How should interest rates be set?


The economy would benefit from a weaker Bank of England, stripped of its principal power to set interest rates. No one should be allowed to set interest rates. Interest rates are simply prices of borrowing. As with all prices they should be determined with market mechanisms. When they are set by a ‘wise man’, or by a ‘wise committee’, they do not carry the information about the preferences of consumers and the scarcity of resources. Quite the opposite, interest rates set in this way are bound to be a kind of misinformation, leading those who act on them into error.

Take for example a car tyre. In a free market, the price mechanism would find the optimum price for the tyre to be supplied and consumed at, in order that it is allocated efficiently. If the price of the tyre is fixed higher than this price, then tyres will be under consumed; similarly, if it were fixed below this price, the firms would not be able to meet the excessive demand. In both instances, the resources are not allocated as efficiently as they could be.

This also applies to money. Suppose the demand for borrowing rose. This would increase competition for access to the scarce supply of savings and drive up interest rates. Saving would now be more rewarding, so more people would do it, and the supply of savings would rise. However, when interest rates are set by a central bank, demand for borrowing can increase without interest rates changing and moreover without the price signal that would cause people to save more. When dictated, interest rates stop playing their market role of optimally allocating resources between current consumption, and investment that will deliver future consumption.

Had interest rates been set by the free market, interest rates would not have been so low for so long, and this recession would have been a lot less damaging.

Much of the argument for this blog was inspired by this piece in The Times by Jamie Whyte.