It’s been a while since I’ve discussed any economic issues, so I guess a post like this one is well overdue and will be unfortunately relatively short. (Relative to how I usually carry on about these things.)
I attended the inaugural NYU Objectivists’ event for the 2009-2010 school year Monday night. It was a discussion panel with Yaron Brook and John Allison. It was simply fascinating.
Dr. Brook did his typically solid job of defining and defending the role of rational egoism in a proper economic policy, but the star of the show was clearly John Allison, Chairman and former CEO of BB&T. Mr. Allison is dripping with southern charm and good humor and demonstrated a clear, well-integrated view of our economy and the role philosophy plays in it. He made his understanding of the ebbs and flows of money look so easy!
I’m not going to summarize the entire talk. It was meaty and interesting and I didn’t take any notes. 
One point that struck me was a very simple, wildly obvious one: The Fed’s manipulation of interest rates is actually a simple price control on loans. I don’t know why this didn’t occur to me earlier without assistance, but when Dr. Brook made the point (I believe he is the one who introduced it in the discussion.) it was like a bolt of lightning to me.
Price controls are economically destructive. Let’s just get that out of the way.
In any market, even partially free, prices get set by a balance between supply and demand. More supply pressures prices to go down. More demand pressures prices to go up. If prices are not permitted to fluctuate with supply and demand, then some portion of the population will be left with an unmet need, which is a long way to say that you end up with shortages and gluts.
A shortage is the result of prices being too low. When prices are below what they should be on the free market, consumers buy whatever it is all up and there is none left even for people who will pay a WHOLE lot of money. Let’s say I have private jets and I price them for $1 each. I will sell out of them very quickly to people who have $1, but the people who are willing to pay $1,000,000 probably won’t get a chance to buy them. I would look really stupid having made $10 when I could make $10,000,000.
A glut is the result of prices being too high. When the prices are too far above demand, then people don’t buy them and the owner is stuck with an overstock they can’t unload. Let’s say I have some jelly beans, which I propose to sell for $10 each. Given that jelly beans are FAR cheaper than that it is unlikely anyone will buy them. Again, I look a fool.
In a free market, prices are constantly in a state of flux reflecting shifting demands and supply. To see this happen rapidly, watch your favorite stock on the stock market. The price per share wiggles and wobbles around throughout the day.
If you think about it, an interest rate is the price of a loan. If you’re my friend and I loan you $10 and you give me $10 back next week, that loan was free. It was the equivalent of letting you borrow my rake. But if I give you $10 and I charge you 10% interest, the price of that loan just became $1. It’s like me renting my rake out to you.
This is all fine and good, but given that rake rentals are in high demand, your $1 rate really is a steal! If I rent my rakes for that much to everyone, I shall soon be out of rakes really quickly, which is a HUGE problem if an autumn wind comes along and litters my yard in leaves.
This is part of the problem with the Fed dabbling in our financial markets.
Banks take your money (capital) and they lend it out to other people. Before the Fed and the FDIC, banks were relatively cautious about lending money because if they had a lot of bad loans out and too many people came in to get their money back they might not have enough to give it back. This is called a run on the bank. Watch It’s a Wonderful Life. You’ll see.
It’s pretty terrifying when there’s a very real risk that your savings might disappear over night because some banker started making loans simply out of the goodness of his heart. His profit motive is actually what keeps your money safe because he wants to only loan money to people for a high interest rate who are going to pay it back. For this reason, an altruist is the worst banker in the whole world. Do NOT give him your money!
But the FDIC made it where banks could be more risky in making loans because deposits up to a point are insured by the government, tax payers.
And the Fed sets the price of the loans.
See where I’m going with this?
Because the Fed sets prices for loans, the price is nearly always wrong for the market conditions at the time.
So, you’re a bank and there are a bunch of people handing you their money in return for a modest return in interest payments. In order to make those interest payments to your depositors, you need to invest a portion of their money. You might invest in anything, but whatever you do, you need to get your money back PLUS a little more than the interest you owe your depositors. So, it makes sense that you will turn to simply lending the money out at interest — as opposed to buying stocks or whatever, although you might do that, too.
The rate of interest on the free market would be set between you and your customers based on the amount of money you have to lend out and how many and what sort of customers want to borrow the money. Rates would fluctuate between deals and between financial institutions. The financial institutions who are best able to assess risk and choose the right borrowers and investments and set the right interest rates are the ones who will succeed. People would be obliged to choose their financial institutions wisely before putting their money in there. The alternative to putting your money in a bank, of course, is to keep it yourself, at home.
But with the Fed stepping in and artificially setting the rates, they’re fixing the price. This means that there are loans that could be made that aren’t getting made and it means there are loans getting made that shouldn’t get made. No matter what rate the Fed sets that’s the case because banks aren’t free to change the rates as they see fit.
I doubt any of my readers are stupid enough to believe this is a good thing, but if you were one of those people who believes banks are just horrible, giant corporations who are seeking to screw you over and it serves them right, you should stop and think a minute about what that means for a banks depositors. It means that banks also cannot simply attract more depositors by offering higher interest rates based on the success of their lending policies.
The entire idea of a government-controlled/influenced central bank is pretty idiotic, and the answer to the moral question is that it’s abominable, but with the size of our economy it’s unconscionable.
And apparently that loon Ron Paul has a book out about it:
