[ Question ]

Should government set interest rates?

by yhoiseth1 min read6th Jul 20218 comments

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One common free-market argument against government control over interest rates goes something like this:

The Federal Reserve should pull out of the interest rate manipulation business completely. Having a Fed whose main job, at least in the eyes of the public, is to set or move interest rates in centrally determined directions makes no more sense than having a powerful government agency determining what should be happening with any other price in the economy. If the Fed could know the right price for loanable funds, then there is no reason to think that they couldn’t also know the correct price for shoes, computers, or food. It is the fact that neither the Fed nor any other central authority can know the right price for any of these products, interest rates included, which makes efficient socialist central planning impossible.

In other words, they are arguing for some variant of free banking.

I find this to be a thorny issue to think clearly about. Theoretically, the free-market argument makes sense. But, on the other hand, we have nominal rigidity and the risks involved with change. Also, some governments are more competent than others — the right answer for Switzerland may be different than the right answer for Zimbabwe.

Note that I think the political feasibility is very low. Government control over the money supply seems to be a stable equilibrium. So this question is mostly of academic interest. But it might be relevant for, e.g., charter cities.

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Determining interest rates and determining the nominal value of currency are two sides of the same coin, so to speak.  In  order to be useful, the nominal value of a currency should be relatively stable.  As you've noted, due to nominal rigidity, it is also beneficial if the value of the currency depreciates over time.  If you take these two conditions as a requirement, you arrive at average inflation targeting (which is what the US Federal Reserve currently does).  As a final condition, money needs to be widely used in order to be useful (which is why you cannot simply set up your own Federal Reserve).

Could the task of determining the supply of money be taken over by an institution other than the Federal Reserve?  If you try and do this in the real world, you will likely get a lot of push back from the actual Federal Reserve.  But if we ignore the switching cost, there's no reason that we couldn't have the same job done by a decentralized institution (say perhaps on a blockchain).  

What would be the benefits of this?  First,  it  would eliminate the fear that the Central Bank my change rates due to political pressure.  Second, it would make it harder to monitor and censor unpopular financial transactions.  Although depending on your point of view, this might be a bad  thing.  

How will this play out in practice?  I suspect that countries with poor central bank independence will gradually lose the ability to issue currency as citizens move to safer alternatives.  More importantly, better financial tools will allow people to hold their savings in assets other than money and quickly change between types of assets.  I expect some sort of "robot advisor" will eventually take over this job for most people.

Of course, this is assuming that the singularity and post-scarcity don't make the whole concept of money irrelevant for 99% of people.

I'm curious what people think is most likely say 50 years from now?

  • current system
  • 2-5 regional currencies
  • single currency, governed by nation state or UN
  • single currency governed by blockchain/decentralized/free banking
  • post scarcity, money doesn't exists
  • other

Considering the work of Krugman an others on Optimal Currency Areas (and taking the lessons of the Euro crisis into account) it looks like being able to depreciate currency in a stable way in a limited area is a useful tool. I would expect the current system to continue, with a slow transition towards fewer currencies as regions tie closer together (eg if N. and S. Korea unify they won't keep separate currencies).

Even post scarcity there will still need to be a unit of account to prevent trolling, so I don't see that replacing currencies.

1Logan Zoellner5moI would expect as the world becomes more economically integrated in the future, the size of the optimal currency area will grow. My take on this is that growing trade is basically inevitable and the current headwinds [https://d33wjekvz3zs1a.cloudfront.net/wp-content/uploads/2018/04/World-Trade-GDP.jpg] are mostly a result of China decoupling from the world economy and blowback from the poor handling of the 2008 financial crisis. I agree that there will still be some unit-of-account post-scarcity. However I think most people will simply never look at their bank-account in the same way that I never look at my water-bill (which is paid automatically and generally a small amount).

(which is why you cannot simply set up your own Federal Reserve).

Except if you are Tether?

Low interest rates are like giving free money to banks etc .  Why not just give us ordinary people free money ? Why don't I get  to borrow at the fed rate ? I will happily provide colateral.  The right question is not why the fed sets interest rates, but why it does not provide the same rates directly to everyone including us little folk while cutting out the banking middlemen. We should all have a a fed account.

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I find this to be a thorny issue to think clearly about.

Heh.  Way to understate a problem.

It helps a little to realize that the government doesn't (and can't) control interest rates directly.  Most public debt is auctioned off, at rates set by the market.  The QUANTITY is controlled by the government, and various reserve requirements for banks, both of which have a LOT of influence over the rates the market expects/accepts.  

Set interest rates in what sense? 

As Dagon noted, it doesn't, in general, only in some specific cases. It doesn't control the interest rate on its own debt, even in countries like the US where the government controls the currency in which its debt is denominated.

I'm not an economist, but I think central banks would do better to focus on something like NGDP level targeting rather than trying to use interest rates to control specific metrics of inflation. That's a narrower question, but maybe closer to the one you're trying to ask?

There are also laws against lending at extremely high interest rates, or other aspects of loan terms, or discussions of the effective interest rates charged by payday lenders, which are less about monetary policy principles and more about the innumeracy of most people and society not addressing that innumeracy, or the desperation of its more vulnerable members, in useful and practical ways. It's banning a product perceived as dangerous by those with the banning power instead of finding other ways to get people not to  buy the product.

I think there are also much deeper questions tied into any discussion of interest rates, some of them very old. What is a debt? When is it just to incur a debt or impose a repayment obligation on someone or refuse to pay a debt? When is it immoral or coercive to make a loan, and what steps are permissible to ensure repayment?

The Fed uses the short-term interest rate to either promote growth or fight inflation. The government has other methods to do this using fiscal policy and some MMT economists argue that the Fed should freeze interest rates at 0 and use fiscal policy instead for promoting growth by more fiscal spending or fighting inflation by raising taxes. If the free market was to determine interest rates without central bank intervention it would probably prefer growth and not fear inflation as growth benefits the market and companies and wealthy investors would offset inflation by rising prices and holding real assets. High inflation would lead to instability so it probably does make sense to have a government role in managing the economy to prevent instability.