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Friday, November 28, 2008

Interest Rates in a True Free Market

TLP has left a new comment on your post "The Federal Reserve Caused the Great Depression":

What would low interest rates signify in a true free market?

In a true free market, interest rates signify what businesses are worth an investment.

Suppose the free market interest rate is 2%. I predict I can earn a 4% rate of return on my business. Therefore, it pays for me to borrow at 2% and invest in my business yielding 4%. Of course, I should include a margin of error in my calculation.

Suppose the free market interest rate is 6%. I predict I can earn a 4% rate of return on my business. Therefore, it does not pay for me to invest in that business. I'm better off doing something else.

Current prices represent the value of goods in the present.

Interest rates represent the value of future work. Interest rates are a price signal that indicates "This is worth an investment".

When the State tampers with fiat money by printing it, it tampers with present prices. People can't make rational decisions about what work to perform right now.

When the State tampers with interest rates, it is tampering with future prices. People can't make rational decisions about what work to perform in the future.

In a true free market, "return on capital" and "interest rates" converge over time. If they diverge, people borrow and start new businesses. The lower the spread between "return on capital" and "interest rates", the more efficient the market.

In the present, the Federal Reserve literally has an infinite budget. It can set interest rates at any arbitrary level, at no economic cost to insiders.

This sends the false signal about what investments are profitable. Suppose that, during the boom, an investment is expected to yield 10% while interest rates are 2%, an artificially low rate. Therefore, you borrow and invest. This causes an asset bubble. When the bubble pops, prices crash. That investment that seemed profitable is not profitable during the bust.

When the State tampers with interest rates, it prevents people from making rational economic decisions about what businesses are worth starting. Large corporations are shielded from competition and are "too big to fail". When they make mistakes, they qualify for a bailout (FRE, FNM, Bear Stearns and JP Morgan Chase). When individuals make mistakes due to false price signals, they lose their home or their business.

6 comments:

Anonymous said...

I agree to some extent that the State should cease to exist, including its central banking etc. However you employ a completely 'quantitative rationalist model' (that the only thing worth calculating for man is monetary profit... if I do this based on the calculation that less plus a bit more I will make more, or not).

Morality and ethics can prevent someone from pursuing something 'because they will make more'. Its just that morality and values are completely distorted in a Statist society, so that even people like you think in those terms.

If it makes rational economic sense to sell alcohol (and make lots of money personally) does it mean we all should do it and ignore the social costs of such a business venture? Most people in a Statist society may agree that 'profit' is king, or we need 'The State' to regulate...but I think normal balanced human beings would not do it, because their values would be based on something other than 'rational economic man'.

I hope I have made some sense.

Anonymous said...

Free Markets if the concept is taken seriously means that the 'forces' (taken from Physics) supply and demand will determine prices and the market, so long as no other 'force' or 'power' regulates or distorts this 'law'.

Logically taken to its conclusion then it means if you are a food producer and there is a shortage of food, you are 'morally right' to raise your prices. People will starve and die....but so what its 'the law of economics'.

Thomas Malthus said this then, and many 'economists' say this now. this is where 'modern atheist man' has reached with his banking and 'interest is good' doctrines and practices. I would not like to live in a society where people would raise their prices of food because there is scarcity, I would prefer to live where people have feelings for each other...this is not utopian, it is possible, its just that modern atheistic man projects his own values on all societies and says 'we are all just animals' and materialists (food, sex, power, wealth is all that matters to us glorified apes).

Sphairon said...

"I would not like to live in a society where people would raise their prices of food because there is scarcity"

No, you would like to live in a world where there is scarcity, but no means of indicating it which will basically prolong the situation and not eliminate the bad side-effects of scarcity at all.

Dude ...

Anonymous said...

scarcity can be caused by many things, usually because man or men have acted in ways to benefit themselves to the detriment of others.

Hoarding, cartels, monopoly etc.

Famines and natural disasters also can cause scarcity, but in an area where people are not like Hobbes described (life is short and brutish), people if they help each other they will survive and thrive.

There is more to life than rationality or quantity can account for, more than the sum of its parts.

To materialists (only matter is real) and atheists if you have bread for one person to eat and get full on, there is no way that 2 people can share the bread and both become full, it is impossible, however from my perspective ('call it irrational, idealistic or stupid'), those 2 people can be full if they both agree to share (in the spirit of brotherhood) the food and they start the meal by praising God....this causes the food to be blessed and it provides nourishment for both.

To materialist and atheists this is just crazy... and their 'economics' reflects this attitude.

michael said...

Well, there's a big difference in the way you want things to be 'what feels good' and the way things actually are.

Price controls do not guarantee that the poor eat. In fact, history will show that price controls are much more damaging to 'the poor' and 'the brotherhood' than free market economics.

What the 'feel gooders' fail to recognize is that their policies of price controls and socialism cause the very negative circumstances they are, in fact, trying to prevent.

But hey, ignore history, ignore economics, and go with what feels good...

and you'll be hungry, you'll live with a lower standard of living, and destroy technological and market advancement.

but hey it 'feels good' right?

keep dreaming.... it's working for America right?

Anonymous said...

"Logically taken to its conclusion then it means if you are a food producer and there is a shortage of food, you are 'morally right' to raise your prices. People will starve and die....but so what its 'the law of economics'."

And that rise in prices ENCOURAGES PEOPLE TO GROW MORE FOOD, SOLVING THE FOOD SHORTAGE. If prices do not rise, THERE IS NO ENCOURAGEMENT TO PRODUCE MORE FOOD AND THERE WOULD STILL BE A SHORTAGE.

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