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Money and Interest

July 12, 2001

Tags Financial MarketsMoney and BanksThe FedBooms and BustsCapital and Interest TheoryFiscal TheoryMoney and BankingBusiness Cycles

On June 27, citing the downturn in economic activity, the Fed announced that it had lowered the target for the federal funds rate by 0.25 percent, to 3.75 percent. Since January, the U.S. central bank has lowered its target by 275 basis points.

Can aggressive lowering of the federal funds rate prevent the U.S. economy from falling into a recession? Those who believe it can also believe that the interest rate is the outcome of supply and demand for money: For a given demand, an increase in money supply will lower interest rates. This, in turn, will revive expenditure on capital goods, which in turn propels the economy ahead. 

Contrary to the popular belief, however, interest rates have nothing to do with money. As the medium of exchange, money merely facilitates the flow of real savings from lenders to borrowers, or from suppliers to demanders. Interest rates, on the other hand, emerge because every individual assigns a greater importance to goods and services in the present against identical goods in the future. Interest is the price we pay for preferring goods sooner rather than later, and a measure of the degree to which we do so. 

For example, let’s say a baker exchanges his saved bread for $1,000, which enables him to buy an oven. The new oven, in turn, raises the money value of the output of his bread in one year's time to $1,200. Observe that what makes this possible is not money but the fact that the baker has made the decision to save and invest his savings. This decision emerged because he considers the expected benefits of greater production in the future to outweigh the benefits of using the same money on present consumer goods. 

Thus, the baker has concluded that a return of $1,200 in one year's time on the investment of his $1,000 is of a greater benefit to him than spending the $1,000 on present consumer goods. In other words, his time preferences, so to speak, have allowed him to exchange his present $1,000 for $1,200 in one year's time—for a 20-percent return. 

His time preferences, however, will not permit the exchange of his present $1,000 for $1,000 in one year's time—that is, a 0-percent return. If the pool of his savings had been larger, he may have agreed to consider an investment that yields 15 percent. In this way, the time preferences of individuals determine the level of interest rates. They also impose a general rule that interest cannot be zero.

As a rule, when people have greater savings—a pool of funding—they tend to allocate more toward the accomplishment of distant goals to better their quality of life over time. With scarcer means, an individual can only consider a very short-term goal, like making a primitive tool. With more real means at his disposal, however, he can consider undertaking the construction of better tools. 

Changes in interest rates instruct businesses about the feasibility of undertaking various future projects. A fall in the interest rate will mean that a greater proportion of real means was made available for future projects. Conversely, a rise in the interest rate will imply that less funding is available to these projects. Consequently, when interest rates are not tampered with, they serve as an important tool in facilitating the flow of real savings toward the buildup of a wealth-generating infrastructure.

Whenever the central bank tampers with interest rates through an artificial lowering, it falsifies this indicator, thereby breaking the harmony between the production of present consumer goods and the production of capital goods, i.e., tools and machinery. In short, such interference creates an overinvestment in capital goods and an underinvestment in consumer goods. An overinvestment in capital goods results in a boom, while the liquidation of this overinvestment produces a bust. Hence, the boom-bust economic cycle. 

On this, Rothbard wrote: "once the consumers reestablish their desired consumption/investment proportions, it is thus revealed that business had invested too much in capital goods (hence the term 'monetary overinvestment theory'), and had also underinvested in consumer goods. Business had been seduced by the government tampering and artificial lowering of the rate of interest, and acted as if more savings were available to invest than were really there."[1]

Rothbard's comments shed light on the likely course of the U.S. economy in the months ahead.  The severity of distortions caused by the loose interest-rate policies of the Fed are illustrated by the record-high ratio of capital-goods investment to personal consumption.

Between 1959 and 1990, the average of this ratio stood at 0.127. In the first quarter of 2001, this ratio stood at 0.225 after reaching a record high of 0.227 in the third quarter of 2000. The massive overinvestment in capital goods relative to consumer goods should force a severe liquidation of capital-goods production. 

Obviously, this will weigh heavily on the profitability of the capital-goods sector. Profitability in the underinvested consumer-goods sector, however, will fare relatively better. The Fed probably will lower interest rates further, thereby preventing the necessary decline in the investment-to-consumption ratio and thus prolonging the economic slump. 

Rather than preventing an economic slump, the Fed’s lower-interest-rate policy will achieve the exact opposite. Is there a possibility that the U.S. economy will stage a strong recovery? Yes, it is possible—provided the real pool of funding is still expanding. 

A massive fall in the savings rate casts doubt that this could be the case. The artificial lowering of the interest rates has sharply reduced people’s willingness to save. Thus, the personal savings rate fell to –1.3 percent in May. This rate has been negative for eight consecutive months.

To conclude, it is a myth that an artificial lowering of interest rates can revive the U.S. economy. If anything, such policy will only eat further into the already-depleted real pool of funding, thereby diminishing prospects for a meaningful recovery in the months ahead.

 

Frank Shostak, Ph.D., is a frequent contributor to Mises.org. Send him mail at frank.e.shostak@ords.com.au (or fshostak@bigpond.net.au) and see his outstanding Mises.org Archive.  See also Ludwig von Mises: The Non-Neutrality of Money (1938) 

[1] Murray N.Rothbard, For a New Liberty (Collier Books, 1978), p. 189.


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