Getting Interest Rates Right (Is a Job For Markets)

Russell Lamberti

When the central bank meets to decide on the level of interest rates, most people care about only one thing: are my home loan, car, and credit card repayments going up, down, or staying the same? Although this is no trivial concern given the importance of managing a household budget, such a limited view does scant justice to the broad, critical, and complex role interest rates play in an economy.

What Soda Prices Tell Us About Interest Rates

The usual narrative is that low rates are good and high rates are bad. But the real problem is not “high” interest rates, but wrong interest rates. You see, interest rates are like prices. Like the price of a soda drink is agreed between seller and buyer, so interest rates are the price of loans agreed between lender and borrower.

Suppose the government forced the price of sodas to half their market level, jailing anyone caught selling them at any price above this new level. What happens? Soda lovers flock to the stores to buy soda. Soda makers, by contrast, take heavy losses and either close down or find some way to make cheap and less tasty soda for half the original cost. The supply of soda plummets, while the quality of good soda free falls.

Paradoxically, setting a price artificially low makes a product easy to buy for a while, but eventually leads to shortages. Interest rates in most modern economies work in a similar way. The central bank forces this price (the interest rate) to a desired level through extensive regulatory control over the banking system, relying on the fact that the money it creates is the only legally permissible money used in trade. When the central bank forces interest rates too low, borrowers think life is great. Houses, cars, and furniture seem cheap and starting a business with a loan is easy. Except that discerning lenders don’t see much point in lending anymore, because they are no longer adequately compensated for their costs and risk. Not only do loans from these lenders dry up, but the quality of remaining loans falls.

Make Lots of Cheap, Low-Quality Loans

How does the quality of loans fall? Just like the soda makers who sourced cheap and less tasty products, so credit providers (banks) move away from sourcing funds from discerning investors who would charge more, and rely instead on getting cheap money directly from the central bank, which prints it out of thin air and lends it to the bank at the cheap rate.

With this cheap funding, and with the ability to resell the loans to governmental and quasi-governmental organizations like Fannie Mae, the banks don’t have to be nearly as careful who they lend to and can happily accept lower interest repayments from borrowers. And, if things go wrong, the banking system can also appeal to the Fed and the US treasury for bailouts.

Risky borrowers who were unable to pay the rate of interest discerning lenders demanded can now access cheap loans. Simultaneously, even prime borrowers are misled by the reduced interest rate into projects that turn out to be malinvestments.

Furthermore, because the loans created out of thin air look exactly like the money in the hands of discerning lenders, this poor quality is veiled and people are fooled into thinking that discerning lenders are supplying loans, when in fact they’re running for the hills. (But even the discerning lenders are fooled in the initial phases of the boom as the new money makes borrowers look more stable and profitable than they really are.)

Consuming More Than We Produce

This ends in disaster. Borrowers get into too much debt and the money loaned out of thin air floods into the economy. New money in people’s hands causes the economy to consume more than it produces and the result is a gaping and unsustainable trade deficit. The new flood of money pushes prices up and causes the currency to weaken.

After initially feeling flush, people realize they are not as well off as they thought as price increases eat into their real living standards. Forced to rein in inflation before it destroys everyone’s living standards, the central bank hikes interest rates to entice the discerning lenders to do more lending. Businesses addicted to cheap loans find their input and funding costs rising unexpectedly, damaging profitability.

The return of discerning funding is critical for sustainable economic growth, because it funds productive capital investments that yield the highest return, creating jobs and quality, affordable products. Meanwhile, higher interest rates punish those who gorged on artificially cheap credit, restoring the economy to healthy reality and balance.

The next time the central bank meets to decide on the level of interest rates, don’t just ask how much your home loan payments are going to cost next month. Also ask: are interest rates at the right level to foster sustainable economic progress, and might I be living an illusion?

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