What happens when governments control prices?
Some of you might remember the answer, having learned it the hard way.
Government price controls create either shortages or unnecessary surpluses.
If the government sets the price too low, there’s a shortage of goods. Producers don’t produce enough because the price they get paid is too low. And consumers consume more than they otherwise would. Or, at least, try to.
If the government sets the price too high, there’s a surplus. Producers overproduce to rake in profits. And consumers don’t want to buy at the high prices. You’re left with waste. And a lack of the goods and services that should’ve been produced instead.
Without price controls, the market is constantly trying to rebalance to the optimal level of supply and demand. Not just of prices, but of quantities too.
That’s where the old mantra “the cure for higher prices is higher prices” came from. High prices encourage more production. And that returns prices back to a lower equilibrium.
Prevent the higher prices from emerging and you hamper the production of more stuff to bring prices back down again. Prices are like a signal to an economy on how much of what to produce, when and where.
Do you really agree?
Here’s a quick pop quiz for you, to see whether you’ve grasped the concept: should the government make price gouging during a natural disaster illegal?
The answer, if you believe in my claims above, is no.
In my view, the best way to ensure as much aid as possible gets to people in need is to allow the prices they pay to rise. This activates a huge relief effort of people trying to sell to those in need. It harnesses the power of capitalism to help people. And that’s more effective than any bureaucracy, in my view.
Worse still, preventing price gouging discourages shifting resources to the aid effort. There’s no way to recoup the higher costs which the disaster has caused.
And even worse than that, local business can’t get back on its feet by charging more to recoup losses from the disaster.
Enough of that. Back to today’s real topic. We managed to get rid of all sorts of price controls last century. People now believe and understand why they were a bad idea. Except during a natural disaster, for some reason.
My favourite example of price controls we’ve abandoned are exchange rate controls. Exchange rates now flow freely and the risks of a fixed rate are understood. The European Exchange Rate Mechanism (ERM) taught us that lesson.
Unless you’re in the eurozone, of course, which has a single exchange rate between a number of different economies. They didn’t learn their lesson during the ERM. But that’s another story too.
Anyway, for some strange reason, we kept the price of money in the hands of the Bank of England and its counterparts around the world. This price control – the interest rate – is especially important. In fact, I believe it is behind most of the financial booms and busts of the last 100 years.
It’s a big claim to make, I know. But if you agree with the laws of supply and demand, and the problems of price controls, it makes perfect sense.
First, some anecdotal evidence.
How price controls gave you the sub-prime crisis
Which parts of the economy boomed and busted before and after 2007?
Which parts of the economy are most influenced by the interest rate set by the Bank of England and its counterparts around the world?
The answer, in both cases, is house prices and banking. These are the things most influenced by interest rates. Because bankers charge interest rates and you borrow money to buy a house. And both boomed and busted in spectacular fashion around 2007.
Those crises are precisely what you’d expect when a government institution is controlling the price of debt. You get surpluses and shortages of debt.
First central banks engineered a debt boom by keeping interest rates too low for too long – a surplus of debt. And then the crunch hit when they raised rates. Banks and borrowers struggled for funding – a credit crunch is a shortage of lending.
My explanation begs the question – what if the boom and bust cycle is caused by manipulation of interest rates and money instead of mitigating it? What if central bankers cause the very problems they’re supposed to alleviate? Just like all other price-controlling government boards of the past did…
If government fiddling with prices creates chaos in all other markets, why wouldn’t it do so in debt markets?
What does this mean for today?
Yesterday’s Fortune & Freedom kicked off a discussion about debt. Today, we connect this fiddling of interest rates to that story.
Central banks have lowered interest rates over the last few decades. Sure, there were some blips. But it’s been a long a steady downtrend. And now they’re even considering going below zero, where they haven’t already.
But what are they really trying to do? What’s behind this downtrend in rates?
We told you yesterday. They’re trying to get you to borrow money. To bring forward consumption. To steal from our future GDP.
Over the past few decades, interest rates were forced ever lower as central bankers tried ever harder to sacrifice the future for the benefit of the present. Each central banker, worried about their legacy, was happy to bring forward more consumption from the future, to make the present look better. The consequences would be their predecessor’s problem, in the future.
Each central banker managed ever lower interest rates, since Volcker in the 70s. Each one tried to spur on the economy with ever more debt by goosing the price of that debt ever lower.
But, at some point, there’s just too much debt. The future is exhausted. And we may have surpassed that threshold thanks to Covid-19 as we saw yesterday.
But it’s important that you understand central banks’ role in all this. They’ve been the ones encouraging the behaviour of stealing future GDP to try and goose present GDP. By encouraging debt via low interest rates. That’s where the shift lies.
Have they hit the zero bound in zero per cent interest rates? Or are we going negative?
I don’t know. But I’m not sure it matters. Not to the success of their policies at least. The future is simply too exhausted, as we saw yesterday. The benefits of central bank manipulation have expired.
The concerning conclusion is the same as yesterday’s, only from a different angle. What got us out of trouble each time the economy slowed in the past was lower interest rates and more debt.
The signs are that this method has been exhausted. The medicine isn’t working like it used to.
If you’re considering taking on more debt thanks to the low interest rates, you need to bear in mind that future GDP growth is likely to be weak, as we discussed yesterday. That’ll make it harder to repay the debt.
It’ll be hard to repay in a low economic growth world of the future.
Tomorrow we take a look at the newly popular ideology which denies all this. I call it fiscal fanaticism. You’ve seen it called Modern Monetary Theory. Which is ironic because it’s not modern, it’s not monetary and it’s no longer theory…
But what are the implications? Find out tomorrow…
Editor, Fortune & Freedom
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