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Source link: http://archive.mises.org/4530/the-make-believe-world-of-central-banking/

The Make-Believe World of Central Banking

January 6, 2006 by

The Fed and the ECP are trying to create what they cannot: a growing economy with low interest rates, minimal inflation, and no business cycles. In truth, a forced lowering of rates is a serious government interference with the market economy. Low rates prevent less economically efficient players being forced out of the market, and make it harder for more efficient producers to gain market share. Ensuing disappointment with lacklustre income and employment growth could provoke public calls for lower rates – in the hope of reversing the lacklustre economic performance. FULL ARTICLE


George Giles January 6, 2006 at 9:29 am

A good read is William Graham Sumner’s the History of Banking in the Leading Nations (4 volumes). In it he illustrates that this problem gov’t confiscation of wealth is a historical plague effecting all naitons. As long as man has had currency this problem has existed. The nature of government (a legalistic criminal facade) requires bankruptcy as a long term result. There are two kinds of government those that have gone broke, and those that are on the way.

Roger M January 6, 2006 at 9:50 am

So how would Adam Smith’s view of low interest rates in Holland figure in here? He wrote “The province of Holland, on the other hand, in proportion to the extent of its territory
and the number of its people, is a richer country than England. The government there
borrow at two per cent., and private people of good credit at three. The wages of
labour are said to be higher in Holland than in England, and the Dutch, it is well
known, trade upon lower profits than any people in Europe.20 The trade of Holland, it
has been pretended by some people, is decaying, and it may perhaps be true that
some particular branches of it are so. But these symptoms seem to indicate sufficiently
that there is no general decay. When profit diminishes, merchants are very apt to
complain that trade decays; though the diminution of profit is the natural effect of its
prosperity, or of a greater stock being employed in it than before…
As the capital of a private man, though acquired by a particular trade, may increase
beyond what he can employ in it, and yet that trade continue to increase too; so may
likewise the capital of a great nation.” http://oll.libertyfund.org/EBooks/Smith_0141.02.pdf p. 135

Professor Reisman also writes in his book on capitalism that interest rates reflect profits. Can there be a more benign explanation for low interest rates than Polleit’s? How do we separate out the various effects?

Roger M January 6, 2006 at 9:51 am

By the way, Holland, as part of the Dutch Republic, operated on a gold standard with the freest markets in the world at that time and probably since then.

Paul Marks January 6, 2006 at 3:19 pm

An interest rate should be decided between the person who is giving up their money for a period of time (or the commercial organization, such as a bank, that is investing the money on their behalf) and the person or organization that is borrowing the money.

Investment must be financed by real savings (i.e. someone giving up their money for a period of time – not buying goods or services they want at this time).

It is not a matter of “the level of interest rates” it is matter of whether the investment is being financed by real savings (either by the people who are doing the investing, of by people who they are borrowing the money from) or whether a shell game (such as credit bubble finance) is going on.

Of course people will tend to ask for a lower interest rates where there is less risk of the borrower defaulting on the loan (so interest rates tended to be lower in Holland than in France in the 18th century) and yes it is good for government to borrow at lower interest rates (as it means that less tax will have to be raised to pay back the money) – but it is better still for government not to borrow money at all.

And (of course) it is absurd for government spending (whether in France, Holland or Britian in the 18th century or any other century) to be described as “investment”.

Efforts to reduce interest rates (either to government or to private enterprises) via credit expansion (rather than financing borrowing by real savings) are the root of the boom-bust cycle and the basic distortions in the capital structure.

Certainly Ludwig Von Mises explored this better than any person before his time, but (as Mises himself stated) the basics of the above have been known since the time of David Hume (and before).

Government shouuld not be in the position of trying to rig the loan market (“increase the money supply”) at all – whatever the “price level” may be doing.

The whole basis of the modern financial system is not only damaging, it is corrupt – remember “Long Term Capital Management” and all the rest of the bailouts?

The Federal Reserve Board and all the rest of the mess (going back to the National Bank Act of 1861 and other Federal and State activities before this date) must be got rid of – it is just a vast shell game which gets worse and worse every year.

The longer dealing with the mess is put off the worse the reckoning.

A bank should be in the business of lending out the savings of its depositors – not playing credit expansion games. And if a bank insists on playing games it should be allowed to go bankrupt – which, eventually, it will.

“But all modern financial institutions play these game” – I know, that is the problem.

Roger M January 6, 2006 at 3:44 pm

I agree with Paul Marks, but can’t square Polleit’s article with Smith and Reisman. Polleit seems to be arguing that loose credit is driving down interest rates. But as I understand the biz cycle, rates should fall in the short run, but go back up as bizmen quit borrowing and inflation appears. We don’t see inflation appearing and interest rates aren’t rising. Seems to me that Smith and Reisman’s explanation is more straightforward.

averros January 6, 2006 at 7:58 pm

Roger M — the market-derived interest rate for loans denominated in very hard money (i.e. money with fixed total amount) will be ZERO plus risk premium for the particular loan/borrower (plus whatever fees needed to cover transaction costs).

Increasing money supply will add to the baseline interest rate, to compensate lender for inflation. Gold is certainly “hard”, but its total available quantity increases nonetheless, so gold-denominated zero-risk loans will have positive, but smallish interest rates. Fiat money have fast-increasing supplies, so minimal market-based interests rates in them will be much higher.

So this is not surprising that Holland back then had small interest rates.

Note that market-derived interest rates have nothing to do whatsoever with the growth or profit *in real terms*. The only linkage between interest rates and illusory growth is due to the fact that growth is measured in terms of fiat money, and that the commonly used measures of growth (such as GDP) fail to take into account loss of accumulated wealth caused by the “loose” monetary policies.

C. Cathey January 6, 2006 at 10:15 pm


Interest will not be zero, even with a hard currency. But will be a non-zero value reflecting the average time preference of the market. This is due to the fact that we prefer money now to money in the future and must be paid to wait.

All things being equal, the interest rate in a hard money market will be lower than the interest rate in fiat money market because in the first the market will be growing with respect to the money supply and reversed in the fiat money market. (One of the things held equal is that the government does not artificially hold the interest rate down.)

The Economist January 7, 2006 at 1:35 am

It’s pretty easy to explain what scam the central bankers are running. If someone comes to you asking what the hell the Federal Reserve does, you answer that they subsidize borrowing, and they finance it by printing money. The consequences of this subsidy are the same as that of any subsidy. Their power to inflate adds an unnecessary complication to the argument, when it is sufficient to say that people are hurt by central banking by being unable to save through the banking system.

William January 7, 2006 at 3:34 pm

The sad part is the faith the peoples and governments of the world have placed in the hands of central bankers. This has led to the theft of trillions of dollars from rich and poor nations alike.

The article mentions that there may be some economic growth from increasing the money supply. This is always false in the long term where individuals and businesses that financed their behavior with cheap credit find that commodities, real estate, services and labor are more expensive.

Mario January 8, 2006 at 3:06 pm

It is interesting to note that Mr Polleit works for an institution (Barclays Capital) that has greatly benefited from central banks’ inflationary policy. This is in no way a criticism as I have also been working in for similar institutions for the last 13 years!

Marco January 9, 2006 at 5:18 am

Where exactly did Mises advocate stopping money supply growth under a fiat money regime (a very bad idea, IMHO)?

Thorsten Polleit January 9, 2006 at 5:23 am

He did so in “In return to sound money”.

jeffrey January 9, 2006 at 5:27 am

Yes, Mises writes: “What is needed first of all is to force the rulers to spend only what, by virtue of duly promulgated laws, they have collected as taxes. Whether governments should borrow from the public at all and, if so, to what extent are questions that are irrelevant to the treatment of monetary problems. The main thing is that the government should no longer be in a position to increase the quantity of money in circulation and the amount of checkbook money not fully—that is, 100 percent—covered by deposits paid in by the public.”

Thorsten Polleit January 9, 2006 at 5:36 am

To take the discussion a bit further, in “return to sound money” Mises writes: “There is need to realize that the economic policies of self-styled progressives cannot do without inflation. They cannot and never will accept a policy of sound money. They can abandon neither their policies of deficit spending nor the help their anticapitalist propaganda receives from the inevitable consequences of inflation. It is true they talk about the necessity of doing away with inflation. But what they mean is not to end the policy of increasing the quantity of money in circulation but to establish price control, that is, futile schemes to escape the emergency arising inevitably from their policies.”

Marco January 9, 2006 at 6:14 am

But Mises’ definition of “inflation” was not “an increase in the money supply”. In The Theory of Money and Credit, he wrote:

In theoretical investigation there is only one meaning that can rationally be attached to the expression inflation: an increase in the quantity of money (in the broader sense of the term, so as to include fiduciary media as well), that is not offset by a corresponding increase in the need for money (again in the broader sense of the term), so that a fall in the objective exchange value of money must occur (p. 240)

I have never come across a passage by Mises in which he advocated a fiat money system with a fixed money supply – a very different system from a gold standard. The problem with a fiat money system is that it is impossible for the central bank to estimate the market’s demand for money. In a gold standard economy the total supply of gold can increase, but this is usually a result of market interactions depending on the profitability of gold extraction and production.

Pete Canning January 9, 2006 at 7:36 am

Marco, have you read the later chapters of The Theory of Money and Credit? Take a look at Part Four (written in 1952).

“The first step must be a radical and unconditional abandonment of any further inflation. The total amount of dollar bills, whatever their name or legal characteristic may be, must not be increased by further issuance. No bank must be permitted to expand the total amount of its deposits subject to check or the balance of such deposits of any individual customer, be he a private citizen or the U.S. Treasury, otherwise than by receiving cash deposits in legal-tender banknotes from the public or by receiving a check payable by another domestic bank subject to the same limitations. This means a rigid 100 percent reserve for all future deposits; that is, all deposits not already in existence on the first day of the reform (p. 448).”

Pete Canning January 9, 2006 at 7:42 am

The line is on p. 491 of my 1983 edition.

billwald January 9, 2006 at 11:37 am

Banks are like zoning laws in that they play a zero sum game, determining who wins and who loses. The can’t raise the bottom line.

Yancey Ward January 10, 2006 at 10:28 am

Antal Fekete’s latest. I promise it has nothing to do with RBD.

Paul Marks January 10, 2006 at 2:07 pm

I am surprised that I need to remind people that asset price inflation (whether in the real estate market or in the “booming stock market”) is just as much inflation as price rises in Walmart.

To increase the money supply via a credit bubble is inflation (and it will set up a boom bust cycle) whether the “price index” goes up or not -after “prices in the shops” did not tend to go up in the 1920′s.

As a matter of fact even the nonAustrian (indeed antiAustrian) Milton Friedman eventually came to the view that goverment should not increase the money supply.

The trouble with that is that financial instutions may continue to expand “broad money” (“M3″ or some other measure of credit) even if “M0″ or “MB” is frozen – as long as they expect to be bailed out when trouble comes along.

We must remember that the vast majority of people in the financial industry assume that if things got really bad the government (of the Fed if one wishes to pretend that it is “private”) would come to the aid of the system (i.e. expand the money supply to help prop it a bit longer) – and they play games accordingly.

This is a serious problem.

Swantar S. Mamboni January 11, 2006 at 9:26 am

The economy has all the intrinsic properties of an oscillating system. Interest rate changes temporally lead money supply changes which temporally lead aggregate demand which later impacts on prices, etc. These reactive elements, akin to economic capacitances and inductances, act in shifting phases, resulting in peaks and troughs of economic activity. The central bank is attempting to stabilize this oscillator using time-delayed variable values and actions with time-delayed and imprecise effects (i.e. asset bubbles, speculations etc.). Such a technique cannot stabilize the economic oscillator, only activate reactive elements and cause greater amplitude swings in economic activity (i.e. actuate resonances and nulls). The simple answer to stabilizing an economic oscillator is to minimize or eliminate reactive element variables and avoid stimulus, period. To wit: stable currency and static money supply linked to a hard asset (i.e. gold), and real-time decentralized adjustments to supply through pricing by the consumer (this is the intrinsic resistive element that provides for self-damping) with no influence or coersion by central planners, and the elimination of central control of interest rates.

In defiance of the unavoidable (but small and self-correcting if unperturbed by external interventions) swings of the economic oscillator, the central bankers insist on coersing economic growth consistently upward (i.e. creating false prosperity) with ever increasing credit expansion, akin to raising the voltage ever higher in an attempt to maintain current. Unfortunately, the longer and higher the oscillator is pumped upward, the greater the imbalances created and the more violent the ultimate and unavoidable swing back to correction (i.e. bust must follow boom – only the timing of the correction is uncertain). Eventually, the world economy will have to pay a great price for the credit and debt excesses of recent decades, all courtesy of the central bankers that believe that they can defy the fundamental laws of economic action indefinitely – they cannot.

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