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Control of Interest Rates Inhibits Productivity

September 24, 2015

 

We are pleased when the Reserve Bank keeps interest rates on hold at their low, low levels. For we know that low interest rates encourage consumer spending and that is good for the economy. Where did we learn these fallacies? And why are they perpetuated by our politicians and financial journalists?

 

Our new Prime Minister, Malcolm Turnbull, has indicated that he wants us to be optimistic about the future and his government’s ability to create a prosperous, high wage economy.

 

Now a high wage economy cannot be achieved by fiat. It cannot be achieved by increasing the minimum wage and having that flow though our industrial relations award system. The price of labour operates like all other prices. If the price is higher then there is less demand. Marginal workers are priced out of a job. This is evidenced even now where the young are denied work opportunities because the regulated price is too high. Throughout the Western world youth unemployment is typically twice the average.

 

Wages impact the price of all other goods and services. It will be pointless to have high wages if the price of everything we buy is also proportionally higher. To produce a prosperous high wage economy we need to improve the marginal productivity of the workforce. We do this by applying capital to our work.

 

Capital comprises the useful store of money, goods and knowledge from past work. It enables ingenuity, labour and nature to be used more effectively. It enables goods to be produced more quickly because we are not starting from scratch.  We are building on the work that was done in the past to produce goods that were not consumed. Progress requires that we spend less than we earn, and consume less than we create; that we save and invest.

 

We are better off than earlier generations because we are equipped with the capital goods our predecessors accumulated for us. In a modern city there is a stock of houses, factories, warehouses, offices and shops, road and rail infrastructure, supply and reticulation of gas, electricity and water, sewerage systems, telephone and internet communications and so on. Less obviously there are the systems and processes by which businesses, capital markets, courts and government operate. There is an educated and skilled workforce, experienced entrepreneurs and staff used to working in successful teams. All these contribute to making work more productive. This explains, in part, why we are more prosperous than many other nations.

 

Savings create funds for investment in new processes. Historically, it has been observed that to encourage saving we need to have interest rates at about 3% above the inflation rate. Government and Central Bank control of interest rates inhibits this. The Federal Reserve in the US has operated a zero interest rate policy since the global financial crisis. In seven years there has been no increase in productivity, and wages have declined. Similar policies have led to slower growth rates in Australia in recent years.

 

Price controls always have deleterious effects. They reduce the quality and the quantity of the products and services affected. In Venezuela the price of bottled water, toilet paper and condoms are fixed by the government. Colleagues, on a recent holiday, observed that the consequence is that they are generally available only on the black market. Price ceilings on housing rents reduce the number of properties available and ensure that maintenance is minimal. Price fixing of agricultural products has often led to further interventions to subsidize farmers for the shortages that the controls have caused.

 

But controls on interest rates are the worst. Interest rates are the most important price in a market economy. They have an impact on everything else. If interest rates are set artificially low, then there will be insufficient saving. Then there will be insufficient investment. Consequently, there will be a decline in the capital required to increase the marginal productivity of our workforce.

 

If we want to be prosperous, we need to allow interest rates to be set by the market, not by the Reserve Bank.

 

For more, read my book The Fragility of Freedom: Why Subsidiarity Matters

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