Thursday, July 24, 2008

Another interest rate decree set to distort the economy

In less that an hour, Reserve Bank governor Alan Bollard will bring down from the mountain tops his latest decree on the country's interest rates, which he will deliver to us with all the gravity of one who has just been to the mountain tops communing with the economic gods.

He hasn't, of course -- instead, he's been interviewing his calculator.

In his view, and the view of those who support the mainstream economic model on which his pronouncements are based, from his calculator issues forth all the wisdom that the market lacks. According to these mainstream economic models, interest rates can't do their job -- they are governed by irrational "animal spirits" (yes, this is the sort of 'thinking' on which the mainstream economic models are based) -- and they require the likes of Bollard to do the job for them with calculations like this one, in which the interest rate, r=p + 0.5q +0.5 (p-2) +2, and p is defined as the inflation rate over the previous year, and q represents a notional figure based on guessing what 'full output' looks like.

Elegant, huh? The figures '2' appearing there, by the way, indicate the banker's nominal inflation target of two percent.

If you've ever wondered why economies experience severe business cycles -- lurching cyclically from boom to bust, from inflation to stagflation -- then the heart of the answer lies in the failure of this flawed economic model, and the difference between the interest rates brought down from the the mountain (or received from their calculators) by the likes of St Bollard, St Greenspan and St Bernanke, and the 'natural interest rate' that would be set by the market if interest rates and the money supply weren't being meddled with by the likes of these beatified few.

The 'natural' interest rate is not set by central bankers. In fact, it's not set by bankers at all. It's set by the natural time preference for money of numerous individuals, as shown by their spontaneous decisions to save or consume or invest.

Time preference is simple to explain, but profound in its implications. It is simply a measure of how much I prefer present satisfaction to future satisfaction, as demonstrated by my own actions. If I demonstrate by taking out a loan that I prefer $100 dollars now to $110 one year from now, then that suggests a 'natural' interest rate of ten percent, as demonstrated by my own demonstrated time preference. If I find a lender willing to forego his own consumption of that $100 for one year on the basis that he will receive my $110 in a year, then he has demonstrated a similar and reciprocal time preference.

It is on simple decisions such as this on which a rational market is based.

The natural market interest rate is simply the sum of all such preferences shown by borrowers and lenders across all markets, and if coordinated through the voluntary choices and actions of individual actors the result is to provide the necessary constraints and incentives to keep savings in line with investment, and to distribute new resources to future investment projects, based all the time on people's demonstrated willingness to forego present consumption. Left alone, instead of being used to further the political goals given to the world's central banks, interest rates can do their "growth governing" job - if, to stress the point, they are allowed to.

I'll leave it as an exercise for you, the reader, to work out what happens when people's demonstrated willingness to forego present consumption does not match the resources distributed to future investment projects -- which is what happens when interest rates are set by saints bringing down wisdom from the mountain tops instead of by simple market forces.

NB: In fact, I'll only leave it until tomorrow to muse upon the question, since I propose to answer it tomorrow with some rather tasty looking graphs. Keep watching.

UPDATE 1: As you've probably heard if you're reading this now, Bollard's calculator told him to make a cut in interest rates this time, the first interest rate cut in five years [Herald story here]. The NZ dollar had already eased slightly in anticipation...

UPDATE 2:  ... the dollar had eased slightly, but not as quickly as it 'eased down' after forex dealers heard the sound of Bollard's chickens coming home to roost.  Interest rates: they play a huge part in setting our exchange rate; they're the means by which we divide up our income between consumption and investment; they set the levels at which resources are distributed to projects with  a long-term payoff ... and all Bollard's calculator is able to do for him is confirm the failed myth that he is capable of  influencing inflation, without apprising him of the damage he's doing in the process.  [Thanks to Lou at No Minister for the graph.]

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9 Comments:

Anonymous Sean said...

In an age were policy makers have generally come to see the irrationality and destructiveness of price controls, it seems bizarre that the most important price is set centrally.

7/24/2008 09:46:00 am  
Blogger Ruth said...

Bollard can't influence anything - let alone the exchange rate -for longer than a week or so. NZ is way too small in the global marketplace. Offshore traders come in and take their pickings - as we have seen this morning -then move on to the next thing.

I wouldn't bolster the man's ego by suggesting he sets prices.

7/24/2008 01:12:00 pm  
Anonymous Sean said...

Ruth,

You make a good point. However, most New Zealand citizens can not avoid the interest rates set by the RB.

7/24/2008 02:17:00 pm  
Blogger Ruth said...

They can and do avoid it though Sean. Unless they have funds on call and cannot access the international market.

That is what Mises 'Human Action' is about.

I'm just saying that Bollard does far less damage than unreconstructed Austrians like to admit. Globalisation and EFT have changed things.

7/24/2008 03:28:00 pm  
Anonymous Sean said...

Ruth,

1)I am not convinced you understand exactly how the OCR works (to control the interest rate that is--It is dubious to claim it controls inflation).

2) The evidence is that most NZers do not transfer funds overseas. So my point stands. Additionally, you provide no solution for how NZ borrowers are to avoid the OCR rate.

7/24/2008 04:39:00 pm  
Blogger Ruth said...

Perhaps you can tell us all how the OCR DOES work eh?

If it worked we would not be in the mess we are in today.

All C/A deficit is borrowed offshore so you don't know what you are talking aboout my dear. Borrowers are hedged so can avoid it almost indefinitely if they are smart.

7/24/2008 05:59:00 pm  
Anonymous Sean said...

Ruth,

We are agreed, the OCR does not work! (though we may be using different standards).

Of course all CA debt is financed through borrowing (that's definitional!). But that does not mean that they are getting a rate less than the OCR. Why would overseas savers give you a rate less than the OCR when the can get the OCR rate from NZ banks thanks to the infinite finance provided by the RB?

7/24/2008 06:10:00 pm  
Anonymous Fat Girl said...

Sean, Ruth knows exactly what she's talking about because she is in the business of dealing in the forex market. Listen to the experts and stop trying to argue like someone who pretend to know.

7/25/2008 09:52:00 am  
Anonymous Sebastian said...

Ruth's Fat Girl,

What does the Forex market have to do with the OCR exactly? PC is talking about the OCR. That is, the loanable funds market. Not the foreign currency market.

Ruth,

Sure people can hedge, but that is a one of protection. It does not provide endless protection. Really, your posts are rather vague and unsubstantial assertions thus far. People you illuminate us with your wisdom with a detailed post.

7/25/2008 03:01:00 pm  

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