I’ll argue
below that there are two reasons, both of them bizarre. One reason stems from
corruption. The second is that those positive rates stop what would otherwise
be rampant inflation caused by the fractional reserve banking system. Hope that’s
bizarre enough for new year’s day. Here goes.
As everyone
knows, the current zero or near zero rates are an exception: normally central
banks implement a positive rate of interest of a few percent: perhaps about 3%
on average over the decades.
But why does
the government of a country that issues its own currency borrow money? Such a
government can simply print money. Borrowing something, and paying interest for
the privilege when you can produce the thing yourself for free is crazy. At
least that is certainly true where a government needs money for stimulus
purposes.
As to where a
government borrows as substitute for collecting taxes, it may well have to pay
interest. But such borrowing makes no sense, for reasons I set out in detail
here. As I pointed out in the latter article, the REAL REASON that politicians
borrow instead of collecting tax is that voters tend to blame politicians for
tax increases, but not for any interest rate increases that stem from
government borrowing. So borrowing is a great way for incumbent politicians to
buy votes and that is plain straightforward corruption.
So there you
have one reason why central banks normally impose positive rates of interest: corruption
– a brilliant reason for such positive rates, don’t you think? But there is
another reason for positive rates which will never have occurred to you, and it’s
as follows. It’s a bit complicated, but here goes.
Fractional
reserve banking.
Several
economists have advocated, I think quite rightly, that the rate paid by
governemnts / central banks should be permanently set at zero. For example Milton
Friedman and Warrant Mosler have advocated that the government / central bank
machine should not issue interest yielding liabilities: that is the only
liability (if you can call it that) that they should issue should be cash, or “monetary base” to be exact. And
cash pays no interest.
But there is
actually a problem with that zero interest rate policy not spotted by Friedman
or Mosler. It’s a problem alluded to by Selgin and Huber (p.31), and it’s the
fact that commercial banks can print and lend out money. That is, such banks do
not always need to pay interest to anyone in order to obtain funds to lend out:
i.e. such banks can simply create money from thin air and lend it out. That way
they undercut what you might call “genuine savers”.
Now if
commercial banks do that when the economy is already at capacity (which is
exactly when they’re likely to do it), the result will be excess demand and
inflation. But why should commercial banks or those they lend to care about
inflation? No reason at all. As to borrowers, they are more than happy to see
their liabilities eaten away by inflation. As to commercial banks, their money
printing operation costs nothing, so if the value of that money when repaid has
halved, why should commercial banks care as long as they get paid interest?
In short, I
suggest that fractional reserve based on a fiat monetary base leads to rampant
inflation, unless the inflation is controlled by having central banks
artificially boost the rate of interest a bit. In contrast, fractional reserve
based on a gold monetary base does not suffer the same problem because gold
blocks the inflation.
Banks’
administration and bad debt costs.
The above
argument is a slight over simplification in that part of the so called interest
that banks charge is necessary to cover administration and bad debt costs. But
in addition to the two latter, there is what might be called “genuine interest”:
that’s a reward to the lender for foregone consumption. In other words the
above argument ignores (for the sake of simplicity) administration and bad debt
costs.
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