An article by David Frost appeared today in The Telegraph titled “It’s almost too late to rescue the West from the disaster of low interest rates. Britain is stuck in a vicious cycle. The only route out is economic reform that changes almost everything“. This title made me hope for a second that finally someone in the political right understood interest rates and was ready to support structural reform in the direction of the free market in the money sector. Unfortunately, no such luck.
The interest rate is defined by Mr. Frost as the “price of money”. This is similar to defining money as a “medium of exchange”. Sure, money is indeed a medium of exchange (this is one of its three functions, the other two being store of value and unit of account). This, however, does not say much about what money is. In fact, also monetary gold was a medium of exchange. However, fiat money and monetary gold are very different things.
In a free market economy, the interest rate is the price of time preferences: if, in a free society, individual time preferences decrease (meaning that individuals give relatively more importance to the future than to the present: i.e. they save more and consume less), then there will be more resources available for investments. Because of the law of supply and demand, (other conditions being equal) the price of these resources (the interest rate) will be lower: this will allow for a more “powerful” and long-term-oriented structure of production. And vice versa: “higher” individual time preferences will produce a higher interest rate, and will allow for a less “powerful” and less long-term-oriented structure of production.
Being essentially the price of time preferences (the risk premium is only an additional component of the interest rate, not its essence), the free market interest rate successfully coordinates savings and investments in time. Only the free market interest rate can do this “miracle” because only the spontaneous free market process can use individual knowledge about time preferences: no central bank can have access to that kind of individual knowledge. This means that no central bank can ever produce the “right” interest rate (and therefore successfully coordinate savings and investments in time).
Booms and busts are produced by the artificially low interest rates obtained via the artificial expansion of money and credit: either directly via the central bank or indirectly via fractional reserve banking. Booms and busts did not exist before artificial expansion of money and credit: “Before the Industrial Revolution in approximately the late 18th century, there were no regularly recurring booms and depressions. There would be a sudden economic crisis whenever some king made war or confiscated the property of his subjects; but there was no sign of the peculiarly modern phenomena of general and fairly regular swings in business fortunes, of expansions and contractions” (M.N. Rothbard).
Mr. Frost rightly suggests that “we need to drive up productivity so that we can withstand higher interest rates. Then those more normal interest rates can start to get investment and the price mechanism going again“. However, given the above, if the higher interest rates will be arbitrarily decided by a central bank they will necessarily be wrong and continue discoordinating savings and investments: in other words, they will continue producing cycles of booms and busts.
The price mechanism works only if prices are free market prices (only free market prices convey information about real scarcity): this is also valid in relation to the price of time. The premise for any economically sustainable virtuous cycle is the end of central banking and the beginning of the free market in the the money sector.
This does not seem realistic: the state will never surrender its ability to extract huge financial resources via inflation, i.e. via the production out of thin air, in regime of legal monopoly, of fiat money that businesses and individuals are forced to accept and whose purchasing power decreases over time. This is why censorship-resistant Bitcoin was invented.
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