Market or Government: Who Determines Interest Rates?
Understanding Fisher's theory of interest rates is crucial in comprehending the current economic landscape. According to this theory, the level of interest rates is primarily determined by market forces, which are influenced by two key factors: investment opportunities for capital and people's time preferences for money. However, in modern societies, governments and central banks play a significant role in regulating and controlling interest rates. This prompts us to question the necessity and effectiveness of government intervention in interest rate regulation.
First, let’s distinguish between two concepts that are often confused:
One is the interest rate determined by market forces, which we can refer to as the "base rate." The other is the interest rate formed through government intervention, which we call the "intervention rate."
Base Rate
According to Fisher's interest rate theory, the base rate is determined by the fundamental economic forces of the market. For instance, if people generally lack patience, then consumption today will be high and savings low, leading to a shortage of money in the market and consequently higher interest rates. Similarly, if there are many investment opportunities in the market with high returns, many people will want to borrow money for investment, leading to tight capital and higher interest rates.
Consider a country that discovers substantial oil reserves and earns much money from selling this oil. What should be done with this windfall? It should not be spent all at once but saved and spent gradually, much like Norway’s Sovereign Wealth Fund or Saudi Arabia’s Sovereign Wealth Fund, which saves the proceeds from oil sales. These enormous funds increase the money supply in the global capital market, which tends to lower world market interest rates. In fact, since the 1980s, there has been a trend of declining interest rates worldwide, mainly due to the increased supply of capital. This increase comes not only from oil-exporting countries but also from the accumulation of savings across various nations.
Intervention Rate
In modern economies, it's rare for a country to let the fundamental market forces determine interest rates without any intervention. For example, the Federal Reserve artificially lifts the market's capital cost when raising rates. Market forces do not solely dictate the fluctuations in market interest rates but are influenced by government intervention.
The essence of a Federal Reserve rate hike is to increase the price of lending money in the market, i.e., the interest rate, thereby raising the cost of capital. Usually, interest rates are determined by the supply and demand of capital in the market. For instance, if few investment opportunities are currently available, people's demand for investment weakens, capital becomes plentiful, and the cost remains low. Conversely, if there are many investment opportunities, people rush to invest, leading to a strong demand for capital and increasing interest rates.
This resembles when the real estate sector was highly profitable a few years ago, prompting everyone to rush into real estate. Companies and individuals continuously finance themselves through banks and other channels to buy land, build, and purchase houses. With robust demand for capital in the market, interest rates rose. In contrast, during a bear market, everyone rushes to liquidate their positions and exit the market, increasing the supply of capital and causing interest rates to fall.
Government Intervention in Interest Rates Has Limited Long-Term Effects
In reality, the market and the government often manipulate the interest rates we observe. On one hand, interest rates tend to decline when capital is abundant and rise when capital is tight.
On the other hand, in real economic life, few countries allow interest rates to be solely determined by market forces. Instead, the government makes various interventions. In such cases, interest rates are influenced by both the visible hand of the government and the invisible hand of the market, being affected by these two forces simultaneously.
So, does this mean that the law of supply and demand fails regarding interest rates? The answer is no.
Although governments attempt to counter economic cycles by adjusting interest rates through measures like rate hikes or cuts, these interventions can change the supply and demand of capital in the short term and alter the trends of rising or falling interest rates. For instance, the global financial crisis 2008 resulted in significant economic downturn pressures and weak investment desires worldwide. In response, many governments adopted quantitative easing policies, such as lowering interest rates to stimulate economic growth. The United States kept its rates near zero; some Eurozone countries even reduced their rates to negative values. These government actions can temporarily boost public investment enthusiasm, spur consumption, and promote economic development.
However, countries like Japan have maintained low or negative interest rates yet continue to experience sluggish economic growth. Why is this the case? This is where the supply and demand dynamics come into play. While government interventions can alter the supply and demand of capital in the short term, their effects are limited over the long term. Sustainable increases in interest rates require solid economic growth and a continuous stream of worthwhile investment projects to drive demand growth and push interest rates upward persistently. Government interventions are only effective against short-term economic cycle fluctuations, changing the immediate capital supply and demand situation, but cannot serve as long-term tools for fostering economic growth and increasing interest rates.
In summary, interest rates are the product of the combined forces of the government and the market. While government intervention in interest rates can counter fluctuations in economic cycles in the short term, its effectiveness in promoting long-term economic development and altering the long-term trend of interest rates is minimal.
Should the Government Regulate Interest Rates?
Government regulation should adhere as closely as possible to market principles, intervening only when market mechanisms fail to ensure the economy's recovery.
Healthy inflation is a sign of market vitality, typically indicating economic development and growth in societal wealth.
In such an environment, investment and consumption increase, and money circulation becomes more fluid.
However, excessive investment can lead to an imbalance in industrial structure, as capital often flows into the most profitable industries. Similarly, excessive consumption can result in the inefficient use of resources.
To curb these irrational behaviors, the government can increase deposit rates to encourage savings and reduce the amount of money circulating in the market. Likewise, by raising loan rates, the government can limit excessive corporate financing and prevent the economy from overheating.
On the other hand, mild deflation might not necessitate excessive intervention. The government can stimulate consumption and investment by lowering deposit and loan rates, encouraging people to invest their bank savings in the market, increasing monetary circulation, and promoting economic expansion. In both scenarios, changes in deposit and loan rates are proportional.
Summary: Government intervention is only necessary when market mechanisms fail to ensure the economy gets back on track.