Interest rates serve many purposes in a free market economy, making artificial manipulation all the more destructive.
- The interest rate signals societies' time preference for capital goods, intermediate and end stage goods. In other words, it is a signaling mechanism relayed to the entrepreneur regarding the amount to invest and in what area in the structure of production to allocate capital. Distortions in the interest rate causes even great entrepreneurs to missallocate capital, which would have been allocated efficiently otherwise, preventing productive jobs from being created, among other things.
- Market determination of interest rates would prevent asset bubbles due to the fact that when abnormal profits are recognized by potential investors they try to exploit these profits, which causes the demand for money to rise as more and more entrepreneurs seek out these abnormal profits. But as the demand for money rises, interest rates in a free market will necessarily rise. In other words, the abnormal profits have a decreasing net present value as interest rates rise. This rate also has implications regarding consumption and savings.
- The natural market mechanism is to save your way out of recessions, promoted by the high cost of money. In a recession, the demand for money increases as well (people tend to be cautious when they are uncertain about their financial future, thus driving up the demand for money). So in recessions/depressions, interest rates should be higher than normal, not lower than normal. This is basic economics as savings generates investment or "capital formation" which is what creates viable and productive jobs.
- As high interest rates drive down peoples' time preference, the process of capital formation begins immediately.
Interest Rates In a Centrally Planned Economy: What The Fed Is Doing
- Drive the boom-bust cycle as we have seen recently in 2001 and 2008. It was the artificially low cost of borrowing that caused the missallocations of capital (as entrepreneurs interpretation of societies time preference was distorted).
- The Prolonged period of cheap money bred a society that didn't hold savings in high regard. The consumer culture the US has transformed into was a direct result of this anti-saving mentality. The savings rate went negative for a while but is being prevented from reaching a level that will generate capital accumulation because of our 0% interest rate policy.
- Individuals took out loans which wouldn't have been granted to them had the market determined the prevailing rate of interest.
- The economy has fallen and can't get up. The savings rate continues to remain dangerously low, even in the current environment. It had picked up for a while, but the most recent GDP report showed a record 71% was composed of consumer spending. In other words, the opposite of what we need to have a real recovery.
- Investments taken on now, will only serve to cause further capital missallocation.
- To keep rates low the Fed is injecting money into the system, having multi-billion treasury auctions, engaging in interest rate swaps with the ECB, monetizing hundred of billion of debt, all in an attempt to keep rates low.
- The long end of the curve (which helps determines the cost to service our interest on the public debt) is also being held down artificially, but this will only lead to skyrocketing rates (look at Iceland).
The Federal Reserve has to get out of the way before it is too late. By letting the market determine the interest rate(s), this will not only allow for the quickest recovery possible, but also take hyperinflation off the table.
