Rob's Blog

Interest rates are controlled politically. They have no relationship to any market. Detlev Schlichter argues that in a free market, interest rates are simply indicative of time preference. It’s no good artificially changing them to encourage investment, because you’ll be diverting money away from present consumption that people want, to future consumption they don’t want.

For any society that prefers more goods and services to fewer goods and services, a high savings rate and low interest rates are certainly desirable, as these two will help build and maintain the capital stock that allows for high-productivity production processes. Yet, it is also clear that any attempt to force interest rates lower through market intervention is dangerous and ultimately futile. Low interest rates are of no use but, indeed, harmful if they do not correspond with the population’s time preference. If the government of a poor country managed to artificially lower the interest rates on the loan market with the aim of encouraging borrowing, investing, and the expansion of a wealth-enhancing capital stock, they would certainly not do their population any favors. The low rates would cause the reallocation of scarce resources away from where they help meet present consumption needs to where they will deliver future and better and cheaper goods. However, the time preference of the population is still high. Meeting the needs of the present is still a priority, and only higher interest rates will communicate these preferences correctly and ensure the appropriate use of resources. In an extreme scenario, we could imagine people having to go without food, clothes, or shelter while resources get shifted to building factories and office buildings.

Schlichter also shows how fractional reserve banks can reduce interest rates to encourage people to take out loans. This is how they decrease their reserve ratios, creating money.

in order to expand their loan business, fractional-reserve banks lower the interest rate on new loans and, as more loans are extended, bring new money into existence. Since the effect on the loan market is identical to an increase in voluntary savings, the entrepreneurs who take up the extra funds and invest them have no way of distinguishing one from the other.

So entrepreneurs, encouraged by all this cheap credit, invest in new projects. This applies particularly to marginal projects that would not be viable at a higher interest rate. These projects are likely to fail when demand fails to materialise and prices start to rise as a result of the new money creation.

What I don’t understand is how this fits in with the current situation. We are told that banks are not lending enough money and no-one is investing. And yet interest rates couldn’t be much lower. What is the missing part of the picture?

A comment by COB on ESR’s blog:

A problem with social contract theories that allow taxation (and other forms of institutionalized conscription) in the name of some collective good is that they purport to bind people not yet able to participate in the decision-making process (future generations). This is especially pernicious when future resources are allocated for current consumption through government debt and deficit spending. Generational indentured servitude is incompatible with personal liberty, and it’s just one of the milder consequences of collectivist philosophies.

If I steal £100 from you and use it to pay the wages of a railway worker, I have not stimulated the economy because you will now be unable to use that £100 to buy a new pair of shoes.

It really is that simple. So why do ministers and intergovernmental organisations struggle with it so much?

In response to my review of The Spirit Level Delusion, commenter John asked:

If I had a chance from birth of living in a competitive environment, based on hierarchical ranking, acording to ‘public achievement’, or a more cooperative one in which everyone thought more about the welfare of each other rather than themselves, based on ‘personal fulfilment’, I know which one I’d prefer.

What about you?

I think this explains a lot about why people find socialism appealing. They want to live in a village from a children’s story, with the postman always helping out the baker. They want to live in Happyland. But they forget that human nature makes this impossible, so they get into all kinds of trouble trying to bend human nature.

It is possible for people to co-operate and think about each other’s welfare. Families, groups of friends and even companies do it all the time. But it does not scale. It is not human nature to care very much about the welfare of someone in another city you’ve never met. You might say you care, but are you willing to sacrifice a family holiday for a random stranger?

The Spirit Level is not a book about places where people are co-operative and care about each other’s welfare. On the contrary, it describes societies where wealth is redistributed by force.

If people really cared more about the welfare of strangers than their own, you would not need the force. Wealth has to be redistributed through taxation, that is to say by threatening to put people in prison unless they pay money to the government. Since they’re not doing it voluntarily, it’s safe to presume that the people who are net payers into the system either resent it, or have been persuaded that they are really paying into a fund that will at some point in the future benefit them personally, or otherwise do not understand what is going on.

It’s not sounding much like Happyland.

So what really happens when people are forced to “co-operate” and “care” about each other’s welfare? Human nature is revealed: people follow the incentives in front of them. If I find that I have to do twice as much work to earn 50% more, I am likely to decide that it’s not worth it. So you lose some of my productivity. What you get from me will be less than my ability could provide.

If people find their needs are met without any effort, they’ll take that deal; it would be irrational not to. But it’s not a very satisfying existence, so you end up with lots of unemployed, unemployable people causing trouble, and the productive people resenting them. After all, people know what is fair. If half of your earnings are taken away so that a stranger can live in a big house for free, it’s not fair.

So perhaps if Happyland was on offer, I would choose to live there. But it’s not. Attempts to force Happyland into existence invariably end up like the Twentieth Century Motor Company of Starnesville, Wisconsin. Everyone might be equal, all right, but they’re a lot poorer and not too happy about it.

Now you might be getting the impression that I take a dim view of human nature. Far from it. If people are left to their own devices; if they stand by their own achievements; if they are not faced with perverse incentives such as being better off by not working; then they are resourceful, they co-operate, and they help each other. It’s much easier to help someone if you know him personally, and you can decide for yourself whether or not to help him based on your own judgement of his merits. You’ll do it willingly.

If you know you can work twice as hard and reap all of the benefits, you’re more likely to do so and your productivity will be of value to others. The generally increased productivity means people are richer.

If you know that your choices are to work hard to feed and house yourself, or to go cap in hand to your family, friends and neighbours, you will work hard. And if you fail, people will see that you tried and will help you. That’s human nature too.

It’s the Happylanders who think that freedom equals chaos who have a dim view of human nature.

So I’ll take the competetive environment, thanks. I’m a net producer, so I already know I’d do well in it. And given the chance, I’ll look after me and mine, and they’ll look after me.

I found myself at a social gathering sitting between a civil servant and a fireman. “What do you do?” asks the fireman. “I’m a civil servant,” answers the civil servant.

Why do they answer like that? Surely you must do *something* in the civil service? Are you a tax inspector and don’t want to admit it in front of strangers, or do you do something utterly mundane and think that civil servants command respect? Or perhaps the explanation is mundane and your job is a bit hard to explain and it’s easier to be vague.

In any case, “did you go on strike?” asks the fireman. Apparently, the civil servant has to reapply for her job, and either had a day off to do that or had to go somewhere else to do it, because whatever it was that needed to be done, she chose to do it on the day of the strike. “Because I didn’t want to cross the picket line, but I didn’t want to lose a day’s pay either.”

“It’s terrible isn’t it?” says the fireman. “Something has to be done.”

“The MPs are riding roughshod over everyone,” says the civil servant. “*They* get better pensions than us. I wish I had gone on strike. I wouldn’t mind doing anything to annoy that lot.”

It really is another world.

I held my cool, only for my wife’s sake, really. I have no particular desire to be friends with such people. But if I was to say:

Reapplying for your job is par for the course in the private sector. We don’t get nice final salary pensions, either. And frankly, it sounds like you civil servants are riding roughshod over everyone, and perhaps the MPs are, for once, representing people like me who have to pay for your pensions. But they’re not going nearly far enough. There’s no money to pay for you any more. Taxes could be increased, but it would not increase revenue because we have reached the point where production is retarded enough by a tax to more than cancel out the benefit. The government is borrowing £5000 per household per year, and this cannot continue, partly because the people doing the lending are about to realise they will never get paid back. So I wish you would lose your job and go and do something that doesn’t cost me quite so much money.

If I were to say that, I would be considered a very bad and mean person and no longer welcome at the social gathering. And yet, I’m not the one whose income depends on violence against others.

The only way this state of affairs has come about is through euphemisms like “civil servant” and “tax”, and the failure of pretty much everyone to think properly.

I listen to Radio 1 partly because it is apolitical, and I mostly don’t want to hear about other people’s politics (especially the BBC’s) first thing in the morning. But this morning, Chris Moyles started talking about tax.

He was jokingly persuading listeners to give breakfast show team members £200,000 each if they won the lottery. (With 8 million listeners someone is bound to win!) Then someone pointed out that they would only get £120,000 after tax.

…and the taxman goes [knock knock knock] “I think you’ll find a little bit of that belongs to me.” How does that work? He’s not done anything for it.

I have recorded the segment to MP3.

Now Moyles is a kind of man-in-the-street sort of character as far as views on this sort of thing go. So this could be considered what the man in the street thinks about tax. Most people would probably agree. So why don’t they follow opinions like this through to their logical conclusion?