"Most people are in arrested development and cannot use logic." Jacob.
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"America is unique in that our economy is totally dependent on global charity." Peter Schiff

Wednesday, July 27, 2011

Deep Stuff on Interest Rates, and Why It Matters.

We've talked about interest rates in our humble blog already [and here and here].

Today I saw a very intriguing line in an article over at fee.org, and so we'll quote it and talk about it.

Keynes argued in the General Theory (1936) that interest rates are determined by the supply and demand for central-bank money (cash) and not by the supply and demand for savings (or loanable capital), as his predecessors from David Hume and Adam Smith on down to Alfred Marshall  explained.

Fascinating, hey? What does it mean?

One of the grandest mistakes ever made was Mercantilism. Its central tenet was that wealth means money. In the old days it was gold. Nowadays it's dollars. But the object of all enterprise is to get more gold or more dollars.
Clearly a Mercantilist.
 They forgot that getting money is not the end in itself, but a means to an end. The end is getting what money can buy.

Keynes is making a similar mistake. He thought that people want not what money can buy, but money itself. When they lend money they want interest not because they are delaying their chance to get what money can buy, but rather delaying their possession of the money itself. Classical economists thought the opposite.

OK, that's the difference. But what's the big deal? Isn't it hairsplitting?

Nope. In fact it is a vital component, perhaps the single most important reason, why we are in the mess we are in today, and why we won't get out of it unless something drastic happens. To see why, let's quote a bit more from that amazing FEE article. It goes on:

Therefore, in Keynes’s view, it is the responsibility of a central bank to so increase its supply of money as to depress interest rates to such a low level as to result in the “euthanasia of the rentier, of the functionless investor,” who relies on “the cumulative oppressive power of the capitalist to exploit the scarcity-value of capital” to demand interest payments.  That is, money should become so plentiful that no one would be obliged to pay interest to borrow it.  (Of course, Keynes here confuses money with savings or wealth.) Indeed, the money (cash) supply-and-demand theory of interest rates was the predominant view among the sixteenth-eighteenth-century Mercantilist thinkers.

In other words, interest exists because there is not enough money. When gold is the money, we are in a fix. We are not alchemists and cannot make more gold. But if we are one of those lucky lucky countries where paper is the money, then we are good to go. We just print up huge piles of dollar bills [paper or digital], so much that there is no shortage of the stuff. Thus we lower interest rates, which ends oppression. We are freed, do you hear me, freed!

And indeed, as we speak, Ben Bernanke and every other central banker in the world is actively creating paper and digital money for the precise goal [among others] of lowering interest rates. They believe that it can be done, because they believe Keynes, that interest rates are determined by the supply and demand of money itself.

OK guys, FEE deserves to be looked at. So read up over there why Keynes is wrong, why interest rates cannot be held down by printing money [except for a short time]. Read up on the Austrian Business Cycle Theory to find out why lowering the rates artificially like that causes exactly the disasters we are in the middle of right now.

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