We live in a world of interest rate communists. Governments, not the free markets, set our interest rates. It’s one of the last vestiges of outright central planning. But nobody questions it. Despite our opposition to other forms of government intervention in our economy.
Do you believe in price controls? The idea that the government should set the price of goods and services?
Many nations have tried it. And it proves to be a disaster each time.
The only thing worse than letting the free market forces of supply and demand set prices is letting the government do it. That’s because they might be able to set the price, but this just creates bigger problems elsewhere.
There is, after all, a reason why the price is too high or too low for our liking in the first place. The price is a symptom of something else going wrong. Addressing the symptom with price controls is very different from curing the disease. Throw in side effects and you might be making things even worse.
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A high price is a signal that more needs to be produced to meet demand. And the same high price is of course the incentive to produce more as well, in a free market. Hence, as commodity traders on Wall Street like to say, ‘The cure for higher prices is higher prices’. Because it encourages the production that brings prices back down.
A strangely low price likewise discourages production, resolving the excess surplus, which caused the low price in the first place. But let’s stick with high prices and shortages for today. Otherwise I’ll have to explain everything twice.
If the government, in its infinite wisdom, decides the price of some goods is too high and it butts in with artificially set lower prices, you get continued shortages. The right amount isn’t produced. The problem, which caused the higher prices in the first place (a lack of production), persists. Because more production isn’t incentivised. The price doesn’t warrant it.
Once this is exposed under government price controls, the government has two choices. Either the government takes over the industry and forces it to produce more, or it issues rationing. Under rationing, politics decides who gets the limited goods and services. And that’s when people wish they’d never asked a politician to mess with prices. Unless they are distantly related to a politician, of course.
The odd thing is that, despite most people either understanding all this, or at least believing it, they don’t apply the same logic to interest rates. For some reason, we all accept the idea that governments should control interest rates. We’re a bit like North Koreans in that sense. Interest rate communists. Even my free market hero Milton Friedman thought the government should fiddle with the interest rate!
Of course, the government abdicates the responsibility to their friends at central banks these days. But the effect is the same. Interest rates are set by the Reserve Bank of Australia instead of by supply and demand. It isn’t a free market. It’s central planning. Even if academics are marginally preferable to politicians, they’re still incapable of getting it right. We don’t ask them to set any other prices for a reason.
The consequence of interest rate manipulation is of course the same as any other price control. You get the same problems. Shortages and surpluses, rationing and dumping. The good in question is of course debt. Because the interest rate is the price of debt.
The booms and busts of Goodhart’s law
Ever wonder why we have housing bubbles?
Well, which asset is most impacted by central bank-controlled interest rates?
House prices, of course!
And so, if you were to argue that government fiddling with interest rates would only cause trouble, what sort of trouble might you be inclined to expect?
Housing bubbles, of course!
And what sort of trouble have we had over the last 20 years in global capital markets?
Housing bubbles in the US and parts of Europe, of course!
None of this should surprise you, in other words. It’s precisely what you should expect if you believe in free markets and apply those beliefs to the interest rate. Just as you’d expect chaos in any other industry subject to price controls.
But how does it work? First you get a surplus of debt as central bankers keep interest rates artificially low to spur on the economy. House prices are bid up because they are most impacted by this cheap debt.
But eventually the economy overdoses on all this debt. And so higher interest rates are needed. Those higher rates pop the housing bubble.
Central bankers are mystified by this basic cycle. Despite being the ones who cause it…how do they delude themselves? They claim that they only focus on inflation in consumer prices; so housing bubbles are not their problem.
Goodhart’s law is that, ‘When a measure becomes a target, it ceases to be a good measure’. This explains what I’m trying to get across. Central bankers target inflation. The problem is that the definition of inflation is a little flexible.
You could, for example, just hypothetically speaking, include the Consumer Price Index, but not house prices, in the definition. This enables you to cause massive house price bubbles with your low interest rates, which you don’t notice because you only keep your eyes firmly on the consumer prices. Hear no house price bubble, see no house price bubble, speak no house price bubble. But cause one.
Let’s move on to Hubble’s law, which is derived from Goodhart’s, but more relevant to our discussion today:
‘When a signal becomes a tool, someone will end up looking like a fool.’
You see; interest rates (and all prices for that matter) are important signals. They guide economic activity. If you muck around with them, you cause chaos. If you treat them like a tool instead of a signal, you will end up looking like a fool. That’s Hubble’s law.
In other words, when central bankers manipulate interest rates, they end up causing trouble. Just as central planners of the UK Price Commission caused trouble for the UK economy when they set prices too.
Maybe bankers are not to blame?
Usually, when governments attempt to fiddle about with the price of goods and services such as debt, it’s because they want things to be affordable. But, by meddling and forcing prices down, they just end up with shortages and rationing instead.
Debt is a little different because there is no inherent constraint on the amount of debt in an economy. Papers that say ‘IOU’ can be produced in infinite amounts. By both banks and central banks.
But when central bankers fiddle with interest rates, it does still cause debt booms and busts. How?
We mentioned house prices and housing bubbles already. But what’s the other part of the global economy that booms and busts? What other industry is dependent on interest rates?
Banks, of course. They are likewise exposed to central bank interest rates, for obvious reasons.
Now, let me ask you another question: If the government controlled the price of orange juice and the orange juice business went bust because of over- or underproduction, who would you blame for the failure?
Would you blame the orange juice industry? Or the government, which sets its prices?
In the end, if the industry struggles, it’s rather likely that the orange juice industry is a victim of government mismanagement of prices. Orange juice producers don’t have the most important piece of information they need for their business planning, after all. The price, which tells them how much to produce and when. If the government sets the orange juice price as a tool, someone will end up looking like a fool.
Now I know it’s fun to hate bankers. But I come to praise Caesar, not to bury him. Considering that central bankers control the interest rate, don’t you think the blame for banking’s booms and busts should lie with those price manipulators? And don’t you think unaffordable house prices should be blamed on those inflating their prices with cheap interest rates?
The good news is, there’s an opt out clause. Investors can escape these shenanigans. There is an antidote. You can find it here.
Until next time,
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Nickolai Hubble,
Editor, The Daily Reckoning Australia Weekend
P.S: Our publication The Daily Reckoning is a fantastic place to start your investment journey. We talk about the big trends driving the most innovative stocks on the ASX. Learn all about it here.
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