8. Interest Rates and Investing Against Our Will

In order to better understand the how and why of interest rates it is revealing to consider interest rates in a barter society and then consider how things behave with the introduction of money. The idea of an interest rate even existing in a barter system may sound like a contradiction in terms, but it is actually perfectly possible.

Interest rates in a barter economy

Imagine a primitive society where much of the labour is tied up in the process of simply collecting enough food to eat. Also imagine that they have the technology to make non-perishable food, let’s say salted fish. The society is organised enough so that all the citizens pool their spare food and place it in the hands of a wise and trusted person, the world’s first “banker”. The idea is people can be “loaned” food so that they can temporarily be relieved of the burden of having to find food for themselves. This enables them to carry out some project, like building a house or a boat. People can approach the banker and ask to “borrow” some of the food (we say borrow, but of course they will consume it and have to pay back new salted fish, which they will either catch themselves or obtain by bartering goods they make in the future). People who save their fish with the banker tell him how long he is allowed to lend it out before they want it (or a replacement) back and the banker keeps this in mind when making loans.

The banker will charge some kind of interest rate, i.e. will insist that the borrower pay back all the fish plus some extra amount that would correspond to profit shared between the banker and the community. Assuming that the banker wishes to maximise this profit, what interest rate should he charge?

The banker’s best option is to adjust his advertised interest rate to exactly balance the supply and demand for loans. As demonstrated in chapter ?, the banker will aim to tweak the interest rates such that all his possible loans are taken up, but only just. If he sets it too high then not all of the spare food will get lent out. If he sets it too low then the food will very quickly get lent out, but new borrowers will still be coming into the bank asking for loans and the banker will have to turn them away.

To summarise:

In a barter system, interest rates will be adjusted to balance the supply and demand for loans.

Interest with money in a fractional reserve banking system

Now let’s consider what would happen if instead of storing their spare salted fish with the wise and trusted person, the same society switched to using money, cheques and fractional reserve banking. What would happen to the supply and demand for loans then? Presumably the characteristics of the demand for loans would be unchanged; after all, it’s the same people with the same list of projects that they’d like to pursue. But now the characteristics of the supply of loans are completely different. The amount of money that can be supplied has the potential to be much larger than the amount of money that the society gave to the banker by way of savings. Exactly what happens next is subject to all sorts of complications, but for the moment let us consider three possible interest rates that the banker could choose to charge:

• Barter rate: The banker could choose exactly the same rate as had been determined under the barter system. This was the rate that led to people borrowing an amount equal to what was being saved, i.e. the total spending power of all the cheque books handed out would be approximately equal to enough money to purchase the salted fish that the community wished to save.

• Greater than barter rate: The banker could choose a higher rate of interest than the barter rate. This would deter people from borrowing and lead to less money being lent out than society had saved, i.e. the total spending power of all the cheque books handed out would amount to less than enough to purchase the salted fish that the community wished to save.

• Less than barter rate: The banker could choose a lower rate of interest than the barter rate. This would encourage people to borrow and lead to more money being lent out than society had saved, i.e. the total of all the spending limits of all the cheque books that were handed out would amount to more than enough to purchase the salted fish that the community wished to save.

Now clearly the barter rate and higher are both perfectly possible; no laws of physics are being broken. But the less than barter rate seems perplexing at first glance. How could banks lend out more than was being saved? This does sound like breaking the laws of physics! But it can all be resolved. The lending of “money” (cheque books with spending limits) over and above barter rate corresponds to a newly expanded money supply and will naturally lead to inflation. This inflation decreases the spending power of the money held by the community. It’s almost as if the community were paying a kind of tax. The community is forfeiting part of its spending power. This loss of spending power of the community corresponds to the new spending power of the “excess” borrowers, i.e. the extra people who got loans over and above that which would have been lent out under the barter system.

Setting a too low interest rate is effectively forcing the community, against its will, to make these extra loans. The inflation deprives them of real goods and services which are instead being purchased by the excess borrowers. This is a subtle mechanism that the community may not even realise is going on.

So now that we know that all three options are available to the banker, and none of them break the laws of physics, we need to ask what rate the banker will actually choose. Because the supply of money for lending has the potential to expand enormously, the banker is no longer constrained by the normal forces of supply and demand. Instead the banker only need consider whether he can make a profit on the loans.

With fractional reserve banking, interest rates are not set to balance the supply and demand for loans. Instead they are a politically controlled tool that determines the amount of lending that can occur in an economy. The interest rate can be adjusted such that the amount of borrowing that occurs can be set to lower than, the same as or higher than society would naturally choose to lend out had it been left to its own devices.

This idea is not new. Indeed it is one of the cornerstones of Austrian economics. The ability of bankers (in conjunction with governments) to effectively set the amount of lending to above or below what society is naturally willing to save is not necessarily a bad thing in and of itself. If, for example, society had an inclination to save too little then industry may suffer from a lack of investment, and the society as a whole would suffer in the long term. It could potentially be a good thing for the government to force more savings. Having said that, it is also true that the ability for excess lending to take place has the potential to do great harm and so would need to be controlled with great skill and care. Sadly, perhaps more skill and care than most governments are capable of delivering.

In conclusion

Bankers have every incentive to do as much lending as they can make a profit from rather than simply lending out what has been saved by society. This fact leads to many interesting behaviours on the part of bankers which we shall explore in the following chapters.

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