Vytautas Žukauskas. A Distorted World of Cheap Money

A few weeks ago the Fed expressed no intention to increase interest rates, but the will to maintain the current ones of 0 to 0.25%. However, in the long run such record low interest rates set to stimulate economy are detrimental, rather than effective. Cheap money does not only indicate the prevailing economic problems, but imply long-term negative impact on both savers and economy.

Quite a few economists forecasted an increase in the current interest rates valid since December, 2008. Even the head of the Fed has promised an increase this year. However, the organization did not take this course for fear of depressing the US economy. Moreover, the threat posed by decelerated growth of China and other developing countries was named among the key motives for the renunciation. Therefore, this decision challenges a common belief that the US economy is in a much stronger position than that of Europe – can we call it strong and growing whilst fearing the slightest increase in interest rates?

The current development makes us think of living in a bizarre economic world of cheap money. Interest regulation is similar to that of price regulation in the market. And even for ordinary people who barely know the very basic laws of economy and, especially, those who have soviet experience; it is evident that any form of price regulation always lead to anything but good. It is unwise to regulate bread prices in order to make it more affordable for the demand would outstrip the supply and result in a shortage of bread.

Moreover, when it comes to money and interest rates, people naturally think that they are created and determined by central banks such as Fed in the United States or the ECB in the European Union. It is a common belief that central banks are inseparable from market economy.

However, it is not the case. The activities of central banks are central planning tools, rather than market elements. In the Soviet times there was a need of centralized decisions on the amounts of pots, chickpeas and toilet paper necessary. The decisions on setting interest rates and issuing money are rather similar. Today interest rates mostly reflect central decisions as opposed to market situations. In the past, central planning was based on estimated consumption rates while bank‘s actions today are based on future inflation and unemployment forecasts. The procedure prevails, although the object is different.

Of course, there are several adverse consequences of central planning. Firstly, low interest rates distort borrowing decisions as both, private and public sectors are encouraged to borrow. Although constant borrowing and repayment of debts is anything, but irresponsibility, instead of fighting the issue, central banks seem to adhere to this practice. Paradoxically, the European Central Bank promotes borrowing while the Central Bank of Lithuania seeks for various borrowing standards to achieve responsibility. It is not unheard of that the possibility of cheap borrowing can rapidly turn into reckless public expenditure and further postponement of the decisions necessary to deal with economic problems. Indeed, central banks claim that public sector reforms are necessary for the economic recovery, but continue lending cheaply and recklessly as they are threatened by enormous public debts of the United States and EU countries.

Secondly, cheap money and zero interest do not only encourage borrowing, but punish savers as well. Speaking of the continuation of cheap money policies, ECB President Mario Draghi is frequently asked of how he would defend such decisions against savers. After all, such interest rates are nothing else but indirect mockery. Mr. Draghi‘s comment that interest rates are determined by commercial, rather than central banks is probably one of the most careless and false answers he has ever expressed. The current situation when commercial banks offer virtually zero interest rates and, due to inflation, depositors withdraw less than they contribute, is a direct consequence of the decisions made by central banks, rather than market developments. Therefore, savers’ interests are simply sacrificed to short-term goals. It is not the consumption, but saving and investment that lead to the long-term economic growth and prosperity. Future-oriented consumption combined with investments into efficiency is what triggers a tangible growth.

Thirdly, central banks create an illusion that the problem lies in the shortage of money rather than the scarcity of resources. But central banks cannot miraculously multiply country‘s iron, cement, bricks and labor force, can they? They have no measures apart from that of issuing money, but, sadly, it is not paper money that results in productivity. This illusion diverts our attention from the actual challenge of allocating scarce resources in the best way possible. However, central banks have no or very limited powers in this regard.

Therefore, an illusion of a free lunch is created so to delude people into thinking that a decrease in interest rates and an artificial multiplication of money would benefit all. Nevertheless, people are perfectly aware that artificial price reductions result in a shortage of goods and (or) lower quality. This poses a question whether central banks take the consequences of their decisions seriously or not. The perception of interest rates as mere prices of money that may be freely manipulated is wrong. Similarly to market prices, interest rates are not random and artificial regulation of them would result in anything but good.

Non-regulated interest rates reflect the actual consumer choices of how much to allocate for immediate consumption and how much to save for the future. Future-oriented decisions and an increase in saving is the signal to investors to invest and increase consumption in the future. Natural market-determined interest rates allocate resources between the present and the future while centralized and artificial interest decreases distort the decisions of market players as they are encouraged to consume and invest into unrealistic or sunk projects. This results in artificial economic upturns followed by severe crisis. Interestingly, although Fed was established in order to decrease the frequency and amplitude of economic cycles, crises are more frequent and severe now that they were prior the establishment.

Therefore, we are living in a bizarre world of central banks and virtually zero interest rates. Such rates could be referred to as drugs that the economy is addicted to and the escape from which is very difficult. However, although the absence of low interest makes life harder, a beneficial increase in a long term is inevitable and will certainly help us to return into a less distorted economic reality.