Central banks don’t control the rate of credit creation and therefore cannot control inflation or induce economic recovery with interest rates. In fact, they are not originators of money at all — commercial banks are. A bank creates money out of nothing if it assumes that customers are credit worthy. On the demand side of credit, the economy is largely immune to incremental changes in the price of credit since they take on loans for life essentials such as mobility and housing. The interest rate approach to monetary policy has little empirical evidence behind it. Central banks should abandon this approach and perpetually fix their interest rates somewhere between 0% and 2%. They should then work alongside governments to control prices and guide money creation where it is needed by monitoring and guiding commercial banks.
The central bank operates a closed market to settle balances between the treasury and commercial banks. The security instruments that are traded are called reserves and are denominated in money figures. Central banks set a target rate for the price of reserve deposits. Paying tax? The bank will have to acquire reserves and pay the treasury. Settling a bet with a friend who is at a competitor bank? Your bank may have to transfer—perhaps even acquire and transfer—reserves to your friends’ bank. Unless your bank has another payment of the same or larger amount coming it’s way from friends’ bank. That nets it out. So reserves are not needed for the whole of transfers, just to settle balances at regular intervals.
Banks can trade reserves between them and the CB monitors prices closely. It interacts by buying and selling reserves to keep the rate at target. Why? It hopes that the price that banks pay for reserves will influence their deposit interest and loan interest rates. Why? Because when loans are issued it creates deposit claims against another claim on future payments — simply by increasing the amount of money in your bank account without any further inputs from the CB or deposits from other clients. Loan payments of the principal steadily decrease the amount of deposit claims you have on the bank and the interest payments gradually settle the cost you have created for the bank. The spread between the banks’ cost and your payments are the bank’s profit. The bank’s cost includes; risk of inflation, risk of default and the price the bank pays for being able to confidently settle balances of reserves in the likely scenario you will ask the bank to transfer to other banks or perhaps the treasury to settle tax payments.
If this bank was the only game in town and there wasn’t even a treasury it would probably issue its own cash bills and it would not need reserves or even an interbank market to begin with. Its cost would be inflation and risk of default — but not the interest rate.
So why does the central bank change the price of reserve deposit? The fear of inflation or the fear of stagnation. Central banks that deploy interest rates as their primary tool seek to affect the price of loans and in turn make debt more expensive. They do so by changing the cost of reserves banks are at risk of needing to eventually acquire due to the increased deposit claims granted to loan recipients.
The increased price of accessing new deposit claims in banks can—and the central bank hopes—delay car purchases, scale down a firm’s expansion plans or force someone to live with their parents for another year — to name a few examples. This way it hopes to stimulate economic activity that easier or more constrained credit increases or decreases.
Increased cost of credit is supposed to shift some households to the non-credit-worthy segment of the economy. But for most people they remain credit-worthy for banks without having the luxury of being able to delay purchases — in other words; they are unlikely to factor in the cost of credit in their decision. People need to eventually find their own homes, perhaps at a lower cost in suburbs where they will then also need a car to remain mobile and employable. This is where the perceived elegance of demand and supply logic falls short. It fails to curb credit demand for the exact segment of the population that is most at risk of keeping up with payments. For those that are impacted they are denied the choice altogether.
The other problem is that interest rates don’t work as intended when banks and consumers alike start expecting rising value of leveraged purchases. Housing especially is prone to price inflation due to a nasty combination of steady demand and supply of capital manufactured by banks. This means that rational consumers and banks will both be satisfied with any interest rate as long as housing prices climb faster than the rate of interest on credit. This viscious cycle of more loans inflating land and property has been observed again and again. The time it takes to inflate-then-crash a housing market is in direct proportion to the controls on credit creation. Economies today with housing bubbles are Sweden, Canada and Australia. But most home owners are not speculative investors. They are riding the bubble, perhaps getting caught in the bust, by force and not will.
In both of these cases the rate of interest fails to curb economic behavior, but can also act as a poverty tax for the poor when alternatives to credit are scarce.
A comparison of the reaction of the US’s Fed and the Eurozone’s ECB to the GFC of 2008 illustrates the effectiveness of interest rates in relation to other measures. The Fed was quick to lower interest rates but it also capitalized its banks by moving toxic assets from their balance sheets. This minimized the impact of defaults reducing bank capital, which would hinder their ability to lend. The ECB was more stubborn to move interest rates but more importantly fiscal stimulus was scarce under the Germany enforved austerity culture. Most importantly too little was done to move non performing loans away from banks’ balance sheets. A lot has been written about the QE activity on both sides of the pond. Unfortunately QE is only trades reserves for middle and long dated bonds in an effort to pressure those interest rates downwards. As we’ve seen this has negligible impact on the economy.
It should be questioned to what extent interest rates are justified and why credit controls are not favored instead to spur demand or curb inflation. Even though interest rate changes shift the bottom tier of income earners in and out of credit the central bank as an institution is outside the reach of democratic politics. Credit should instead be guided to productive projects and social means at steady and low interest rates. We need controls on bank lending where money originates rather than fiddling around with interest rates.
This was the river which Japan, then South Korea and now China went down. They ensured that credit creation was reserved for productive activity and let interest rates concerns remain secondary. Such a shift would be welcome to fight global warming and reduce inequality.
Central banks will still have their hands full in a world of perpetually fixed interest rates. They would closely monitor the acceleration, volume and quality of bank lending — not just leverage and capital ratios. They would work to implement (not design) industrial policy and industrial greening initiatives by guiding credit to the sectors of the economy that sustain the economy and maximize opportunity. They would continue to operate the interbank market, treasury operations and issue bonds on behalf of the government to provide the market with safe investments. They would help governments intelligently govern the trilemma of independent interest rates, the floating exchange rate and free flow of capital. The plumbing of the economy needs good design and maintenance.