Let the market set the right interest rates.

By Medecci Lineil

I refer to the article “End of the cheap money area” on The Star newspaper written by M. Shanmugam dated 14 November 2015.

In the article he states three reasons why our central bank cannot afford to raise the interest rate just yet.

The reasons are slowing capital formation, inflation and overhang housing market. I think those reasons are flawed and political than economics.

Here’s why.

One, he is wrong about inflation by definition. Inflation is not rising prices. If one reads a school of economic thought known as Austrian economics, inflation means an increase in the quantity of money caused by government and central bank as a result of an artificial low interest rates policy. One should also know that interest rates are form of prices.

Like the price of mee kolok agreed between seller and buyer, so interest rates are the price of money (i.e. loans) agreed between lender and borrower.

In the simplest of terms it basically determines savings and investment. If central bank did not intervene, interest rates would regulate people whether they want consume now or postpone consumption for future.

The higher interest rate is the more people will save. The lower the interest rate is the smaller will be saving followed by smaller investment.

But in this case, without savings as real backup, interest rates are set low arbitrarily by central bank because nowadays investment is seen as crucial element for economic growth.

My question is, at what cost?

When central bank sets low interest rates people are being able to borrow easily and profitably with the availability of cheap money in the market.

After a while everyone spending money like there is no tomorrow and we can see people tend to pay to buy goods now before their prices rise even further such as housing and cars.

In the long run this unsustainable economic phenomena normally ends in disaster such as lack of personal savings, high household debts, bankruptcies and businesses raise prices.

The solution to the economic problems is crystal clear. If low interest rates cause so much problem, why not raise the rates to address the problem?

If central bank can afford to set low interest rates policy for too long why suddenly they cannot afford to raise them now?

Is he suggesting while we wait for the rate hike from US Federal Reserve central bank should implement even more cheap credit expansion (that will make a bad situation worse for the people) and more price fixing without jeopardizing our economic growth?

What economic growth are we talking about here?

Real economic growth happens when we can raise our productivity that not only lowers cost per unit of output, it increases total output. The higher output, in turn, lower prices.

If this is the case can we defend low prices if too much quantity of money chasing too few goods? No.

Can we defend low prices if less amount of money chasing too many goods? Yes.

Two, if we put this economic question in the context of housing we will see why overhang in the sector is not due to anything else but too much inflation!

One important question to propose affordable housing, if low interest rates cause the rising house prices will house prices be cheaper if interest rates are set higher?

Three, slowing in capital formation.

We must remember that capital is accumulated on a foundation of saving. And savings are determined by interest rates!

Since we have low interest rates policy for too long I wonder how on earth we want to accumulate saving and invest in capital in a sustainable way? Unless we create money out of thin air, is that it?

When people spending more on consumption we must first produce more and to produce more requires more better capital, better salaries and better workers making sure consumer demands satisfied at lower costs! We don’t eat money by the way!

But if we are unable to save and invest in capital how do we want to cut down our production cost, enable lower prices for consumer and more importantly achieve economic growth right?

Even if we invest more cheap money, it will make the crisis worse because the bidding process of scarce capital resources become more aggressive and costly. We can’t solve cheap money by spending more cheap money.

To reverse the trend is to let the market set the right interest rates. This solution is to allow goods prices to fall to levels that accurately reflect what our economy can produce.

First quoted in The Ant Daily on December 4, 2015.

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