Interest rates and the price system


The key thing to realize about market economics is that prices function as signals. They emerge spontaneously, and co-ordinate the actions of millions of people, all over the world, who may not know each other and may have nothing in common.

At the basic level, it's a question of supply and demand. If the supply of X rises relative to the demand for X, then the price of X will fall. That falling price is a signal to entrepreneurs that they should probably switch their investment somewhere else, which in turn leads to lower production. On the other hand, if the supply of X falls relative to the demand for X, then prices will rise. And rising price is a signal to entrepreneurs that they should invest in X, in order to increase production and satisfy market demand. To put it very simply, it is the system of market prices that co-ordinates supply and demand, avoiding big shortages or surpluses.

The problem when government tries to control the price of anything is that prices no longer reflect supply and demand, and no longer serve as a useful guide to entrepreneurial activity and investment. No one has any reliable way of knowing, in the absence of market prices, whether we need more of X or less of it. Inevitably, we end up with a shortage or a surplus. Consider, for example, what has happened when governments have interfered with food prices. In Europe, we've had lakes of milk and mountains of butter. In Africa, they've at times ended up with nothing much at all. Such outcomes are unavoidable when you don't have market prices to guide activity.

Crucially, of course, governments can never 'set' prices correctly – the information they would need to do that is so dispersed, so complex, and so constantly changing, that real market prices can only ever arise spontaneously.

Let’s apply this to interest rates. As I pointed out yesterday, interest rates are prices – in this case, the price of loaned capital. And again, this price is essential for the co-ordination of economic activity. The supply/demand point made above holds true. If savings are in short supply, but demand for borrowing is high, then interest rates will rise. That reduces demand for borrowing (because borrowing is expensive) but also increases the incentive for people to save (because they'll get a better return on their money). As more is saved, more loanable funds become available, and the price of loaned capital (that is, the interest rate) falls. That makes borrowing more attractive, so demand for loans rises. If it starts to outstrip the supply of loanable funds then the whole process starts again. It is like a constant balancing act – the price fluctuates spontaneously in an unplanned effort to match the supply of savings with the demand for credit.

Now, that is a bit of a simplification, because there's actually a more sophisticated point to be made about interest rates, which is that they also express the extent to which people are willing to forgo something now for the prospect of a greater reward in future. In economic jargon, it's called time preference, and it tells entrepreneurs whether they should be investing in capital goods (that is, in things which are used to produce other goods), in ‘durable consumer goods’ (things like cars, fridges, even houses), or in goods for immediate consumption. Again, when governments mess around with interest rates, they distort the allocation of capital – investment goes to the wrong stages of production, and the wrong goods are produced. Supply and demand, once again, does not meet up.

And that’s the fundamental problem with governments, or government agencies setting interest rates. Inevitably, they don’t have the information they need to set the ‘price’ correctly, and so the proper functioning of the market is disrupted. That’s when you get misallocated capital, bubbles, and an exaggerated boom and bust cycle.