factors is, well that’s hard to say.

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