Manipulating Interest Rates Does Not Solve Problems in the Economy

The interest rate is the price of money, manipulated by the central bank (Bank of England) and government in the short and long term to create distortions in production and human decision-making. Thus reversing millennia of progress, writes Mises Institute member Connor O’Keeffe.

The following is an opinion piece by Connor O’Keeffe that appeared on the website of the Mises Institute:

“The US Labor Department reported in early August that the unemployment rate jumped to 4.3 percent in July. The rate of growth in the unemployment rate is one that tends to occur just before a recession – an indicator known as Sahm’s rule. Sahm’s rule caused panic in the stock markets, which gained momentum as the days passed as economic data from East Asia was also poor.

Many pro-government economists and politicians say the rising unemployment rate and the accompanying fear on Wall Street do not signal a recession. However, there are also those who are clearly worried.

Senator Elizabeth Warren used the labor market data as a reason why the Federal Reserve should start cutting interest rates immediately.

“Federal Reserve Chairman Jerome Powell risks driving the US economy into a ditch,” Warren said. “He should cut his summer vacation short and cut interest immediately.”

Paul Krugman has said the same thing. In early August, he said the Fed’s reluctance to cut interest rates was already a “big mistake” and that the central bank must cut interest rates immediately to prevent a recession.

Both of them expressed themselves in such a way that it might be too late to cut interest rates. At the same time, they think the Federal Reserve can prevent a recession. Our monetary politicians should understand that if we follow Krugman and Warren and lower interest rates by half a percent, the good times will continue.

The Proposals are Not in Line with Reality

Of course, this is not in line with reality. If we want to escape the debilitating boom-bust cycles, we don’t need higher or lower interest rates. We need accurate rates.

Interest rates are prices

And as with any other price, it is formed based on people’s preferences. In the case of interest, this is a time preference. Every person prefers satisfaction now rather than the same satisfaction in the future. Whereas it is the basis of all approaches to human behaviour. How much we value the satisfaction of the present moment also depends a lot on the individual.

For some – especially children – preference for instant gratification is a higher priority. Even if the satisfaction to be obtained is considerably greater in the future. These people have a high time preference. When we become adults, we usually realize that withholding consumption allows us to increase satisfaction in the future through the creation of products and services. Those who constantly postpone instant gratification have a low time preference.

A similar evolution takes place at the level of civilisation. In his book A Short History of Man, Hans-Hermann Hoppe wrote that early humans lived a nomadic (continuously nomadic) life because they were forced to move to new areas when food and other resources ran out. The development of tools and hunting methods allowed human culture to develop, but their time preference was still high by today’s standards.

The Neolithic Revolution

The time preference remained essentially constant until the Neolithic Revolution, which took place 11,500 years ago. People then began to realise that growing crops and herding animals made it possible to produce more food.. The consolidation of these practices also brought with it private property and a homogenous family functioning as one unit. After a while, a situation arose where people began to do things that were not related to food – be it metalwork, architecture or philosophy.

With the increase in production, it was possible to more and more cover the immediate basic needs of people, which made it possible to invest more resources in production. This in turn made it possible to consume more in the future. Economies grew, civilizations developed, and time preference declined.

The next major acceleration occurred in the early 1800s with the Industrial Revolution

Developments in the energy sector made production significantly more efficient. The result is the developed world we live in today. It is important to understand that the decline of time preference was not a symptom of the development of human civilisation, but one of the main underlying reasons for the emergence of civilisation.

Interest rates are the prices that derive most from society’s time preference. It is a reward to be paid for the present use of future money. Essentially throughout human history, interest rates have very well reflected the decline in time preference. That is until the moment when governments started artificially manipulating interest rates.

The Price of Money Began to be Controlled

Central banking and the politicisation of money created a situation where interest rates have started to be controlled through the supply of money and credit on the credit market. An increase in loan money pushes down interest rates (the price of money) and vice versa.

First, artificially low interest rates send a message to producers that more resources are available for production than actually exist, which in turn creates boom-bust cycles. In addition, it motivates people to consume more than they would otherwise, because saving and investing are no longer as profitable due to low interest rates.

This means that the artificial control of interest rates reverses more than 10,000 years of progress in which people learned to act with foresight and based production on value creation, not short-term gratification. Artificially low interest rates imposed by the government lead to overconsumption and economic chaos. This is exactly the policy that Krugman and Warren want to see again.

If our economy is ever to recover, interest rates must begin to reflect people’s real time preferences. As with other market prices, interest rates cannot be stable in the market because reality is not always stable. If we want the constant economic depression and mass consumption to end, we need to stop listening to the people who benefit from the current system. We must return to the fair interest rates that have for thousands of years juggled and coordinated production for a better future.”