Price discovery, the natural rate of interest and the price of money

 

The most important thing you need to know about interest rates is that they are a price: the price of money. The price of money is a signal. If it’s cheap, people and businesses tend to borrow. If it’s expensive, people and businesses tend to save rather than spend and invest. The economy slows down, interest rates fall, credit gets cheaper and the cycle begins again.

That’s the theory anyway. And that’s why central banks use interest rates to ‘manage’ the economy. By changing the price of money, they believe they can give the economy a boost when it needs it (falling interest rates, or a lower price for money) or they can tap on the brakes if the economy is ‘overheating’ (rising interest rates, or a higher price for money).

You can find all of this explained in almost any basic macroeconomics text book. What you won’t find is a simple fact: it’s all a big fat lie.

When I say lie, perhaps that’s unfair. It’s more like a myth that people believe because it’s been repeated for so long. If you believe you can control a complex system like an economy by adjusting the price of money on a daily basis, what you really believe is that the economy is a machine.

If the economy is a machine, or an engine, then getting ‘optimal’ performance would be simple. You’d want low employment, moderate inflation, the correct rate of interest, reasonable government deficits, and rising stock prices. Sounds good, right?

Not at all!

The economy most definitely isn’t a machine. It’s a vast market where people exchange goods and services voluntarily through trade. No one tells them to do this. No one designed it. It just happens.

The key to make it happening is ‘price discovery.’ It sounds complicated, but it’s not. ‘Price discovery’ is what happens when supply and demand meet in a dark room. The price of anything is determined when producers and consumers agree on how much money to exchange for a given good or service.

Take bread. Do you decide how much you’ll pay for a loaf of bread? Certainly not. When you walk in the shop, the price is the price. But how did it get that way?

The producer of the bread – the bakery – has some basic costs: flour, butter, wheat, plus things like rent, electricity, equipment, and of course, the baker! He knows that when he adds up all those costs—both fixed and variable—what you pay him has to exceed his costs plus a little extra.

The ‘extra’ is profit. And without getting into a philosophical discussion of whether profit is good or evil, I’ll just say it’s good. Nobody would do anything if it didn’t give them a chance to improve their circumstances in life, get ahead, provide for their family, and leave their children something when they die.

You can think of profit as ‘surplus value’

It’s what the baker earns after he’s covered his costs. In an economy, if we all routinely create surplus value, we have savings. Those savings can be put in a bank to earn interest.

Once in the bank, those savings exist as ‘loanable’ funds. Because the banking system is based on fractional reserves, a bank can lend £10 for every £1 pound in savings. This is how credit expands in an economy; how small businesses get loans to start up, how mortgages are extended, and how money is created.

That last part is important. Despite central banks dominating today’s discussion about money creation, it’s actually commercial banks that create the most money. They do this through a kind of financial magic (fractional reserve banking). When a bank makes a loan, it’s usually creating brand new money that didn’t exist before.

This is why saving and profit are so important to a healthy economy. In a healthy economy, the source of all credit is available savings. I don’t want to get too technical here because there’s an important point. The point is: in a normal, healthy economy, there is a natural rate of growth.

That rate of growth is determined by quality

By ‘quality’ I mean if businesses and entrepreneurs are creating ‘surplus value’ or ‘profit’, it creates savings for the banking system. Those savings, prudently allocated after proper risk assessment, become the capital for future growth.

Let me acknowledge that the financial world we live in today doesn’t work that way at all. Far from it. And that’s the problem.

The problem is growth for its own sake. A rising GDP tends to win elections. Politicians of every stripe pressure the central bank to make the price of money cheaper. By lowering interest rates, they can ‘bring forward’ growth.

Credit expands. Businesses invest in projects they hope will make money, or at least pay the interest on their loans. Normal Britons see house prices going up. Fearful of missing out on the gains, or simply waiting to buy until prices have gone up much further, they borrow large amounts of money now they wouldn’t have normally borrowed. Economic miscalculation abounds.

Central banks think they’re managing the economy for everyone’s benefit when they lower the price of money. It entices people to borrow money now. In my view, this is immoral. It’s the ultimate false signal. It’s a deliberate deception about ‘risk’.

By artificially lowering interest rates, you mis-state the level of risk in the economy. It causes people to base important financial decisions (like buying a house) on information that’s been distorted. Instead of saving, people borrow. Instead of investing, people consume.

Consumption and borrowing aren’t evil things of course

We all do them. After all, if there was no buyer on the other end of a sale, there would be no transaction. Without a transaction, you can’t know the price of anything, or its value. Consumption is important… as long as it’s based on valid price signals.

For your savings, there’s a far more destructive point to make about lower interest rates. While the central bank is fixated on credit growth, inflation, and consumer spending that might benefit from lower interest rates, it’s throwing your savings under the bus.

Even if you’ve never heard that phrase before, I’m sure you know what I mean. Imagine you’re a pensioner in your retirement years. You’ve worked hard. You’ve done the right and saved for your retirement so you’re not a burden to society.

Low interest rates are killing you. First, they reduce the amount of interest you earn on the money in the bank. That’s money you spent a lifetime earning. Low interest rates might be good for borrowers. But for savers, it’s lost income. Anyone on a fixed income is bound to suffer in a low-interest rate world.

And then there’s inflation. Yes, I know official measures of inflation like CPI and RPI are described as ‘tame’. But you tell me – if you’re on a fixed income, is life getting cheaper for you? Is your money keeping up with inflation? Or does your money seem to get you less and less with each passing year?

It’s true, some things are a lot cheaper

TVs and mobile phones seem to get cheaper and better each year. And so do some clothes, biscuits, and household items like brooms and mops.

But what about the goods and services you buy every week? Fuel? Food? Insurance? Rent? Are they getting cheaper? I don’t know about you. But for me, those items always seem to go up in price faster than the official rate of inflation.

That’s my point. Low interest rates hurt savers. They hurt pensioners. And they lead to higher inflation. Higher inflation makes all that money you’ve saved less powerful. It doesn’t go as far.

Economists say your ‘purchasing power’ has been eroded. That’s just a complicated way of admitting that inflation leads to higher prices. If you’re paying higher prices and you can’t increase your savings and or your wages, how do low interest rates actually create wealth and promote growth?

They don’t – or they do, in the way that cancer feeds on sugar. Cancer is growth, but it’s unregulated, unrestricted growth. Unnatural growth. It kills you.

A ‘natural rate’ of interest is the subject matter of much intense academic debate. It’s too technical to go into there. But let me define it for you: the price of money determined by the free market, not by central banks.

If you’re an economist, I know that will disappoint you

But if you’re for free markets, how can you be for a free market in everything else but money. How can you believe that price signals work well to regulate supply and demand everywhere else in the economy, but the price of money is too important to be left to the market place?

Manipulating interest rates and deceiving people about the real price of money is immoral. It causes bad economic decision making. It destroys real wealth. It also destroys values.

I know that’s not the sort of commentary you’d expect to read from a broker or a fund manager, but I don’t care. One of the great things about having my own alert service is that I can break the rules. It’s more important for me to try to get to the heart of the matter for you than to confuse or baffle you with a lot of charts and jargon.

Low interest rates destroy values. When you tinker with the price of money, you make it hard for people to make rational, sensible economic calculations. So they don’t. They make decisions. Hasty decisions. Bad decisions.

They stop thinking about the future. They stop saving. Why would you when it’s punished? They live for the now. And while that may produce one or two quarters of GDP growth, the quality of that growth will be very poor.

And that’s really the big point

It’s not the quantity of growth that matters, just as it’s not the quantity of your possessions in life that determines your wealth. It’s the quality.

There’s more to wealth than just quantity. If you’re like me, your quality of life matters just as much as your net worth. In fact, experience tells me that there’s no correlation between net worth and happiness.

Don’t get me wrong. Money can make you comfortable. I’d rather have it than not. It’s the whole purpose of my professional life to help you protect and grow your money. And not to pat myself on the back, I think I’m pretty good at it. The results speak for themselves.

But I’d humbly suggest that part of my success—which I hope will lead to your success—is that quality matters. You don’t want to live in a financial system that actively destroys value. That’s why I feel so strongly about a subject so seemingly mundane as interest rates.

Interest rates are a price, the price of money

When you manipulate and distort that price you manipulate and distort people’s lives. Some people—a very small elite at the top of the financial system—benefit from this manipulation. They borrow money cheaply and invest vast quantities of it in rapid-fire fashion, capturing small gains and ‘leveraging’ them up into big ones.

Truth be told, I believe that’s why they like the monetary system we have. It favours them. They profit from it. And I’m sure that on some level, central bankers believe they are doing the right thing for people.

But I wouldn’t be writing this if I didn’t think we were on the edge of a great danger. For the majority of Britons, lowering interest rates doesn’t make you wealthier. It just exposes you to greater risks when the crisis hits.

I want to alert you that crisis before it hits. Your savings are at risk. Your investments are at risk. Your quality of life in Britain is at risk. I’ll show you exactly why I think it’s inevitable that interest rates will rise in a moment.

When will rates rise? How do you protect yourself when they do?

Category: Central Banks