I've read many articles on inflation and money creation and economics but I think this article puts it in simple terms that most people would understand if they have the time and attention span to read through it.
Understanding Interest Rates in One Lesson
http://financialsense.com/fsu/editorials/2006/0904.html
by David Van Der Klauw
September 4, 2006
Introduction
Now that interest rates are rising throughout the world many people are starting to ask why. Many people who owe money face unpleasant higher repayments, and many voters are angry, feeling they have a right to borrow money at lower interest rates.
The Australian Reserve Bank recently raised the official interest rate by 0.25% to 6%. This caused many people to complain that their mortgage will cost more. Prime Minister John Howard at the last election campaigned heavily on the low interest rate record of his govt. Although he never promised to keep interest rates low, he was sure that he could keep them lower than the other popular political party could.
Now that interest rates have risen, many voters are angry with John Howard, believing him to have broken a promise. But John Howard has blamed the interest rate rise on high world oil prices and high banana prices caused by a recent storm.
On a popular forum (http://blogs.smh.com.au/newsblog/archives/your_say/005381.html) many people expressed their thoughts and blamed the rate rise on all kinds of things including:
* John Howard
* buying CD's and DVD's
* spending on imports
* underlying strong economic growth
* neglect in investment in trade and skilling and educating the workforce
None of these explanations are any good. So I wrote this article to fill the gap and provide an explanation of interest rates that could be read as a single lesson. I will keep the lesson as free of complexity, economic mumbo-jumbo and controversial theories as I can.
Loan Market
Interest rates are the price of borrowed money. The interest rate is the price of a loan. Whereas the price of bananas is given in dollars per kg, and the price of petrol is stated in cents per litre, the price of a loan is given as a percentage per year. eg 6% pa.
Loans of money can occur between any two parties. Loans can come from relatives or various financial institutions. But for simplicity I will write as if all loans come from banks.
The first thing to consider is whether the loan market is a normal competitive market or a price-fixing arrangement.
Normal market supply and demand
In a normal competitive market the price of something is set by supply and demand. You can read about supply and demand in detail in many places eg (http://en.wikipedia.org/wiki/Supply_and_demand). The simple rule is that price will go high enough to choke off frivolous demand and/or encourage extra supply, to automatically ensure that supply and demand perfectly balance at the market price.
With bananas, the recent storm destroyed half the crop. So prices rose high enough to choke off the most frivolous half of the previous demand. Half the people who would have bought bananas at the old price stopped buying them at the new price. On the supply side it is likely that next year farmers will plant more bananas to take advantage of price rises from possible storms.
In the case of petrol, increased demand from China has caused price to rise high enough to choke off some frivolous demand in Australia. Eg we reduced fuel use 7% last year. On the supply side the high oil price is encouraging further production of difficult oil such as the Canadian tar sands and is encouraging much additional oil drilling worldwide.
Price fixing
The market for money loans however is not a normal market. In the last decade borrowing has surged, saving has plunged, and yet interest rates have maintained historic lows. If loans were a normal market you would expect different behaviour. You would expect that a surge of borrowing money out of banks that was not matched by a surge of depositing money into banks would result in higher interest rates. The higher interest rate would both choke off frivolous borrowing, and encourage extra saving - thereby automatically causing supply and demand (of loan money) to perfectly balance.
If the govt and central bank did not intervene, you could expect interest rates to adjust frequently to automatically balance supply and demand of loan money. But the central bank does intervene. It steps in to peg the interest rate, stop its fluctuation, and hold it lower than otherwise would be the case. The central bank announces an interest rate, forces it down and holds it steady. This is price fixing by the central bank.
How does the central bank do price fixing, why, and to what effect? These are the questions we must answer in order to understand interest rates.
How price fixing is done
Every market is based upon laws that create a definition of legal private property. Govt writes these laws and citizens must obey these laws and can choose to trade the private property as defined by the laws. Such trading is a market, and prices at which trades occur are called market prices.
Markets and market prices can be altered by two kinds of activity:
1) Outside existing market law - Assaults on the market - Govt can change laws or citizens can break laws to affect the market
2) Inside existing market law - Normal activity - Participants such as citizens and govt can buy or sell legally and thereby influence price.
If we are able to ignore "assaults" on a market, the only ways to lower the market price are to demand less or supply more of a substance.
What this means in our examples of bananas, petrol and loans is that:
* If govt wanted to force the banana price down, say to $1 per kg, govt must reduce its banana consumption (eg in govt hospital kitchens) and/or get a big supply of bananas from somewhere, to sell.
* If govt wanted to force the price of petrol down, say to $0.20 per litre, govt would need to cut its petrol use, and/or gain control of a big source of oil somewhere, to sell.
* Similarly if govt wanted to force the price of borrowed money down, say to 2% per annum, govt would need to cut its own borrowings and/or have a big source of money somewhere, to lend.
In fact most modern govts are persistent heavy borrowers. This means that they require a giant source of money if they want to force interest rates down. This is exactly how they do it. Understanding the giant source of money, and how it is used to keep interest rates lower, is critical to understanding interest rates.
Govts have two giant sources of money available to them. They can:
1) collect existing money from citizens. eg income tax, fees, charges, duties, levies and fines
2) create new money. eg inflate the money supply, print money, etc
Study reveals that govts do indeed tap both these sources of money for all kinds of purposes. Our largely out-of-control govt collects enormous amounts of money from citizens and creates enormous amounts of new money. Our govt, however, is not completely out-of-control and does try to minimise voter discontent by always selecting the least unpopular device to get its way. Since our govt would be unpopular if it directly taxed one group of people in order to get money to lend to another group, our govt instead choses to create new money to have its way on interest rates.
Govt inflates the money supply by using the banking system to effectively print as much money as is required to force interest rates down. By printing new money and lending it out, govt is always able to force interest rates to be lower than they otherwise would have been. At least in the short-term govt, by printing a large amount of money, govt can drive interest rates down to any level they like.
What this means is that when you borrow from an Australian bank at today's artificially low interest rates, a big chunk of the money you get does not come from depositors but is freshly created.
Using monetary inflation to lower interest rates is a policy that is very popular with govt and stupid voters in the short-term, but is damaging to society (including the stupid voters) in the long-term. In order to understand the damage it does, we must have a basic understanding of money and inflation.
Creating old-fashioned money
In olden times gold (or silver) was used as money. Goods and services were priced in terms of a weight of money. Buyers could pay this weight of gold in any form they liked. Eg. A horse would be for sale at a price of "10 ounces" and a buyer could pay for a "10 ounce" horse in gold coin, gold bar, gold flecks, or gold nuggets.
This is similar to how nowadays a car might cost 1000 dollars and a buyer can pay for a "1000 dollar" car in dollar notes, dollar coins, or a cheque or credit account denominated in dollars.
The most convenient form of gold was a solid chunk with the weight honestly marked on it. This saved the effort of each person having to weigh the gold at each transaction. The crime of counterfeiting involved making a gold block with a false weight marked on it. eg a gold block with lead-centre could be passed-off as pure gold.
It was no crime for any person to make their own money coins out of gold. A citizen could go out and mine 1-ounce of gold, purify and pour it into a 1-ounce coin and stamp "1-ounce of gold" onto it. Such a coin was a 1-ounce gold coin, contained 1-ounce of gold and would exchange for 1-ounce of gold money in any form, and hence was worth the same as every other 1-ounce gold money coin (Rare collectors coins excepted).
Gold is gold, silver is silver and paper is paper. Whenever someone holds money they possess the raw material the money is made of. They also possess, as money, a vague promise of future purchasing power. The money promises that the person can later buy what they actually want with the money. This promise is always vague and never certain. If no person can be found to "honour" the money, then the holder is left with the basic raw material that the money is made of.
Gold money is worth whatever someone will give for it, but tends to be worth its difficulty of mining. In olden times it may have taken on average one month of mining labour to dig up 1-ounce of gold. Therefore 1-ounce of gold tended to be "worth" one month of (semi-skilled) labour. The reason is simple to understand. If for any reason the exchange value of gold money fell below one month of labour, then it no longer made sense to mine gold for use as money. Better to put the labour into something else. Gold mines would close, and money would become scarcer, until the exchange value of gold and labour coincided again. Likewise, if for any reason the exchange value of gold rose above one month of labour, then the smartest use of labour was to mine gold into money. Labour would pour into gold mining creating a shortage of labour for other things and an eventual abundance of money thereby restoring the parity.
The creation of old-fashioned gold money was performed freely and legally by citizens mining. It was the difficulty of creation by mining that set the value of the money. Old-fashioned counterfeiting was an attempt to trick people by passing-off a lesser metal that did not involve such difficulty of mining.
Gold derived its monetary use from woman's desire for jewellery and man's struggle to mine enough of it. Some would scoff that this makes gold a fickle or crude money, its value pinned to the fashions of vain women and the shortcomings of the working men who mine it. Fair comment, but paper money is even worse. Its alternative use is all the more crude, and its value is pinned to the failings of the politicians who issue it.
Creating new-fashioned money
In modern times we work under a fiat money system, using paper notes, coins and bank accounts as money. The gold system was a peoples' choice and the number stamped on each coin was a truthful weight of gold. Now we use govts' choice of money and the number printed on it, in truth, doesn't mean very much at all.
Some gold-bugs claim that "gold is money" whereas the dollar is a "broken promise to pay gold" or an "IOU nothing". These claims are amusing and thought-provoking, but I prefer to differentiate gold and fiat by their source. Fiat money, like gold, is a vague promise of future purchasing power. But whereas gold was mined with effort by citizens to suit citizens, now fiat money is created with no effort by govt to suit govt.
With gold, by granting citizens freedom to create money, govt passively ensured that the value of gold money would keep parity with production costs (eg mining labour). By contrast, in order to function as money, paper money must have a value far higher than the production costs of the paper and ink that it is so easily made with. Now govt must actively prevent citizens from turning paper and ink into money, and must force citizens to use this paper in transactions.
Govt has done this by a combination of force and lies. Citizens are now forced to earn dollars to give to govt in the form of taxes, fees, levies, charges and fines. Govt used lies in the 1930's to blame gold for the Great Depression, banned gold, and replaced it with paper money. By doing these things, modern govt was able to convert people to using govt fiat money instead of the gold money previously preferred.
This use of paper fiat money is not necessarily bad for people. Anything can be used as money. But the use of force and lies should surely ring alarm bells in the mind of a thinking citizen and voter (rare though they be).
Counterfeiting causes inflation
Nowadays govt must maintain a monopoly on the creation of money. Govt defines the crime of counterfeiting to be when citizens print their own money.
Most people do not need to be told why it is a crime to counterfeit paper money. The concepts behind it are so simple that most people can figure it out for themselves. While it is possible for any one person to counterfeit money and become rich without working, it is clearly not possible for all people to live this way simultaneously. Clearly if few people worked and most people merely printed money, there would be a massive increase in the amount of money in circulation and there would be massive price rises as the large amount of money sought to buy things from the few people left working. Widespread counterfeiting would destroy the value of the paper money.
Because the harm of counterfeiting is so widely understood, every govt on earth makes counterfeiting a crime. Govt does not want to allow an ordinary citizen to live without work at the expense of others. Govt reserves this privilege for itself and its cronies. Therefore ordinary citizens must be stopped from creating new paper money.
Something for nothing - the inflation tax
The creation of money, and the inflation scenario, is a typical something-for-nothing scheme that has identifiable winners and losers.
A simple explanation is that money obtains its value from how hard it is to get. When nobody can easily create new money, the only way to get money is to do some work, or trade something of real value for the money. An absence of new money is an absence of something-for-nothing. If money is always hard to get, and no one gets something-for-nothing, then this basically safeguards the future purchasing power of money (as much as the future can be safeguarded).
Gold money meets this test because it has always been hard to find and recover from the ground. However, when new counterfeit or new genuine fiat money comes into being, the test is not met. There is a case of a winner who gets something-for nothing, and hence logically there must be a countervailing loser who gets nothing-for-something in some shape or form. In the case of new fiat money, the purchasing power of the winners will be exactly matched by a loss of purchasing power of the losers.
When money is illegally created by counterfeiters, counterfeiters gain purchasing power at the expense of other citizens who lose purchasing power. Similarly when money is legally created by govt, govt gains purchasing power at the expense of citizens who lose purchasing power. Govt may do more good with the proceeds than counterfeiters, but the gross loss to citizens is identical.
Whenever citizens lose some of their purchasing power to govt it is essentially no different to what happens when govt seizes greater control of a citizen's life, or when govt takes money from a citizen in any guise. Unfortunately people confuse the whole issue by using many different words to describe what is essentially the same thing:
* When govt seizes control from a citizen, they call it regulation, protection, control, imprisonment, or justice.
* When govt seizes money from citizens, they call it a tax, or a duty, charge, levy, fine, fee, etc.
* When govt seizes purchasing power of money from citizens, it is called inflation and citizens are largely ignorant of the cause. Citizens should realise that the obvious main cause of the inflation they suffer is the excessive money creation by their own govt.
All three of these govt seizures are essentially the same thing. These are ways that govt takes more control over citizens. Citizens must recognise these things and withhold their vote when govt goes too far on any of them.
Yes, inflation is a tax, it is regulation, control, and a loss of freedom. Citizens should realise the similarity between these things. When govt does any of them, citizens lose some control over their lives. Citizens should also realise the similarity between govt money creation and money creation by counterfeiters. If unlimited counterfeiting by private hands will destroy a currency and social order, then at a minimum, fiat money creation must be kept in public hands and strictly limited.
As a minimum, I'd like citizens to recognise inflation as a tax, and demand their govt treat it like all other taxes. Govt should be forced to act openly, keep the inflation tax rate as low as possible and ensure the proceeds are wisely spent.
Better still, I'd like citizens to realise that inflation is the worst kind of tax, most unfair, and highly corrupting and demand their govt stop inflation by installing an inflation-resistant monetary scheme, such as a gold-based or market-determined money.
How govt inflates and sets interest rates
To summarise our understanding to this point what I have said is this:
* Interest rates can be forced down by govt if govt obtains a big supply of money to lend out.
* With fiat (paper) money, govt can obtain a big supply of money by inflation of the money supply.
* Inflating the money supply is like counterfeiting and is like a tax that robs purchasing power from citizens.
To explain how inflation can be used to get low interest rates, I will first describe a hypothetical simple method of inflation using counterfeit money, and then explain the more complex method of inflation that govt actually uses. Once you understand the basics of the counterfeit example, it is much easier to understand what actually goes on.
Imagine that we had a large group of friends who wanted to borrow money to fund various activities. Let's assume our friends were voters in marginal seats, so we approached govt, explained the situation, and got special permission to run a counterfeit money printing press to achieve our goals. We open a bank and advertise a 2% interest rate for both depositors and borrowers. Not many deposits come at this low rate, but many borrowers do (including our voting friends), so we print the money to loan to them all.
People swarm to our bank to borrow and leave with gobs of money. Little of this money came from depositors, most was freshly printed. Borrowers now have huge quantities of freshly printed money to buy whatever they like such as houses and businesses. The price of these assets rise and savers now struggle to save-up to buy them. The effect of this would be to make borrowers happy, savers angry and people would start to notice counterfeit notes and higher prices become more abundant. The essential parts of this scenario are that we inflate the money supply and drive interest rates down. There will be some winners, some losers and many rising prices as a result of this activity.
Visualising a counterfeiting machine in every bank is a excellent way of viewing the govt low interest rate policy. It demonstrates the stupidity, short sightedness and injustice of the scheme. It also explains why the money supply expands so fast and prices rise so much during and after a low interest rate period.
Every voter who asks for low interest rates should stop thinking about lower repayments in the short-term and start thinking about the damage of all that counterfeit-like inflation money in the long-term. Every smug voter who would laugh at the ridiculous idea for counterfeit machines in banks should make sure they know precisely how the current scheme works and precisely how it is any better.
Today when govt gives voters low interest rates it does not place a money printing press in every bank. Govt does not even print every extra dollar and send it to the banks via armoured car. Govt only prints a small portion of the extra money. The banking system creates the extra money "out of thin air" via the fractional reserve bank deposit system and this is what is used to get those interest rates down (at least in the short-term).
Fractional Reserve Banking summary
Modern money in one simple form is paper or coin cash money that is printed by govt. However, more generally, money is whatever people use as a medium of exchange. Far more of the money in existence is, and far more transactions occur with, "bank deposit" money, not cash money. We must understand how bank deposits form and how bank deposits serve to replace cash.
Bank deposits come into existence when cash is deposited in a bank. The cash does not remain in the vault awaiting withdrawal. The bank keeps only a fraction on hand, and lends out the bulk of the deposit. This lent money is spent and spent and spent and eventually deposited in a bank somewhere and then lent out again. To prevent banks (as a whole) from creating infinite bank deposits the govt requires a fraction of each deposit to be kept on hand. Typical rules allow the banking system to create 10 times the deposits as cash exists.
The bank deposit system would breakdown if all depositors asked for all their cash back at the same time. This would not be possible because 9 times more has been lent out than physical cash exists on the planet. Acting to prevent a breakdown is confidence in the system, confidence there is no reason to need cash, and even confidence that the central bank could print any new cash to meet redemptions.
The reason that cash is not needed is that bank deposits suffice for many transactions. When a credit card is used no cash is required, deposit amounts are merely adjusted at various banks. When a cheque is written and deposited, no cash is used. Similarly when a large new loan is taken to buy a house, no cash is typically used. The whole system creates 10 times as much money as there is cash, but functions quite "happily" because bank deposits are used 10 times as much as cash, and function in that sense as a perfectly good form of money.
Fractional reserve banking gives benefit to politicians and banks. The politicians get to inflate the money supply in a sly vote-winning fashion. Banks get to collect perpetual interest on money they never earned. And the average citizen remains either pig-ignorant or totally confused by these shenanigans.
Further reading can be found at: http://en.wikipedia.org/wiki/Deposit_creation_multiplier
Inflation and Prices Changes
Before getting back to interest rates we must briefly discuss inflation and price changes.
Prices change all the time. When two humans exchange any resources at any time, that's the price of those resources. It is impossible to predict prices, because any two people can set a price at any time as they chose.
When govt inflates the money supply prices change. Three factors act to change prices:
(1) Normal
These are the changes unrelated to the govt inflation. For example eating fashions and crop yields might both effect the price of tomatoes. As these fashions and yields change, the price of tomatoes will also change. These price changes cannot be predicted and have nothing to do with inflation.
(2) Debasement
Debasement is the obvious tendency of monetary inflation to cause a general rise in prices. eg. if govt expands the money supply by 5% by spending a freshly printed $14 billion then you know citizens have lost $14 billion of purchasing power and, all other things being equal, prices should rise to be 5% higher than they otherwise would have been.
(3) Disturbance
When govt inflates, all other things are never equal. Govt always acts to confer benefit, and this action will cause winners and losers and various effects on prices. For example if govt inflates to pay for a new safer road, then this might cause an enormous rise in road-worker wages, but a fall in hospital and undertakers wages in that region. The price changes due to disturbance can only be guessed at.
Prices responding to govt inflation is like the way a pool surface responds to a fat man jumping in:
1) There are the normal movements of the water due to the other swimmers that would have happened despite the jump.
2) When the man jumps in the pool, his entry must cause a general sustained rise in the water level to equal his displacement.
3) In the short-term his jump will cause tremendous disturbance in the water. You could not possibly predict the exact water level anywhere in the pool shortly after his jump.
It would be nice if there was a single number that described inflation, but this is not possible because inflation is not about a single thing, but is about many complex things. Inflation has three aspects:
Monetary inflation
An increase in the supply of money in circulation is "monetary inflation" or what good economists call inflation. If we used only paper money and we knew how much new paper money govt printed then we could know the precise amount of monetary inflation. Unfortunately our system is more complex and, to my knowledge, the best measures of money supply inflation we have are the M3 money supply figures produced by govt statisticians.
Price inflation
A general increase in the prices of things people buy is called "price inflation" or what many ordinary people call inflation. Every person suffers differently as prices change, depending on what they buy and sell. Therefore no single figure can exist for this price inflation.
CPI inflation
A consumer price index (CPI) is a number that govt makes up and says is inflation. The CPI is deliberately constructed by govt to suit govt and is more-or-less a fraud.
Monetary inflation is the cause. Price inflation is the symptom. CPI inflation is the disguise.
The Truth about interest rates
The truth about interest rates is that the whole scheme is not about interest rates at all. The whole scheme is about inflation of the money supply. The govt focus on interest rates is a trick to draw attention away from the govt policy of inflation.
Govt talks about interest rates and wants voters to focus on interest rates in the same way a magician draws attention to what he is holding in his prominent right hand. Whilst attention is drawn there, the magician uses his left hand to do a part of the trick he does not want the audience to see or understand.
Govt pretends that the aim of the exercise is to achieve the interest rate that is best for citizens. In truth the aim of the exercise is to achieve the level of money supply inflation that is best for govt. Govt basically wants as much money supply inflation as they can get away with.
Govt pretends that the central bank is independent of govt and is not influenced by desires of politicians, does not serve the interests of the extremely rich bankers who run it, but instead runs the economy for the good of the ordinary citizen. Govt says that the economy is like a motorcar driven by the central bank. The central bank can press on the accelerator by lowering interest rates and thereby grow the speed of the economy to create more jobs and wealth. But if the economy car starts going too fast it will cause excessive demand, price pressures and inflation and the central bank must then apply the brake by raising interest rates to fight inflation. This load of rubbish is mindlessly believed and parroted by all kinds of ignorant people.
The truth is that central banks are run by extremely rich bankers selected by politicians. They meddle with interest rates and other stuff to suit themselves and the politicians who appoint them. These elites inflate the money supply at a rate which maximises benefit to elites. These elites are not ordinary citizens, are not selected by citizens and are not accountable to citizens, so there is little reason to think they would act in the interest of ordinary citizens.
Govt and their banking cronies work to take wealth from citizens in a similar way to a small time pilferer or embezzler. They naturally want to steal as much as possible, yet realise it can only continue so long as the victim does not notice or take action to stop the theft. If the thief gets too greedy, the victim will notice the loss, figure out what is going on, and put a stop to it. Make no mistake. Voters can easily stop inflation by withholding their vote from inflationist politicians and parties. Before this can happen they must notice the damage, figure out its cause, and decide to stop it. Today's Australian voters are so far from that point it is not funny. In fact at the last election many voted purely on the hope of getting a low interest rate i.e. they voted FOR inflation.
If we examine the way govt and bankers benefit from monetary inflation then we can better understand their motivation. Govt and banks benefit from inflation in many ways:
* when govt prints new cash, or issues bonds which are "purchased" by the central bank, then govt gets to spend this new money on popular vote-winning programs without having to collect money via unpopular direct taxes.
* banks collect interest on any new inflation money multiplied by the fractional reserve multiplier.
* inflation-caused wage rises force citizens into higher income tax brackets.
* inflation-caused house price rises cause govt to get more money from higher land valuations and stamp duties, etc
* inflation-caused asset price rises cause citizens to have greater taxable capital gains. Even if the entire price rise is due to inflation and the citizen has made no real gain in purchasing power, govt still collects more taxes on the "profit".
* inflation-caused house price rises will please some voters and displease others. The current fad is to consider expensive housing to be wealth. Old people feel that their expensive house makes them rich and young people hope their house will become more expensive and make them rich too. These nongs wish for more house price inflation and continue to vote for a govt that causes it.
Inflation has plenty of feel-good benefits, however the amount of money supply inflation that govt and banking elites can get away with is limited by two factors. Firstly, extremely high rates of price inflation cause a lot of hardship and are unpopular with voters. Secondly the result of trying to reduce out-of-control inflation will often cause a bust and both bankers and politicians suffer from the fallout of this.
To see an example of inflation taken into the danger zone, take the recent example of Zimbabwe where the govt has printed countless billions of dollars and price inflation has recently hit 1000%. (http://www.newzimbabwe.com/pages/inflation62.14150.html)
The inflation is playing havoc with the finances of ordinary Zimbabweans, who must often go shopping with huge wads of cash for simple purchases that can cost millions of Zimbabwe dollars. The central bank last month raised its key interest rate to 800 percent to put brakes on spiraling inflation. Analysts say the government would have to borrow or print money to finance a 300 percent salary hike awarded to civil servants and soldiers ahead of the planned opposition protests. Mugabe has previously said his government will print money to shore up the economy and says sabotage by the West, led by former colonial power Britain in retaliation for the seizures of land from white commercial farmers, has fanned Zimbabwe's crisis.
Let me get this straight. The govt prints money to pay soldiers, borrows money to pay teachers, and prints money to shore up the economy. It has printed so much money that shoppers carry huge wads of cash for simple purchases. Price inflation is 1000% pa and interest rates are 800%. So much money printed, yet the problem is caused by foreign sabotage. Yeah right!
The typical policy of a western democratic govt is to not let things get as bad as Zimbabwe, to avoid losing votes. They typically will surreptitiously inflate by 5%-15% pa, and try to keep price inflation down below about 10% pa. Govt constantly plays a dishonest game with its citizens. It might inflate the money supply by 15%, hoping that productivity gains and population growth will keep price inflation to around 10%. Govt then uses a CPI that says inflation is only 5% and might blame this inflation on extraordinary one-off factors, or else govt claims the inflation is a sign of a booming healthy economy (or similar twaddle).
When luck is on the govt's side, it can inflate even harder. And when luck runs against the govt it knows it can find scapegoats. For example if one year good price conditions such as cheaper Middle-East oil or bumper crops mean that prices should fall by 5%, then govt can sneak in an additional 5% monetary inflation and have prices not reflect the good conditions. Govt trumpets its good economic management. The next year these conditions revert to normal, but govt still inflates 5% so prices rise 10%; being two years worth of 5% inflation with the good and bad conditions cancelling out. This second year govt can blame the inflation on the specific worsening oil or crop factors. Most voters are too stupid to understand what has happened.
Boom and Bust
The biggest risk of all is that the inflation might get out of hand and necessitate some kind of bust. Govts are currently raising interest rates worldwide to deal with this risk.
Imagine a very simplified situation where monetary inflation is zero, price inflation is zero and a normal market interest rate is 8% pa. Under this arrangement, every loan is matched by savings and govt is not inflating the money supply. This arrangement gives govt none of the benefits of inflation, so imagine that this govt sets out to change this and achieve 10% pa money supply inflation and gets its central bank cronies to drop interest rates to 5% with this aim in mind.
This simplified situation of 10% money supply inflation and 5% interest rates would be great for govt, but there is a real chance that it could lead to price inflation of as much as 10%. One problem with this is that interest rates below the rate of price inflation are termed a "negative real interest rate" and they give speculators enormous incentive to borrow at the low interest rate and buy assets that are rising by the high inflation rate.
Now the reality is that a 10% money supply inflation is not quite as dangerous as my simplified example makes out. In reality productivity growth and population growth subdue price inflation and also speculators may be too cautious or may be limited by strict bank lending criteria. The fact is that high rates of money supply growth can continue for long periods without getting out of control.
However if inflation-caused speculation does get a foothold then govt faces a boom and bust scenario and may end up raising interest rates drastically to prevent the money supply from expanding to infinity and destroying the currency. The obvious way to deter speculators from taking advantage of negative real interest rates is to raise interest rates to well above the rate of expected price inflation. eg If houses are going up by 15% pa, then an interest rate above 15% may be required to deter housing speculators.
Recall the article about Zimbabwe where their central bank raised interest rates to 800% to "put brakes on spiraling inflation". The trouble is that 800% is too low an interest rate for Zimbabwe's situation. Since Zimbabwe's inflation rate is 1000%, it is quite likely that assets such as houses are rising by 1000%. Therefore its speculators could borrow at 800% and buy assets that rise at 1000% and make huge profits. If that is the case then an interest rate of 800% is FAR TOO LOW and is equivalent of having the foot on the inflation accelerator, not the inflation brake. To really control inflation in Zimbabwe the central bank has to raise interest rates to well above 1000% to deter speculators from borrowing, and the Zimbabwe govt must run a balanced budget and stop borrowing and stop printing money.
Imagine your task is to pull a cart slowly up a hill, and you take a short break then look up and notice your cart is rolling back down the hill. To save the cart, you must run like hell to catch it, and pull like hell to stop it. In fact, if the cart has developed sufficient downhill momentum, then the same effort that previously would move the cart uphill will be insufficient to arrest its descent. Once too far gone, the cart will continue to accelerate downhill in a runaway vehicle situation. This is the situation a central bank faces if it lets interest rates go slack for too long, then looks up and sees price inflation racing away. To catch up and regain control it needs to raise interest rates far higher than was appropriate shortly before.
Alternatively imagine a drug addict, taking higher and higher doses to get through each day. He really should quit but is too far gone to endure a cold-turkey solution. The best treatment is to continue to drug this addict but slowly reduce the dose. Imagine if the best dose to wean him off drugs is actually so strong it might kill a healthy non-addict. In the same way, an inflation-addicted economy can be weaned-off with interest rates and monetary inflation so high that they would kill a healthy economy.
Of course the economy is not a car with powerful brakes and a wise central bank driver. The economy is not a cart being pulled up a hill by an inattentive loafer. The economy is not a drug-addict. However when elites take the dangerous step of meddling with money and interest rates, the economy can sometimes appear to act like one of these things and all kinds of analogies can be made.
Modern central banks are like that pilferer I mentioned earlier. They take as much as they can but must keep a low profile. If the public cottons-on to the big price rises, or speculators over-leverage a negative real interest rate, then the game is up. This is analogous to the pilfering becoming noticeable and security being installed. To prevent this the banking elite inflate the money supply but remain vigilant that prices don't rise too fast, and that speculators don't excessively leverage into inflating assets. Like pilfering, it is a dangerous game and there is no guarantee of getting away with it.
If the elite sense they may be about to lose control, they won't admit that they have over-inflated the money supply. Instead they will blame demand pressures or claim something is overheated or similar nonsense and will then raise interest rates to solve this problem. Effectively the elites are merely reducing their theft for a while, until the heat cools off and they can resume their scam.
The rate-raising action they take to head off a runaway boom is often unpopular with voters and often causes some kind of crash or some kind of financial bust. Boom and bust cycles, if not caused by central banking, are certainly exacerbated by them.
The truth about central bankers
Central bankers are a largely unaccountable elite tasked by politicians to meddle with the economy for political goals. But exactly what central bankers believe is open to debate.
It is human nature to accept what you are brought up with as normal. It is human nature to develop pride in one's work and to become defensive and resist change. It is fair to say that many Enron employees felt proud to part of a profitable productive business. Many German WWII soldiers were similarly proud of their jobs. Many alternative and mainstream medicine practitioners truly believe in their treatments, and would vehemently deny that their treatments are a waste of time (although some treatments no doubt are). It is a rare person who is happy to lose their power, lose their livelihood and admit their life's work has been a waste of time or worse.
In the same way it is likely that many central bankers truly believe in what they are doing, and see no harm in it. They control the levers of monetary policy. They see their influence on price inflation and unemployment. They enjoy their salary, their prestige and their power, and they will vehemently deny that their activities are harmful.
In olden times people did bloodletting and other medical treatments that we now see as completely idiotic. But at the time the treatment was truly believed in by the bloodletters and the bloodlettees. It took a brave contrarian to call it the quackery that it actually was. Now we have central banking and monetary policy that some of us think is idiotic. But we must realise that, at this point of time, these monetary policies are truly believed in by central banks, politicians and the majority of voters. It does not make the quackery right, but it does help explain the roles of these believers.
Exactly what central bankers believe is controversial. Look no further than the world's most famous central banker, the knighted, celebrated Maestro, the subject of several books, Sir Alan Greenspan. Alan Greenspan is truly a monetary enigma.
On the one hand as the boss of the most important Central Bank in the world he oversaw the greatest expansion of money and credit in history and won the disrespect of many writers from the hard-money camp. eg http://www.safehaven.com/article-4538.htm
On the other hand Greenspan gives clear evidence that he understands the flaws of fiat money and the use of gold money:
* his classic essay titled "Gold and Economic Freedom" is well worth reading. http://www.afr.org/greenspan66.html
* when recently asked about a return to the gold standard, Greenspan said "I've been recommending that for years, there's nothing new about that." http://fraser.stlouisfed.org/historicaldocs/senate/download/17619/CMP_104S_02221995.pdf
* and he tips us the wink when he jokes in http://www.federalreserve.gov/Boarddocs/speeches/2002/200201163/default.htm
If the evident recent success of fiat money regimes falters, we may have to go back to seashells or oxen as our medium of exchange. In that unlikely event, I trust, the discount window of the Federal Reserve Bank of New York will have an adequate inventory of oxen.
In the end we can only guess what each central banker really believes. When they retire we may find them more candid and forthcoming. If we like, we can argue and judge central bankers the same as we might judge a German soldier or an Enron employee. I don't see much point. Bankers are chosen by politicians who are chosen by voters. Each does what he must to get chosen, and if he doesn't is sooner or later replaced by one who does. Rather than bash central bankers and see them as the problem, I see central bankers as a product of the society we live in.
Summary
I have tried to explain modern interest rates in one lesson. Here are the main points:
* interest rates are not a normal market where demand for borrowing is matched by supply of savings at a market price
* interest rates are a price-fixing scheme where govt holds the interest rate down artificially by inflating the money supply
* inflating the money supply causes price rises which are inevitable but not precisely predictable
* the talk about interest rates is a ruse to disguise money supply inflation
* gold money can only suffer inflation via mining, and its value is tied to the "costs" of mining
* fiat money can be inflated in an unlimited fashion by govt
* fractional reserve fiat banking adds to the confusion, danger and difficulty of controlling inflation
* talk of central bank independence and altruism is nonsense. The central bank is unelected, unaccountable, elite govt cronies.
* the central bank is really trying to inflate the money supply to suit govt/banks, whilst pretending to control interest rates to suit citizens
* central banks do not fight price inflation for citizens' good, they cause monetary and price inflation for govts' good
* inflation works like a tax to rob purchasing power from citizens
* to avoid runaway inflation, central banks sometimes raise interest rates drastically
* inflation and interest rate meddling is not feasible with gold money and not desirable with any money
