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Wednesday, July 16, 2014

Yes, Interest Rates Are Artificial

Noah Smith discusses at the Bloomberg View the strange idea that floats around on the internet - that the current low interest rate regime is "artificial". The idea being that "the market", if left to its own devices, would set interest rates higher. He discusses why that view makes little sense. However, I would amplify his arguments to state that it is almost impossible for "markets" to set interest rates, other than by completely restructuring the economy in a fashion where the government and existing pools of finance capital largely disappear.

There was some discussion on Reddit of this article.  The commenter 'usuallyskeptical' argued,
Why would the market be inherently worse than the Fed in "determining" (which misleadingly personifies the market but I can't think of a better word for it) how much cash and credit should be in the economy? I can think of a great reason why the Fed would be worse: they base their decisions on necessarily incomplete information.
I would amend his argument to be about interest rates rather than "how much cash and credit should be in the economy", as I am in the camp that market forces determine the amount of cash and credit is in the economy, not the central bank.

I would not argue that the Fed (or any central bank) is necessarily doing a great job setting the level of benchmark interest rates, rather my argument is that the markets really cannot fulfil that function (in anything resembling the current economic environment).

The Current Situation

I like referring to the Canadian example, as "reserves" do not exist and add unnecessary complications to the discussion. (I discussed how the Canadian banking system operates without reserves in this earlier article.)

Since there is no need to create reserves, one could imagine a policy regime where the Bank of Canada (BoC) is extremely passive, mainly only undertaking monetary operations to accommodate increases of notes in circulation as well as increases of deposits held there (the major depositor is the Canadian Federal government). But even so, the BoC could keep very tight control of the overnight rate. This is because the BoC posts interest rates for:

  1. excess settlement balances of Banks at the BoC; and
  2. the interest rate charged for a settlement balance deficiency.
Since the BoC does not need settlement balances itself, and there are no other suppliers, there is no "market" for these interest rates.  They are administered rates. (There are plenty of examples of private sector administered rates as well; for example, my credit card company sets a rather hefty rate of interest on any unpaid balances.)

Even though the amount outstanding of these net settlement balances are negligible, they are still the benchmark rate that other inter-bank and money market rates are priced off of. (Longer term instruments are priced off of the expected path of these short-term rates.)

How could this benchmark rate be market determined? It is an administered rate, after all. If it was mechanically set to follow some "market" rate like LIBOR*, it would be a likely disaster. Other market rates of interest include a credit (or term) premium. If that premium increased, the benchmark rate would rise in response. This would push up the market rate further, creating an upward spiral.

In a sophisticated financial system such as we currently have in the developed economies, it is impossible to avoid having a committee setting the benchmark rate.

OK, Let's Not Be Sophisticated

Noah Smith argued:
But the fact remains: As long as we have a fiat money system and a central bank, the Fed will exert an influence over interest rates. Unless you think the government should get out of the money-creating business [Emphasis mine- BR] -- that we should switch to a system where independent banks, or individuals, create their own private currencies -- then you have to accept that interest rates, especially safe rates, are always going to be artificial in some sense.
There is a considerable contingent of people that wish to move away from government-controlled money, either to use gold and silver, or digital currencies like Bitcoin. Although it would be theoretically possible for the government "get out of the money-creating business", that would not be enough to eliminate the entanglement of the government and money. The key is what currency taxes are denominated in. If the government demanded taxes in the form of gold, gold would become the de facto state currency. Income taxes require all transactions to be translated into a single currency so that progressive taxes can be applied. Whatever currency is used for this calculation would be privileged, and businesses and individuals would gravitate towards its use for simplicity.

Once the government privileges a particular currency, the inevitable financial crises would force the government to step in as the lender-of-the-last-resort in that currency, and we would back where we are now.

The Gold Standard Was No Different

There is a good deal of nostalgia in some circles for the Gold Standard. The implicit assumption is that the operation of the Gold Standard would force the central bank to adopt "market" interest rates.

That is largely a misreading of history. The central bank still administered interest rates, but it just added a constraint that they sometimes had to worry about the gold cover of their currency (they would hike interest rates to attract gold inflows). But if the system was not stressed, central banks had some freedom to determine interest rates (but they were broadly constrained by the decisions of the committees at the major central banks).

You Would Need A Small Government, And Small Banks

The only means to avoid administered interest rates is to have a small government, and a small financial sector. You would need to revert to a system where rich families control almost all of the money in the society, and thus lending is the preserve of "small" lenders. This is largely how economies were organised before the Industrial Revolution.

Although some progressives feel we are moving in that direction, the reality is that there are very large pools of capital controlled by pension and mutual funds, which are ultimately owned by a large number of people in the middle class. Since these funds are intermediaries, some form of bureaucratic organisation is necessary to control lending decisions. Therefore, there is no obvious way of avoiding there being large financial intermediaries.

And no matter what the legal organisation of those intermediaries is, they will be end up looking like banks. And once again, financial crises would probably force those institutions to organise themselves around some central bank to provide lender-of-last-resort operations. And that central bank would have a committee to set the level of the benchmark discount rate...

Concluding Remarks

Although one can name societies without administered interest rates, developed countries could not end up in that state without some cataclysmic reset of the wealth distribution and the form of government.


* The LIBOR fixing is a rather strange beast; it is the result of a poll of banks which asks them at what rate they can borrow, and there is no reason to believe that this is based on any transactions. Setting the benchmark rate by a similar poll would be asking for trouble.

(c) Brian Romanchuk 2014


  1. AFAICS this is a distracting issue. The issue that should be debated is why are we messing around trying to influence interest rates. They clearly don't 'do' what people think they do - much as exchange rates don't 'do' what people think they do.

    For interest rates to work they require private entities to borrow money, because it is an uncertain indirect mechanism - rather like trying to steer a car by moving your weight from left to right.

    About the only people who think that is a better idea than the alternative are those that make money out of lending, and their tame economists.

    1. I agree that this is not too serious a issue, but it does show up a lot in comment threads. I have seen the argument "the market should set interest rates and not the central bank" too many times.

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