The Rate of Savings and the Rate of Interest, Part 1

What causes booms and busts? Why is the upward procession of the economy so prone to downward recessions? It is nothing so exciting as things like animal spirits, drops in consumption, or anything like. It is caused by a divergence of the rate of savings and the rate of interest. To put it very simply before I elaborate: the rate of savings determines the natural, or “real,” interest rate; if the interest rate is distorted so that it does not reflect the rate of savings, and thus is no longer a natural rate of interest, then it follows that the building up and consumption of resources in the pursuit of investments to ultimately produce items of consumptions will eventually lead to the market being systematically overfilled with products that consumers do not buy because they did not save so that they could buy such items at a later time. At this point it is discovered that investments are not profitable, so a readjustment of ownership and capital ensues economy-wide, which leads to widespread unemployment to a degree as high as the original distortion. This will be painful, but will quickly lead back to resources being properly utilized, and employment will pick up again. That is, it will pick up again assuming the economy isn’t further distorted.

The moral of the story: Investment not backed by someone’s real savings will lead to recession.

So first, what does savings have to do with the interest rate? The interest rate is essentially the price of borrowing, wherein the price is paid at a later date for present resources. It makes perfect sense to borrow in the expectation of paying it back; if I can borrow $1 today to pay back $1.10 tomorrow, but with that dollar I make $2.10, then I’ve made $1. The person who lent now has an additional $.10, I have an additional $1, and I will (presumably) have provided an economic resource to someone else who is also better off for having it (otherwise why would they use their money to buy that, and not another thing?).

If it is difficult to save, say because one lives in a poor society and a large amount of income is dedicated to immediate consumption, then one must be offered more future money to part with present money. The extent to which present saving, or present withholding of consumption, is found less preferable than simply partaking in present consumption, drives up the price of borrowing, which is to say that it increases the rate of interest.

On the other hand, if one finds it easier to save, either because they do not need to devote such a large portion of their income to present consumption or just because they are able to easier restrain their spending, then they will be more easily persuaded to lend at lower rates of interest.

Of course, supply is only one element of the price of something. The lender, who supplies savings, has only half the say in the rate of interest. Of course, if they had perfect control, then they would raise the rate of interest to infinity, which would lead to extremely high rates of savings.

If interest rates were that high, however, then no one would borrow. Borrowers are those with a demand for present money greater than a demand for future money. That is, they are in a position where they judge it to be likely profitable to spend money in the present on something in order to produce for the future.

If someone is more sure that they will be able to turn present money into future money by investing in some venture, then they will have greater demand. Greater demand means they are more willing to pay a higher price for borrowing, which means that greater demand for present consumption (much like with the lender!) leads to higher rates of interest. Conversely, a lower demand for borrowing would lead to lower rates of interest.

The real rate of interest then reflects that middle between what persuades people to save money and what lets borrowers to spend future money.

We can note that the rate of interest in its own right is a form of information. Low interest rates tell people now is a good time to spend in the present, whether potential lender or actual borrower, while high interest rates tell people now is a good time to save for the future, whether actual lender or potential borrower. Expressed as a simple formula, the (natural) rate of interest correlates inversely to the present rate of consumption. In other words, higher interest rates mean lower present consumption, lower interest rates mean higher present consumption.

Seeing that such a relationship holds, it is obviously tempting to economists and politicians of a certain disreputable bent to have it in their designs to lower the interest rate at whatever means, since such would lead to an increase in spending and thus give the appearance of prosperity as people who would otherwise save are persuaded to spend on items of consumption as well as borrowers to spend on investments, which provides people jobs and uses up resources. The aggregate effect of a lowered interest rate will be a higher GDP, since higher spending = higher GDP. As you surely have heard, high GDP is good. The effects of such a plan, if it could be implemented, will be systematic and economy-wide. It follows then, that if such a design will lead to investments which produce more than people will later consume, there will come a period of time when it is understood that the investments made in the past are not as profitable as they seemed they might be; this would lead to a selling off of accumulated capital and the firing of employees. If such plans are unsound, they will lead to an economy-wide recession as the economy readjusts by redeploying previously committed capital and employees.

How would such a design to lower interest rates through artificial means be achieved? Who advocates such a design? Is it a reflection of present policy? If such a policy is unsound, what makes it unsound? I’ll come back to that in Part 2.

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