Sunday, 7 May 2017
What’s the optimum or GDP maximising rate of interest?
Absent any particularly good reason for thinking otherwise, it is reasonable to assume the optimum rate of interest, i.e. the optimum price for borrowed money is determined in the same way as the optimum price for apples or anything else: supply and demand. In fact that is a standard assumption made in economics, i.e. it is normally assumed in economics that absent what economists call “market failure” market forces should prevail.
In the case of apples, apple growers and apple consumers, i.e. households, effectively meet in a market. Consumers buy whatever amount of apples they want at the going price. Producers produce whatever amount they think is profitable, and so on.
So the optimum rate of interest is presumably determined the same way. That is, the optimum rate would obtain where borrowers and savers effectively meet in a market.
Now apples are purchased with money. Nothing wrong with that. But suppose apple wholesalers managed to boost the purchase of apples by printing apple tokens which could be used for the purchase of apples. Those tokens would effectively become a form of money.
Not only would it be possible to use the tokens for the purchase of apples, but the mere fact the tokens being in effect worth a specific number of apples would make the tokens good for the purchase of other goods and services. Exactly the same applies to tokens issued by firms in other industries, e.g. air mile tokens issued by the airline industry.
Air mile tokens and the like CAN BE restricted to the person who has earned the air miles. But equally, if airlines so choose, airline tokens can be good for the purchase of flights with any airline. (Personally I don’t fly much, so I’ve no idea which of those two options the airline industry goes for. And it doesn’t matter for the purposes of this article).
As with apple tokens, if airmile tokens are accepted by every airline or almost every airline, and if almost everyone flies regularly, then airmile tokens become as good as cash.
There is however a problem with specific industries issuing tokens used in the first instance for the purchase of that industry’s products. Suppose the economy is already at capacity (aka full employment). As pointed out above, apple tokens are as good as cash because almost everyone purchases apples. And if the private sector’s stock of cash is increased when the economy is already at capacity, the effect is inflation.
Alternatively, if the economy is NOT AT capacity, the extra tokens / cash may not matter if the volume of tokens issued is not excessive. Indeed, the extra tokens / cash might bring the economy up to capacity without causing excess inflation.
But in either case, one thing is for sure: if extra demand is created by the printing of “apple cash”, the result will be an entirely artificial boost for apple growers: that is, the number of apples sold and bought will be above the GDP maximising level.
Doubtless some readers will have tumbled to where this is leading. But for the benefit of those who haven’t….
Private banks do exactly what apple wholesalers do in the above hypothetical example. That is, private banks print or issue their own tokens which can be used in the first instance for the purchase of the product that banks have to offer, namely loans.
Plus, as with apple tokens, once private bank issued money or “bank tokens” have been spent by the initial users of those tokens (i.e. those who borrow from banks), those tokens go into general circulation and are used as cash.
Private bank issued tokens / cash is not actual cash (in the sense that it is legal tender – i.e. central bank issued cash). Anyone can turn down private bank issued tokens / money on the grounds that it is not legal tender. But that does not happen very often.
Apple tokens, if they were issued, would not be desirable because they would result in an excessive or “non GDP maximising” number of apples being sold and bought.
Exactly the same applies to private bank issued money. It results in an artificially low rate of interest, and hence in an artificially high level of lending of debt.
And finally, this article is dedicated to all Cumbria apple pastie producers and (without his permission) to Nick Rowe who has used apples on dozens of occasions to illustrate various aspects of economics.