by Derek McDaniel
To manage a currency, there are two primary tools: fiscal policy and monetary policy. Fiscal policy is all the spending done by the political authority (The Treasury), while monetary policy (setting the price for borrowing liquidity) is conducted by a so-called independent body (The Central Bank).
- Fiscal Policy: Political Authority
- Monetary Policy: Technical Authority
Imagine, if you will, a computer lab in a school. The principal of the school, in conjunction with the teachers, determines the goals and programs for computer lab use. Meanwhile, an IT tech person is charged with making sure the computers are working properly and that the rules of the lab can be enforced. The IT person can’t judge all the needs of the students and the school, but the school’s leadership probably doesn’t have the skills or time to take care of the computers themselves. They both have to work together!
Managing a currency requires similar coordination. In the US, Congress is the political authority, and they determine how the Treasury spends its money. Meanwhile, the Federal Reserve, serving as a “central bank,” is the technical monetary authority. The US Federal Reserve has been tasked, by Congress and the People, to control inflation and help the economy. Ideally, the Fed operates according to the mandates of Congress subject to democratic accountability. In practice, however, the political process is messy, and subversion, corruption, and inefficiency can be frequent even when they are contained to a “functioning” level.
But a considerable problem has arisen. The money technicians seem to be at a loss for how to do their job. If this issue were described as a title of a children’s book, it might go like this: “Central bankers and the mystery of the low, low, interest rates.”
Interest rates are a complex topic, both philosophically and practically. We can only really scratch the surface. They can be measured in one of two ways: real or nominal. Real rates adjust for inflation, nominal rates do not. When you go to the bank asking for a mortgage or car loan, they will tell you a nominal rate.
One interesting difference between real and nominal rates, is that nominal rates are often fixed by contracts, meaning we can tell what they will be in the future, but real rates are impossible to predict. Inflation, even if it is well contained, can never be predicted with 100 percent confidence. So when it comes to real interest rates, all of us are just making our best guess.
Central bankers use low interest rates to try to increase economic activity. Low interest rates are supposed to help increase the amount of activity in an economy. If interest rates are zero, everyone will take interest-free money, worst case scenario, you could just hold on to it and then give it back… But surely one could think of some way to turn a buck?
What this discussion clearly ignores, in addition to the lack of discipline of your average consumer, is the impact of prices. If the way prices are structured is bad for economic development, it doesn’t matter how easy it is to borrow a buck, if it is hard to earn a buck, no one will want to borrow, for fear they will default and get punished.
This is why it’s so important to look at taxation and Government spending (money spent by the political authority). Fiscal policy can be incredibly powerful, because the political authority can always spend money. Better yet, the political authority is incentivized to spend money productively, even when the price structure makes commercial development hard, because they will reap long term benefits. Neil de Grasse Tyson presents this idea with regards to space travel and scientific development.
Fiscal policy is always a direct option, and can be a powerful stabilizer and economic safeguard, but often, monetary policy can be more flexible and adaptive, because it involves all credit worthy individuals and credit worthy firms borrowing money to use how they see fit. “Credit worthiness,” what banks use to assess whether people can borrow money, how much they can borrow, and at what interest rate, often is affected by factors people can’t directly control.
Many people who are able and willing to work, often can’t find work that meets their needs. A lack of reliable work can hurt their credit history as well, making it harder for them to move or start a business. Sometimes background can be a limitation, whether race, parental affluence, immigration status, or education. Often these advantages and disadvantages can be self-replicating. Someone who comes from a poor family might struggle to do well at school, and that in turn will limit what they can do for a career.
Private financial entities can only assess “Credit Healthiness”, and not “Credit Worthwhileness.” And they compensate for low “Credit Health” by charging even higher rates, which in turn puts more burden and stress on the borrowers. Many people in society are worth helping, even if they aren’t in good financial health. That’s often the situation where the biggest impact can be made. But without public processes and social programs, you don’t really have the information or accountability you need to evaluate “Credit Worthwhileness.”
All of these factors limit the effectiveness of interest rates, and how much low interest rates can really increase economic activity. If the people getting the low interest rates are already the same people getting rents and other incomes from the status quo, what motivation do they have to help us reach full employment or build an economy that truly serves society’s needs?
The moral implications this has for the high rates applied to consumer credit are truly disheartening. Consumer credit is designed to be used in small or moderate amounts for very short terms to reduce the costly frictions of zero liquidity.
Let’s say you are driving to the store to buy groceries. En route, your car breaks down. Now you pull to the side of the road, and have to get it towed. You no longer have time to get groceries and will probably be late to work on top of that. Your car gets picked up and towed. You take the bus to work, and afterward you have to walk 5 miles home, because the buses don’t run that late.
It takes you an hour and 40 minutes to walk home, and you have to wake up a half hour earlier than usual to catch the bus to your other job. You don’t have much food left, so you can’t pack a lunch. You end up relying on a crappy vending machine for food. You can’t pay for the required car repairs until you get your paycheck, except for the fact that you have this nifty thing called a credit card. If you are late for your second job again, you will get fired. You pay for the repairs with your card, hoping it doesn’t happen again. In a bad job market, the cost of “zero liquidity” becomes exponentially dangerous. It could lead to weeks or months of under-employment if you can’t access the resources you need to get to work or perform reliably.
While a credit card can be a lifesaver, it is also a curse. High rates of interest are a blatant exploitation of people’s ignorance, desperation, or both. When a consumer runs up debt month after month, it often means their financial situation is so precarious that society has them on the edge of ruin. Perhaps a minimum wage job would be fine if one had no debts and they were sharing an affordable apartment – a short walk from a stress-free and risk free job – but that is rarely how things work out. Readily available jobs are not close to readily available housing, and a whole host of other factors conspire to make our communities inhospitable and alienating environments. While lenders don’t necessarily create these hostile environments, they operate with cold disregard for the immoral condition society collectively imposes on their clients.
When you are valued at less than your cost, your access to credit dries up, forcing you into contraction. In the long run, lending is not “paid back,” but either expanded or contracted. Default is merely a form of legally enforced credit contraction, while paying off loans is either voluntary contraction or merely changing who your creditors are. Borrowers are not supposed to ask what they want to do, or even what they need to borrow, but rather how much they should borrow, at any possible rate of interest. It is the job of the central bank to tune the total amount of borrowing such that it fits the limits of the macro-capacity of our economy.
This scheme, while convoluted, promises to be wonderfully and perfectly adaptive. In practice, it faces the significant challenge that we don’t know the future (besides the fact that interest on lending is inherently unfair and completely unnecessary). People can’t accurately assess whether something will be successful or not, so they err on the side of caution, and the economy stagnates. People are often willing to sacrifice giant “black swan” upsides to avoid probable burdensome downsides, and this irrationality stagnates our economy (financial demigod Nassim Taleb will readily explain to you, how black swans are much more common than “normal” distributions would suggest).
Banks don’t facilitate credit, they insert themselves in the middle of social credit processes. In this sense, interest is not time value (as if owners have an intrinsic right and not a contingent claim to their property), but rather, a form of property-based social domination that extracts economic rents. If an owner cannot use a resource themselves, their choices should be to incur the costs of ownership without benefits, or sell the resource for something they can use. Financializing resources supports and reinforces a disadvantageous distribution of ownership.
Adjusting the interest rate is effectively meaningless because it completely disregards the “who,” “what,” and “why” of our resource choices and only affects the “how much.” Any of these questions considered in isolation is meaningless. The answers to all of them have to be known.
It is in fact the institutional choice structures of our financial systems that determine how the economy operates, and the Fed’s game with interest rates is just a random variable that mixes up the works. Interest rate changes throw random advantages to one group or another. When the Fed changes interest rates to induce a certain behavior in markets and the economy, pricing and portfolios simply adapt. For this reason, adepts of Modern Monetary Theory make the claim “monetary policy is a blunt tool.”
Political action, legal rules, and social culture ultimately determine resource utilization. The hubris that we can direct the economy with interest rates is as incredible as society’s ability to continue to function even under such a flawed system of resource management.
Derek McDaniel is a programmer. He is interested in many things, especially in economics and mathematics. He can be reached over Twitter https://twitter.com/derekmc_ and Medium https://medium.com/@derek7mc/