Why Fixed Interest Rates Are Bad

Given the actions of the Federal Reserve, particularly over the last twenty years or so, we have become accustomed to the fixing of interest rates as normal. Indeed, there appear to be benefits for many from such policies, at least in the near term. After all, given mortgage rates as low as 2% to 3%, people can afford to buy more expensive homes, and given the near-zero federal funds rate, quite a few borrowers find that their debt service is much more manageable.

These benefits are examples of what 19th century French Economist Frederic Bastiat referred to as “that which is seen:” The obvious consequences of government policies. We ignore the hidden consequences of those policies (“that which is unseen”) at our peril, and with good reason.

Interest rates are prices, and prices arise naturally from the constantly changing conditions of supply and demand in markets. Both History and sound economic theory tell us that whenever government fixes prices, the relevant markets are distorted. This happens because prices carry essential information about market conditions, and this information is destroyed when the prices are not allowed to fluctuate with changing conditions.

Forex Money for Exchange in Currency Bank

Photo by epSos.de

For example, many will remember the gasoline shortages, long lines, and alternate day rules that arose from price controls in the early 1970’s. As with other prices, artificially low interest rates cause shortages. Demand rises independent of supply, and prices rise in answer to increased demand.

This market distortion generally does not appear immediately, and so is not often associated with the policies that caused it. We eventually see the negative consequences, such as astronomical housing prices in San Francisco or market shortages; but we soon become embroiled in the social discord that arises from skyrocketing prices and from blaming the wrong people.

While allowing the market to determine interest rates may not provide the immediate perks which an artificially manipulated rates does, the long term effects will be much stable for the economy. Rates will then communicate date about markets, and either encourage or discourage borrowing and investment. When we fix interest rates, we are deafening these signals.

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