Wednesday, 4 June 2014

Interest Rates


Interest Rates


I have been trying to follow the argument of Gerardo Coco in his interesting, but confusing, piece posted on the Cobden Centre website. I wonder if I have got the gist of his argument in the two short paragraphs below. 

Interest rates have to play several different roles.
(1) The first role that springs to mind is that of indicating the price of credit; interest being a regular (e.g. annual) fee paid to the lender for the temporary use of his capital. This capital may be invested in a productive investment, to buy tools, or a mill, or an extra field. A rational investor will pay no more in interest than he can gain (per annum) from his investment. Good times will allow interest rates to rise, and conversely bad times will hold interest rates down.
(2) For some people liquidity is the problem; they want cash in hand, not to invest, but to pay the bills. Their desperation will determine the upper limit of the interest rate they will pay. Let us call this process of turning credit into cash 'discounting'.
(3) People have grown to expect money to breed, to yield an annual income. The relationship between capital and income is of course the interest rate. There is a backwards way of thinking which says "My assets yield £100 a year; interest rate is 1%; so my assets are worth £10,000."  If interest rates were 5% I would value my assets at a mere £2,000. A form of this argument may be driving up current house prices; "My house is worth £300,000 and I can afford a mortgage (at 6%) costing £18,000 per annum. If mortgage rates drop to 3% I can sell my house for twice as much."
(4)  Central banks use their 'base rate' as a means (essentially their only means) of controlling the money supply, and with it the 'growth of the economy', 'unemployment', and 'inflation'.

It is hard for a single 'Interest Rate' to fulfill all the roles required of it. It is true that Bank Base Rate does not impinge directly on the high street borrower, for the normal citizen cannot borrow money at the present comically low rate of 0.5%. But it remains a problem that a lender does not always know to whom he is lending and for what purpose. If Central Banks set a very low interest rate, some entrepreneurs may borrow money (as it is so cheap); but others will conclude that 'times are bad' for investing and consequently will wait for better times. The Bank's one available signal of Bank Base Rate can have a damaging effect while trying to have a stimulatory effect.

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