Monday, May 9, 2011

Interest Rates: How Interesting

Back in the olden days, in the long long ago, before about 1913, we didn't have a monopolistic cartel of private banks headed by a few unelected officials who were in charge of the nation's (and, more recently, the world's) money supply.  But, other than money supply, another great power of the Federal Reserve is to dictate interest rates, either directly or indirectly.  It's this power that gives us nearly every economic boom (Read: Bubble) because the central bank loves to keep interest rates too low for too long, thereby creating excess credit that eventually funnels into a single area and creates a bubble. But what would the world be like if Bernanke couldn't control interest rates? Well, this thing called the "free market" could take care of that.  And it's actually pretty simple.

In a truly free market the interest rate would be determined by the amount of savings.  When someone deposits money into a savings account, what they're essentially saying is that they are going to under-consume today so that they can consume more in the future.  If enough people do this, and the amount of deposits on the bank's book increases, banks will lower interest rates.  This lowering of interest rates does two things.  First, it makes it cheaper for businesses to borrow money, thereby encouraging it.  After all, interest is simply the cost of money.  Lower interest rates can make a huge difference to a business that plans on investing a lot of money that won't start to turn profits for many years.  Think of R&D departments that attempt to invent new technologies that won't be sold in a store for 10 or 20 years.  The difference between 5% and 4% could be millions and millions of dollars.  So as savings are build up, interest rates go down and long term investments become feasible.  This works out wonderfully because the money that is being used to finance these long term investments that don't pay off until some future date is the very savings that people put away in order to be able to consume something in the future.  This consistency in the time factor cannot be stressed enough.  Not until people decide to consume in the future (save) can business start to invest in their future (borrow).

The second thing lower interest rates do is discourage savings.  If you're only gaining 2% on a savings account you're going to save a lot less than when you were getting, say, 5%.  This allows the banks to lend out their deposits, which is how they make most of their money.  Once most of the deposits are lent out, the banks will need to start raising interest rates.  This will encourage more savings and allow banks to rebuild their deposits at the same time that it discourages borrowing.  Again, the time factor works out perfectly here.  As people are consuming more today, it becomes harder for a business to invest in the future.  This cycle continues with the competition between banks, saving habits of the individual and borrowing needs of business all working together to determine the interest rate.

But like I said, that system died a long time ago.  How wonderful that we progressed enough to cast away those quaint relics of yesteryear.  That awful era where unintelligent rubes didn't have the know-how to properly manage a nation's economy, money and credit.  At least now we realize that we simply need the right people in charge.  And as long as we just allow those brilliant economic planners to turn the dials the perfect amount and press the right buttons in the proper sequence we'll be alright.  They'll give us the perfect amount of credit and just the right level of money supply.  The waste and inefficiency of saving can be eliminated without effecting the ability of business to borrow and invest.  I don't see how this could possibly go wrong...

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