Friday, June 10, 2005

Alan sets the Price of the Future

In March, Alan Bollard, the governor of the Reserve Bank of New Zealand (our own Alan Greenspan) raised the official cash rate to 6.75%.

interest rate is the price of the future. It is the price we have to pay to bring purchases out of the future into the present. From the other side, it is the price that people get for postponing their spending to the future. By raising the interest rate, he made the future cheaper and the present more expensive. But how can a banker who cannot predict the future set its price?

In medieval times, the church set the price of bread (the so-called just price). This caused enormous problems, as at times the price was set to low and there were bread shortages. At other time they set the price of bread to high and there was plenty of bread but people could not afford it. One of the benefits of the Reformation was that the church got out of the price-setting business and let the market set the price of bread.

The communists in the Soviet Union missed the lesson and attempted to control the price of bread for most of the twentieth century. The result was enormous shortages and people queuing for hours to get a loaf of bread.

If bishops and presidents cannot set the price of bread without making mistakes, how can a banker, no matter how clever, determine the price of the future. A truly wise man would leave the people of New Zealand to make their own guesses about the future and decide what price they are willing pay to bring it forward.

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