What Are Interest Rates And Can They Be Artificially Low Or High?

Many economic commentators believe that interest rates in America and around the world are “artificially low”. Indeed, I too have used the term in the past to refer to the condition in Europe that saw interest rates across the member states converge to a uniformly low level at the introduction of the Euro, only to diverge and soar in the periphery during the ongoing crisis.

So what is an interest rate? An interest rate is the cost of money now. As Eugen von Böhm-Bawerk noted, interest rates result from people valuing money in the present more highly than money in the future. If a business is starting out, and has insufficient capital to carry out its plans it will seek investment, either through selling equity in the ownership of the business, or through credit from lenders. For a lender, an interest rate is their profit for giving up the spending power of their capital to another who desires it now, attached to the risk that the borrower will default.

In monetary economies, money tends to be distributed relatively scarcely. In a commodity-based monetary system, the level of scarcity is determined by the physical limits of how much of a commodity can be pulled out of the ground. In a fiat-based monetary system, there is no such natural scarcity, but money’s relative scarcity is controlled by the banking system and central bank that lends it into the economy. If money was distributed infinitely widely and freely, there would be no such thing as an interest rate as there would be no cost to obtaining money now, just as there is no cost to obtaining a widely-distributed and freely-available commodity like air (at least on the face of the Earth!). Without scarcity money would lose its usability as a currency, as there is no incentive to trade for a substance which is uniformly and effectively infinitely available to everyone. So an interest rate is not only the cost of money, but also a symptom of its scarcity (and, as Keynes pointed out, a key mechanism through which rentiers profit).

So, where does the idea that interest rates can be made artificially low or artificially high arise from?

The notion of an artificially low or high interest rate implies the existence of a natural interest rate, from which the market rate diverges. It is a widely-held notion, and indeed, Ron Paul made reference to the notion of a natural rate of interest in his debate with Paul Krugman last year. A widely-used definition of the “natural rate of interest” appears in Wicksell (1898):

There is a certain rate of interest on loans which is neutral in respect to commodity prices, and tends neither to raise nor to lower them.

This is easy to define and hard to calculate. It is whatever interest rate yields a zero-percent inflationary level. Because interest rates have a nonlinear relationship with inflation, it is difficult to say precisely what the natural interest rate is at any given time, but Wicksell’s definition specifies that a positive inflation rate means the market rate is above the natural rate, and a negative inflation rate means the market is below the natural rate. (Interestingly, it should be noted that the historical Federal Funds Rate comes pretty close to loosely approximating the historical difference between 0 and the CPI rate, despite questions of whether the CPI really reflects the true price level due to not including housing and equity markets which often record much greater gains or greater losses than consumer prices).

The notion of a natural rate of interest is interesting and helpful — certainly, high levels of inflation can be challenged through decreasing interest rates (or more generally increasing credit-availability), and deflation can be challenged by decreasing interest rates (or more generally increasing credit availability). If the goal of monetary policy is price stability, then the notion of a “natural interest rate” as a guide for monetary policy is useful.

But policies of macrostabilisation have been strongly questioned by the work of Hyman Minsky, which posited the idea that stability is itself destabilising, because it leads to overconfidence which itself results in malinvestment and credit and price bubbles.

Austrian Business Cycle Theory (ABCT) developed by Ludwig von Mises and Friedrich Hayek, most influentially in Mises’ 1912 work The Theory of Money and Credit, theorises that the business cycle is caused by credit expansion (often fuelled by excessively low interest rates) which pours into unsustainable projects. The end of this credit expansion (as a result of a collapse resulting from excessive leverage, or from the failure of unsustainable projects, or from general overproduction, or for some other reason) results in a panic and bust. According to ABCT, the underlying issue is that the banking system made money cheaply available, and the market rate of interest falls beneath the natural rate of interest, manifesting as price inflation.

I do not dispute the idea that bubbles tend to coincide with credit expansion and easy lending. But it is tough to say whether credit expansion is a consequence or a cause of the bubble. What is the necessary precursor of an unsustainable credit expansion? Overconfidence, and the idea that prices will just keep going up when sooner or later the credit expansion will run out steam. This could be the overconfidence of central bankers, who believe that macrostabilisation policies have produced a “Great Moderation”, or the overconfidence of traders who hope to get rich quick, or the overconfidence of homeowners who see rising home prices as an easy opportunity to remortgage and consume more, or the overconfidence of private banks who hope to make bumper gains on loans or loan-related securities (Carl Menger noted that fractional reserve banking and credit-fuelled bubbles originated in economies with no central bank, in contradiction of those ABCT-advocates who go so far as to say that without central banking there would be no business cycle at all).

And is price stability really “natural”? Wicksell (and other advocates of a “natural rate of interest” like RBCT and certain Austrians) seem to imply so. But why should it be the norm that prices are stable? In competitive markets — like modern day high-tech markets — the tendency may be toward deflation rather than stability, as improving technology lowers manufacturing costs, and firms lower prices to stay competitive with each other. Or in markets for scarce goods — like commodities of which there exists a limited quantity — the tendency may be toward inflation, as producers may have to spend more to extract difficult-to-extract resources form the ground. Ultimately, human action in market activity is unpredictable and determined by the subjective preferences of all market participants, and this applies as much to the market for money as it does for any market. There is no reason to believe that prices tend toward stability, and the empirical record shows a significant level of variation in price levels under both the gold standard and the modern fiat system.

Ultimately, if interest rates are the cost of money, and in a fiat monetary system the quantity and availability of money is determined by lending institutions and the central bank, how can any interest rate not be artificial (i.e. an expression of the subjective opinions, forecasts and plans of those involved in determining the availability of credit and money including governments and central bankers)? Even under a commodity-money system, the availability of money is still determined by the lending system, as well as the miners who pull the monetary commodity or commodities out of the ground (and any legal tender laws that define money, for example monetising gold and demonetising silver).

And if all interest rates in contemporary markets are to some degree artificial this raises some difficult questions, because it means that the availability of capital, and thus the profitability (or unprofitability) of rentiers are effectively policy choices of the state (or the central bank).

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53 thoughts on “What Are Interest Rates And Can They Be Artificially Low Or High?

  1. All prices are artificial in the way that you use the word in this context.

    If banking were competitive, these artificial decisions would have to be adjusted and rates would converge around the theoretical construct of the “real interest rate” (or any other price). But the banking system in most Western nations isn’t a competitive environment, more like a broken cartel held up by the state or central bank. So “prices” are meaningless because they’re just set by semi-state agents guessing without any feedback on their guesses.

    • The reserve requirement, the central bank’s interest rate, and the quantity of money are set by the central bank, which are the three most important features in determining interest rate, and this permeates every market that contains money. Price feedback mechanisms can still exist, though, although there will be some monetary distortions. But even in an unadulterated commodity-money system there will be monetary distortions (e.g. rate of gold discovery, rate of silver discovery, competition between various variations of the Bitcoin).

      • I would offer forth the definition of the natural interest rate as the sum of the cost factors of the real growth rate, to wit: the population growth rate, n’/n , the productivity growth rate, a’/a and the capital depreciation rate d’/d. These are slowly changing over time and can be taken as constants. The sum of these is in the 4.5% to 4.75% range, so K = 4.5% say. Real growth also depends on employment level E’/E which causes the real interest rate to oscillate about 4.5%, making the real interest rate higher when employment is rising and lower when workers are being laid off.

        The employment cycle (business cycle) is obvious in all economic data and doesn’t have anything to do with central banks. It is caused by the Phillips Curve which is the observation that wages catch up with productivity gains during labor shortages and do not decline when workers are laid off, because employers compete for the best workers and prefer to lay off marginal workers when inventories get ahead of demand.

        A good introduction to the employment cycle is http://en.wikipedia.org/wiki/Goodwin_model_(economics) . If you download Scilab (free) you can write a simple 2 equation differential equation system to solve for the 2 variables . The 2 equations are orthogonal , i.e. out of phase by pi/2

        The simple Goodwin model can be adapted to the Quantity Theory of Money by adding 3 more equations which you will have to discover on your own.

        • ” do not decline when workers are laid off, because employers compete for the best workers and prefer to lay off marginal workers when inventories get ahead of demand.”

          Agreed. This must have more focus in economics research.

          Even if you are good at your job, human psychological frailty, especially insecurity can go a long way to explain increased savings rates, declining big ticket purchases, and collapsing asset bubbles (Convert to cash)

  2. I view the rate of interest in a very simple manner. It is the level at which the marginal hoarder of cash puts his money to work. The interest rate determines what rate borrowers borrow and the income savers get from their cash sitting in a bank or the yield of an asset(whether this is a capital asset or a financial asset).

    The role of the rate of interest is NOT what equalizes the level of savings to the level of investment. That’s where the classical theory of the rate of interest is wrong.

    • I must admit, from a psychological standpoint, I only save cash when the rates are so high and exciting, it makes it worthwhile. Otherwise, I put it to work in projects or just spend it. I do not know what other people do. I am irrational sometimes.

      When I was in banking, we had to increase the rate to build our book, so there is a market force at play. If there were no projects that met our lending criteria (Very risk averse Credit Manager) we would drop the rate to keep the book balanced.

      Cheap credit is flooding the system. I got an offer from Citibank today. Pre approved personal loan, 35K so I can “Buy a Car”, “Have that European Holiday” 10.99% fixed 3 years.

      I have not seen that for a while. Is 10.99% Cheap or expensive? Rabo Bank is offering 4.5% on savings, so 5.5% is not a big margin for an unsecured loan.

      Is Citibank pricing the rate correctly? Or is it loss leading?

      Benny Bucks are now hitting the street. I don’t think inflation will hit because of excess productive capacity. So Inflation is 3% or less.

      If people take their savings out and buy into the stockmarket, will Banks have to raise money for loans? Or we they issue Corporate Bonds to “Institutions” i.e. Retirement savings accounts are funding the “European Holiday”

  3. I’m not aware of Austrian economists who argue that without a central bank you wouldn’t have a business cycle. That’s pretty silly if they did, given the 19th century in the U.S. My understanding is that Austrians universally acknowledge fractional reserve banking as a source of the business cycle which the central bank amplifies and protects. Austrians are split between favoring FRB and opposing it, but I’ve never heard or read an Austrian favoring having a central bank, ever.

    Austrians absolutely, do NOT, say a policy aim should be price stability. Sure, they’re against expanding the money supply via fiat, but they aren’t like the monetarists in going for stable prices. Rothbard was highly critical of the the money expansion in the 1920s even though prices were relatively stable. My sense is that they are generally is favor of the natural and modest deflation that occurs with a growing economy.

    Austrians are primarily concerned with the production structure of society when the money supply is expanded by fiat. Obviously, nothing really has changed. However, the rate of interest has, and thus more capital intensive projects become feasible, apparently, but they are also illusory. If you don’t touch the money supply and prices naturally hee and haw, then so be it, that’s the market.

    All interest rates in a FRB / central bank economy are to a degree illusory. It’s to that degree that we have 2001 or 2008. It’s tempting to say that the interest rate solely represents how much money we can make and since its all fiat, a 0% rate could be manufactured. But, at a deeper level, its measuring how much capital is available in the sense of how much are people willing to forego spending in order to have greater wealth in the future. When you print extra fiat money, that time preference of society, as the Austrians call it, has not changed. Thus the disconnect between price signals, and thus the eventual demise of poor investments.

    • Andrew,

      Good comment. I’d add that Hayek, at least in Prices and Production, considered the cycle to be recurrent in any banking system practicing fractional reserve banking. However, banking theory has come a long way since 1933. There is a large literature that suggests that free banking, even fractional reserve banking, would be stable and I think most Austrians — except some of those at the Mises Institute and elsewhere — are gravitating towards this position.

      • I try not to read into to many theories from the past. I look at how society is structured today, and geopolitical realities, technology and consumer habits to decide on what we “theoretically” should do today.

        Although human nature never changes, and the free money that was handed out to the people of the “Radio Craze” to buy a radio, car, and other technological innovation is no different today.

        Also, do businesses who do not get a return from producing goods and services that are useful, plow their borrowed funds into property, because the returns are better? Indeed. But are the returns from easy credit given to the consumer i.e. cheap mis-priced money at Central Bank direction, the cause? I think so.

        Imagine if Japan bought real assets, such as mines, instead of property. It would ave had deflation through production, i.e. low rates, but the asset would have increased instead of decreased. Instead of being broke they would have been the kings of the world.

        Well China is doing this, and those ghost cities. The poor are being given the opportunity to put a small deposit down and pay back. That is good social policy.

        Japan’s mistake was listening to Keynesian Western thinking.

    • My understanding is that Austrians universally acknowledge fractional reserve banking as a source of the business cycle which the central bank amplifies and protects.

      Fractional reserve banking is a source of the business cycle. The position of some self-described Austrians particularly of those Ludwig von Mises Institute variety (such as Vereyser whose book I have been reading), though, is not that it is a cause but that it is THE cause. Personally, I think the original cause of fractional reserve banking in its original form (i.e. without a central bank liquidity backing) was (over)confidence.

      Austrians absolutely, do NOT, say a policy aim should be price stability. Sure, they’re against expanding the money supply via fiat, but they aren’t like the monetarists in going for stable prices. Rothbard was highly critical of the the money expansion in the 1920s even though prices were relatively stable. My sense is that they are generally is favor of the natural and modest deflation that occurs with a growing economy.

      I don’t think you can really describe a standard Austrian position at all on a lot of these subjects. How can you try and consolidate the positions of Rothbard and Hoppe with people like Fekete and Lachmann? The single uniting variable of “Austrian economics” is subjectivism. So on a question like “should we have a central bank?” I don’t think there is any uniform Austrian position (although there is a Ludwig von Mises Institute position, but I don’t think LVMI has a monopoly on Austrian economics!) There are even some self-described-Austrians who favour a central bank, people like Selgin and White, who believe in NGDP targeting. Hayek might fall into this category too.

      • When I wrote about “Austrian” views I talking about the general sense I’ve gather from the authors I’ve read over the years. It was not an exact definition of what it means to be Austrian. As far as Austrians supporting central banks, it doesn’t seem to be the norm, but clearly I was ignorant of the Austrians who do support them. The label “Austrian” may be subjective, but it still implies a vast difference from Keynesian even though neither terms are neatly defined.

        • Please see Selgin’s response below; he certainly does not favor central banking (check out the great blog freebanking.org ). Selgin and White favor NGDP targeting only as a step on the path towards a Free Banking system.

          As a Free Banking advocate myself, I would be quite happy to see even this much:
          1) NGDP level targeting at 4%
          2) End of too-big-to-fail (#1 will protect against any resulting sharp monetary contraction)
          3) End of deposit insurance

          Scott Sumner wrote a nice post about NGDP targeting as a necessary step to precede #2 and #3:

          “we’ll abolish TBTF, as we’ll no longer fear that big bank failures will lead to recessions. And then we’ll abolish FDIC. And then we’ll allow free banking; after all, even if a few wildcat banks fail it won’t affect the macroeconomy. But it matters how you do this. Go to wildcat banking without first getting rid of deposit insurance and you end up like Iceland.”
          http://www.themoneyillusion.com/?p=10503

      • As far as price stability, I suppose I should have said something like rothbard absolutely does not….I thought you were confusing Austrians with monetarists…so maybe some Austrians in fact are in favor of price stability even if that means increasing the money supply by fiat. Just seems to go against the ABCT because, if you believed ABCT, I would think you’d have to conclude doing that would lead to a bust.

        • The label “Austrian” may be subjective, but it still implies a vast difference from Keynesian even though neither terms are neatly defined.

          By “subjectivist” I was referring to the Mengerian subjective theory of value, augmented by von Bohm-Bawerk. That is the defining characteristic of Austrian economics.

          Some self-described “Austrians” confuse themselves with Monetarists by subscribing to the Quantity Theory of Money, which is directly in contradiction to the Mengerian idea that the value of money (or any good) is in the eye of the beholder. The other key ideas in Monetarism are rational expectations, and the efficient market hypothesis, neither of which I agree with. To me, Monetarism and Austrianism are very clearly opposed because of these contradictions.

          The key idea of Keynesian economics is that some markets (e.g. unemployment) don’t naturally clear, which is an idea that I and very many Austrians (except perhaps the Mises-Rothbard variety) very much agree with. I am more sceptical of the second key Keynesian idea that increased government spending can be a “solution” to non-clearing markets, although there are some Austrian economists (e.g. Ludwig Lachmann, Arnold Kling) who buy into the idea of countercylical macrostabilisation. I certainly don’t support austerity in depressions, but I don’t think increasing aggregate demand through government purchases is a general solution in itself (though maybe it can be a partial solution under certain conditions).

          So to me, Austrian economics is actually closer to Keynesian economics than it is to Monetarism.

    • I’m not aware of Austrian economists who argue that without a central bank you wouldn’t have a business cycle. That’s pretty silly if they did, given the 19th century in the U.S.

      George Selgin (Austrian influenced, but doesn’t self-identify as Austrian) shows in this lecture that Canada, which didn’t have a central bank until 1935, largely avoided the US “currency panics” due to its Free Banking system which allowed banks to supply banknotes w/o limit to satisfy increased demands for currency (such as during the harvest season).

      The US, despite not having a central bank, had numerous currency panics in the 19th century primarily due to two bad govt regulations:

      1) the prohibition on branch banking (which led to undiversified unit banks prone to failure, leading to a chain of runs)
      2) the requirement that banks purchase state (and later, federal) debt to back new issues of currency. This severely limited the ability of banks to issue new notes when the Federal govt began retiring debt after the Civil War.

      Video link: (Canada/US comparison is from 14:55 to 19:35; the entire lecture is excellent and worth watching).

  4. Neither Hayek or Mises believed that a monetary policy consistent with the natural rate would lead to price stability. In fact, both of them were vocal critics of the concept of price stability.

    • I didn’t say that they thought a monetary policy consistent with the natural rate would lead to price stability. In fact they were both critics (to varying degrees — Hayek may have supported some forms of it, Mises mostly didn’t) of the concept of monetary policy entirely!

      But the concept of a natural rate of interest (at least as Wicksell defined it) implies a kind of price stability in itself (although certainly not the same kind as is defined by Monetarists today!)

      Ludwig von Mises Institute:

      It was this work by Swedish economist Wicksell that drew Mises’s attention to the effects of interest rate manipulation on the capital structure. This was the first to present the idea of the natural rate of interest, which Wicksell argued can be different from the prevailing rate on the market. The natural rate is equal to the return on capital in an imaginary economy without money. Mises took that idea and made it a central component of his business cycle theory.

        • They didn’t support price stabilisation, but they did support the idea of “natural interest rates”… That doesn’t mean price stabilisation, but it does mean a noninflationary rate of money creation (and thus rates). Mises might not consider that a stabilisation mechanism, but at best it’s a stabilisation mechanism via negativa.

  5. These are the difficulties that arise when you forget that money is simply the abstraction of labor-value. Interest rates are not possible without this abstraction.

    Interest rates are a claim on future income. It is the enslavement of the labor-value producer by controlling his access to the production/consumption process, so ingrained in this system that people refuse to question its existence, as if doing anything at all, should involve paying tribute to the bankers and their dis-graceful ploy of taking ordinary people and transforming them into pathetic serfs, seemingly more than happy to give 50% of their labor-value earned to the government and nearly the rest to the banks.

    How interesting that it is so difficult to understand interest rates. What must this mean? It means that you are so far from the truth of the matter that even with the help of Santa Claus, The Easter Bunny, The Boys Scouts, The Girl Scouts, the Green Berets, Batman, Superman, and all the rest, NOTHING would make sense out a system that comes down to one thing…THEFT.

    It is a just a grand scam to steal as much money as is possible without anybody figuring out exactly how they do it.

    Bankers are NOT your friends.

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  7. “For a lender, an interest rate is their profit for giving up the spending power of their capital to another who desires it now, attached to the risk that the borrower will default.”

    Yet there is no risk in lending out their money…and money by itself does not produce anything it needs to be put to work with risk and labor involved, for it to generate profits. Therefore lending out money and charging interest for it, is parasitic, unless the lender actually faces a risk of loss in the enterprise they have chosen to invest in. Risk free money lending is a state given privilege to the rentier class.

  8. The problem is you have “Economists” dictating government policy and laws which cause all types of unintended consequences. This is a direct result to their ivory tower syndrome.

    I think all Economists should:

    1. Run a lemonade stand (Retail)
    2. The following summer mow lawns (Service)
    3. Make something and sell it to a wholesaler. (Manufacturing)
    4. Go get a mining licence, stake a claim, and dig a hole (mining)
    5. Raise some animals for market, grow a crop (Agriculture)
    6. After they have saved money from their obviously profitable business, lend it (Banking)

    Lets see what rate they set for their interest then.

    My Economics Professor is still wearing his cardigan inside out and back the front, in the same old University institution. Would I trust his Economic judgement today? NO!

    In the old days, the rate of interest was high because people had to be bribed to lend their money to the banks, to then on lend to the first home owner. Now that money is zeros and ones on a screen, and this money is on lent to Banks (Face it they made bad bets and pushed the crap onto the Fed), and this money is now being lent to consumers through “Special TV Offers”, well I would say the are ARTIFICIALLY LOW.

    Bubbleonomics.

    • What is your mechanism for determining whether interest rates are artificially low or high? Doesn’t Australia have a massive housing shortage relative to population and housing demand? Couldn’t that imply an excessively high interest rate (or at least some other kind of blockage)?

      • “What is your mechanism for determining whether interest rates are artificially low or high?”

        Let’s change money back into labor-value for a moment and consider this question.

        Imagine wanting to borrow some labor-value from a labor-value bank. You would go into the bank and tell them that you need such and such labor preformed and they would tell you that they could supply you with said labor, plus charge interest, that is, you would have to give an equal amount of labor back to the bank [principal], and labor over and above this amount [interest].

        After a while, you become indebted to the point where the bank now owns a great deal of your labor preformed to the point where you are laboring 50% for the government and approaching the same amount [for many people] for the banks.

        This is called serfdom. This is what debt creates. There is no such thing as responsible debt anymore than there is such a thing as responsible theft. NOBODY should be able to make a claim on your future income, an idea which has been understood for THOUSANDS OF YEARS.

        Debt DESTROYS individuals, families, communities and societies.

        Bankers are NOT your friends.

  9. “There are even some self-described-Austrians who favour a central bank, people like Selgin and White.” How anyone can possibly take Mr. Aziz seriously when he makes assertions like this one (and his post is full of others no less unfounded) is a puzzle. I’ve eschewed the “Austrian label for over twenty years now–largely to avoid being associated with internet “Austrians” like him–and no one has written more consistently against central banking that Larry and I have. The (internet Austrian) suggestion that I “favor” central banking because I have argued the virtues of stable NGDP is idiotic: I have indeed argued those virtues, but I have also claimed that the ideal is one that is best achieved by means of free banking. I have never even imagined, let alone publicly declared, that we can ever hope to have responsible monetary policy so long as we have a central bank.

    Aziz’s claims about the “natural rate of interest” are equally ill-informed and foolish. As all who are familiar with its history should know, ABCT is based on Wicksell’s natural-rate notion, as is evident from many, including some of the best, presentations of it.

    Those who want to learn some economics, Austrian or otherwise, are advised to look elsewhere then to Aziz for their lessons.

    • I’ve eschewed the “Austrian label for over twenty years now largely to avoid being associated with internet “Austrians” like him

      Thank you for the clarification on that. I got this muddled because other people who I have discussed your work with have referred to you as an “Austrian”, but it is certainly true that most verbiage refers to your school of thought as “free-banking”, rather than “Austrian”. But I think using the pejorative “internet Austrian” to describe my views shows a pretty basic failure to engage with any of my ideas. My views are closer to Hyman Minsky and Ludwig Lachmann than to “internet Austrians” like followers of the LVMI.

      The (internet Austrian) suggestion that I “favor” central banking because I have argued the virtues of stable NGDP is idiotic: I have indeed argued those virtues, but I have also claimed that the ideal is one that is best achieved by means of free banking. I have never even imagined, let alone publicly declared, that we can ever hope to have responsible monetary policy so long as we have a central bank.

      I don’t understand how it’s possible to target or moderate NGDP along the lines you suggest without some kind of central banking mechanism, whether or not you want to call it a central bank. I think free banking with or without a central banking mechanism is an interesting idea, but I certainly don’t see any mechanism that will stabilise NGDP beyond central bank interventionism. There are certainly no historical examples I can think of of a free banking system with stable NGDP, either in absolute value or in its first derivative.

      Sure, central banking under a free banking system would look very different to central banking today (both functionally and formally) but a central bank stripped of its LoLR function is still a central bank inasmuch as it defines and has power to redefine, expand or contract the monetary base — even if this power is infrequently used (although, once again, I don’t see how it’s possible to have stable NGDP without some pretty aggressive interventionism).

      Aziz’s claims about the “natural rate of interest” are equally ill-informed and foolish. As all who are familiar with its history should know, ABCT is based on Wicksell’s natural-rate notion, as is evident from many, including some of the best, presentations of it.

      When did I say or imply that ABCT was not based on Wicksell’s natural-rate notion? I think I was pretty clear that ABCT is an intellectual descendant of Wicksell’s idea (which of course brings with it the uncomfortable insinuation that — however much Rothbard protests the idea — ABCTers favour a kind of Wicksellian price stability).

      You’re most welcome to point out any other errors.

      • Please cut Prof. Selgin some slack; he’s been fighting the good fight against ignorant Austrians (I don’t mean you, of course) for decades now. He still gets pestered (for the millionth time) about why he doesn’t oppose fractional reserve banking, so I can sympathize with his occasional frustration!

        “There are certainly no historical examples I can think of of a free banking system with stable NGDP”

        It’s difficult to get relevant statistics, but Canada and Scotland both seemed to enjoy financial stability and steady economic growth during their Free Banking periods (Scotland went from poverty to near per capita parity with England in less than a century).

        For Canada, please refer to the video link above. For Scotland, you can read White’s excellent “Free Banking in Britain.” Also, “The Experience of Free Banking” has summaries of both cases (and many others): http://mh19870410.files.wordpress.com/2013/02/the-experience-of-free-banking-by-kevin-dowd.pdf

        “I don’t understand how it’s possible to target or moderate NGDP along the lines you suggest without some kind of central banking mechanism”

        Here are two possible methods (for moderation, not targeting):
        1) Option clauses on deposits: http://monetaryfreedom-billwoolsey.blogspot.kr/2013/03/free-banking-and-bank-runs.html

        2) Private liquidity options: http://jpkoning.blogspot.kr/2012/05/free-banking-alternative-to-centralized.html

        As White mentions in his writing, private clearninghouse associations (like the Suffolk Bank of Massachusettes) in Free Banking systems tend to evolve into private LOLR (http://www.minneapolisfed.org/publications_papers/pub_display.cfm?id=758). And if NGDP did occasionally plunge under Free Banking, we could have some kind of emergency, night watchman monetary policy such as the Aldrich Vreeland Emergency Currency http://www.answers.com/topic/aldrich-vreeland-act

        • I am rather nonplussed that Professor Selgin chose to jump at me for accusing him of being pro-central banking. This may have been an accusation/canard thrown at him by the LVMI, but the context to me mentioning it (as an aside, no less, not an attack!) is very different. I mean, whether or not Selgin would like a central bank in theory, he was an advocate of quantitative easing (QE1 and 2) as well as NGDPLT both in theory and in practice. These may be Hayekian positions, but it is incorrect to say that these are not central banking functions, whether or not the entity that carries them out is called a “central bank” or something else.

          I personally think free banking (and other currency competition) ideas are very interesting, and as you rightly point out the empirical record is quite favourable (although as I note, in none of the cases we are talking about is NGDP stable). Privatising the LoLR function puts some skin in the game, for one thing and in theory is a good bulwark against the zombification of the banking system.

          Personally, I think the most realistic option right now is to keep the system we have now (state fiat currency, centralised activist monetary policy, centralised LoLR) but augment it by scrapping all legal tender laws except for the payment of taxes to allow for a broader range of choice for market participants. I see Bitcoin as an interesting development in this regard.

        • I understand you being taken aback by his response. But for someone who has devoted his entire professional life to condemning central banking, to be called a central bank advocate, even in passing, must be a cruel twist of the knife! (He evidently isn’t familiar with your views and considers them another in a long line of uninformed attacks like this: http://www.economicpolicyjournal.com/2011/07/george-selgins-sandbox.html)

          he was an advocate of quantitative easing (QE1 and 2) as well as NGDPLT both in theory and in practice.

          This can be likened to Bagehot’s advocacy of LOLR–second best solutions to a Free Banking ideal. He hardly can be blamed for trying to make the best of our current flawed system! Re: the latter–he doesn’t want NGDPLT in perpetuity, just until we get Free Banking. He advocates it now b/c he believes NGDPLT most closely mimics the result we would see under Free Banking (you’d have to read his “Theory of Free Banking,” which I’m working through now, to understand his views on Free Banking and NGDP stabilization better).

          In short, I hope you overlook this unfortunate outburst and delve deeper into his (and White’s) Free Banking and Monetary Disequilibrium writings. It’s a rich, thought provoking literature that fits in well with your decentralized, anti-fragile ideals.

        • Australia had “Free Banking” in the Gold rush era 1850-1900. Men of money could meet at a “Gentleman’s Club” and set up a bank very easily. Bank runs were commonplace and there was a spectacular land price collapse. Many Banks went under.

          Could free banking work today. Possibly. But the internet could see runs occur quite quickly. However rumors on the net would be drowned out by other information overload, so unless there was a serious Bank collapse, no run would take place due to malicious rumors.

          Having being involved in a Bank from Head office fit out to branch rollout, it is not to hard. You just need good software and people with some experience in their respective areas. The hard part is earning trust to get the book built with funds, and finding a business or home owner to lend to that is not a dead beat. If you find a good one, other banks will beat you down on price. If they come to you for a loan, they are usually rejected by the big banks.

          Setting interest rates is a art not a science.

    • Prof. Selgin, I think you are a bit harsh on Aziz. He is undoubtedly one of the most polite and gracious economics bloggers out there. If he is mistaken, I think it would be more productive to point out those issues rather than berate him.

      As always, I remain a devout fan of your work. Looking forward to your “Little Fed Book.”

  10. No economy can leave interest rates at zero.
    The ability for banks to borrow from the fed at near zero rates will artifically create asset bubbles.
    The question is when will it pop, what are the first signs of a bubble popping, bitcoins at $175 maybe?

    I see the first real problem when China stops buys US debt.
    Anyone who states that China must buy United States debt, it does not understand what the word must stands for.
    China does not have to buy US bonds, once bonds start to sink which they have from their all time highs, I believe the bond bubble will burst first.

    Now I know there is a current pop from Japan doing their own Quantitative Easing. But that is temporary.

    Bonds will go first , then stocks , then the asset bubble will pop.

    • No economy can leave interest rates at zero.

      Look at Japan.

      The ability for banks to borrow from the fed at near zero rates will artifically create asset bubbles.
      The question is when will it pop, what are the first signs of a bubble popping, bitcoins at $175 maybe?

      Bitcoin now at $220. I don’t know if this symptomatic of a “bubble bursting”. It’s certainly symptomatic of the formation of a new asset class, decentralised crypto-currencies. I think zero interest rates for banks has a Cantillon effect, in that it transfers purchasing power to the banks. The interesting thing is the spreads. Mortgagees and credit card holders aren’t getting 0% rates. Far, far from it. For them, interest rates (and indeed credit availability) still very tight.

      I see the first real problem when China stops buys US debt.
      Anyone who states that China must buy United States debt, it does not understand what the word must stands for.
      China does not have to buy US bonds, once bonds start to sink which they have from their all time highs, I believe the bond bubble will burst first.

      There’s still massive appetite in US markets for Treasuries. Institutional investors chasing yields. US Treasury still very keen to keep China buying bonds. The end of the US dollar reserve system may come from the rise of the BRIC reserve currency (or currencies), but things aren’t accelerating as rapidly as I saw them a year ago.

      • Yes, look at them. They have had a real estate and stock market repression since the market exploded back in the late 80s.

        You should really read Kyle Bass’s theory on Japan and what is happening. He has developed his short strategy precisely because Japan is on the precipice of increasing interest rates. Rates actually increased days after the $1.4 Trillion stimulus program was announced by the BOJ.

        His point is that Japan is no longer a net saver nation because of its massive demographic problem. He is right, the first time ever that savings were being net drawn out of banks happened last year. It will only continue.

        There will no longer be the insatiable native demand that Japan has traditionally enjoyed for its treasuries. The game is over for them and for us.

        They are already paying about 25% a year on interest payments alone. If rates were even to go to 1% or 2%, the gig is up.

        It doesn’t take a big move in rates for either the US or Japan to start paying massive amounts towards the interest a year.

        • Any nation that produces the monster porn and manga porn they love is hell bent on destruction.

          Their Samurai spirit was crushed. There women call their men herbivores.

          However I might buy their products, since they have dropped nearly 25% in trade weighted price to Australian Dollars. But with higher import costs, will this be profitable for them?

          They went to war back in the 40’s because they needed resources. China has taken their place in the line now. At the end of the day they are a small island. They will be no more significant than the Philippines soon.

          Besides Samsung is killing them in the Electronics business today, Ipods replaced Sony Walkmans, and European cars (Cheap eastern Europe EU Labour) are flooding their traditional markets.

          They are FCUKD.

          But Kyle Bass will lose his shirt because the market can remain irrational longer than one can remain liquid. He should have known that.

    • “Anyone who states that China must buy United States debt, it does not understand what the word must stands for.
      China does not have to buy US bonds, once bonds start to sink which they have from their all time highs, I believe the bond bubble will burst first.”

      The relationship between the U.S. and China is symbiotic. If China wishes the U.S. to buy its crappy products, then they must accept U.S.D.’s. There is no other market [other than U.S. Treasuries] that could absorb this amount of money. Besides, the U.S. must export U.S.D.’s massively to fund world trade [being the reserve currency]. There is ENORMOUS demand for dollars.

      The reserve currency [under a fiat system] must run deficits. If it ran surpluses, how would the rest of the world get dollars?

      Who the hell knows what’s going to happen, but I would not be betting against the U.S. in the short term. You have to look at this thing in relative, not absolute terms. The U.S. is in much better shape than everybody else [in all kinds of ways].

  11. Wow. That thread got heavy quickly, and went mostly right over my head. I think I have to read a lot more books. Reminds me of possibly an apocryphal story concerning an american president despairing about what to do about the economy. An aid suggested obtaining advice from expert economists. ‘I have ten expert economists with eleven different opinions’ was the frustrated reply. If there are so many opinions, it suggest to me that economics is still very much a science in it’s infancy, too easily bent to the whims of those with vested interests.

    • Agreed. That is why I don’t read too many books. I just apply common sense. It usually is correct.

      Baffle with bullshit is what Economists do to keep their Government job.

    • Read Adam Smith’s Wealth of Nations. It is pretty much spot on and applies today just as it did back in 1776. Back then, there were many changes going on (Revolution in USA, France. People were networking. He saw simplicity in commerce, governance, trade and thus economics. It is the same today, just quicker. I could not believe people argued the same things we argue today. Gives me no hope for Liberalism.

      Humans, Politicians, and Regulatory Capture have not changed.

  12. ‘The notion of a natural rate of interest is interesting and helpful — certainly, high levels of inflation can be challenged through decreasing interest rates (or more generally increasing credit-availability), and deflation can be challenged by decreasing interest rates (or more generally increasing credit availability).’

    Eh?

    I’m not sure I understand the following passage either, but then it’s very likely to be a failing on my part:

    ‘…but Wicksell’s definition specifies that a positive inflation rate means the market rate [of interest] is above the natural rate, and a negative inflation rate means the market is below the natural rate.’

    This suggests to me that the inflation rate can be lowered by lowering the interest rate, yet I always thought that interest rates are often increased to try to lower the inflation rate. Is it that I have the cart before the horse and that falling interest rates arise from a decreasing rate of inflation, or am I missing something else?

    • “eh” my thoughts too, but I knew what John was trying to say, he just got ahead of himself :)

      Inflation has decreased due to rising productivity, and if they did not lower rates there would have been deflation, and people would have just waited for prices to drop. Effectively they printed money to keep up with global production from free trade. Gold currency would not have allowed that. This is the premise of Ben Bernanke, which I agree with, but I don’t agree with how the money was distributed.

      It should have been lent to Governments directly, and distributed via cash transfer payments to the tax paying public. Not Banks who can Proprietary Trade and make monster profits, repairing their balance sheets.

      With more cash in the hands of the public, they rate of interest would have been dropped naturally anyway, as too much cash would have flooded the banks, and the availability of cash to business would have seen greater competition in banking.

      The problem I see, is too much Government regulation stifling business investment. So you have nearly zero percent rates, business scared to invest, and possible deflation, despite zero rates.

      Take out Government regulation and watch private investment soar. The Government is the problem, and it will take a massive collapse to clean it out. Look at Russia. After cleaning out Communism, and free market capitalism, it has improved. If you are from Moscow, can you agree with that? Or is their stifling regulation of business in Russia?

      Can you drive a truck to China come back and can you set up a stall and sell goods? Or do you need permits etc. Are they easy to acquire?

      • I’m English and have no particular connection to Moscow. It’s just a handle chosen for rather mundane reasons :-)

        I’d agree with most of the sentiments you expressed in your reply. However, I’m still no closer to fully understanding the article. As I wrote, the fault is likely to be mine. I’m a chemist by training rather than an economist.

  13. U.S. interest rates are not artificially low. Rates would have indefinitely floated after QE2 ended if that thesis were true. Instead, the opposite occurred.

  14. Pingback: A Visual Representation of the Zero Bound | azizonomics

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