Tuesday, January 1, 2013

Why do central banks normally impose positive rates of interest?

I’ll argue below that there are two reasons, both of them bizarre. One reason stems from corruption. The second is that those positive rates stop what would otherwise be rampant inflation caused by the fractional reserve banking system. Hope that’s bizarre enough for new year’s day. Here goes.
As everyone knows, the current zero or near zero rates are an exception: normally central banks implement a positive rate of interest of a few percent: perhaps about 3% on average over the decades.
But why does the government of a country that issues its own currency borrow money? Such a government can simply print money. Borrowing something, and paying interest for the privilege when you can produce the thing yourself for free is crazy. At least that is certainly true where a government needs money for stimulus purposes.
As to where a government borrows as substitute for collecting taxes, it may well have to pay interest. But such borrowing makes no sense, for reasons I set out in detail here. As I pointed out in the latter article, the REAL REASON that politicians borrow instead of collecting tax is that voters tend to blame politicians for tax increases, but not for any interest rate increases that stem from government borrowing. So borrowing is a great way for incumbent politicians to buy votes and that is plain straightforward corruption.
So there you have one reason why central banks normally impose positive rates of interest: corruption – a brilliant reason for such positive rates, don’t you think? But there is another reason for positive rates which will never have occurred to you, and it’s as follows. It’s a bit complicated, but here goes.

Fractional reserve banking.
Several economists have advocated, I think quite rightly, that the rate paid by governemnts / central banks should be permanently set at zero. For example Milton Friedman and Warrant Mosler have advocated that the government / central bank machine should not issue interest yielding liabilities: that is the only liability (if you can call it that) that they should issue should  be cash, or “monetary base” to be exact. And cash pays no interest.
But there is actually a problem with that zero interest rate policy not spotted by Friedman or Mosler. It’s a problem alluded to by Selgin and Huber (p.31), and it’s the fact that commercial banks can print and lend out money. That is, such banks do not always need to pay interest to anyone in order to obtain funds to lend out: i.e. such banks can simply create money from thin air and lend it out. That way they undercut what you might call “genuine savers”.
Now if commercial banks do that when the economy is already at capacity (which is exactly when they’re likely to do it), the result will be excess demand and inflation. But why should commercial banks or those they lend to care about inflation? No reason at all. As to borrowers, they are more than happy to see their liabilities eaten away by inflation. As to commercial banks, their money printing operation costs nothing, so if the value of that money when repaid has halved, why should commercial banks care as long as they get paid interest?
In short, I suggest that fractional reserve based on a fiat monetary base leads to rampant inflation, unless the inflation is controlled by having central banks artificially boost the rate of interest a bit. In contrast, fractional reserve based on a gold monetary base does not suffer the same problem because gold blocks the inflation.

Banks’ administration and bad debt costs.
The above argument is a slight over simplification in that part of the so called interest that banks charge is necessary to cover administration and bad debt costs. But in addition to the two latter, there is what might be called “genuine interest”: that’s a reward to the lender for foregone consumption. In other words the above argument ignores (for the sake of simplicity) administration and bad debt costs.

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