By Frank Shostak*
Most experts agree that through the manipulation of short-term interest rates, the central bank by means of expectations regarding future interest rate policy, can also dictate the direction of long-term interest rates. In this way of thinking expectations regarding future short-term interest rates are instrumental in setting the long-term rates. (Note the long-term rates are an average of short-term rates in this way of thinking.)
Given the supposedly almost absolute control over interest rates, the central bank by correct manipulations of short-term interest rates could navigate the economy along the growth path of economic prosperity, so it is held. (In fact, this is the mandate given to central banks.)
For instance, when the economy is thought to have fallen below the path of stable economic growth it is held that by means of lowering interest rates the central bank could strengthen aggregate demand. This in turn will be supportive in bringing the economy onto a stable economic growth path.
Conversely, when the economy becomes “overheated” and moves onto a growth path above that which is deemed as stable economic growth, then by lifting interest rates the central bank could slow the economy back onto the path of economic stability.
But is it valid to suggest that the central bank is the key factor in the determination of interest?
Individuals Time Preferences and Interest Rates
According to great economic thinkers such as Carl Menger and Ludwig von Mises, interest is the outcome of the fact that every individual assigns a greater importance to goods and services in the present against identical goods in the future.
The higher valuation is not the result of capricious behavior, but because of the fact that life in the future is not possible without sustaining it first in the present. According to Carl Menger,
Human life is a process in which the course of future development is always influenced by previous development. It is a process that cannot be continued once it has been interrupted, and that cannot be completely rehabilitated once it has become seriously disordered. A necessary prerequisite of our provision for the maintenance of our lives and for our development in future periods is a concern for the preceding periods of our lives. Setting aside the irregularities of economic activity, we can conclude that economizing men generally endeavor to ensure the satisfaction of needs of the immediate future first, and that only after this has been done, do they attempt to ensure the satisfaction of needs of more distant periods, in accordance with their remoteness in time.1
Hence, various goods and services that are required to sustain man’s life at present must be of a greater importance to him than the same goods and services in the future.
On this Menger wrote,
To the extent that the maintenance of our lives depends on the satisfaction of our needs, guaranteeing the satisfaction of earlier needs must necessarily precede attention to later ones. And even where not our lives but merely our continuing well-being (above all our health) is dependent on command of a quantity of goods, the attainment of well-being in a nearer period is, as a rule, a prerequisite of well-being in a later period. Command of the means for the maintenance of our well-being at some distant time avails us little if poverty and distress have already undermined our health or stunted our development in an earlier period.2
Similarly, Mises wrote that,
He who wants to live to see the later day, must first of all care for the preservation of his life in the intermediate period. Survival and appeasement of vital needs are thus requirements for the satisfaction of any wants in the remoter future.3
Life sustenance therefore serves as the standard of valuation regarding present goods versus future goods. According to Mises,
If he (the consumer) were not to prefer satisfaction in a nearer period of the future to that in a remoter period, he would never consume and so satisfy wants. He would always accumulate, he would never consume and enjoy. He would not consume today, but he would not consume tomorrow either, as the tomorrow would confront him with the same alternative.4
As long as the means at an individual’s disposal are just sufficient to accommodate his immediate needs, he will most likely assign less importance for future goals. With the expansion of the pool of means, the individual can now allocate some of those means toward the accomplishments of various ends in the future.
Life Sustenance and Zero Interest Rate
As a rule, with the expansion of the pool of means people tend to allocate more means toward the accomplishment of remote goals in order to improve their quality of life over time.
With scarce means, an individual can only consider very short-term goals, such as making a primitive tool. The meager size of his means does not permit him to undertake the making of more advanced tools. With the increase in the means at his disposal, he could consider undertaking the construction of better tools.
No individual undertakes a goal, which promises a zero return. The maintenance of the process of life over and above hand to mouth existence requires an expansion in wealth. The wealth expansion implies positive returns. It is through the generation of wealth, after allowing for the maintenance of life and well-being in the present, that savings become possible.
These savings in turn permit further expansions in wealth. The expansion in the pool of real wealth permits a greater allocation of savings toward longer-term goals, implying a greater preference for future goods, i.e., a lowering of interest rates.
While prior to the expansion of real wealth the need to sustain life and well-being in the present made it impossible to embark on various long-term projects, with more wealth this has become possible. The extra wealth that becomes available is invested because the expected future benefits outweigh the benefits of consuming them in the present.
Interest rates Guide Business Decision Makers
Since in the market economy interest is calculated in money terms, it would appear that money is a determining factor of the level of interest. Being the medium of exchange, money only facilitates the flow of real savings from lenders to borrowers, or from suppliers to demanders. Money however, has nothing to do with the fact that interest is the outcome of a higher valuation of present goods versus future goods.
Changes in interest rates instruct businesses about the feasibility of undertaking various capital projects. A fall in the interest rate will mean that a greater proportion of means was made available for these projects. Conversely, a rise in the interest rate will imply that less funding is available to these projects.
In setting an interest rate, both a buyer and a seller of real savings must allow for the fact that central banks relentlessly depreciate the purchasing power of money by means of the printing presses.
Hence, expectations for depreciation in the purchasing power of money will contribute to an increase in interest expressed in money terms. Conversely, expectations that money’s purchasing power will increase will contribute towards the lowering of interest.
Observe that monetary pumping, which erodes the purchasing power of money, also weakens the flow of real savings by setting an exchange of nothing for something. This weakens the formation of real wealth, which in turn increases people’s preference toward present consumption and hence to a rise in the underlying interest rates that corresponds to individuals’ time preferences. To conclude then over time, monetary pumping lifts the level of interest rates.
Does the Lowering of Interest Permit Greater Capital Formation?
Being the outcome of the fact that life sustenance imposes a greater importance to present goods versus future goods, interest as such does not cause more or less investment, as popular theories have it.
It is true that businessmen react to interest rates. In this sense, the interest rate can be regarded as an indicator. What permits an expansion of capital goods production is not interest rates as such but the increase in the pool of real savings. A greater allocation of real saved wealth toward the buildup of capital goods, manifested by the lowering of people’s time preferences — the lowering of interest rates. (Note again what enables the expansion of capital goods investments is the greater allocation of real saved wealth and not the lowering of interest rate as such, which just reflects the greater allocation of real wealth toward the capital investment.)
When interest rates are not tampered with, they serve as an important tool in facilitating the flow of real savings toward the build-up of a wealth-generating infrastructure.
Whenever the central bank tampers with interest rates 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. An overinvestment in capital goods and an underinvestment in consumer goods emerges. While an overinvestment in capital goods results in a boom, 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.5
To conclude, as long as life sustenance remains the ultimate goal of human beings they will continue to assign a higher valuation to present goods versus future goods and no central bank interest rate manipulation will be able to change this.
Any attempt by central-bank policy makers to overrule this fact will undermine the process of real wealth formation and thus lower people’s living standards.
The central bank can try to manipulate the interest rate to whatever level it desires. However they cannot exercise control over the underlying interest rates as dictated by people’s time preferences. When the central bank engages in a persistent lowering of interest rates this policy sets in motion an increase in the underlying interest rates as dictated by people’s time preferences. (The exact opposite of the central bank’s intention.)
It is not going to help true economic growth if the central bank artificially lowers interest rates whilst the people did not allocate an adequate amount of real savings to support the expansion of capital goods investments. It is not possible to replace real saved wealth with more money and the artificial lowering of interest rates. It is not possible to generate something out of nothing as suggested by Keynes and his many followers.
About the author:
*Frank Shostak’s consulting firm, Applied Austrian School Economics, provides in-depth assessments of financial markets and global economies. Contact: email.
This article was published by the MISES Institute.
1. Carl Menger, Principles of Economics (New York: New York University Press, 1976), p. 154.
2. Ibid., p. 153.
3. Ludwig von Mises, Human Action, 3rd rev. ed. (Chicago: Henry Regnery, 1966), p. 486.
4. Ibid., p. 484.
5. Murray N. Rothbard, For a New Liberty (New York: Collier Books, 1978), p. 189.