Negative Interest Rates and the Science of Choice

When I was in high school back in the middle ages, I had an economics teacher named Mr. Stevens, who had a simple definition of economics. None of these dry paragraph-length textbook definitions about production, consumption, wealth, and distribution for him! Nope, his definition of economics consisted of four words:

The science of choice.

I hope he realizes that even though we were sometimes a rowdy bunch back then, his teaching had an impact, and still resonates with at least one of his students today. Many of my readers may recognize a familiar theme here, which harkens back to that simple ingenious definition.

After all who is it that’s making these choices? It’s individual people of course, which ties back to my recurring theme that there’s no such entity as the economy. That concept is just a way to describe the everyday process of people making choices about how to convert the resources in their environment into things they value.

A classic illustration of the relationship between human choice and economic outcomes is the idea of supply and demand curves along with the resulting concept of price equilibrium. As the price of something rises, more people are willing to produce it, so supply curves are normally sloped upwards. Demand curves slope downward as price increases though, because fewer people are able or willing to buy the product. The point at which these curves cross is the natural equilibrium of price and quantity, where everyone is as satisfied as possible given current production possibilities.

Of course, the supply and demand curves can shift positions as a result of some event in the real world such as changes in taste, technology, policy, or even weather. So a viral video about hula-hoops might shift the demand curve for those useful items upwards, meaning that the number wanted at each price point increases. The invention of cars shifted the demand for buggy whips downwards, while fracking technology pushed the supply curve of oil upwards. A recent blight on orange trees pushed the supply curve for orange juice down, and so on. Notice that except in cases of natural disaster, most curve-shifting events are driven by human choice.

Free choice allows for the most efficient production and the most just distribution of wealth. Interference with free choice changes those outcomes, ultimately damaging the process so much that people eventually begin to starve (I’m looking at you Bernie Sanders, modern day icon of all the disastrous socialist experiments throughout history). For today though, let’s shine our light of Truth, Justice, and the Capitalist Way onto just one institution notorious for interfering with free choice; the central banks.

Monetary policy, as practiced by central banks around the globe, attempts to influence the economy through interest rates (i.e. the price of money) by interfering directly with the money supply. Since 2008, the U.S. Fed and other central banks have been trying to combat the so-called great recession, first with various quantitative easing schemes, and lately, in Europe and Japan, with negative interest rate policy, or NIRP (an acronym which always makes me want to exclaim, “Derp!” for some reason).

In effect, QE involves vast purchases of assets like government bonds in return for newly created reserves at member banks. NIRP goes a step further by charging interest on any unlent reserves, making it painful to hoard them.

The goal of all this is to induce banks to lend, thus inducing people to spend, thus helping the problems to mend by making the recession end.

Ahem, right. Ok, Leaving my horrible rhymes aside, let’s look at the various human choices involved to see why this doesn’t make sense.

1. Banks pass costs on. The management of a bank is responsible to its shareholders for profits. So they’ll do the most obvious thing, which is to raise fees and add more fees on customer accounts. Each bank can do this without losing business to competitors, because every bank has to do it. Way to go central banks! You just clobbered Aunt Millie with fees and she didn’t even get a new toaster.

2. It takes two to tango. Note that the central banks are trying to encourage commercial lending by fiddling with the price and supply of money. But that leaves out the other side of the equation; demand. There have to be two sides to every transaction. Without customers walking in the door asking to borrow, it doesn’t matter how much the bank has in excess reserves or how low interest rates go. Nothing’s going to happen.

So that brings us back to the question of choice. Why aren’t businesses choosing to take advantage of these killer rates to expand capacity? In other words, why has the demand curve for money shifted so far down? The problem is what Larry Kudlow would call a lack of “animal spirits” in the economy, meaning the willingness of companies to borrow, invest, hire, take risks on new ventures, etc.

Well if the question involves the idea of free choice, maybe the answer does too. I think Kudlow and other commentators have it right when they place the blame squarely on the shoulders of statist administrations like the ones in socialist Europe and our present administration in Washington. When business owners and managers are faced with a capricious, overbearing beaurocracy of regulators, they can’t plan for the future. When they’re faced with a president who constantly scorns “millionaires and billionaires” and negates their accomplishments by declaring, “You didn’t build that!”, many no longer even want to plan for the future.

I wouldn’t be running to the bank for a loan either.

So, Mr. Stevens, I heard you, and I agree. Economics is the science of choice. Now if only the statist governments and economy-planners around the world would listen to you and return freedom of choice back to economics.

Don’t hold your breath. But as currency traders, at least we can watch, anticipate, and profit from what the statists are doing. The best revenge is often selling a country’s currency short, as I always say (actually, this is the first time I’ve said that, but you get the idea).

Next week, the case for raising rates. Until then…keep pipping up!

 

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