According to the US President Donald Trump, the Fed is failing at its job in supporting the economy by not lowering the policy interest rate. The president believes that the lowering of interest rates by the central bank will prompt businesses to increase production and investment, which will spur stronger economic growth. Lower interest rates, according to such thinking, strengthen consumer spending, which is popularly considered to be the key driver of economic growth. Given such faulty reasoning, it is not surprising that the US President has expressed outrage at some of the Fed’s policymakers’ refusal to lower interest rates. But does this make any sense?

This position implies that interest rates are determined by the Fed. Now, if this is the case, then the US president’s criticism of the central bank should be seen as valid. After all, by lowering interest rates, the Fed can lay the foundation for a stronger economy. However, the Fed does not determine interest rates, the Fed only distorts interest rates by tampering with financial markets.

Individuals Time Preferences and the Interest Rate

According to thinkers such as Carl Menger and Ludwig von Mises, interest is the outcome of the fact that individuals assign a greater importance to present goods versus identical future goods. Life in the future is obviously not possible without sustaining it first in the present. According to Carl Menger:

To the extent that the maintenance of our lives depends on the satisfaction of our needs, guaranteeing the satisfaction of earlier needs must necessarily precede attention to later ones. And even where not our lives but merely our continuing well-being (above all our health) is dependent on command of a quantity of goods, the attainment of well-being in a nearer period is, as a rule, a prerequisite of wellbeing in a later period.

Also, according to Mises,

He who wants to live to see the later day, must first of all care for the preservation of his life in the intermediate period. Survival and appeasement of vital needs are thus requirements for the satisfaction of any wants in the remoter future.

Hence, various goods are required to sustain individuals’ in the present before considering goods in the future. Therefore, there is a premium for present goods over identical future goods, which is what interest is all about. Consequently, this means that interest must necessarily be positive.

Consider a case where an individual has just enough to keep himself alive. This individual is unlikely to lend or invest his paltry means. The cost of lending or investing to him will be very high. However, once saving expands, the cost of lending or investing begins to diminish. Allocating some of his goods or money towards lending and investment now becomes possible, thus lowering the interest rate. From this we can infer, all other things being equal, that the expansion of private savings will result in a natural lowering of the premium of present goods versus future goods, i.e., to the decline in the interest rate.

Conversely, factors that undermine private saving will tend to increase in the interest rate. Hence, increases in saving, because of lower individual time preferences, tend to be connected to economic growth.

Individual time preference rates are not automatic, but are based on the subjective valuations of individuals concerning the intensity for present goods over future goods. Every individual, based on his subjective ends, decides how much to consume, save, and invest, and how much to allocate for present consumption versus future consumption. Market interest rates mirror people’s time preferences.

A natural and private lowering of interest rates—based on time preferences—signals to businesses that more savings are available for the advancement of capital investment. An increase in capital goods enables the increase in the production of goods and services in the future. This, in turn, implies that individuals have instructed businesses to increase the production of consumer goods in the future in relation to the current production of these goods.

Activities that have emerged due to the central bank’s low-interest rate policy—made possible by the artificial expansion of money and credit—represent distortions in the structure of production. Consequently, the central bank’s artificial lowering of the interest rates in the absence of an increase in private savings diverts resources to activities that would otherwise not exist. This diverts resources from wealth-generating activities to non-wealth-generating activities. Thus, lowering interest rates by central bank inflation—without an increase in voluntary savings by individuals—all other things being equal, cannot generate true economic growth; it simply drains savings into artificially-stimulated activities away from wealth-generating activities.

Does the lowering of the interest rates strengthen capital formation?

When the interest rate is not tampered with, it serves as an indicator to businesses regarding individual time preference, essential as a price-cost input in economic calculation. Whenever central banks tamper with interest rates via inflation, it falsifies this indicator, thereby causing businesses to unknowingly disobey individuals’ instructions regarding the production of present consumer goods versus the production of future consumer goods. On this, Rothbard wrote,

…once the consumers reestablish their desired consumption/investment proportions, it is thus revealed that business had invested too much in capital goods (hence the term “monetary overinvestment theory”), and had also underinvested in consumer goods. Business had been seduced by the government tampering and artificial lowering of the rate of interest, and acted as if more savings were available to invest than were really there.

The lowering of interest rates by the central bank leads to malinvestment—an artificial overinvestment in capital goods and to an artificial underinvestment in consumer goods. The overinvestment in capital goods results in artificial economic activity, not justified by the market, which is an economic boom. The liquidation of the overinvestment is the bust. Hence, the boom-bust economic cycle.

Without the expansion of capital investment, it is not possible to increase the greater supply of consumer goods. The expansion and the enhancement of the structure of production through capital investment hinges on savings.

Why supply precedes demand?

Could the artificial decrease of interest rates by the central bank strengthen economic growth by strengthening consumer demand? After all, it is often said that the spending by one individual becomes the income of another individual. Hence, the greater the spending, the greater the economic growth. However, economic growth first requires an increase in the production and saving before more consumption can take place.

In the market economy, producers do not produce everything for their own consumption. Part of their production is used to exchange for the goods produced by other producers. An individual’s demand and consumption are constrained by his ability to produce goods and services that others want. The more valued goods and services that an individual can produce, the more goods and services he can demand from others.

Without an increase in prior production and savings, greater consumption does not lead to greater wealth or economic growth, rather it is the result of economic growth. In fact, simply stimulating consumption without prior production and saving is at the expense of some other activities in the economy. Further, if consumption is spurred by inflation of money and credit, generating artificial economic growth, this weakens the wealth-generation process. Without an increase in voluntary savings, no general economic growth will take place.

Conclusion

Changes in the interest rates should reflect the voluntary time preferences of individuals, not the wishes of central bank bureaucrats nor the wishes of the US president. The artificial lowering of interest rates generates the misallocation of savings and resources. This, in turn, weakens economic growth. Hence, contrary to President Trump, the best policy of the Fed should be not to tamper with interest rates via monetary inflation. Such tampering only distorts the economy and undermines genuine economic growth.