Set the Interest Rate at Zero. Why Not?
As you climb on top of the shed, your superhero cape flapping in the breeze, and your 10th birthday a few days in the future, you don’t doubt for a second that when you launch yourself into the air, you’ll be able to fly. That such dreams can be dashed by something so outrageously inconvenient as the law of gravity is one of the great disappointments embedded into the fabric of the universe. But there it is. And there are not just physical laws written into the system. There are economic laws too. And trying to defy them is as consequential as trying to defy gravity. The economic laws are related to the physical and temporal world in which we find ourselves. We discovered them. We did not create them.
One of these laws is that the value of an apple today is greater than the value of an apple to be received in the future. A related law is that roundabout methods of production have higher yields. You can have more apples if you plant an orchard than if you rely upon wild apple trees. People are generally impatient, and life is uncertain. We value what we have now more than the promise of the same thing in the future. The more distant the promise, the more the relative valuation favours the present.
Roundabout methods of production are related to this impatience, this temporality. We can climb a nut tree and harvest the nuts by hand and eat two handfuls a day. Or we can save one of today’s handfuls and eat them tomorrow instead of going climbing and picking. With the time spared, we can build a rod with a hook to enable us to save time climbing into the trees or allow us to reach to the farthest branches. The day after tomorrow, with our new tool, we can pick five handfuls. We can sell what we don’t need and invest in still better equipment. Getting this process underway, taking advantage of the greater productivity of more roundabout production processes, requires someone to save, it requires someone to be patient.
No matter how hard we try or how many laws we pass, there is no way to really make $1 promised 10 years from now worth more than $1 to be received right now. There is no rational way to make the picking of nuts with the use of tools and machines less productive than picking them by hand. The interest rate reflects the oscillations in the relative value of present and future goods. Sometimes people are patient and will value future goods more highly than they usually do, though still not as much as present goods. Interest rates fall. Sometimes people become even more impatient and interest rates rise. We might hold down interest rates or hoist them high, but the forces that interest rates reflect will win in the end, just like gravity. In fact, the assertion of these forces might be quite destructive if we have been particularly arrogant about our ability to control them.
To provide one final piece of evidence to show that interest is not a human invention, consider the relative values of two sets of present and future goods that are quintessential roundabout products: timber and wine. If you store wine in the right way for 30 years, it is worth more than wine that has been stored for a year. That difference in value is interest. If you grow strong oak trees, their mature timber is worth more (and there is more of it) than the saplings you planted 3 years ago. The difference is interest. While we usually experience interest as a monetary phenomenon, it is real. And, indeed, it is the real rate of interest, the real difference in value between present and future goods, the extra timber, the better wine, that matters.
With that said, let’s explore what would happen if we jumped off the roof in our cape. If we try to set interest at zero. In fact, we already can see some of the consequences of this because since 2008 and especially during 2020-2021 governments and central banks leaned in this direction. Construction companies have collapsed. Restaurants have closed. Houses have become unaffordable. Inequality has increased. Rents are high. Food prices are high. These are the consequences.
If we were to issue an edict that interest rates are, from tomorrow, equal to zero, what would happen? To suppress the rate of interest, the central bank (RBA) would be forced to print huge quantities of money. The first people to benefit would be those who own assets. Houses and share prices would jump and keep rising. Those who scramble to the bank tomorrow morning and get first in line for a 0% loan might be able to get in on the party. Others could borrow at 0% but if they didn’t get in first, they would have to borrow twice as much, then three times as much and so on. People would also borrow money to spend on consumer goods. Cars would double, then triple in price. So would televisions. Before long, the money would flow into the prices of everything. An inflationary boom would be underway. But this is a treadmill on which the central banks must run ever harder to keep up. More and more and more money would be printed.
There is an even more destructive side. Some of the money might be mistaken for capital and make its way into projects such as new buildings or new factories. However, if the central bank ever stops printing, many of these projects will collapse. Half-finished skyscrapers would dot the horizon. Worse, because people are generally impatient and short-sighted, we would have on our hands the economic equivalent of the world’s biggest sugar high. People would consume capital equipment, living only for today. Of course, like a sugar-only diet, the first three days might be a rush, but sickness will soon set in. The system begins to die. A wasteland is the inevitable result. Only the deepest of all depressions, deep enough to eviscerate all the printed money can return the system to health. And that is a medicine that those who helped create the illness will be reluctant to take. So, the sickness will grow until there is no choice but for the medicine to be swallowed. That is the consequence of trying to set the value of saplings equal to the value of mature oak trees. The difference between gravity and economics is that unlike gravity, you can experience the feeling that you are really flying, that you really have defied the laws of the economic system. Then comes the crash landing.
Discussion Question
Some people will argue that setting interest rates to zero (or a very low level) will help people acquire assets. Is this true or would such a policy merely take those assets further out of reach?