For most experts the central bank determines short-term interest rates by setting the target to the benchmark policy rate such as the federal funds rate in the US. Many economists are of the view that through the manipulation of short-term interest rates, the central bank by means of expectations regarding future interest rate policy can also dictate the direction of long-term interest rates. By this way of thinking, expectations regarding future short-term interest rates are instrumental in setting the long-term rates (and long-term rates are an average of short-term rates).
Given this supposedly almost absolute control over interest rates, the central bank through its manipulations of short-term interest rates can navigate the economy along the growth path of economic prosperity. Or so it is held. (In fact, this is the mandate given to many central banks, including the Fed).
But we must ask ourselves: does it makes sense to hold that the central bank is so key in the determination of interest rates?
Individuals’ Time Preferences and Interest Rates
According to great economic thinkers such as Carl Menger and Ludwig von Mises, interest is the outcome of the fact that every individual assigns a greater importance to goods and services in the present against identical goods in the future.
The higher valuation is not the result of capricious behaviour. It is due to the fact that life in the future is not possible without sustaining it first in the present. According to Carl Menger,
Human life is a process in which the course of future development is always influenced by previous development. It is a process that cannot be continued once it has been interrupted, and that cannot be completely rehabilitated once it has become seriously disordered. A necessary prerequisite of our provision for the maintenance of our lives and for our development in future periods is a concern for the preceding periods of our lives. Setting aside the irregularities of economic activity, we can conclude that economizing men generally endeavor to ensure the satisfaction of needs of the immediate future first, and that only after this has been done, do they attempt to ensure the satisfaction of needs of more distant periods, in accordance with their remoteness in time.1
Hence, various goods and services that are required to sustain man’s life at present must be of a greater importance to him than the same goods and services in the future. On this Menger wrote,
To the extent that the maintenance of our lives depends on the satisfaction of our needs, guaranteeing the satisfaction of earlier needs must necessarily precede attention to later ones. And even where not our lives but merely our continuing well-being (above all our health) is dependent on command of a quantity of goods, the attainment of well-being in a nearer period is, as a rule, a prerequisite of well-being in a later period. Command of the means for the maintenance of our well-being at some distant time avails us little if poverty and distress have already undermined our health or stunted our development in an earlier period. 2
Similarly, Mises wrote that,
He who wants to live to see the later day, must first of all care for the preservation of his life in the intermediate period. Survival and appeasement of vital needs are thus requirements for the satisfaction of any wants in the remoter future.
Life sustenance therefore serves as the standard of valuation regarding present goods versus future goods. According to Mises,
If he (the consumer) were not to prefer satisfaction in a nearer period of the future to that in a remoter period, he would never consume and so satisfy wants. He would always accumulate, he would never consume and enjoy. He would not consume today, but he would not consume tomorrow either, as the tomorrow would confront him with the same alternative.
As long as the means at an individual’s disposal are barely sufficient to accommodate his immediate needs, he will most likely assign less importance for future goals. Only with the expansion of his pool of means would the individual be in a position to allocate some of these means towards the accomplishments of various ends in the future.
What We Need Now In Order to Think About the Future
As a rule, with the expansion of the pool of means, people tend to allocate more means towards the accomplishment of remote goals in order to improve their quality of life over time. With scarce means, an individual can only consider very short-term goals, such as making a primitive tool. The meager size of his means does not permit him to undertake the making of more advanced tools. With the increase in the means at his disposal, he could consider undertaking the construction of better tools.
No individual undertakes an outcome which promises a zero return. The maintenance of the process of life over and above hand to mouth existence requires an expansion in wealth. The wealth expansion implies positive returns. It is through the generation of wealth, after allowing for the maintenance of life and wellbeing in the present, that savings become possible.
These savings in turn permit further expansions in wealth. The expansion in the pool of real wealth permits a greater allocation of savings towards longer-term goals, implying a greater preference for future goods i.e. a lowering of interest rates.
While prior to the expansion of real wealth the need to sustain life and wellbeing in the present made it impossible to embark on various long term projects, with more wealth this has become viable. The extra wealth that becomes available is invested because the expected future benefits outweigh the benefits of consuming them in the present.
Does the Lowering of Interest Permit Greater Capital Formation?
Being the outcome of the fact that life sustenance imposes a greater importance to present goods versus future goods, interest as such does not cause more or less investment, as popular theories have it.
It is true that businessmen react to interest rates. In this sense, the interest rate can be regarded as an indicator. What permits an expansion of capital goods production is not interest rates as such but the increase in the pool of real savings. A greater allocation of real saved wealth towards the buildup of capital goods – manifested by the lowering of people’s time preferences – will result in the lowering of interest rates. (Note again what enables the expansion of capital goods investments is the greater allocation of real saved wealth and not the lowering of interest rate as such, which just reflects the greater allocation of real wealth towards the capital investment).
When interest rates are not tampered with, they serve as an important tool in facilitating the flow of real savings towards the build-up of wealth-generating infrastructure. As a rule a major factor for the discrepancy between observed interest rates and the interest rate that reflects people’s time preferences are the actions of the central bank. For instance, aggressive loose monetary policy by the central banks leads to a very low observed interest rate. The aggressive monetary pumping however also undermines the real wealth formation process and works towards the increase in peoples time preferences i.e. to the increase in the underlying interest rate.
As the emerging positive gap between the time preference interest rate, which is not observed, and the observed interest rate widens, this ultimately leads to an economic bust. Whenever the central bank tampers with interest rates it falsifies this indicator, thereby breaking the harmony between the production of present consumer goods and the production of capital goods i.e. tools and machinery. An over-investment in capital goods and an under-investment in consumer goods emerges. Whilst an over-investment in capital goods results in a boom, the liquidation of this over-investment produces a bust. Hence, the boom-bust economic cycle. On this Rothbard wrote,
…once the consumers reestablish their desired consumption/investment proportions, it is thus revealed that business had invested too much in capital goods (hence the term “monetary overinvestment theory”), and had also underinvested in consumer goods. Business had been seduced by the government tampering and artificial lowering of the rate of interest, and acted as if more savings were available to invest than were really there.
The longer the central bank tries to keep interest rates at low levels, the greater the damage inflicted on the real wealth formation process. Consequently, this would extend the period of stagnation. If central banks could set interest rates at very low levels and set in motion genuine real economic growth then surely by now most poor economies should be wealthy. These economies have central banks that also know how to print money and how to keep interest rates at a zero level. What most commentators who support low interest rates policies during the times of economic recessions overlook is that central banks do not know how to generate real wealth.
To conclude, as long as life sustenance remains the ultimate goal of human beings they will continue to assign a higher valuation to present goods versus future goods and no central bank interest rate manipulation will be able to change this. Any attempt by central bank policy makers to overrule this fact will undermine the process of real wealth formation and thus lower people’s living standards.
The central bank can try to manipulate the interest rate to whatever level it desires. However, it cannot exercise control over the underlying interest rates as dictated by people’s time preferences. When the central bank engages in a persistent lowering of interest rates this policy sets in motion an increase in the underlying interest rates as dictated by people’s time preferences. (The exact opposite of the central bank’s intention). It is not going to help genuine economic growth if the central bank artificially lowers interest rates whilst people did not allocate an adequate amount of real savings to support the expansion of capital goods investments. It is not possible to replace real saved wealth with more money and the artificial lowering of interest rates. It is not possible to generate something out of nothing as suggested by many commentators.
- 1. Carl Menger, Principles of Economics (New York: New York University Press, 1976) p 154.
- 2. ibid , p153
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