Monetary Policy and Inflation (7) - Managing the Future

Governments used to believe that they could control the supply of money. Now they realise that is impossible and the best that they can do is control interest rates. But even this is too much for them.


The interest rate represents the value that society puts on the future. It is the price we have to pay to bring purchases from the future into the present. From the other side, it is the price that people get for postponing their spending to the future.

Interest rates should reflect changing attitudes to the future. If people are full of faith and confidence, interest rates should fall. However, if people want to eat drink and be merry, because the future is dark, interest rates will be high. As attitudes to the future change, interest rates should reflect them.

Interest rates affect the level of investment in the economy. If they are low, entrepreneurs will be keen to borrow money and purchase equipment, because they expect a good rate of return. This investment will make the economy more productive. If interest rates are high, many potential projects will be unprofitable. Investment in machine slow and productivity will decline.

The interest rate is a really important price, as it influences many important economic decisions. If it is set at the wrong level, the economy will become distorted and less productive.

In medieval times, the church set the price of bread (the so-called just price). This caused enormous problems, as the price was generally set to low and bread shortages followed. Sometimes, they set the price 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, 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 things forward.

The Reserve Bank Act allows the governor of the bank to manipulate interests. This is an absurd authority to give to any man, no matter how clever. The chances of a political appointee getting the price of the future right are fairly slim, given that only God knows the future. Alan Bollard does not know the future, so how can he set its price?

Allowing the government to control interest rates is an enormous mistake. They will generally get it wrong.