Can the Manipulation of Interest Rates Create Wealth?

UK Savings Ratio

UK Savings Ratio

The Cobden Centre’s Chairman, Toby Baxendale, explores whether cheaper money will make for greater prosperity.

You often hear politicians and economic commentators say that we must have low interest rates to make sure the price of money is as low as possible to allow people to borrow and thus spend. This is very much the common view whatever your political outlook. The thought behind this is the Keynesian notion that one person’s spending is another person’s income. This is the famous circular flow of income. In a further article, I will address the latter notion. The first notion — whether cheaper money will make for greater prosperity — I will address now.

First of all, I would like to recap how we entrepreneurs create wealth.

How is Wealth Created?

I would like you to absent the concept of money and consider a situation of barter. As a butcher, when I kill an animal, I may get for the sake of argument, 10 cuts of meat: this is my production. I only need 2 for my immediate consumption, so with the remaining 8 cuts, I trade with Andrew, a garment manufacturer, for some garments to keep me warm. I consume 2 cuts and I save 8 cuts in order to trade for other goods and services. I need to produce to consume: I need to save/invest to consume.

If I wish to consume more of Andrew’s garments as I have a family to dress and keep warm, 8 cuts of meat may well not be enough to purchase these new needs and requirements of mine. At this point in time, I am faced with a choice, either my production has to increase so I can generate more cuts to exchange for other goods, or I accept my fate and stay where I am. I decide that I can invent a method of cutting up the parts quicker by using a sharper knife, thus I seek to invent the “steel” or knife sharpener that improves my productivity from generating 10 cuts in a day to 15. With these 5 extra cuts, I can get more garments.

The problem is , that in order to get the steel built, I need to spend some of my time that would be making the 10 cuts. Thus, I have to save and forgo some consumption while I have the steel built. I also have to rely on my savings — those stored cuts of meat — that I have not consumed to keep me afloat. This is what an economist may mean when he says adding capital to an economy lengthens the structure of production. The steel in this example adds a stage to the capital structure of society, to make me more productive, so I can consume more things.

To be clear, saving is the only thing that allows this to happen. In this example, my personal capital structure has gone from me with a knife in my hand consuming two cuts a day and exchanging 8 saved portions, to me and a knife and a steel to produce 15 cuts of which I consume 2 and exchange 13 saved cuts. Now Andrew will be doing the same, i.e. lengthening his structure of production to meet my new found desires for more goods. He will also have to save — i.e. forgo consumption — to invest with the sustenance that savings gives him, to become more “capitalistic” or capital intensive in his production structure, to meet my demand.

Money, as we have established elsewhere, like language, never arose by government decree, but by the spontaneity of individual human action to solve the problem of barter. If my cuts of meat were exchanged for 13 monetary units of gold from Andrew as I did not want his garments, I would now have 13 monetary units of gold as this was the final good chosen by most to exchange for other goods and services. Note that the gold in this illustration has been “backed” by my productive activities i.e. the cutting of the cuts in the first place.

Consider now the advent of money by decree or the fiat currency or paper money we have now, that could be just created at the touch of a computer key board as I have written here. In this simple example, enter the bandit into the economy, who I am going to call Gordon Brown, who says to Andrew and me, “from hence forth, you will accept, by pain of imprisonment, my new money paper notes.“ With this new money, he offers me the paper money in exchange for my saved cuts of meat. He has achieved an exchange whereby he gets my meat i.e. real goods and services and I get his bits of paper. There has been a one-off wealth transfer from me to him. Granted that I now have this new purchasing power and can spend on other things, but Gordon has got goods, my meat, for which he has done no prior production. My article on Quantitive Easing here, explains this process further.

What is the Interest Rate?

The Time Preference view of interest says that there is always a difference in value between present goods and future goods of equal quality and quantity.

Simply put, you value more highly present goods of the same quality and quantity than you do future goods. Furthermore, the value of future goods diminishes as the length of time necessary for their completion increases. This sets up a price differential between goods now or goods later. This price differential is called an interest rate. In reality it is also the rate of profit in the economy as it is these saved resources that are the only source of future funding for investment and the associated return on that investment. So it is arguable to say that this is the most important metric in the economy.

In our simple economy of Toby, Andrew and Gordon, we have demonstrated that in order for Toby to gain more of Andrew’s goods, he must save i.e. forgo consumption and invest the saving that is sustaining him. Time and resource to make the steel is required — a lengthening of the structure of production from just knife, to knife and steel that is now more capitalistic — that allows him to sharpen his knife, to be more productive, to produce more to buy more of Andrew’s garments.

Andrew to has to save to invest more in, say, a loom rather than hand stitching to be able to meet Toby’s new demand. How do we get this right? How does entrepreneurial insight work more times than it does not? The price mechanism helps us know what is needed most in society. Thus Andrew noting that Toby will pay more for his garments, “reads” this price signal and chooses to invest in a loom.

For every given structure of production, every allocation of goods through its various stages of production needs a relationship between the final finished goods — the meat and the garments — and the means of production — the labour, the knife, the steel, the stitching the loom. If we are in perfect equilibrium, these two sets of prices must equal the interest rate; at this rate, just enough money is saved from production to facilitate just enough investment to support this capitalistic production structure.

If Toby’s time preference changes and he decides to postpone even more consumption and saves in a bank, he is notifying to the likes of Andrew that he is putting away consumption today and postponing it until a future date. Taken as a whole economy and in the light of what we have said in the above Toby and Andrew example, it is clear that the more savings, the more postponement of extra consumption, so that more investment in more capitalistic methods can be developed, the more production and consumption of goods and services there will be. Disturb this symbiotic relationship and you will get a structure of production in society that does not reflect the needs and desires of its citizens.

It is bizarre in the extreme to hear the mass of politicians and commentators advising us to “spend, spend, spend” without giving any thought to where the future investment / profits of the economy are going to come from. It is bizarre that they always argue for a lower interest rate or “cheaper money” so you can spend more. A quick reflection on your personal circumstances will tell you that if you just spent the entire sum of your monthly salary each month on consumption goods, could you ever save to purchase a large capital item such as a car or a house.

It is a tragedy today that we have governments trying to tell the world, “consume! consume! consume!” when in fact, they need to consume and save as well so they can consume ever more of the things they want later with their saved money. One-sided consumption will only lead to an impoverishment of society.

Very low interest rates not artificially set low would reflect plentiful savings. This would be a postponement of present consumption for future consumption, for entrepreneurs to use this money, via bank intermediaries, to invest in making our processes of production longer or more capitalistic to bring forth more consumer goods to provide for future consumption. Higher rates should indicate the reverse.

It is of no surprise that at the height of the boom period during 2007/08, the savings ratio hit rock bottom. When you have just consumption you can never save to invest in the future. As these savings are the future profits of business, it is no wonder that the whole economy fell off the edge of the cliff.

UK Savings Ratio

UK Savings Ratio

Interfere with this process and set a rate under or over that natural rate of interest of all economic agents and you will distort the capital structure away from that which people want to serve their needs and requirements. This is boom and bust that we have all become so accustomed to. In my business for sure I have had activity and customers that have only been supported by low interest rates over the 10 years or so.

Now the merry go round has stopped.

The lesson for politicians is let the market rate of interest prevail as this matches investment and profits with future needs of society. Artificially setting a low rate of interest distorts the productive structure through investment to make more goods and services — a boom — than consumers actually can afford or want — the bust.

Further reading