Monday, 28 September 2015

Conflict Of Interest

One of the most important things anyone can master about economics is that prices are not just numbers, they are vital information carrying signals too. Prices are the result of billions of transactions all over the world, and while they are always in states of fluctuations, they are the only reliable mechanism for exhibiting economic value in society.

If the supply of oranges rises or falls relative to the demand for oranges, then the price of oranges will fall or rise accordingly. That falling or rising orange price is a signal to suppliers that they might be wise switching their business to something else or perhaps that they should augment their business. Governments are not very good in the supply and demand market, because any price fixing they do is bound to be either too low or too high (it is almost always too high).

Interest rates, like oranges, are subject to these fluctuations too. If savings are in scarce supply but there is a high demand for borrowing, then interest rates will rise. This will reduce demand for borrowing (because with compound interest borrowing is expensive) but it will also increase the incentive for savers (because people who save will get a better return on their money). As more money is saved, more capital becomes available to be loaned out, and the price (that is, the interest rate) will fall, making borrowing more enticing, and increasing demand for loans. Just like with oranges, the price of borrowing fluctuates in order that as closely as possible it matches savings supply with the credit demand.

Consequently, interest rates provide signals regarding the extent to which people are willing to forgo something in the present for something more desired in the future. So interest is basically a tax on borrowing, but you should know too that interest rates do not mean the 'price' of money as most people seem to think. They think in those terms because interest rates are mostly attached to borrowed sums of money (for a mortgage, a car, a university degree, and so on).

Remember though that although a bank loan appears in the form of money, it is usually spent within a few hours or days - and whoosh, it is back in the banking system in somebody else's account. Interest rates, then, are not to do with the price of money - they are to do with the price of consumption - what you buy with the money. The rate you pay in interest is the price of consumption now against future consumption. As an example, suppose you have £25,000 in your account and you buy a new kitchen tomorrow for £5000. You're left with £20,000, and you haven't had to borrow anything, so you've paid no surcharge on your consumption. But suppose instead that you have no savings but you want a new kitchen right away. You can borrow the £5000 with a 5% yearly interest rate and pay back £5250. The £250 surcharge is the price you've paid for consumption in the here and now.

Most people don't realise this - they see that the Bank of England sets interest rates and they assume it's to do with the price of money not the price of consumption. Interest rates are determined by banks, but they are based on the supply and demand related to consumption. Banks don't control people's supplies and demands, so ultimately they don't control interest rates, only at a proximal level. A ship's captain is in control of the ship, but he's not in control of the weather that controls the state of the ocean.

When interest rates are lowered a lot of keen borrowers come along to capitalise. To satisfy this demand the Bank of England must increase the money supply, which drives up prices. As people are borrowing to consume goods, not to store money, they will need more money, which the Bank of England must respond to with a further increase in the money supply, which further drives up prices, and round and round we go. To avoid hyperinflation the Bank of England raises interest rates again.

Suppose the government wastes £50 billion on a building a whole new railway project that never comes to fruition. The key of the cost is not the £50 billion in monetary terms - money is just an abstract concept - it is the cost of the materials and the labour that went with the project. The materials and the labour amount to a £50 billion deficit that could have been used elsewhere; building aircraft or improving sea defences, for example - so with fewer materials and labour available the British public has a deficit in what can be consumed - a £50 billion deficit to be precise. With 63 million people in the UK, the £50 billion costs each person just over £790.

Imagine you have some money you want to invest - in what should you invest: in consumable goods or services? Say it's in consumable goods, then ok, what kind? After all, car investment is a different investment to a sweet shop. In countries where governments mess around with interest rates, they distort the allocation of capital – investment doesn't consistently go to the optimal stages of production, which means we don't get ideal production of goods. That, in a nutshell, is why we shouldn't desire that governments set interest rates. For all his faults, Gordon Brown granted the Bank of England operational independence over monetary policy, which meant that politicians were no longer setting interest rates.

A lot of people hailed this move, but the trouble is it was only a step in the right direction, it didn't go far enough. It's better that banks set interest rates than politicians, but it's even better if interest rates are determined by the market rather than by the Bank of England.

The problem with governments or de facto government agencies like the Bank of England setting interest rates is that they don’t have the information signals they need to set the price correctly, any more than they would with oranges or kitchens. Because interest rates are prices for borrowing, they should be determined by the supply and demand market in exactly the same way that oranges and fridges are. It's only because most people don't see the 'price' factor of interest rates in the same way they see the 'price' factor of oranges and kitchens that see them differently. But the same principle still applies as in my opening paragraph: artificially setting prices, even interest rates, means things like consumer preferences, quantity of resources and risk levels are distorted.

In the banking sector, saving is simply the supply of new capital, and investment is the demand for new capital. They need to be equalised by market price mechanisms just as much as oranges or kitchens. What equalises the supply and demand for savings and investments is interest rates - it is simply the name for the price of borrowed capital. So when we read articles like this one in The Telegraph about how the Bank of England may need to push its interest rates into negative territory to fight off the next recession, we get a glimpse of one of the many problems that occurs when governments or government agencies mess around with the price system.

If interest rates are kept artificially low, this will increase the demand for government supplied capital and reduce supply of actual capital, which will increase levels of borrowing and discourage saving. Similarly, if interest rates are artificially high it distorts the levels of borrowing and savings the other way. Moreover, the injection of more money into the economy through quantitative easing creates the illusion of more capital only in the same way a bartender could create the illusion of more Jack Daniels by pouring some water in the half empty bottle.